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How U.S. plan sponsors can handle historic drop in bond yield—reflecting March market movements

How U.S. plan sponsors can handle historic drop in bond yield—reflecting March market movements

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In our blog post from nearly four weeks ago, we noted that risk-free interest rates have dropped precipitously, due to a “flight to quality” caused by the early impact of the COVID-19 crisis. At the time of the market close prior to our post on Thursday, February 27, 10-Year Treasuries were yielding 1.30% and 30-Year Treasury Bonds were yielding 1.79%. We pointed out then that it was possible for bond yields to drop even lower, with consequences for plan sponsors required to use marked-to-market corporate bond yields to disclose pension and post-retirement medical (OPEB) liabilities under GAAP.

Disruptions

That was—literally—dozens of news cycles ago. Since that blog entry, as we know, our worlds have been disrupted.

  • The number of COVID-19 cases in the United States has risen from 59 COVID-19 positive tests on February 27 to 46,455 confirmed tests as of Tuesday, March 24. In that interval, the number of fatalities has sadly risen from 0 to 593.
  • Millions of office employees—including this blog’s authors—have been adjusting to working from home. But millions of other workers, including restaurant wait staff, personal services employees (haircutters, nail salon employees, masseuses), non-essential retail workers, hotel workers, airline employees, etc. have had their hours reduced significantly or have been furloughed entirely.
  • On Sunday, March 15, The Federal Reserve cut its Federal Funds rate by a full 1.00%, down to 0.00%-0.25%.
  • The Fed has created two new facilities designed to keep bond markets liquid: the Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.
  • Risk-free interest rates have continued to plummet. As of close of business on Monday, March 23:
    • 10-year Treasury bond yields were down to 0.76%. At the end of the day March 9, this bond was yielding 0.54%—its lowest level ever.
    • 30-year Treasury bond yields were down to 1.33%. At the end of the day March 9, the 30-year was yielding an unfathomably low 0.99%.
  • Nonetheless, while risk-free interest rates continue to yield near-historic lows, corporate bonds have begun to rise in yield.
    • As of close of business February 28, most “standard” single-equivalent pension discount rates ranged from 2.68% to 2.95% (average 2.83%), depending on the composition of their pension liabilities.
    • As of close of business Wednesday, March 18, “standard” pension discount rates ranged from 3.62% to 3.83% (average 3.74%), an increase of 90 basis points in barely over half a month.

Economic consequences

Yes, Treasury yields are way down, while corporate bond yields are up sharply. This means that the credit spread on high-quality corporate bonds has widened significantly while the COVID-19 pandemic and the associated economic consequences have begun to affect our world. This is a sliver of good news for plan sponsors—the higher discount rates will mean lower measurements of liabilities, as interest rates and liabilities are inversely correlated. But, except in the cases of sponsors who have fully or nearly fully hedged their liabilities using Liability-Driven Investing (LDI) strategies, the losses in the equity portion of their portfolios will far exceed any reduction in liability due to higher AA discount rates. As of close of business March 23, the S&P 500 is down 29.6% from its all-time high on February 19.

Furthermore, the widening of credit spreads is considered a warning sign for the whole economy. When investors demand higher credit spreads—that is, higher risk premiums for purchasing corporate bonds rather than risk-free Treasuries, the less confidence they show that those corporate bonds won’t default or downgrade—and the less confidence they have that the bond issuers will be in position to pay bondholders their coupons and return of principal. As of March 18, credit spreads on high quality corporate bonds that were similar in timing to pension liabilities were nearly 2.00%, more than 75 basis points higher than the average of the preceding 12 months.

This is a good time to revisit the three questions that we first addressed in our February 27 blog.

What does this mean for actuarial valuations?

Absent any legislative relief, the increases in yields on bonds used to compute spot and segments rates under IRC Section 430 (reflecting A, AA and AAA bonds) will increase. However, due to the interest rate averaging that is part of the calculation of pension liabilities, the reduction in liabilities may be modest at first.

But as this pandemic crisis continues to play out, many entities are working to pass legislation that would provide funding relief to plan sponsors during this unprecedented time. The American Benefits Council has proposed a set of measures designed to ease cash and reporting pressures on sponsors:

  • An extension and modification of the interest rate corridor around the 25-year average rate
  • A fresh-start 15-year amortization of unfunded liability
  • Additional asset smoothing
  • Benefit restriction relief
  • A limit on 2020 PBGC premiums
  • Deferral of reporting obligations by 90 days, which we believe would extend the due date for the impending Annual Funding Notices

Of course, a suggested legislative proposal is far from a bill, and even further from enacted law. Your Buck consultants will keep you apprised of these developments.

What does this mean for liability-driven investing (LDI) strategies?

Investment performance for plan sponsors using LDI strategies remains strong, especially for those sponsors whose LDI strategies have tilted more toward risk-free bond strategies. However, even those whose portfolios tilt more toward credit bonds intended to hedge GAAP liabilities have done well.

We reiterate the points that we made three weeks ago.

  • Can rates go lower? When we asked this question three weeks ago, the answer turned out to be a resounding yes—and for the reasons we hypothesized (stock market correction, COVID-19 flight to quality, and negative interest rates in other regions such as the Eurozone and Japan). We believe it is possible, as the economy strengthens, that credit spreads may shrink faster than risk-free interest rates increases. If that happens, accounting discount rates would drop.
  • Convexity may cause liabilities to further outpace assets. As interest rates decline, durations—interest rate sensitivities—of assets and liabilities increase due to convexity Therefore, a further drop in interest rates could have even greater consequences beyond the movement that we have seen recently.
  • Perception of de-risking as advantageous. At times of high volatility and uncertainty in financial markets, stakeholders react favorably to any steps taken to reduce volatility and avoid further negative surprises.

What does this mean for pension risk transfer (PRT) strategies, including group annuity transactions?

In our February 27th post, we observed that “plan sponsors may be reluctant to pursue PRT strategies and group annuity buy-outs when interest rates are at or near all-time lows.” The economic turmoil and disruption since that post did nothing to alleviate any reluctance. Instead, some plan sponsors may have to postpone discretionary annuity buy-outs and reexamine future plan termination strategies.

Insurance companies in the PRT market are still writing group annuity contracts. Over the past few days, we have reached out to all the insurance companies that sell group annuities for pension plans to confirm. In fact, we anticipate that at least one insurer will enter the PRT market in the next 12 to 18 months. Therefore, plans with LDI strategies in place prior to the economic storm will be able to pursue discretionary buy-outs and purchase terminal funding group annuity contracts.

The key takeaway is that de-risking through group annuity purchases remains an important part of a pension plan’s overall asset-liability management. We continue to advise plan sponsors to look beyond the near-term ups and downs of group annuity premium levels and make sure that assets backing annuity buy-out transactions are being managed strategically. We will keep a close eye on the PRT market and the insurance companies that write group annuity contracts.

Note: On March 25 we held a webinar on managing risk in an era of uncertainty. PIMCO market strategist Tony Crescenzi joined Buck’s investment team for a discussion on market trends and the implications for plan sponsors and the capital markets. You can listen to the replay and download the slides here

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