$20 billion club strategy series – Funding policy
Executive summary:
- A plan’s funding policy determines the contributions made its sponsor to pay for benefits. Under the Pension Protection Act (PPA) of 2006, plan sponsors must make minimum required contributions—and many plans’ funding policies are linked to this law.
- Last year, contributions among $20 billion club members were at their lowest level since the PPA went into effect, largely due to funding relief measures passed by Congress. If expected contributions for 2024 among members hold, they’ll be the lowest seen since we started monitoring the club.
- For plans that haven’t attained full funding status, we generally advocate for greater contributions if the sponsor has the capacity to do so. In many instances, this can be achieved by contributing a small percentage of cashflow from operations.
In the final article in our deep-dive series into strategy insights among members of the $20 billion club—our term for the U.S.-listed pension plans with the largest liabilities—we’ll examine the latest trends in the funding policies of these mega plans. Our two prior installments, which covered investment and benefits policies within the club, were published earlier this month.
To recap, defined benefit (DB) plan sponsors have several major levers available to help successfully manage the costs, benefits, and risk of their plans. At the broadest level, we split these into three polices: investment, benefits, and funding policies. These levers are often closely intertwined and pulling one lever can lead to adjusting another. What each of these policies aims to achieve is:
1. Investment policy - This lays out how the assets and contributions go to work for the sponsor
2. Benefits policy - This directly impacts plan participants’ benefit accruals
3. Funding policy - This determines the contributions made by the sponsor to pay for those benefits
The intertwined nature of pension management can lead to wide ranges in how each of these policies is set and adapted.
Many plan sponsors have official funding policies to “contribute at least the amount required under the law” but under the hood, there is often much more going on than meets the eye.
Like the other policies we’ve discussed over the course of this series, the funding policy is connected with the other policies but, perhaps even more so than the others, it is a function of the funded status of the plan. Of course, there are regulatory contribution requirements under the Pension Protection Act (PPA), based primarily on funded status, but it goes further than that. Depending on the goals of the plan sponsor, funding can continue up to and beyond the plan being fully funded. Before we dive into some more contribution specifics, let’s take a step back and review the funded status of the plans in the $20 billion club.
Last year we discussed how extraordinary 2022 was with respect to the large increase in interest rates we saw over the year. While 2023 didn’t see another large increase, we did see a peak that even surpassed 2022 during October 2023. In broad terms, interest rates have been declining over the past 40 years, but 2022 and 2023 have really flipped the impact of shifting interest rates on its head. In the past, falling rates created a headwind to funded status by increasing liabilities as rates declined. However, in the current higher interest rate environment, even though liabilities are now at decades-long lows, the discount-rate impact persists in the form of a significantly higher interest cost component. This is creating a much larger headwind than just two years ago, as liabilities are now accruing at over 5% instead of 3%. This difference must be made up either through investment gains or contributions in order for plans to remain at the same funded level.
Exhibit 1: Discount rates during 2022 and 2023 for a 12-year duration liability; discount rate based on ICE BofA A-AAA corporate yield curve.
Source: Russell Investments. Discount rate based on Merrill Lynch A-AAA yield curve.
As mentioned, for better or worse, many plan sponsors’ funding policies are linked to minimum required contributions under the PPA. While the PPA does provide a path to full funding in large part due to the shortfall amortization, regulations over the past decade have enabled plan sponsors to reduce or delay contributing to their plans, as seen in Exhibit 2. With the exception of the Tax Cuts and Jobs Act (TCJA), each noted piece of legislation with pension-funding-relief-related measures has led to a reduction in contributions in the following years. The Tax Cuts and Jobs Act led to a large increase in contributions in 2017 and 2018 due to the tax benefits of contributing to pension plans. While funding relief sometimes provides much needed cash flow flexibility for plan sponsors, plan funded status has not always benefitted from it.
Exhibit 2: $20 billion club members contribution history in the context of legislation
We also see in Exhibit 2 that contributions for the $20 billion club members were at their lowest point since the PPA became effective, and that if the expected contributions in 2024 hold, they will be the lowest we’ve seen while monitoring the $20 billion club.
What does this all mean for your DB plan?
As previously mentioned, while the different levers available to plan sponsors are often intertwined, the industry trend on funding policy has geared itself to taking advantage of the funding relief and opportunities offered up by regulatory changes over the past decade. Plans have also benefited from an increase in funded status due to the large rises in interest rates from 2022-23.
Since the introduction of MAP-21 (Moving Ahead for Progress in the 21st Century Act) legislation and subsequent pension funding relief legislation, discount rates for contributions have been disconnected from discount rates for accounting disclosures. Because of the large increase in rates the past few years, however, today’s market interest rates are near or above the interest rates used to determine regulatory contributions for the first time since MAP-21 was passed. This can lead to interesting decisions, which we discussed last year, that have direct impact on the regulatory contributions and therefore many plan sponsors’ funding policy.
Leading up to the plan being fully funded, we would generally advocate for greater funding for the plan if the sponsor has the capacity to do so. In our 2023 prudent pension funding report, we discussed what it might look like to fund a plan in the context of cash flow from operations. Once the plan is fully funded, managing the plan can then be simplified through hibernation, and costs of the plan decrease in a meaningful way. In most cases, this will allow plan sponsors to forgo making annual contributions and also largely reduce the risk of significant downside contribution events.
A note on $20 billion club membership
Over the past several years, inclusion in this group of mega-plans could have increased a few times due to falling interest rates, which caused liabilities to soar. However, we have kept this group stable in the past to maintain a certain level of consistency. While the last couple of years have been exceptional in many ways, the impacts have arguably been reflected more keenly in the DB plan space than in many other areas due to the dramatic decline in liabilities. We have used this as an opportunity to refresh the membership of our $20 billion club. The most recent list of 21 companies—many of which have long been members of the club—can be found in our 2024 update. We expect this list to continue to evolve over time.