How the American Rescue Plan impacts funding relief for pension plans

When the impact of COVID-19 hit financial markets in early 2020, many corporate defined benefit plans saw their mark-to-market funded status drop precipitously. However, by the end of 2020, equity markets had rebounded. And despite large drops in discount rates, many pension plans' funded statuses even came out ahead, as evidenced by our $20B club report. Funded status improvements continue into 2021, as rates continue to rise on the back of vaccine news, a presidential administration change and early rounds of economic stimulus.

Even as funded statuses have improved, many plan sponsors are still facing economic uncertainty and stress on their core business at a time when contributions to underfunded plans had been expected to rise. Now yet another stimulus package is on its way in the American Rescue Plan Act of 2021 (ARPA) and included in that is further pension funding relief. Here is quick overview of what's included in the newest relief and how that will impact the funding of corporate defined benefit pension plans.

Amortization fresh start for plan years after 2019

Underfunded plans will start a new amortization base and over-funded plans will continue to not have any amortization bases. Given that most plans were fully funded on a cash contribution (PPA) basis at that time, this does not have a major impact on pension plans. This is presumably being done in large part to usher in the following change:

Amortization period increased from 7 to 15 years

The purpose of the shortfall amortizations is to provide a path to full funding over the amortization period, which is currently seven years. Extending this to 15 years lowers year-by-year payments and increases the theoretical time it takes a plan to reach full funding, if the plan only contributes the minimum amount required.

Discount rate corridor widening postponed

When the first round of funding relief was introduced in 2012 (MAP-21), funding interest segment rates were tied to 25-year averages, with a corridor applied that was set to widen over several years. Nearly 10 years later—and thanks to a few more iterations of funding relief—those corridors are still at the same levels, but were set to widen beginning with the 2021 plan year.

With current market rates significantly below the corridor, a widening corridor was expected to decrease the funding discount rate, leading to an increase in liabilities and the minimum required contribution as a result. Postponing corridor widening does not change the fact that the 25-year average continues to decline, as the higher interest rates of 25 years ago drop-off in favor of the recent low interest rates. However, the tighter corridor keeps the impact more gradual and further away from market rates.

All 25-year average segment rates are floored at 5%

This may be the most dramatic change to come with this round of funding relief. The 25-year average for the first segment rate is already below 5% and the other segment rates are headed that direction. We expect the second and third segment rates to be below 5% by 2025 and 2029, respectively.

Funding relief that tied the interest rates to the 25-year average has created a disconnect between the markets and what contributions are made. However, as the 25-year average moves away from the historical high rates and the corridor widening, the gap between funding and reality was expected to go away. Flooring these rates to 5% not only prolongs the disconnect but exacerbates it. Yes, the corridor will still widen eventually but, being around a floored rate, it can only go so far.

Does funding relief solve the problem or create problems?

Each of these relief provisions is focused on the long-term nature of defined benefit plans. Longer amortization period and high interest rates—and corresponding lower liabilities—will lead to lower minimum-required contributions. All this taken together means pension plan sponsors will have the ability to continue their funding holiday if they so choose. A job well-done and problem solved, right? Maybe.

The funding relief in the ARPA, like past funding relief, accomplishes its goal of reducing the year-to-year contribution requirement early on, but it doesn’t stop these plans from having liabilities that must be paid at some point. Our analysis of representative plans (both frozen and open) shows required contributions being higher in later years than they would be, absent these law changes. Our projections also show them being in worse funded positions at the end of 10 years on a market basis when only making minimum required contributions—as much as 10-15% worse.

The continued disconnect from market rates potentially changes the focus of asset allocation for some plan sponsors. Market rates are currently low enough that funding rates are pegged to the lower corridor for several years, even before the floor is introduced. As the 25-year average declines, this creates an extra hurdle for the assets to clear in order to keep up with liabilities. It also complicates the asset position, as funding interest rates continue to decrease while we begin to see market interest rates rising.

So, what can be done?

This legislation lessens the immediate contribution requirements on sponsors of underfunded plans, providing flexibility at a time when many businesses may not have cash available to fund their plans. For sponsors that are not overly concerned with year-over-year balance sheet volatility, a case could be made to increase return-seeking risk within the asset allocation. Contribution requirements are lower in the near-term, allowing time for future asset returns to help the plan's funded status improve, and the extended amortization period cushions against the immediate impact of adverse equity market events.

If the sponsor of an underfunded plan is still concerned with mark-to-market volatility¹, the fixed income portfolio can be structured to continue to hedge interest rate risk even if equity market exposure is increased. Strategies such as the use of long-dated Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)—or even synthetic rate exposure through Treasury futures—are powerful tools and may be more attractive now than they were at the beginning of 2021, with Treasury rates having risen, year-to-date.

We believe well-funded plans should continue to stay the course, especially if the allocation has been de-risked with prior increases in funded status. If the focus of the asset portfolio has shifted to the economic liability and plan hibernation, this legislation has essentially no impact.

It should also be noted that this law does not change the calculation of PBGC (Pension Benefit Guaranty Corporation) variable-rate premium (VRP), further divorcing cash funding from this PBGC insurance tax. Sponsors who are able may want to fund above the minimum required to avoid some or all the VRP, as this premium is dollars spent that do not benefit of the plan's funded status.

¹ Note that none of the changes discussed here impact the accounting liability or the impact of the plan on the sponsor's balance sheet.

The bottom line

While the funding relief within ARPA does not eliminate the impact of market volatility on the funding requirements of defined benefit plans, it does buy plan sponsors some time and flexibility in making contributions to their plans for plan sponsors who need it. However, care should be taken to ensure that plan assets remain allocated properly to achieve the long-term goal of a fully funded plan liability, ensuring the security of plan participants' benefits.