The Implications of Funding Relief

What Does it Mean for Asset Allocation and Liability-Driven Investing?

With interest rate levels at all-time lows and corporate pension plans potentially facing large cash contribution requirements at an inopportune time, Congress enacted legislation in July 2012 in order to ease the pain. The Moving Ahead for Progress in the 21st Century Act (MAP-21) reduces near-term funding requirements for pension plans by allowing them to discount future cash flows based on the average interest rate experienced over the past 25 years, rather than at the current historically low rates.
While the goal of the legislation was to free up cash for employers to spend elsewhere and increase tax revenue by reducing the amount of tax-deductible contributions, a secondary impact may be a sizable shift in asset allocation away from liability-hedging assets. In addition, this law, the most significant among multiple recent installments of funding relief, may set a precedent that leads to a potential reevaluation of the importance of risk when setting pension investment policies. Under the new rules, the discount rate used for calculating 2012 contributions is subject to a corridor equal to 90% 110% of the 25-year historical average interest rate. Since rates are currently significantly below 90% of their 25-year average (Figure 1), this essentially places a floor on discount rates. Only an extreme event such as the 24-month average of 20+ year bond yields increasing above 90% of their 25-year average (7.5%) could cause a plans discount rate to increase over the next year. This event occurs zero times out of the 5,000 economic simulations produced by Towers Watsons current asset/liability model.
Figure 1. U.S. Treasury bond interest rate history
16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 0.0
1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001 2011

MAP-21 and the Case Against LDI

Liability-driven investing (LDI) trended this past decade in the wake of the Pension Protection Act of 2006 (PPA) and word of potential accounting reform. The rules governing pension plans began to incorporate more mark-to-market concepts and emphasize valuing liabilities at current bond yields. Investors, often tasked with managing their funded status and not simply their asset level, realized the detrimental impact of interest rate risk and the greater stabilization benefits fixed income now offered. Both the incentive and ability to manage funded status via liability-matched investments were on the rise. This strategy proved fruitful as rates dropped in recent years, since liabilities discounted by those lower rates increased in value, and those who implemented an LDI strategy saw a commensurate increase in the value of their fixed-income investments. Four years later, the introduction of MAP-21 represents a departure from the spirit of PPA and perhaps from LDI as well. While the idea behind portions of PPA was to make liabilities move with the current yield environment, MAP-21 accomplishes the opposite.

How was 25 years chosen as the averaging period?

Source: Pre-1953: Robert Shiller Irrational Exuberance data, compiled based upon Sidney Homers A History of Interest Rates 1953 forward: U.S. Government 10-Year Treasury Constant Maturity Rates (GS10 series)

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Funding Relief and the Impact on Asset Allocation and LDI 2

Further, a plans funding discount rate would actually move in the opposite direction of interest rates over the next few years should future rates unfold in accordance with Towers Watson Investment Services views.* The new law calls for the 90% 110% corridor to widen to 85% 115% in 2013 (and then continue in 5% increments out to 70% 130%). This means that a plans discount rate will almost certainly decrease from 2012 to 2013 even if interest rates rise. For example, a 1% parallel increase in the yield curve from 2012 to 2013 and then again from 2013 to 2014 would still result in a plans funding discount rate decreasing in both years. Not only will discount rates Figure 2. Effective interest rate: Market-value method
9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 2012 2013 2014 2015 25th 50th 2016

over the next few years likely be set independently of the interest rate environment, there is actually a strong likelihood that the two will move in opposite directions. This disconnect is illustrated in Figure 2, which utilizes Towers Watsons capital market assumptions to compare the rate used to value a sample plans liability under MAP-21 versus that under a market-value method. If the assumptions materialize as demonstrated below, the decline in the value of a plans long bond portfolio due to rising yields will no longer be offset by a decline in the value of a plans liabilities as measured for funding.

2017 50th 75th

2018

2019 75th 95th

2020

2021 Mean

2022

5th 25th percentile

Effective interest rate: Post-MAP-21

9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 2012 2013 2014 2015 25th 50th 2016 2017 50th 75th 2018 2019 75th 95th 2020 2021 Mean 2022

5th 25th percentile

*Towers Watson Investment Services Global Markets Overview, July 2012

towerswatson.com Funding Relief and the Impact on Asset Allocation and LDI 3

The impact of the new law is clear: There will be less incentive for interest rate matching in the near term than we have seen in the past, and therefore less incentive for corporate pension plans to hold large allocations to fixed income. The impact of the law extends beyond the near term in scenarios where interest rates remain low or when left-tail events occur in future years. While intuitive, we tested this concept using a sample pension plan to determine how material the impact on asset allocation will be. Figure 3 shows an efficient frontier typically examined when analyzing asset allocation. The risk metric in this case is the 95th percentile cumulative contribution required over the next 10 years plus any deficits that still remain at the end of the 10th year. The reward metric is the 50th percentile, or expected result. The relationship between the two is represented by the slope of the line and directs the asset allocation decision.

As expected, the slope of the line using MAP-21 is steeper than under the prior rules. This means that each dollar of risk taken is more heavily rewarded in terms of reduced expected contributions under the new rules than under PPA. The differences in the slope are fairly pronounced for the low-fixed-income portfolios and translate to approximately a 20% change in the asset allocation decision. We arrive at this conclusion by determining that the slope of the line between 40% and 50% fixed income under the old rules is approximately equal to the slope of the line between 20% and 30% fixed income under MAP-21. Of course, every plan has a unique set of characteristics and will be impacted differently, but for this plan, we would expect MAP-21 to result in a 20% increase in equity (assuming the asset allocation was derived solely by the 50th/95th contribution relationship examined below).

There will be less incentive for interest rate matching in the near term than we have seen in the past, and therefore less incentive for corporate pension plans to hold large allocations to fixed income.

Figure 3. 10-year asset/liability frontier

Cumulative contributions plus de cits (PBO) ($ millions) 50th percentile $600 0% FI 10% FI 0% FI 20% FI 30% FI 40% FI 50% FI $800 60% FI 40% FI 50% FI 60% FI $900 30% FI 20% FI 10% FI

Desirable
$700

$1,000 $1,500 $1,600 $1,700 $1,800 $1,900 $2,000

Cumulative contributions plus de cits (PBO) ($ millions) 95th percentile Pre-MAP 21 Post-MAP 21

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Funding Relief and the Impact on Asset Allocation and LDI 4

This analysis also confirms MAP-21s projected success with respect to its goal of reducing cumulative contributions over the next several years. Figure 4 shows a projection of cumulative contributions required through each year for the same plan. Median contributions required over the next five years are expected to be reduced by 38%. However, its important Figure 4. Cumulative contributions ($ millions)
$1,500

to note that the long-term impact is minor for an ongoing,* underfunded plan such as this one (which was approximately 80% funded). Over the 10-year period, median contributions are reduced by only 2% for this plan, meaning that MAP-21 merely pushes contributions from period to period but does not reduce the long-term obligations of the plan.

$1,000

$500

$0

*MAP-21 could reduce cumulative contributions for a frozen plan in a scenario where interest rates rise.

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20 1 Pr 2 eM Po AP st -M 20 AP 1 Pr 3 eM Po AP st -M 20 AP 1 Pr 4 eM Po AP st -M 20 AP 1 Pr 5 eM Po AP st -M 20 AP 1 Pr 6 eM Po AP st -M 20 AP 1 Pr 7 eM Po AP st -M 20 AP 1 Pr 8 eM Po AP st -M 20 AP 1 Pr 9 eM Po AP st -M A 20 P 20 Pr eM Po AP st -M 20 AP 2 Pr 1 eM Po AP st -M 20 AP 2 Pr 2 eM Po AP st -M AP
5th 25th percentile 25th 50th 50th 75th 75th 95th Median cumulative contributions through ten years are nearly identical
Funding Relief and the Impact on Asset Allocation and LDI 5

In contrast, the new law does significantly impact the cumulative Pension Benefit Guaranty Corporation (PBGC) premiums required to be paid to insure the plan (Figure 5). MAP-21 increases both the flat rate and variable rate insurance premiums (to reflect heightened risk to the system posed by permitting lower short-term funding) and maintains a more market-based valuation of the liability within the variable rate premium calculation. While premiums for this plan are expected to more than double and become significantly more volatile, the magnitude, in this case, is small compared to the overall size of the plan. However, since these expenses are essentially lost assets that are no longer owned by the company or its pension plan, some plan sponsors may view this change as significant. This view could subsequently increase a plan sponsors desire to reduce PBGC premiums via additional funding, thereby adding incentive to de-risk. Hence, this part of the law does support LDI strategies, but could be deemed insignificant depending on whether or not ones views on PBGC premiums are strong enough to influence funding behavior. Figure 5. Cumulative PBGC Premiums ($M)
$100

Will the Real 95th Percentile Please Stand Up?

Whenever funding relief is introduced, we cant help but question whether were valuing risk properly. For a typical asset/liability study where the cash contribution is a primary concern, a risk metric examined will often be the 95th or 99th percentile cumulative contributions required over a given period. We rank all of the simulations weve run and pull out the 95th percentile as a measure of risk, which is often loosely referred to as a worst-case event. However, funding relief brings that approach into question. The drop in interest rates over the past year represents an economic event that may have existed as a 95th percentile scenario in a model set up years prior. It is possible that asset allocation decisions were made based on such scenarios. Protecting a plan against a projected risky event seems like a prudent path toward risk reduction.

$75

$50

$25

$0

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20 1 Pr 2 eM Po AP st -M 20 AP 1 Pr 3 eM Po AP st -M 20 AP 1 Pr 4 eM Po AP st -M 20 AP 1 Pr 5 eM Po AP st -M 20 AP 1 Pr 6 eM Po AP st -M 20 AP 1 Pr 7 eM Po AP st -M 20 AP 1 Pr 8 eM Po AP st -M 20 AP 1 Pr 9 eM Po AP st -M A 20 P 20 Pr eM Po AP st -M 20 AP 2 Pr 1 eM Po AP st -M 20 AP 2 Pr 2 eM Po AP st -M AP
5th 25th percentile 25th 50th 50th 75th 75th 95th
Funding Relief and the Impact on Asset Allocation and LDI 6

But when the actual economic environment that transpired in 2011 matched one of these worst-case scenarios, legislation was enacted to prevent the pain from being as severe as indicated by our models. The real worst-case event in this scenario wasnt the 95th percentile result, but rather a change in law ensuring that results did not fall below, lets say, the 75th percentile. This is not the first example of the government stepping in to alleviate the downside. Following the credit crisis in 2008, PPA was amended with the Worker, Retiree, and Employer Recovery Act of 2008, which lowered the short-term funding target. Further relief was offered in 2010 via the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act, which allowed pension plans to extend the amortization period for unfunded liabilities. While MAP-21 is different from these rounds of relief because it is permanent and could eventually impact the upside as well as the downside, this third postcredit-crisis amendment to PPA raises a question: Should we be ignoring the governmental safety net that has consistently been implemented in tough times? If the answer is no, this would again point pension plan investors toward taking more risk. If the upside of equity risk is always attainable but the downside is potentially avoidable due to legislative intervention, the incentive for fixed income is not as strong as indicated in our models. If there is an unspoken floor at the 75th percentile, it is possible that risk/reward trade-offs are not currently being analyzed properly. The more prevalent funding relief becomes, the more likely it could be viewed as a risk management alternative to fixed income.

A fiduciary is responsible for the series of payments promised. In determining the total amount needed in todays dollars that would fund those promises, the conservative (and responsible, in our view) method informing pension asset allocation would be to discount the payments at a rate we were fairly certain to earn (i.e., current bond yields). Investors relying on these principles would always value LDI regardless of the rules surrounding cash contributions.

Despite these two anti-LDI arguments, we feel the role of fixed income in pension plans should never change when considering the true economic liability of a plan.
Conclusion
Liability-matching strategies are valuable when taking an economic approach to liability valuation. However, investors who allow contribution risk to drive their decisions may be apt to take on more return-seeking assets with the recent passing of MAP-21. The new law lessens the current effectiveness of LDI strategies with respect to contributions and also brings into question the importance of risk reduction in a system where relief laws frequently bail us out in hard times.

Further information
If you would like to discuss any of the areas covered in more detail, please contact your local Towers Watson consultant or: Adam Levine +1 212 309 3813 adam.levine@towerswatson.com

Economic Liability and the Case Against RDI

Despite these two anti-LDI arguments, we feel the role of fixed income in pension plans should never change when considering the true economic liability of a plan. The discussion above focuses solely on the contribution rules dictated by the IRS (rulesdriven investing). If, instead, we consider that a plans fundamental responsibility is to fully pay for its obligations regardless of the rules governing its funding, a change in law would not impact asset allocation behavior.

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Funding Relief and the Impact on Asset Allocation and LDI 7

Please note: This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions, and no such decisions should be made on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date.

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