Summary paragraph: Funding stabilization may distract pensions from risk
In July, Congress enacted the Moving Ahead for Progress in the 21st Century Act (MAP-21), which reduces near-term funding requirements for pension plans. While the goal of the legislation is 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, according to a report from Towers Watson. In addition, this law -- the most significant among multiple recent installments of funding relief -- may set a precedent that leads to a potential re-evaluation of the importance of risk when setting pension investment policies, Towers Watson warns.
What will drive this distraction, the report says, is that discount rates over the next few years will probably be set independently of the interest rate environment; there is actually a strong possibility the two will move in opposite directions. Towers Watson compared the model of a sample plan's liability, based on capital market assumptions under MAP-21, to one based on a market-value method; this demonstrated that the decline in the value of a plan's long bond portfolio due to rising yields will no longer be offset by a decline in the value of a plan's liabilities.
"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," the report says.
Towers Watson believes the role of fixed income in pension plans should never change when considering the true economic liability of a plan. Considering that a plan's fundamental responsibility is to fully pay for its obligations, regardless of the rules governing its funding, a change in law would not affect asset allocation behavior.
The company's analysis also confirms MAP-21's projected success, with respect to its goal of reducing cumulative contributions over the next several years. A projection of cumulative contributions required through each year for the same plan shows median contributions required over the next five years are expected to be reduced by 38%. However, Towers Watson notes that the long-term impact is minor for an ongoing, underfunded plan, such as one that is about 80% funded. Over the 10-year period, median contributions are reduced by only 2% for this plan, meaning that MAP-21 pushes contributions from period to period but does not reduce the plan's long-term obligations.