The Pension Protection Act of 2006 (PPA), signed into law on August 17, 2006, by then-President George W. Bush, introduced significant reforms into the funding requirements for private defined benefit (DB) pension plans. Under the PPA, pension funding rules tied the calculation of the target liability, renamed the “funding target,” to the yields of high-quality corporate debt. Under the financial economics perspective, the pension benefit payments represent bond payments to plan participants and should be valued by the plan sponsor accordingly. The most impactful assumption in valuing pension liabilities is the interest rate assumption used to discount expected future payments. For many pension plans, a change of 100 basis points (bps) in interest rates can result in a 10% (or greater) change in the plan’s funding target! As rates rise, the pension funding target shrinks, and vice versa (as rates fall, the funding target increases).
Rather than rely on the spot rates of a bond universe curve as of the measurement date, as required by the Financial Accounting Standards Board (FASB) for sponsors reporting under Accounting Standards Codification (ASC) 715, the PPA instead allowed a level of economic smoothing by taking the average of 24 months of published corporate bond yields. In addition, rather than a full yield curve with spot rates at six-month durations, the PPA established a simplified three-segment yield curve. The first segment rate is used to discount expected benefit payments within the first 5 years of the valuation date, the second segment rate applies to payments from years 5 through 20, and the third segment rate applies to all expected benefit payments beyond 20 years. The segment rates are developed monthly from the corporate bond yield curves, which form the basis for the interest rates that apply under Internal Revenue Code (IRC) Section 417(e) that are used for minimum lump sum payments. The monthly average rates are then averaged over a 24-month period and published by the Internal Revenue Service (IRS) for Section 430 minimum funding purposes.
Following the passage of the PPA, and shortly after initial implementation, the global financial crisis of 2008 hit the economy, ushering in a period of sustained and historically low interest rates. These lower interest rates led to a ballooning of the funding targets for private pension plans, resulting in sharp increases to plan sponsors’ funding requirements.
After intense pressure from industry, Congress passed the Moving Ahead for Progress in the 21st Century (MAP-21) legislation, signed into law by then-President Barack Obama on July 6, 2012. MAP-21 was primarily a reconciliation vehicle to pass necessary budgetary items and it included provisions to decrease the funding requirements for private pension plans (thereby theoretically decreasing sponsor contributions and raising corporate tax revenues, under the budget reconciliation rules). In effect, these pension funding reforms were a pay-for in the reconciliation bill.
MAP-21 introduced the 25-year average of corporate bonds and created a corridor (originally 10% around the 25-year average) such that, if the 24-month smoothed average rates under the PPA were outside (and, importantly, below) the corridor, then plan sponsors could increase the funding target segment rates to those at the bottom of the corridor around the 25-year average. Under MAP-21, the corridor was scheduled to expand over time and reach a 30% range above and below the 25-year average. As the corridor expanded, the theory was that eventually 24-month smoothed interest rates would stabilize and reenter this expanded corridor, effectively ending the relief provisions, and returning the pension funding rules to the norms of the PPA.
Through various reconciliation bills ever since, this proposed expansion in the corridor has continued to be delayed. Under the Bipartisan Budget Act of 2015, the expansion was kicked down the road until 2023. Under the American Rescue Plan Act of 2021 (ARPA), the corridor was narrowed to 5%, with the expansion being further delayed until 2030. In addition, ARPA put a floor of 5% on the 25-year average, as the decade-long period of low interest rates was beginning to cause the 25-year average to dip to historic lows.
Most recently, the Infrastructure Investment and Jobs Act (IIJA) of 2021, signed into law by President Joe Biden on November 15, 2021, pushed the full expansion of the corridor to 2035.
In Figure 1, the mechanics of interest rate stabilization through IIJA can be more easily understood.
- The red dashed line illustrates the level of market interest rates, assuming rates remain level indefinitely at their March 2023 levels. Note the sharp rise in rates between January 2022 and January 2023.
- The green line reflects 24-month smoothing of interest rates as required under the PPA.
- The yellow diamond is the 25-year average of interest rates (with a 5% floor).
- The dark blue bars represent the applicable corridor around the 25-year average. In recent years, the bottom of the corridor has been the required rates for minimum funding purposes (represented by the light blue line), as the 24-month smoothed interest rates fell below the corridors. As we step into 2023 and beyond, with rates entering the corridor, the impact of interest rate stabilization will end.
Figure 1: Interest Rate Stabilization Under IIJA, 2021
The meteoric rise of interest rates during 2022 (see Figure 2) has suddenly changed the economic landscape dramatically. In less than a year, market interest rates have risen sharply from the historic lows. The rise of rates can see their origin in the Federal Reserve’s policy of increasing the federal funds rate in its quest to tame inflation, which remains persistently high and well above the Fed’s target of 2%. The Fed’s announcements make it clear that it is not to be dissuaded from its path of rising interest rates to quell inflation, even if that puts in place the fundamentals for a recession.
Figure 2: Interest Rate Increases Have Been Substantial During 2022
Source: Daily changes in the effective yield of the Bank of America 10+ Year AAA-AA US Corporate Index (C9B0).
The range in corporate bond interest rate changes during 2022 was nearly 300 basis points, with the most significant movement happening at the lower end of the curve, flattening (and in some cases, inverting) the yield curve. These increases in rates have significantly decreased the bottom edge of the corridor (which remains at 5% due to ARPA) around the 25-year average and the PPA 24-month average rates. This effectively signals that interest rate stabilization provisions no longer are required to produce the boost in rates above the historic lows of the last decade.
See Figures 3, 4, and 5, illustrating the impact of interest rate stabilization on each of three segment rates individually.
Figure 3: First Segment Rate Reflecting IIJA, 2021
Figure 4: Second Segment Rate Reflecting IIJA, 2021
Figure 5: Third Segment Rate Reflecting IIJA, 2021
Note that, in Figures 3 and 4, the current monthly market rates for the first and second segments are already near or inside the corridor. However, given the lower interest rates during 2021, the 24-month moving average is still below the corridor.
One quirk of the MAP-21 legislation that may not have been fully appreciated by its drafters was that interest rate stabilization cuts both ways. In recent history, the rates have been stabilized upward to the bottom of the corridor, increasing the rates used for minimum funding requirements (and thus decreasing liabilities and required contributions). However, in the current market environment, we could soon see rates rise above the corridor. If we witness a sustained 24-month period of these higher rates, we could be in a position where the interest rate stabilization corridor requires plan sponsors to reduce the interest rates otherwise available under the PPA to the top of the interest rate corridor, creating artificially high liabilities and required contributions.
In Figures 6, 7, and 8, the impact of the IIJA corridors on the three segment rates can be seen in an environment in which interest rates rise an additional 100 basis points during 2023.
Figure 6: First Segment Rate Under IIJA, Reflecting 100 bps Increase in Interest Rates (parallel shift of the March 2023 segment rates) during 2023
Figure 7: Second Segment Rate Under IIJA, Reflecting 100 bps Increase in Interest Rates (parallel shift of the March 2023 segment rates) during 2023
Figure 8: Third Segment Rate Under IIJA, Reflecting 100 bps Increase in Interest Rates (parallel shift of the March 2023 segment rates) during 2023
As can be seen in the Figures 6, 7, and 8, an additional increase in rates during 2023 (compared to the lived experience of 2022) would cause market interest rates to exceed the top of the corridor in at least the first and second segment rates, leading to the situation in which interest rates are held artificially low (top of the corridor) because of interest rate stabilization.
As noted above, the funding target of a pension plan is highly sensitive to change in interest rates. For a typical mature plan, an increase in 100 basis points in interest rates can produce roughly a 10% to 12% reduction in the plan’s funding target. If the market rates are capped at the top of the corridor, we could see a situation in which rising interest rates have no impact on the plan’s funding target (because rates would be reduced to the top of the corridor under the interest rate stabilization). Plans with assets held in duration matching bonds that are “de-risked” could see unexpected decreases in funded status, because the plan liabilities would not decrease due to interest rate stabilization, but the duration-matched bond asset holdings would have full exposure to the rising interest rate environment.
Given that the Fed’s use of monetary policy tools of interest rate increases has not yet achieved the desired result of taming inflation, we can expect that there may be further interest rate increases coming to the federal funds rate during 2023, which should continue to put upward pressure on other interest rates throughout the economy.
Undoubtedly such a future would create intense pressure on policymakers in Washington, D.C., to make changes to the current relief provisions -- either by repealing interest rate stabilization entirely or accelerating the widening of the corridor that, like the proverbial can, has many times been “kicked down the road.”
A brief history of interest rate stabilization: Rising interest rates may soon test the upper limits of “relief” corridors
Rising interest rates may soon test the upper limits of relief corridors for pension plans, with no impact of further increases on plan funding targets.