New rules, new rates: Investing legacy assets under ARPA

We think final regulations stemming from the American Rescue Plan Act (ARPA), coupled with the recent changes in the interest-rate environment, give multiemployer pension plan sponsors impetus to reassess their investment strategy for special financial assistance (SFA) and legacy assets, including whether to take advantage of liberalized investment rules allowing plans to invest up to one third of SFA assets in US equities and other return-seeking assets.

Final PBGC regulations and higher interest rates

In implementing the SFA provisions of ARPA, which are meant to help multiemployer plans with weak funding positions, the Pension Benefit Guaranty Corporation (PBGC) issued interim regulations in July 2021 and final regulations in July 2022. We would highlight two key developments:

• During this time, interest rates for core and intermediate bond indices, representing what we expect will be the maturity target for most SFA fixed income assets, rose by roughly 300 – 400 basis points (bps), making fixed income a potentially more attractive investment for SFA assets.
• The final regulations specify a lower assumed investment return index for determining the amount of SFA granted, increasing the potential amount of SFA assistance.

As a result of these developments, and assuming rates remain at these levels, fixed income investments are likely to yield more than the interest rate used to determine the amount of the SFA. As of 31 December 2022, some common core and intermediate indices were out-yielding the SFA discount rate by 120 – 190 bps (Figure 1), a welcome change since July 2021, when market yields lagged the SFA discount rate by about 400 bps.

As noted, another key development in the final regulations is the ability to invest up to one third of SFA assets in return-seeking assets. While this change has received a lot of attention, we believe the rate developments are just as or more consequential and that plan sponsors should consider the evolution in rates as they decide how to set their asset allocation across legacy and SFA assets. In some cases, reallocating legacy assets from return-seeking assets to fixed income (while investing the SFA exclusively in fixed income) could be warranted.

Figure 1

Case study: How much of the SFA should be invested in equities?

To assess how different investment strategies, including those that invest a portion of SFA assets in equities, might fare, we offer a brief case study in which an illustrative plan has US$300 million in legacy assets currently invested in a 65% equity/35% bond mix. The plan’s projected net outflows are about US$45 million annually over the next 10 years, reflecting its retiree-heavy population, and are expected to gradually decline over time (detailed in the Important Disclosures section beginning on page 12 of PDF available below).

In Figure 2 (available in PDF below), we compare the plan’s funded status, including SFA, under the interim PBGC regulations and the final regulations. We held the initial asset value and projected liability cash flows constant in order to isolate the effect of changes in market discount rates and in the SFA assumed investment return. We would offer two observations:

• The amount of the SFA is about 15% higher under the final regulations given the lower assumed interest rate specified by the PBGC.¹
• The funded ratio increased from 65% to 98%. This is partly due to the receipt of the SFA assets but also to a lower liability value at current discount rates, which we measure using a market-based Aa rated corporate bond discount rate. While multiemployer plans typically measure their liability using a discount rate based on the expected return on assets or a statutory rate based on four-year average Treasury rates, we find using a mark-to-market high-quality corporate discount rate helps to understand how costly and feasible it would be to cash-flow match (or “immunize”) the plan’s liability with a high-quality …

¹ARPA section 9704(j) states that the amount of SFA shall be determined as “such amount required for the plan to pay all benefits due … ending on the last day of the plan year ending in 2051 … .”

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