Rising Rates and the Impact on ARPA

By Russ Kamp, Managing, Director, Ryan ALM, Inc.

There was a little more activity related to ARPA and SFA approvals, which I will address in my next update. However, the bigger news surrounding ARPA is the impact of rising rates on both pension assets and pension liabilities. For those plans that have filed applications already, the impact of rising rates has more of an impact on the asset side of the equation. As a reminder, SFA assets are to be kept separate from the plan’s legacy assets. Under the Interim, Final Rules, the SFA assets received (7 funds have been paid to date) are to invest those proceeds in investment-grade fixed income. They can do that in one of two ways: either create a total return-focused portfolio or a cash flow match portfolio of plan assets to plan liabilities – the strategy that we at Ryan ALM espouse.

I suspect that those that have received their payouts have likely invested those assets in an IG portfolio designed to outperform some generic index – likely the BB Aggregate Index. If so, their assets have taken it on the chin as rising rates have impaired bond prices. For instance, the Aggregate index has declined on a total return basis by -8.8% YTD through April 19th. The biggest annual loss since 1981 is <3%. Oh, boy!

Depending on the size of the SFA payment, a pension system might be able to defease 8-12 years of pension liabilities. The present value (PV) of pension liabilities falls as interest rates rise, which provides a plan that is defeasing liabilities the opportunity to defease more of those future payments. As mentioned, the assets get hurt in a rising rate environment, but higher rates also help reduce future costs. Furthermore, once the defeasing strategy is constructed, the savings to the plan are locked in and assets and liabilities move in tandem whether that is up or down. Interest rate risk has been eliminated.

Now the liability news. The ARPA legislation calls for eligible pension plans to use either PPA’s 3rd Segment Rate + 200 basis points or the plan’s current discount rate, whichever is lower. A higher discount rate reduces the economic present value of pension liabilities, which impacts the amount of SFA to be received, so a rising rate environment would reduce the present value of that future liability. Fortunately, the legislation uses a 24-month average (unadjusted) to calculate the current 3rd Segment Rate, which as of April is 3.29% before the addition of the 200 bps. Despite the significant rise in rates in 2022, the 3rd segment +200 bps rate has not moved much at all, as US interest rates were in the 4% range for the 3rd Segment in 2020. As that year falls out of the 24-month calculation it is being replaced by a slightly lower # at this time.

We, at Ryan ALM, are not in the business of predicting rates. We are in the business of SECURING the promised benefits. Allowing pension assets to potentially swing wildly as a result of harmful interest rate moves is not a sound financial strategy. We highly recommend that plan sponsors defease pension liabilities with the SFA proceeds. As a reminder, the ARPA legislation’s goal was to secure the promised benefits for 30-years. We know that isn’t going to happen because of how the SFA is being calculated, but there is no reason to not secure benefits for as long as possible. Doing so allows the pension plan’s legacy assets to now grow unencumbered as they build to meet future pension liabilities. Rising interest rates are not a panacea for pension assets, but they do help pension liabilities and defeasement strategies. More to come on this subject!

One thought on “Rising Rates and the Impact on ARPA

  1. Pingback: ARPA Update as of April 22, 2022 – Ryan ALM Blog

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