Despite Asset Gains, Pension Funding Levels Could Disappoint

Most companies were hoping to show improvement in the funding levels of their pension plans for 2010. Pension experts, however, are painting a gloomier picture.

First the good news. The number crunchers at Moody's, Aon Hewitt, and PwC all say that many companies sponsoring defined-benefit pension plans (seriously, some still do) should see a slight improvement in the funding status of those plans, which for most means a reduced deficit. Moody's estimates that companies will boost their funded status from an average of 79 percent at the end of 2009 to 85 to 89 percent at the end of 2010. Translation: Most companies should have assets in their plans adequate to fund 85 to 89 percent of the current liability.

Aon Hewitt expects companies generally to end 2010 with a funded status closer to 90 percent, says Rick Jones, a managing principal at the firm. “Asset returns in general were fairly good,” he says. “It's certainly a move in the right direction. Companies have weathered through another tough financing year.”

That's where the optimism ends. Experts at Mercer and SEI aren't as certain companies can expect overall improvement in funding. Assets did appreciate reasonably well for most plans, they say, but the discount rates companies use (to determine the present cost of the future liability) “dropped by more to offset it,” says Jonathan Barry, a partner at Mercer. “Barring significant contributions, we would expect most plan sponsors to go backward in their funded status. All other things being equal, that will drive a higher accounting expense.”

The discount rate is one item on a long list of factors used to determine a company's pension liability, but it's also one of the most critical inputs, says Barry. Companies follow some well-established methodologies to determine a discount rate based mainly on high-quality corporate bonds. Then they use that rate to determine the present value of future pension obligations. Most companies are finishing those calculations now, Barry says, and Mercer expects the discount rates they end up using will be about 50 to 60 basis points lower for 2010 than for 2009.

A lower discount rate generally translates into a higher liability, so an equivalent growth in plan assets is needed just to offset the lower rate and keep the funding status level. According to Wesley Smith, senior accounting analyst for Moody's, a movement of 100 basis points, or 1 percent, in the discount rate generally will produce a movement of 8 to 12 percent in the opposite direction for the pension obligation. So if actuaries are predicting a 50-basis-point drop in the discount rate, it would produce a 4 to 6 percent increase in the liability.

Calendar-year companies are in the middle of setting the assumptions they will use to measure their 2010 year-end pension obligations and determine the funding status of their plans, Smith says. It's a thick stew of estimates and assumptions that must be established, based on a list of market-based and company-specific factors, to determine the future projected liabilities for any defined-benefit plan. “There are 200 other things that go into measuring the liability,” he says. “Other movements in all those actuarial assumptions would just be complete guesses.”

“There are two camps. The Warren Buffet camp says if plans think they're going to earn more than 6 percent they're crazy. Others say historically these plans have seen 8 to 10 percent returns, and there's no reason to deviate from that.”

—Jack Abraham,

Principal, Retirement Practice,

PwC Human Resource Services

Discount rate aside, the other main input is the company's expected return on assets—and it's typically subject to controversy, says Jack Abraham, leader of the retirement practice at PwC Human Resource Services. “There are two camps,” he explains. “The Warren Buffet camp says if plans think they're going to earn more than 6 percent they're crazy. Others say historically these plans have seen 8 to 10 percent returns, and there's no reason to deviate from that.” Most employers land somewhere in the middle, he says, from about 7.5 to 8.5 percent.

Jon Waite, chief actuary at SEI's Institutional Group, expects the return-on-asset assumption that most companies use to hold relatively stable from the end of 2009. “It's possible it might come down a little bit this year, but it will be pretty close to where it was a year ago,” he says. Despite dramatic volatility in the market over the past few years, companies use a long-term horizon when setting their return-on-asset assumptions that could range from 30 to 60 years, he said.

Living Longer

Life expectancy is another critical assumption subject to lots of scrutiny, Abraham says. Actuarial studies show that mortality rates are improving, meaning people are living longer, but plan sponsors debate how steadily improving rates should be factored into long-term projections. “At some point, that trend has to end,” he says. “The human body has certain limitations on how long you can live no matter how healthy you are, so those improvements will slow down greatly or become eliminated.”

PENSION FUNDING LEVELS RISING

The following information from Moody's Investors Service explains why strong asset returns are expected to boost pension funding levels:

Strong asset returns in 2010 will give a much needed boost to pension funding levels for

year-end 2010.

However, offsetting the strong asset performance is a modest rise in pension obligations

due to contracting discount rates.

Overall we expect funding levels to improve from 79% to 85-89% for our rated universe

of non financial issuers.

Pension contributions will be going up in 2011 which could strain liquidity. Expiring

temporary funding relief had allowed plan sponsors to push contributions out a couple

of years, however absent further market rebounds and/or further legislative relief,

required cash contributions will increase.

We expect more companies will be issuing debt in 2011 to reduce pension

underfundings and take advantage of related tax benefits. We also expect that companies

will shift asset allocations to reduce equity and interest rate risks in the future.

Required Pension Contributions to Increase

While a $75 billion reduction in underfundings is very much welcomed, the fact remains

underfundings must eventually be remedied, which begs the question “When will companies have to

increase contributions to their plans?” The answer lies within the pages of the Pension Protection Act

of 2006, which became effective in 2008. The rules for calculating a plan's funded status are different

for funding purposes than for financial reporting purposes1. While a simplification, at the heart of the

rules is the concept that a company must have a fully-funded plan within seven years.

The U.S. Internal Revenue Service in March 2009 relaxed some of its rules for calculating discount

rates used to calculate 2010 required contributions. This rule change, effectively allowed companies to

cherry-pick the best rates from September, October, November or December, 2008. This one-time

allowance significantly reduced required contributions for 2010. However, despite this fact we believe

that actual contributions in 2010 were in excess of what was required.

We believe the wild ride experienced in pension funding levels since 2008 has left an indelible mark on

the psyche of companies sponsoring defined benefit pension plans. As the market continues to recover,

we expect many companies will be issuing debt in the coming years to contribute to their pension

plans. When companies contribute to their plans they are able to claim a tax deduction, thus making

voluntary contributions even more attractive.

To illustrate the point, in December 2010 Honeywell (A2 negative) announced it is considering

contributing $1 billion to its pension plan in 2011. Given today's low interest rates, Honeywell said

that it is an opportune time to access the credit markets and contribute cash to the U.S. plan.

Source

Moody's on Pension Funding Levels (Jan. 3, 2011).

So far, Abraham says, auditors and the Securities and Exchange Commission have been fairly lenient about using static mortality rates or those reflecting longer life expectancies. “But they are requiring companies to put some thought into those mortality assumptions,” he says.

Jones also sees greater analysis going into life expectancies, with auditors showing heightened interest in how companies set their assumptions. “As we move down the continuum of measuring pension costs, life expectancy factors are pretty high on the list this year-end,” he says.

Salary expectations also hold a key place in the pension equation, Waite says. This is where assumptions are heavily rooted in company-specific circumstances, he says, but overall cost pressures have taken their toll on corporate salaries. “We will probably see it drop a little this year,” he predicts.

Companies that end up with underfunded plans will have to determine their contribution requirements under the Pension Protection Act, although some will want to take advantage of funding relief legislation that Congress approved in mid-2010. The Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act of 2010 provides funding allowances, but Barry says many companies will not want to take advantage of it. “There are so many hooks in it, a lot of sponsors decided not to elect it,” he says.

Pension experts say that as companies finish their estimates and assumptions for year-end pension accounting and financial reporting, the best measure they can take to make sure those estimates pass muster is to document them carefully, pension experts say. “We're moving toward stricter documentation from the auditor's and the SEC's standpoint,” Abraham says. “Every year, more and more is requested in terms of the documentation for all the assumptions sponsors are making.”