pension article

8/8/2019 Pension Article

1/4

Time to Notice Corporate Pension Plans?

Corporate pension plans have been able to hide in plain sight in this past decade of unprecedented assetreturns. While pension plans have generally been well funded throughout 2004 2008, record lowinterest rates and dismal asset returns in the past 2 years have finally forced companies and the media topay much more attention to their pension obligations, and for good reason.

Bloomberg recently reported that the gap between the assets of the 100 largest company pensions and

their projected liabilities widened by $108 billion in August from the previous month to a $459.8 billiondeficit

(1), and that less than half the 50 state retirement systems had assets to pay for 80 percent of

promised benefits in their 2009 fiscal years(4)

, shocking readers at how poorly funded our pension plansactually are despite the rebound in the equity markets last year.

When times are good, a fully funded pension plan neither increases a companys earnings, nor provides afinancial boost to its sponsor, making its financial impact negligible to most companies. However, whenthings go south like the 2008 financial crisis, companies are required to not only book extra pension costson their financials, but also make extra cash contributions into their pensions when they can least affordto. It is the financial equivalent of a company selling a put option on the stock market with no definitematurity date and constant additional collateral requirements, that nobody really pays attention to until it istoo late.

There are 2 sides to pensions, assets and liabilities. Pension assets suffered severe losses in the 2008market downturn, but have been able to recover most of their losses with the 2009 market rally and anincrease in company contributions. The liability side, however, has not performed as well as most peoplewould suspect. Corporate pension plans are mandated to value the liabilities based on investment gradecorporate yields, and record low corporate yields have created a spike in pension liabilities that pensionasset returns arent able to catch up to.

40.0

50.0

60.0

70.0

80.0

90.0

100.0

110.0

120.0

Sep-10Jun-10Mar-10Dec-09Sep-09Jun-09Mar-09Dec-08Sep-08Jun-08Mar-08

Indexed Values from

4.00

4.50

5.00

5.50

6.00

6.50

7.00

7.50

8.00

8.50

CompositeCorporate

Pension Liabilities(Proxy of 40-Year Annuity)

Pension Assets(80% Equities 20% Bonds)

Funded Statusof 78%

Aggregate CorporateYield of 5.16%

Average Corporate Yields(Lehman, Merrill and CitigroupHigh Grade Bond Index)


2/4

As a simple illustration, lets assume a pension fund was 100% fully funded with asset and liability valuesindexed at 100 as of 1/1/2008. According to Towers Watsons Global Pension 2010 Asset Study

(2), the

average pension had an asset allocation of 61% in equities, 19% in bonds and 20 % in other investmentssuch as real estate, hedge funds and private equity. So an asset portfolio of 80% equities and 20% bondswould be a good proxy for the average pension asset portfolio, while the average pension liability durationis somewhere around 15 years, and a 40-year annuity that pays $1 every year (which has a durationclose to 15 years at 6% yields) would be a good proxy for the average pension liability as well.

If we run this asset and liability portfolio through the S&P Index, the Dow Jones Corporate Bond Index,and the average of Citigroup, Lehman and Merrill Lynch composite corporate yields from 1/1/08 to 9/1/10,you will notice how asset values diverged from liabilities in 2008 and have since been unable to catch upto liabilities. This is caused by the long duration nature of pension liabilities, making them very sensitive tointerest rate fluctuations. With an average duration of 15 years, a 100 basis point drop in corporate yieldswould increase pension liabilities by around 15% (not including convexity) and would require assets toreturn at least 15% to break even.

These data points do not reflect the effects of monthly benefit disbursements, company contributions orasset allocation changes, and only seeks to explain the high level divergence between pension assetand liability values given current market conditions.

So how does an under-funded pension plan affect a company?

Companies book their annual pension costs for keeping their staff another year on their incomestatement, and are required to make a cash contribution every year as well. If they have a shortfall, theyare required to book additional pension costs and make extra cash contributions to eventually fill thefunding gap, lowering earnings and decreasing free cash flow, while the actual funding shortfall shows upas a liability on its balance sheet reducing shareholder equity. Below a certain funding threshold,pensions are also considered at-risk and are required to use more conservative assumptions to valuetheir liabilities, resulting in higher financial costs, with increasingly harsher penalties every year it remainsbelow that threshold. Hence given a big enough pension obligations relative, a severe pension fundinggap could bankrupt a company. Case in point: General Motors and the airline industry.

Although rarely mentioned, severely underfunded pension plans also exert a human capital costs on the

company as well. Below a 80% funded ratio, retirees arent allowed to take out their full retirement benefitas lump sums, and below 60%, plan participants have to stop accruing additional benefits and arentallowed to take any lump sums at all. Telling your employees that their pension fund is facing benefitrestrictions not only dampens overall morale, but also makes employees question the financial stability oftheir company. This is especially important as most new employees are part of a defined-contribution401(k) plan instead of defined benefit plans. Defined benefit plan participants are usually managementlevel employees who have served in the company for a long period of time and are highly vested in theirpension benefits. Having managers worried for their future livelihood and retirement income would be anundeniable distraction at a time when they need to focus the most.

So where were we, where are we, and where will we be?

Pension plans have the discretion to use smoothing methods to value their assets and, to a certainextent, pick and choose the assumptions they use to value pension benefits which include discount rates,expected return on assets (which reduces their pension costs), retirement rates and so on, in order toreduce the volatility in their funded status.

During the market crash of 2008, companies were able to average their asset values over 3 years,smoothing out their asset losses against their gains from the prior 2 years, and take advantage ofabnormally high corporate yield rates caused by the freeze in the capital markets in valuing their liabilities.They were able to maintain high funded ratios in their 2009 financial statements and avoid the financialpenalties a pension funding shortfall would have cost them, only through a series of unusualcircumstances. Notice the spike in corporate yields in October 2008 and the drop in pension liabilities thatfollowed.


3/4

In 2009, corporate yields came crashing down as the Federal Reserve set near zero interest rates whichsubstantially increased pension liabilities. The 30 - 40% asset returns in 2009 cushioned the increase inpension liabilities but werent enough to fully offset the increase in liability. Companies had to recordfunding shortfalls on their 1/1/2010 financial statements, forcing them to recognize higher pension costson their books and make extra cash contributions into their pension funds. However, the financial impactwas fairly muted as companies were able to amortize their funding shortfalls over 7 years.

Now with 3 months left in 2010, corporate yields have trended even lower from last year while the equitymarkets have been hovering between negative and positive territory. The 30-year treasury yield hasdropped from 4.63% to 3.52% while the S&P index has returned only about 1%. Companies with hugepension obligations are looking at even higher pension costs and cash contributions next year as theyhave to recognize their prior year funding shortfall and the additional losses they incurred this year.

The Towers Watson Pension Index clocking in its lowest funded ratio since 1990 at 60.0 as of 8/31/2010(3).

Congress is cognizant of this fact and recently passed the Pension Relief Act which lessens the financialimpact on companies facing substantial pension funding shortfalls by extending the period companies canamortize their additional shortfalls. Unfortunately, this relief only applies to additional shortfalls incurred in2009, 2010 or 2011 and only benefits corporate pensions that were fairly well-funded to begin with. It is ofmarginal use to pensions who were already severely underfunded to begin with. Furthermore, it comesattached with conditions such as not being able to pay out excess compensation above $1 million orissue extraordinary dividends/redemptions to its shareholders, which could cause operational and capitalissues of its own. More information can be found at

http://www.plansponsor.com/Senate_Passes_Pension_Funding_Relief.aspx

The interesting question would be, what would happen to pension funds if the economy double-dips?

In a double-dip scenario, the housing and equity markets would collapse while treasury rates and highgrade corporate yields would depress further caused by a flight to safer assets, translating into lowerpension asset returns and higher pension liabilities. Companies will then have to pony up even more cashto make up for their funding shortfall in an environment when they need their cash flow the most. Planparticipants who are worried of the plans financial health would make a run on their pension and takeout lump sum benefits instead of annuities, further depleting pension assets. If the plan sponsor is unableto make its extra contributions, the pension plan would fall into benefit restrictions (below 60% funded),


4/4

pension article

Documents