pension fund perspective: moody's gathers pension data

CFA Institute

Pension Fund Perspective: Moody's Gathers Pension DataAuthor(s): Patrick J. ReganSource: Financial Analysts Journal, Vol. 36, No. 4 (Jul. - Aug., 1980), pp. 16-17Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478358 .

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Iliflol und Persneeliwby Patrick J. Regan, V.P. PIKIEN .~u.... rurmpuin.uu5 BEA Associates, Inc.

Moody's Gathers Pension Data In the March/April 1979 issue, we dis- cussed in this column some of the new tools that credit rating agencies, Moody's in particular, have developed to measure the impact of pension costs and liabilities. Moody's considers unfunded past service costs, adjusted for taxes, to be a "pension debt equivalent." To compute the "adjusted debt ratio," the firm's credit analysts add the pension debt equivalent to both the numerator and the denominator of the conventional debt-to-capitalization ratio. Finally, they calculate an "adjusted fixed charge coverage ratio" by dividing the earnings available for interest payments by the sum of the interest expense on actual debt instru- ments, plus an interest factor on non- capitalized leases, plus an interest factor (using the firm's cost of new debt capital) on the pension debt equivalent.

The rating agencies do not use mechanical formulas, so it is not sur- prising that Moody's attempted to gauge the degree to which companies were over or understating their pension costs and liabilities. In early 1979, the firm sent a questionnaire to all in- dustrial corporations with rated securi- ties. The questionnaire was only three pages long, but it covered such issues as the maturity of the pension plan (e.g., average attained age of the active members, ratio of actives to inactives), the funding method, the prior service liability, the market value of the pension fund assets and a breakdown by asset categories (e. g., stocks, bonds and "other assets"), the projected salary growth assumption and the expected investment return assumption, the period for amortizing the unfunded prior service liability and the extent to which the plan is integrated with Social Security. Approximately half the companies responded, and the results, broken down by bond rating category, were summarized in a recent issue of the Moody's Bond Survey ("Moody's Pension Study" in the November 19, 1979 issue).

Differences Between Rating Categories As Table One shows, the top rated Aaa companies had such substantial pen-

sion assets that they needed a mere 36 per cent appreciation to cover their entire prior service liabilities. On average, they had $15,600 of pension assets per employee (including active and re- tired members) and they owed an average of $20,800 in total prior service costs. As shown by the table, the pension assets and the pension liabilities per employee dropped with the bond rating. For the lowest category, Baa, pension assets per employee were only $7,200, requiring 76 per cent appreciation to fund the $12,100 pension liability per employee. In sum, the Aaa- rated companies needed 36 per cent appreciation, the Aa companies 52 per cent, the A companies 70 per cent and the Baa companies 76 per cent. By this simple standard, the top rated firms have the better funded pension plans.

Table One also shows that gross pension liabilities per employee were much larger for the top rated firms. Moody's analysts suggested that such companies offer the greatest benefit pack- ages to attract top personnel. But the fact that the pension assets per employee are twice as high in the Aaa category as they are in the Baa category suggests that the plans of the former were set up years earlier, with both the assets and the liabilities growing over time. Many of the Baa companies are small and unseasoned and do not have employees with decades of service.

Funding Methods Moody's offered another explana-

tion-that perhaps the top quality companies take a "more conservative actuarial approach" in estimating their pension liabilities. The aggregate method is generally considered the most conservative, in that it tends to result in the highest annual contribu- tion. However, it does not indicate a specific past service liability figure.

If many of the lower quality companies used the aggregate method, that would partly explain the lower pension liabilities per employee. As shown by Table Two, however, 13 per cent of all the companies in the sample used the aggregate funding method, and there was no significant difference between the Aaa companies (18 per cent) and

the Baa companies (14 per cent). The "entry age normal" is the second

most conservative funding method; it generates a larger liability figure than the unit credit method. As the table shows, 58 per cent of the companies in the survey used the entry age normal method, compared with 21 per cent for the unit-credit method. Moody's noted this with favor, commenting that "the survey results suggest that almost 60 per cent of the companies are conservative in their liability estimates." The Baa companies were most conservative, with 71 per cent using entry age normal and only nine per cent using unit credit. However, the Aaa companies were the next most conservative (64 per cent and 18 per cent, respec- tively), so the funding method alone cannot explain the rank difference in Table One.

Actuarial Assumptions Plans may also differ significantly in

their actuarial assumptions. Moody's concentrated on the two key assumptions-estimated salary in- creases and the expected investment return on the portfolio. Most plans are of the final-pay type, so that the benefits owed to an individual will be a func- tion of the number of years of service multiplied by benefit formula (percent- age of earnings per year of service) multiplied by the final years of earnings. Thus the actuary has to estimate how rapidly wages and salaries will be growing. The Moody's survey dis- cerned no major differences; 57 per cent of the companies used wage growth assumptions in the four to 5.9 per cent range, and very few assumptions were below three per cent or above seven per cent.

The interest rate assumption is very important because it affects the present value of the pension liability. The survey indicated that 55 per cent of the companies used an interest rate assumption of 6.0 to 6.9 per cent. How- ever, 20 per cent of the companies were using an assumption of seven per cent or more, and they were mostly A or Baa-rated firms. Whereas none of the Aaa companies was using such a high interest rate assumption, 24 per cent of

FINANCIAL ANALYSTS JOURNAL / JULY-AUGUST 1980 O 16



the Baa and 23 per cent of the A-rated companies were.

Because it applies to the entire plan, the interest rate assumption carries more importance than the salary growth assumption, which applies only to active members. Thus it is important to look at both the absolute level and the spread between the two key actuarial assumptions. Although the salary assumptions for all groups were similar, the lower rated companies had higher interest rate assumptions than the top rated companies. The spread should therefore be greater for the former than for the latter.

Table Three shows that, whereas 73 per cent of the Aaa companies had a spread of less than two points (i.e., the interest rate assumption was less than two points above the salary growth assumption), the figure was 50 to 55 per cent for the other companies. Moody's concluded that "the fact that the Aaa group has a narrower spread explains why this group reports the greatest lia-

bility per employee. However, the distribution of spreads in the Baa, A and Aa groups is rather similar, and it does not explain the liability differences among these three groups."

The Moody's analysts considered one other variable as an explanation for the liability differences: Plans that are "integrated" with Social Security can afford generous benefit formulas, since they use Social Security benefits to offset the sponsor's portion of the total benefit package. Curiously, the survey found that 91 per cent of the Aaa-rated companies had benefits integrated with Social Security, compared with 56 to 64 per cent of the lower quality firms. In other words, the top companies had the largest pension liabilities per employee despite the fact that they generally used the Social Security offset.

Amortization and Pension Assets The top quality firms are very con-

servative in amortizing their unfunded past service costs. Moody's found that

only 23 per cent of the Baa firms used an amortization period of less than 30 years; 32 per cent of the A-rated companies, 38 per cent of the Aa firms and 77 per cent of the Aaa companies used an amortization period of less than 30 years. Moody's concluded that the fas- ter amortization was one reason why the top rated firms had greater pension assets per employee.

Summary Credit analysts have begun to scrutinize pension costs and liabilities, as well as the methods used to compute the numbers. Based on the Moody's survey, top rated companies appear to have the narrowest spreads between their salary growth and interest rate assumptions, use the most rapid amortization schedules and need the least portfolio appreciation to fund their pension liabilities. The next stage for Moody's analysts will be to examine the data by industry; these compari- sons should be even more revealing. a

Table One Pension Assets and Liabilities by Rating Category

Bond Rating Category Aaa Aa A Baa

Total Pension Liability Per Employee $20,800 $18,900 $13,300 $12,100 Market Value Pension Assets Per Employee $15,600 $12,400 $ 7,900 $ 7,200

Asset Appreciation Required to Cover Pension Liability 36% 52% 70% 76%

Source: Moody's Bond Survey, November 19, 1979.

Table Two Funding Methods by Rating Category

Bond Rating Category Aaa Aa A Baa Total

Aggregate Funding Method 18% 23% 10% 14% 13% Entry Age Normal Method 64% 44% 55% 71% 58% Unit Credit Method 18% 23% 26% 9% 21% Other Methods 9% 9% 6% 8% Total 100% 100% 100% 100% 100%


Table Three Distribution of Spread by Rating Category

Nega- O to 1 to 2 to 3 to 4 to 5%or tive 0.9% 1.9% 2.9% 3.9% 4.9% More Total

Baa (2%) 10% 40% 38% 10% 0% 0% 100% A (5) 17 33 36 5 1 3 100 Aa (0) 15 35 27 12 8 3 100 Aaa (9) 27 37 18 0 9 0 100

Entire Sample (4) 16 35 34 7 2 2 100


FINANCIAL ANALYSTS JOURNAL I JULY-AUGUST 1980 1] 17



pension fund perspective: moody's gathers pension data

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