The aggregate deficit in pension plans sponsored by S&P 1500 companies reached $484 billion at December 31, 2011, an increase of $169 billion from year end 2010, according to new figures from Mercer[1]. This deficit corresponds to an aggregate funded ratio of 75% as of December 31, 2011 compared to a funded ratio of 81% at December 31, 2010.
The decrease in funded status in 2011 was primarily attributable to the increase in liabilities resulting from a decrease in discount rates during the year. On the asset side, US equity markets were up approximately 1% for the year, and there were strong returns on US fixed income, with double digit returns for long maturity bonds. However, with less than 45% of pension plan assets generally invested in fixed income and often in shorter maturity bonds, these positive returns only had a small impact on overall funded status.
“With US and non-US equity indices underperforming expectations and interest rates on high quality corporate bonds declining upwards of 100 basis points, driving discount rates down and plan liabilities up significantly, we saw a marked decline in funded status.” said Jonathan Barry, a partner with Mercer’s Retirement Risk and Finance consulting group. “We also saw wide fluctuations in funded status through the year – with the aggregate funded status peaking at about 88% at the end of April, and hitting a low of 71% at the end of September – the largest month-end deficit we have ever seen since we began tracking this information.”
The funded status deficit would have been worse if not for the estimated $50 billion that companies disclosed they expected to contribute during 2011. “Many plan sponsors are merely treading water, or even moving backwards on funded status, despite significant cash contributions to their plans.” said Mr. Barry. “For many companies, the larger deficit will drive higher P&L expense, as well as large increases in pension funding requirements for 2012.”
Increasing pension deficits are a major concern to many pension plan sponsors due to the negative impact on both reported earnings and free cash flow. “Management has a better use for these funds, whether increasing dividends to shareholders or making business investments to increase competitiveness and potentially support job creation,” said Mr. Barry.
Continued funded status volatility is another concern. “We see a growing number of pension plan sponsors seeking to reduce the effect of defined benefit pension volatility on their balance sheets and cash funding requirements,” said Kevin Armant, a principal with Mercer’s Financial Strategy Group. “Dynamic asset allocation approaches that systematically reduce volatility as funded status improves are gaining traction, and many plan sponsors are engaged in detailed planning around the logistics of making lump-sum cashouts available to terminated participants as a means of reducing liabilities. We are also seeing more interest in exploring insurer buy-outs as a means of eliminating liabilities.”
Mr. Armant’s comments are borne out by a recent survey of senior-level financial executives conducted by Mercer and CFO Research Services. Roughly half of sponsors say they are at least somewhat likely to match fixed income duration to their plan liabilities and increase their fixed income allocations (Figure 1). Similar trends also apply to other strategies, such as dynamic de-risking (lowering risk as the funded status improves), lump sum cash-outs for terminated vested employees and annuity purchase.
“We see plan sponsors positioning themselves for when funded status improves – from the impact of rising interest rates, strong equity market returns or additional funding - and we expect there will be a significant shift from equities to bonds once that occurs,” said Nick Davies, Washington, DC-based Principal in Mercer’s Investments business. “Corporate defined benefit plan sponsors are intently focused on risk management issues and many are poised to make significant changes. The open questions are, how quickly will market changes occur, and do sponsors have the conviction and capability to carry out their intended changes?”
Mercer estimates the aggregate combined funded status position of plans operated by S&P 1500 companies on a monthly basis. Figure 2 shows the estimated aggregate surplus/(deficit) position and the funded status of all plans operated by companies in the S&P 1500. This is based on projections of their reported financial statements[2] adjusted from each company’s financial year end to December 31 in line with financial indices. This includes US domestic qualified and non-qualified plans and all non-domestic plans. The estimated aggregate value of pension plan assets of the S&P 1500 companies at December 31, 2010, was $1.37 trillion, compared with estimated aggregate liabilities of $1.68 trillion. Allowing for changes in financial markets though the end of December 2011, changes to the S&P 1500 constituents and newly released financial disclosures, the estimated aggregate assets were $1.45 trillion, compared with the estimated aggregate liabilities of $1.93 trillion as of December 31, 2011.
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