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Improved Pension Funding and Lower Business Risk in 2006

Pension funding has generated considerable interest during the last decade. Former surpluses became shortfalls in 2001 and 2002, as deteriorating market conditions drove plan assets down and pension obligations up. Getting funding levels back where they should be has required steady effort — including large cash infusions — from many sponsors, as well as good asset returns, but in 2006, most employer-sponsored plans regained full financial health.

Watson Wyatt analyzed defined benefit plan funding for the FORTUNE 1000 in 2006. We measured the impact of Statement of Financial Accounting Standards No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefit Plans (FAS 158), on shareholders’ equity using pension finance data for 2004, 2005 and 2006, and it is much less negative than many feared. We also calculated the risk plan underfunding would pose to companies’ core business under a simulation of the “perfect storm” market conditions of the early 2000s, in which both asset returns and interest rates plummeted.

In 2006, asset returns were strong and interest rates climbed higher, although they are still at relatively low levels. The consequent improvements to plan funding also mitigated the effect of FAS 158 on shareholders’ equity and reduced pension risk for the FORTUNE 1000.

Pension Finances in the FORTUNE 1000
Since 2002, the financial position of pension funds sponsored by FORTUNE 1000 firms has gradually improved, although, on average, plans remained well below full-funding levels until 2006. A plan’s funded status is the ratio of the current market value of assets to the projected benefit obligation (PBO). The PBO is the actuarial present value of benefits earned to date, which reflects expected future compensation increases. The accumulated benefit obligation (ABO) also measures accrued benefit liabilities but does not reflect projected compensation increases.

Figure 1 depicts the simple and weighted funding ratios for FORTUNE 1000 plan sponsors from 2000 through 2006. The weighted average ratio is the ratio of total plan assets to total plan obligations in the FORTUNE 1000.

Figure 1
Funding Levels for Plans Sponsored by the FORTUNE 1000

Over the last decade, plan funding has been volatile. In 2000, the simple average funding ratio was 115 percent. But by the end of 2002, the average PBO funding ratio had plummeted to 76 percent. Funding improved slightly over the next few years, but between 2005 and 2006, the simple average PBO funding ratio jumped from 83 percent to 89 percent, while the weighted PBO average ratio rose from 91 percent to 99 percent.

A higher weighted average ratio than simple average ratio indicates that larger defined benefit plans have higher funding ratios than smaller plans. In terms of ABO funding ratios, plans had the highest-ever simple and weighted average ratios in 2006, at 100 percent and 108 percent respectively, since Watson Wyatt began tracking the ratio in 2003.¹

Components of Funding
The previous section illustrated the volatility in funding levels over the last seven years. This section looks at the factors and conditions that affected funding levels over this period, especially the recent jump in 2006. Table 1 shows the drivers of aggregate projected benefit funding ratios from 2000 to 2006.

Table 1
Changes in Pension Funding, 2000-2006 ($ billions)

	2000	2001	2002	2003	2004	2005	2006
Change in assets	9	-146	-118	171	100	81	139
Less increase in liabilities	-61	-78	-103	-112	-91	-71	-28
Equals change in funding	-51	-224	-221	59	9	10	111
Components affecting funding
Contributions	31	13	43	66	48	51	41
Service cost (current benefits earned during that year)	-23	-25	-26	-27	-29	-32	-32
Actual return on assets	54	-89	-89	180	122	114	154
Interest cost	-67	-70	-72	-70	-69	-70	-72
Actuarial gain (loss) on liabilities	-24	-42	-65	-76	-59	-61	21
Other*	-22	-11	-12	-14	-4	8	-1
Change in funding	-51	-224	-221	59	9	10	111

* Other consists of curtailments, settlements, acquisitions, divestitures and plan amendments.

Source: Watson Wyatt Worldwide.

During the late 1990s, plans were generally well-funded and, partly because of the laws that discouraged companies from amassing large pension surpluses, many firms were taking “contribution holidays.” From 2000 through 2002, however, funding took a turn for the worse in response to the perfect storm of lower asset returns and lower interest rates. Between 2003 and 2005, strong market returns and large cash infusions helped to bring plan funding back up despite the continued interest rate decline.

In 2006, firms realized something of an inverse of the earlier perfect storm. Higher market returns, rising interest rates and substantial plan contributions pushed funded status considerably higher. Finally, all the drivers were working in favor of pension plan funding.

The biggest contributor to funding increases was the actuarial gain on liabilities companies recognized in 2006 — the first such gains during this decade. The actuarial gain minimized the effect of otherwise rising liabilities during this period. After years of decline (from 7.60 percent in 2000 to 5.6 percent in 2005), interest rates finally turned a corner, pushing the discount rate to 5.8 percent by the end of 2006. Higher discount rates lower plan liabilities.

During the last four years, plan assets have done very well. Over the past year, aggregate asset returns for FORTUNE 1000 companies were roughly 13 percent — up from 10 percent in 2005. While these weren’t the highest returns in recent years — returns were up more than 20 percent in 2004 — firms outperformed their expectations by a considerable margin.

Last but not least, the cash sponsors pumped into their plans played a significant role in higher funding levels. In 2003, sponsors contributed more than twice their service cost (the value of current benefits earned during that year). The contribution-to-service-cost ratio for the FORTUNE 1000 was 2.44 in 2003, 1.65 in 2004, 1.60 in 2005 and 1.23 in 2006. While some years’ contributions were higher than others, all were higher than their service cost. The decrease in the contribution-to-service-cost ratio over the years may reflect current-law limits on plan contributions, as well as sponsors’ hopes of riding the wave of an increasing discount rate and reserving their cash for other business purposes.

Higher Funding Levels Reduce the Impact of FAS 158
In September 2006, the Financial Accounting Standards Board (FASB) enacted new rules that require firms to put the net financial status of their postretirement plans on their balance sheet. The new requirements eliminate all smoothing of actuarial gains and losses in the funding position that flows into the other comprehensive income section in shareholders’ equity. Under the new rules, a pension’s current financial health is reflected in its sponsor’s book value. In the past, poorly funded pension plans were required to show the ABO funded status as a minimum balance sheet liability.

Since 2005, Watson Wyatt has been estimating the effects of the new disclosures on corporate balance sheets for the FORTUNE 1000 (see Watson Wyatt Insider, February 2006 and December 2006) as if the rules had been in effect for fiscal years 2004 and 2005. But now we can measure the actual effect of this accounting change for 2006. Figure 2 depicts the median reduction in shareholders’ equity of all postretirement plans (pension and other postretirement benefits), which is estimated for 2004 and 2005, and actual for fiscal 2006.

Figure 2
FAS 158 Estimated/Actual Effects on Shareholders’ Equity of Postretirement Plans for the FORTUNE 1000, 2004-2006

Source: Watson Wyatt Worldwide.

The median impact on shareholders’ equity decreased from an estimated -4.83 percent in 2004 to an actual -1.35 percent at the end of 2006. With plan assets outperforming liabilities for 2006, this decrease reflects the lower amount of underfunding now reported on the balance sheet. So the timing of the FASB’s accounting rule was optimal for plan sponsors — so far, there has been less bad news to report. At the end of the day, the impact of the new accounting rules was not nearly as large or as negative as many expected. However, the new rules clearly will contribute to future volatility on the balance sheet, thus making defined benefit plans less attractive to many plan sponsors.

As the next section shows, gains in plan funding have had a similar effect on measures of actual and simulated pension risk.

Watson Wyatt’s Pension Risk Index
Over the last few years, many plan sponsors have been concerned about how their earlier pension funding shortfalls were affecting their core business. Improved funding has eased concerns about the damage that pension deficits were doing to their bottom line. Table 2 shows the distribution of the ratio of pension deficits (pension plan assets minus projected benefit obligations) to firms’ market capitalization for the FORTUNE 1000 from 2003 to 2006. The magnitude of pension deficits against a firm’s value has diminished significantly over time.

Table 2
Pension Deficits/Market Capitalization

	Percentiles of Pension Deficits/Market Capitalization
Year	75th	50th	25th
2003	-0.48%	-2.41%	-7.29%
2004	-0.43%	-1.85%	-5.55%
2005	-0.43%	-1.75%	-5.14%
2006	-0.09%	-0.95%	-2.81%

Source: Watson Wyatt Worldwide.

Companies with a strong core business and large organizations are more likely to have shored up funding for their defined benefit plans. Figure 3 shows plan funding as well as underfunded dollars over market capitalization by deciles. A significant share of current pension risk falls on firms burdened by legacy liabilities.

Figure 3
Funded Status and Underfunded Dollars by Market Capitalization

Source: Watson Wyatt Worldwide.

The funding deficits as a percentage of firm value shown above typically have resulted from the adverse market conditions previously described. While these deficits have diminished over the last few years, plan sponsors are still concerned about the risk/volatility their plans will pose in the future. Since most pension funds hold large equity positions (typically 65 percent of a plan’s asset portfolio), a significant loss in equity values could set off a drop in cash contributions to the pension fund, accounting measures of pension cost and, ultimately, market capitalization.

One way to quantify the additional risk the pension fund implies for a company’s core business is a value-at-risk (VaR) measure developed by Watson Wyatt called the Pension Risk Index (PRI). The VaR is the dollar reduction in the pension fund’s funded position under adverse financial market conditions given the plan’s asset allocation, liability structure and sensitivity to interest rates. An unfavorable VaR scenario is defined as having a 5 percent probability outcome, and is calculated using Watson Wyatt’s capital market assumptions and proprietary asset/liability modeling technology. The dollar value of this outcome is then compared with the market capitalization of the plan sponsor.

For example, a PRI value of 4 percent implies that, given the plan’s current financial position and asset allocation, there is a 5 percent likelihood that the firm will experience a loss in its pension fund worth 4 percent of the company’s market capitalization during that year.

Pension Risk Index for the FORTUNE 1000
Watson Wyatt has been calculating PRI values for the FORTUNE 1000 for four years. Figure 4 shows the distribution of pension risk scores among the FORTUNE 1000 from 2003 to 2006.

Figure 4
Distribution of Pension Risk Index Values, 2003-2006

Among FORTUNE 1000 companies, PRI values have declined during the last four years. The number of companies with relatively high degrees of additional pension risk has decreased by almost half, and the number with lower pension risk has increased. Correspondingly, about 63 percent of FORTUNE 1000 pension sponsors had PRI values of roughly 1 percent or less of their market value. The number of FORTUNE 1000 companies with PRI values of 0 percent more than doubled from 5 percent in 2005 to 11 percent in 2006. Even under adverse financial conditions, these plans should not pose any additional risk to their sponsors’ market capitalization, because more companies are reporting pension plan surpluses.

Another sizable fraction — roughly 30 percent — of plan sponsors had PRI values between 1 percent and 4 percent, suggesting that their pension funds could cause a slight disturbance in the company’s finances if financial markets performed poorly.

A PRI value of more than 4.5 percent generally suggests that the pension fund is large in comparison with market value. The distribution of firms classified as “very risky” has declined from around 17 percent in 2003 to 8 percent in 2006.

During the last four years, median pension risk values have decreased from 1.03 percent in 2003 to .87 percent in 2004 to .77 percent in 2005 and finally to .62 percent in 2006. The total additional dollar amount at risk in the FORTUNE 1000 has decreased similarly, from $83 billion in 2003 to $67 billion in 2006. So in adverse financial market conditions, an average pension plan might increase the total ratio of underfunded dollars to market capitalization at the end of 2007 to 1.57 percent (.95 percent at the end of 2006, plus the additional .62 percent the PRI simulates) — still below the percentage of pension deficits to market capitalization among the FORTUNE 1000 in 2005 (1.75 percent).

This lower pension risk results from higher funding levels, more pension surpluses and improved company performance — and thus higher market value — by FORTUNE 1000 plan sponsors. These trends should ease concerns about the risks pension plans pose and their potentially negative effect on the bottom line, even given the financial storms of recent months.

Future of Pension Funding
The good news from 2006 should help put to rest some of plan sponsors’ concerns about their pension plans. For a significant portion of firms, pensions are fully funded or close to it, and total assets have finally caught up with total liabilities, thanks to advantageous market conditions as well as strong management by plan sponsors. Concerns remain about the continuing decline in rates of plan sponsorship. Many firms froze their defined benefit plans during the last few years and their next step could be to terminate them. There are, however, signs that such activity is easing.²

Now that pension funding has regained lost ground, plan sponsors might consider adopting new investment policies, such as liability-driven strategies, to help lock in current funding levels. These strategies utilize bond and derivative markets, which would help firms better hedge against their long-term pension liabilities and reduce the pension risk posed by large equity concentrations. This has become even more important given the market volatility in the second half of 2007.

The new funding requirements mandated by the Pension Protection Act of 2006 (PPA) also should help keep plan funding stable. The PPA requires a faster but more measured reaction to underfunding and also allows sponsors to make extra contributions, so sponsors could build up some reserves. These changes should reduce the volatility of required contributions, which was a factor in some earlier funding shortfalls and plan freezes.³

¹ With the adoption of FAS 132 (revised), plans had to disclose their ABO after December 15, 2003.

² “Pension Freezes: Has the Worst Passed,” Watson Wyatt Insider, September 2007.

³ See Mark J. Warshawsky, “The New Pension Law and Defined Benefit Plans: A Surprisingly Good Match,” Journal of Pension Benefits, Volume 14, No. 3, pp. 14-27 (Spring 2007).