Declining Funded Status of U.S. Pensions

The funded status of U.S. pension plans has declined sharply since 2000, and more employers will be required to make contributions for the 2002 plan year, according to the 2002 Survey of Actuarial Assumptions and Funding, Watson Wyatt’s 34th annual survey of U.S. pension plans.

The survey covers 472 plans, each with 1,000 or more active participants. About 60 percent of the data is from 2001 plan year actuarial valuations and about 40 percent is from 2002 valuations. As in previous years, we compared results from earlier surveys with the most recent Form 5500 data released by the U.S. Department of Labor (DOL). For most items, our survey tends to track the information in the larger database fairly closely.

The survey examines the funded status of pension plans and the actuarial assumptions used to calculate contribution requirements. It does not examine assumptions used to develop pension expense under applicable financial accounting standards, which is covered in a separate Watson Wyatt survey.

Measuring Funded Status

To measure a plan’s funded status, we compare the market value of assets to current liability. Current liability is the value of accrued benefits disclosed in Form 5500, based on interest and mortality assumptions prescribed by the IRS. The ratio is called the “Accrued Benefit Security Ratio.” If the ratio exceeds 100 percent, the plan’s assets are worth more than its current liabilities. If the ratio is less than 100 percent, the plan’s current liabilities exceed plan assets.

The trend in Accrued Benefit Security Ratios is sharply downward (see Figure 1). In 1998, 84 percent of plans had more assets than current liabilities. By 2002, that percentage had dropped to 37 percent. As shown in Figure 1, the decline accelerated after the 2000 valuation year, mostly due to market declines.

Source: Watson Wyatt 2002 Survey of Actuarial Assumptions and Funding.

In fact, the 2001–2002 decline in funded status has actually been muted to some degree in the survey, because most plans valued in 2002 used a higher interest rate to value current liability, as permitted under the pension funding relief provisions of the Job Creation and Worker Assistance Act of 2002. Using the higher interest rate lowered current liability for a typical plan by about 10 percent.

Given the dismal market performance of 2003 so far, we expect Accrued Benefit Security Ratios to decline even further in the 2003 survey, unless plan sponsor contributions manage to offset investment losses and additional benefit accruals during 2003.

Funding Assumptions

Figure 2 shows the average investment return (funding rate) and current liability interest rate assumptions from the last six surveys. The investment return assumption is used to determine plan liabilities on an ongoing basis (or the actuarial liability for service earned as of the valuation date). The average investment return assumption decreased from 8.3 to 8.1 percent in the 2002 survey. Over the last five years, the average investment return assumption has remained relatively stable, while the average current liability interest rate has decreased from 7.3 to 6.2 percent, due to decreasing yields on 30-year Treasury bonds.

Source: Watson Wyatt 2002 Survey of Actuarial Assumptions and Funding.

Some commentators have suggested that the investment return assumptions used by actuaries are too high and that returns should track long-term government bonds. Others argue that, since a significant portion of pension plan assets are invested in equities, anticipated returns should reflect the historically higher returns of equities over bonds, generally thought to be in the neighborhood of 5 percent. From January 1997 to January 2002, long-term corporate bonds were fairly stable, generally hovering around 7 percent or higher (as measured by Moody’s long-term corporate yields). For this period, assumptions of 8 percent or more do not appear unreasonable. On the other hand, while long-term corporate bond yields decreased somewhat from January 2002 to January 2003, short-term corporate bond yields fell sharply, which may affect the selection of assumptions for 2003 valuations. Using lower investment return assumptions along with dramatically lower asset values would be likely to significantly increase contribution requirements for 2003 valuations, all else being equal.