Pension Fund Finances and Business Risk

While pension finances are very much in the news of late, as recently as five years ago, companies didn't worry much about their defined benefit pension funds. After two decades of strong U.S. equity market returns, most companies were adequately funded and many were overfunded. Indeed, many plans ran up against IRS contribution limits and had to stop contributing for a time. But beginning in 2000, the easy returns came to an abrupt end. Stock markets plummeted, while falling interest rates pushed up present-value measures of liabilities. Suddenly, many plan sponsors found themselves in double jeopardy, facing both pension shortfalls and challenges in their core business at the same time.

Many speculative stories have addressed the risks that pension plans can pose to an individual company's financial health, entire industries and the overall financial markets. But most are not backed up with analysis that quantifies how pension plans relate to other financial measures. Watson Wyatt has developed a measure of the amount of risk that pension plans pose to individual companies and to the larger financial system, which we call the Pension Risk Index. Our analysis suggests that for the majority of the Fortune 1000, pension plans pose little risk to the individual firm's financial health. Additionally, of companies that do sustain a significant level of pension risk, most are on solid financial ground, suggesting that — while they may want to evaluate and manage that risk — they could likely weather a crisis. In a broad context, therefore, pension funds do not pose a significant risk to the functioning of financial markets.

Pension Funding Levels and Asset Allocation Strategies

The swift turnaround in the pension funding for Fortune 1000 companies is shown in Figure 1.

In aggregate, defined benefit plans dropped from a nearly $300 billion surplus in 2000 to more than a $200 billion deficit by year-end 2003. Over the last two years, plans have regained some lost ground but are still collectively underfunded by $137 billion. Through the last six years, pension obligations for active plans have continued to rise, while plan assets have fluctuated drastically due to poor market returns combined with a high degree of equity exposure.

The traditional "65/35" portfolio (i.e., assets allocated 65 percent to equities and 35 percent to fixed-income securities) that served many plan sponsors so well over the 1980s and 1990s led to the current funding shortfalls. When equity prices and interest rates move in the same direction, such allocations create volatility in funding levels. Figure 2 shows the distribution of equity allocations for fiscal year 2004.

The vast majority of companies have most of their assets allocated in equities: the average allocation was just over 64 percent, and equity allocations have generally ranged in the upper 60s for most of the last 20 years. This stable allocation suggests that defined benefit sponsors tend to rebalance their portfolios when markets move and that companies are sticking with their traditional reliance on equities. While sponsors have benefited from positive returns in the stock market during the last two years, such equity-heavy allocations drove funding levels to uncomfortably low levels in 2002 when the market bottomed out.

Watson Wyatt's Pension Risk Index

The funding volatility that can result from large equity positions may in turn set off volatility in funded status, cash contributions to the pension fund, accounting measures of pension cost and, ultimately, market capitalization. One way to quantify the 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). Simply put, the VaR is the dollar reduction in the pension fund's funded position under a worst-case financial market scenario given the plan's asset allocation, liability structure and sensitivity to interest rates. The worst-case VaR scenario is defined as having a 5 percent probability of occurring, and is calculated using Watson Wyatt's capital market assumptions and proprietary asset/liability modeling technology. The dollar value of this outcome is then measured relative to the market value of the sponsoring company. So a PRI value of 4 percent implies that, given the plan's current financial position and asset allocation, there is a 5 percent likelihood the firm will experience a loss in its pension fund worth 4 percent of the company's market capitalization.

Pension Risk Index for the Fortune 1000

The distribution of pension risk among Fortune 1000 sponsors and its evolution during the past two years is shown in Figure 3. One group of companies has very high degrees of pension risk, a larger group of companies has minimal pension risk and many fall in between. Roughly half of the Fortune 1000 pension sponsors had PRI values of around 1 percent or less of their market value, suggesting that their pension fund poses a relatively low degree of risk to their core business. Another sizable fraction — roughly 30 percent — of plan sponsors have PRI values between 1 percent and 4 percent, suggesting that their pension funds could cause a perceptible disturbance in the company's finances if financial markets performed poorly. These companies may want to explore strategies to mitigate the risk their pension funds are posing to their core operations. Finally, a smaller group of companies have very high PRI values, generally suggesting that the pension fund is disproportionately large; and in some cases the company itself is in distress, reflected by low market capitalization.

The degree of risk diminished somewhat from 2003 to 2004, as shown in Figure 3. The blue bars (representing 2004) extend above the green (2003) bars in the lower PRI region. The reductions in pension risk were driven by improved business conditions that pushed up market values, and by large employer contributions and favorable equity returns, which pushed up funding levels, albeit modestly. As discussed above, plan sponsors did not reduce risks by cutting back their equity exposure. While pension risk has subsided to some degree, there are still a number of sponsors whose pension funds pose a substantial risk to their core operations (and through the Pension Benefit Guaranty Corporation, to other sponsors through higher premiums). The total dollar value of pension risk across all of these plans was $81 billion at the end of fiscal year 2004.

Systemic Risk from Pensions

One question that might be of concern to policymakers is whether the risks companies take through their pension funds, coupled with the current combination of underfunding and high degrees of equity exposure, pose a systemic risk to the broader business operating environment. By systemic risk we refer to the possibility that an adverse financial outcome in the pension fund could cause sufficient disruption so as to trigger a broader financial market disturbance — for example, if a number of large sponsors were forced into bankruptcy as a result. In order to get at this question, we divided companies into those with an investment-grade bond rating and those with a junk-bond rating (a Standard and Poor's debt rating of BB- or lower) and totaled the dollars of pension risk for each group (Figure 4).

This snapshot suggests that pensions pose minimal risks to the broader business environment. Most pension risk is concentrated in investment-grade companies that could likely weather an adverse shock. While these companies may want to reduce the risk from their pension operations for the sake of their own financial health, it seems unlikely that the vicissitudes of their pension funds would trigger a broader disturbance among American businesses.

That said, firms with below-investment-grade credit ratings are bearing elevated levels of risk relative to their market capitalization. The average PRI value for these firms was just under 4 percent, as compared with an average value of less than 0.5 percent for investment-grade sponsors. Hence those with the highest degree of pension risk are those least able to weather an adverse financial market shock.