Pension plan funding has been up and down during the last seven years. In many firms, the pension plan surpluses of the late 1990s turned into deficits early in the next decade, as both the stock market and interest rates declined. Then in 2006, an inverse of the earlier “perfect storm” delivered strong asset returns and higher discount rates for pension liabilities. These market trends helped to bring pension plans’ aggregate funding status back to full financial health. To track the latest developments, Watson Wyatt estimated the aggregate financial status of pension plans at 2007 year-end for firms that have made the FORTUNE 1000 list during the last seven years.1
Watson Wyatt has been tracking plan funding levels for eight years. Between 2002 and 2006 aggregate funding status for plans sponsored by FORTUNE 1000 firms increased from 81 percent to 99 percent.2 For 2007, we estimate that pension funding for these firms increased to roughly 109 percent (Figure 1).3
FORTUNE 1000 Companies’ Aggregate Funding Status and Assets Versus Liabilities, 2000 – Estimated 2007 (end-of-year values)
Source: Watson Wyatt Worldwide.
For the first time since 2000, aggregate funding levels in FORTUNE 1000 pension plans are projected to show a surplus. While asset returns were lower in 2007 than they have been in recent years, discount rates were higher, which drove plan liabilities down and funded status up. Table 1 shows estimated aggregate funding ratios and funding components for year-end 2007.
Estimated Changes in Pension Benefit Obligations and Assets During 2007 ($ billions)
|Projected benefit obligation 2006
||Market value of assets 2006
||Return on assets
|Less actuarial gain
|Less benefits paid
||Less benefits paid
|Projected benefit obligation 2007
||Market value of assets 2007
Source: Watson Wyatt Worldwide.
Plan Liabilities Decrease
Plan liabilities are projected to decline by roughly 6 percent during 2007, mostly because of higher discount rates. At the end of 2006, the average discount rate for plans in this study was 5.85 percent. On December 31, 2007, discount rates were roughly 6.48 percent, according to the widely used Citigroup Pension Discount Curve and Liability Index. Variations in the discount rate significantly affect plan liabilities. Liabilities move in the opposite direction of interest rates, and the 63-basis-point increase alone decreased liabilities by roughly 9 percent (assuming a typical plan with 15-year duration). This is represented by the actuarial gain in Table 1.
We projected service cost – the actuarial present value of pension benefits earned by employees during the period – by examining the rate of increase for FORTUNE 1000 firms during the last seven years. We are starting to observe a decrease in service cost growth due to plan freezes and closings.
We measured interest cost by multiplying the beginning-of-the-year discount rate for the firms in this sample – 5.85 percent – by the projected benefit obligation (PBO) for the same period, adjusted for current-year expected benefit payments.
To derive the value of benefit payments to employees in 2007, we used the expected benefit payments over the next plan year from 2006 10-K pension footnotes.
Plan Assets Increase
For 2007, we project a 3.5 percent increase in pension plan assets. Higher asset values typically arise from two components: return on plan investments and employer contributions to the plans. These are balanced out by benefits paid to retirees and other expenses.
We estimate a 5.91 percent return on plan investments for 2007. Investment returns were low this year compared with returns over the last four years, which ranged from 21 percent in 2003 to 9 percent in 2005. We based our 2007 estimates on one-year returns from equity and bond markets, using the S&P index for stocks and the Lehman Long U.S. Government/Credit Index for bonds. We derived a 62/38 equity/bond split in pension portfolios by examining the aggregate dollar amounts from last year’s disclosures. For 2007, equities yielded a return of 5.49 percent, while bonds yielded 6.6 percent. These estimates are conservative – many pension plans will outperform these indices. However, the final rate of return should still be lower than the 8.21 percent expected return assumption for 2007.
The other source of asset growth is cash contributions from plan sponsors. At the beginning of the decade, when funding levels were high, employers’ contributions were low, partly because funding requirements did not allow sponsors to build up cash reserves. When pension funding declined, firms had to make considerably higher contributions to their plans. Despite strong funding levels for 2007, we expect plan sponsors’ 2007 contributions to be roughly comparable to those for 2006, mostly because the Pension Protection Act of 2006 allows – indeed encourages – sponsors to build up cash surpluses. Additionally, the implementation of Statement of Financial Accounting Standards (SFAS) 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans,4 allows firms to make additional contributions between their old measurement date and the current fiscal year-end date.
Our analysis focused on an eight-year history of employer contributions and service cost (see Table 2). To estimate 2007 employer contributions, we multiplied estimated service cost by last year’s contribution-to-service-cost ratio, resulting in aggregate pension contributions of roughly $40 billion.
Ratio of Employer Contributions to Service Cost by Year ($ thousands)
||Estimated funding status
with other cash projections
|Memo: Expected contributions reported in the footnotes – $17.3 billion
|Memo: Cash contributions to match benefits earned over the last year – $31.2 billion
Source: Watson Wyatt Worldwide.
The 2006 pension footnotes for these firms show only $17 billion in expected contributions for 2007, because most firms report their minimum required contributions for the coming year. If firms were to contribute cash for benefits earned over the past year (yielding a 1:1 contribution-to-service-cost ratio), we would estimate contributions of around $31 billion. Clearly these two estimates are lower than the projected value of $40 billion. However, these alternative estimates would reduce funding status by only 2 percentage points – to 107 percent – still well over full-funding levels.
Another Positive Year for Pension Funding
Market outcomes over the last five years have favored pension funding. Plan assets have overtaken liabilities, and most plans should be back to healthy funding levels for 2007. Unfortunately, recent declines in both equity performance and interest rates may already have taken back some of the gains sponsors made in 2007.
Now might be a good time for some plan sponsors to consider investment policies such as liability-driven investment (LDI) strategies to help lock in current funding levels. These strategies use bond and derivative markets to hedge against long-term pension liabilities. Although investors seem interested, asset allocations in the FORTUNE 1000’s pension plans still strongly favor equities (62 percent), presumably in an effort to maximize returns. Many sponsors are reluctant to shift away from stocks, which have worked out well for them during the last few years (and arguably provide the best long-term results). However, equity-heavy allocations can create funding volatility as assets rise and fall along with the stock market, especially if discount rates do not move in tandem.
Equity returns so far this year have been dismal, with the worst January performance in many years. After several years of steady improvement, pension funding could be in for another roller coaster ride in 2008.
1 Our analysis included 401 firms that have been in the FORTUNE 1000 over the last seven years. In 2007, 638 pension sponsors were in the FORTUNE 1000, so the focus is on a large subset of the total universe of FORTUNE 1000 plan sponsors.
2 Funding status is the ratio of the market value of assets to the projected benefit obligation (PBO). Using the accumulated benefit obligation (ABO) to measure liabilities would bring plan funding up to roughly 118 percent (we found a 9 percent difference between ABO funding ratios and PBO funding ratios for firms in the FORTUNE 1000). (See “Improved Pension Funding and Lower Business Risk in 2006,” Watson Wyatt Insider, October 2007). The Financial Accounting Standards Board plans to revisit the measurement of postretirement benefit obligations during the second phase of its accounting reform project, so the measure could change.
3 Many of the pension liability values in 10-K disclosures incorporate nonqualified plans, which are typically not funded, suggesting that the aggregate funding ratio for qualified plans is higher than the values shown in Figure 1.
4 Before FAS 158, companies could measure plan funding up to three months before their fiscal year-end. FAS 158 closes the three-month window, and starting December 31, 2008, plan sponsors must measure their assets and liabilities as of the end of their fiscal year. The FASB wants to ensure that companies record events in the same year they occur. Thirty percent of FORTUNE 1000 defined benefit plan sponsors currently use a measurement date other than their fiscal year-end and will have to change their practices to comply with FAS 158.