Year-End Pension Accounting Declines Might Be Milder Than Expected

Market volatility makes predictions difficult

Unsurprisingly, the value of pension plan assets has dropped sharply so far this year, and under Financial Accounting Standard (FAS) 158, funded status for 2008 will decline for most pension plans. However, today’s higher discount rates will soften the drop considerably. Despite the dramatic drops in the stock market during early October, we project only a moderate decline in average funding status — from 96 percent in 2007 to 88 percent in 2008. Although the drop in funding levels projected for accounting purposes is moderate, it is important to note that funding status is calculated on a different basis to determine required contributions. Without legislative relief, the decline in asset values operating in conjunction with the complex funding rules in the Pension Protection Act (PPA) of 2006 will require many plan sponsors to make sizable contributions precisely when they can least afford them.

To explore the effects of the financial crisis on pension plan funding, Watson Wyatt analyzed pension data for 450 FORTUNE 1000 firms whose fiscal years end in December and projected their pension funding status — pension plan assets over projected benefit obligations (PBO) — for 2008. We based our projections on a scenario in which market conditions in effect Oct. 15 would still obtain at the end of 2008.

On an aggregate level — total assets over total PBO for all firms in this analysis — we project a decline of nine percentage points in funding status for the FORTUNE 1000 — from 106 percent in 2007 to 97 percent in 2008. Despite poor market conditions, the drop is much less severe than declines earlier in the decade, when funding fell by 20 percentage points from 2000 to 2001 and by 19 percentage points from 2001 to 2002 (see Figure 1).

Figure 1
Pension funding status for FORTUNE 1000

Source: Watson Wyatt Worldwide.

Liabilities fall along with assets
Given the slump on Wall Street and based on companies’ specific asset allocation targets, we project a 26 percent drop in plan assets. But the significant increases in corporate bond yields over the same period should also decrease plan liabilities by 19 percent. Even though market returns so far this year are significantly below those in 2002, funding levels are not projected to decline to the extent they did in the earlier perfect-storm scenario. From 2001 to 2002, the discount rates used to measure plan obligations decreased by 52 basis points, driving plan liabilities higher. Figure 2 shows the projected aggregate funding components for year-end 2008.

Figure 2
Estimated changes in PBO and asset values during 2008 ($ billions)

Source: Watson Wyatt Worldwide.

* Actuarial loss due to interest rate change.

Lower asset returns
Plan assets increase due to positive returns on investments and employer contributions.¹ Assets decrease due to negative returns, benefit payouts and other plan expenses. Between Jan. 1 and Oct. 15, the S&P index fell by roughly 38 percent — one of the steepest market declines of the last century. To put these returns in perspective, the S&P index fell by 23 percent in 2002.

To project asset returns, we used company-specific target asset allocation information from the 10-K pension footnotes required by the Securities and Exchange Commission (SEC). The target asset allocation is typically broken down into five categories: equity, debt, cash, real estate and other. We based projected returns for equities on the S&P index and based projected returns for bonds on the Lehman Aggregate Bond Index. So far this year, the returns on bonds are roughly -1 percent. Projected returns for real estate are based on the National Council of Real Estate Investment Fiduciaries index, returns for other investments (hedge funds) are based on Hedge Fund Research Inc.’s Fund of Funds Composite Index, and returns on cash are based on three-month Treasury bills.

As of Oct. 15, we estimate these returns as roughly 2 percent for real estate, -11 percent for other investments and 2 percent for cash. Actual returns could be higher or, more likely, lower. For example, many plans invest in international equities — currently underperforming their U.S. counterparts — which would thus lower our projections slightly.²

Lower liabilities
Fortunately, interest rates have not declined. To the contrary, high-quality corporate bond yields, which are typically used to measure pension obligations, have increased significantly over the last couple of months. On Sept. 30, discount rates were roughly 7.5 percent, according to the widely used Citigroup Pension Discount Curve and Liability Index. This yield has increased by 100 basis points since year-end 2007. Because AA corporate bond yields have risen by almost 80 basis points since the end of September, we use a discount rate of 8 percent in our projections.

The average discount rate for plan sponsors at the end of 2007 was 6.22 percent; our model therefore projects discount rates to increase by 178 basis points.

Due to the financial crisis, however, the firms we used to calculate AA yields in October 2008 could fall into the A category or lower by year-end. Firms with pending or actual lower credit ratings typically produce higher yields and would be removed from the AA group, thereby producing lower yields for this category. (Using a discount rate of 7.5 percent in our projections would reduce the average funding status for the FORTUNE 1000 to 83 percent.) Variations in the discount rate significantly affect plan liabilities — the decrease in liability caused by the increase in the rate is shown by the actuarial gain in Figure 2.³

For the second year in a row, service cost (actuarial present value of pension benefits earned by employees during the year) will likely decrease. An increase in year-end discount rates typically decreases the service cost for the following plan year. By the end of 2007, discount rates had risen from 5.8 percent to 6.22 percent, so we assume service cost will decrease by roughly 6 percent for 2008. Service cost is also affected by pay and employment levels and plan changes, such as freezes, that curtail benefits.

We project interest cost by multiplying the discount rate at the beginning of the year by the PBO for the same period, adjusted by current-year expected benefit payments. To derive the value of benefit payments to employees in 2008, we use expected benefit payments over the next plan year from 2007 10-K pension footnotes.

Market volatility makes year-end outcome difficult to predict
This analysis projects pension funding for accounting purposes under market conditions as of Oct. 15. Given recent market volatility — as much as 10 percent gained or lost in a day — these results could change dramatically by the end of the year. Figure 3 looks at potential outcomes based on different asset return and rate scenarios.

Figure 3
Possible 2008 funding scenarios for FORTUNE 1000

Scenario No.	Returns on equity	Returns on bonds	Discount rate utilized	Average projected funding status* at the end of 2008
1a	-45%	-6%	8.50%	87%
1b	-40%	-4%	8.50%	92%
1c	-35%	-2%	8.50%	96%
1d	-30%	0%	8.50%	101%
1e	-25%	2%	8.50%	106%
1f	-20%	4%	8.50%	110%
1g	-15%	6%	8.50%	115%
2a	-45%	-6%	8.25%	85%
2b	-40%	-4%	8.25%	89%
2c	-35%	-2%	8.25%	93%
2d	-30%	0%	8.25%	98%
2e	-25%	2%	8.25%	102%
2f	-20%	4%	8.25%	106%
2g	-15%	6%	8.25%	111%
3a	-45%	-6%	8.00%	82%
3b	-40%	-4%	8.00%	86%
3c	-35%	-2%	8.00%	90%
3d	-30%	0%	8.00%	95%
3e	-25%	2%	8.00%	99%
3f	-20%	4%	8.00%	103%
3g	-15%	6%	8.00%	107%
4a	-45%	-6%	7.50%	77%
4b	-40%	-4%	7.50%	81%
4c	-35%	-2%	7.50%	85%
4d	-30%	0%	7.50%	89%
4e	-25%	2%	7.50%	93%
4f	-20%	4%	7.50%	97%
4g	-15%	6%	7.50%	100%
5a	-45%	-6%	7.00%	72%
5b	-40%	-4%	7.00%	76%
5c	-35%	-2%	7.00%	79%
5d	-30%	0%	7.00%	83%
5e	-25%	2%	7.00%	87%
5f	-20%	4%	7.00%	90%
5g	-15%	6%	7.00%	94%

*Funding ratio projected on PBO basis.

Source: Watson Wyatt Worldwide.

If discount rates begin to fall and asset returns remain significantly negative, pension funding levels could fall considerably farther. For example, if discount rates fall to 7 percent and returns on equity fall to -45 percent by year-end, funding positions under FAS 158 could decline to a dismal 72 percent. If the market rebounds and bond yields continue to rise, funding positions for 2008 could be considerably better.

Absent relief from legislators, plan sponsors might have to divert funds they otherwise would invest in critical business operations in order to make the contributions required under the PPA. At the time the legislation was passed, no one expected its funding provisions to take effect in the turbulent financial conditions we’re witnessing today.

¹ To derive the value of employers’ cash contributions for 2008, we used expected cash contribution amounts for the 2008 plan year disclosed in the SEC’s 2007 10-K pension footnotes.
² For example, at the time of the analysis, international equities were underperforming U.S. equities by 10 percent. So the projected funding position for plan sponsors holding 25 percent of equities in international funds would be 87 percent rather than 88 percent.
³ We calculated plan duration using expected benefit payment schedules. Where this information was not available, we used an assumption of 13 years.