Dramatic Drops in Interest Rates Forecast Much Lower DB Plan Funding Status on Accounting Basis for 2008

An earlier Watson Wyatt analysis of pension funding in 450 Fortune 1000 firms projected an 8-percentage-point decline in their defined benefit (DB) pension funding status¹ under an assumption that the market conditions of Oct. 15 would persist through 2008.² But interest rates have fallen by more than 200 basis points since then, and we are now projecting a much bigger 29-percentage-point drop in funding status.

The 8-percentage-point drop (from 96 percent to 88 percent) in the earlier analysis reflected the effect of higher interest rates, which mitigated the decline in asset values.³ While market returns on assets haven’t realized much net change since our earlier analysis, the interest rates used in measuring plan liabilities have decreased substantially over the past few months. This dramatic decline in interest rates will result in a substantial decrease in plan funding at the end of 2008 — an average drop of 29 percentage points —as shown in Figure 1.

Figure 1
Pension funding status for Fortune 1000

Source: Watson Wyatt Worldwide.

Another perfect-storm scenario for plan sponsors?
The last significant drop in funding levels (2000-2002) occurred in a perfect-storm market scenario in which both asset values and interest rates dropped, causing plan liabilities to soar and plan funding to decline. This market scenario was unprecedented at the time. Unfortunately, the steep drop in interest rates since October portends another perfect-storm scenario, decreasing plan assets by 24 percent and increasing plan liabilities by 10 percent at the end of 2008 for companies in this analysis.

Interest rates fall by more than 200 basis points since October, 60 basis points since December 2007
Our previous analysis projected liabilities to decline by 19 percent due to the interest rate environment at the time when we witnessed 180-point increases in discount rates. Since the end of October, however, high-quality corporate bond yields have plummeted. According to the widely utilized Citigroup Pension Discount Curve and Liability Index, discount rates were roughly 6.5 percent in December 2007 and rose to 8 percent by the end of October 2008 — a 150-basis-point increase (see Figure 2). As of Dec. 31, 2008, discount rates had tumbled to roughly 5.9 percent — a fall of more than 210 basis points and a drop of 60 points since December 2007.

Figure 2
Discount rate according to Citigroup Pension Discount Curve and Liability Index (December 2007-December 2008)

Source: Watson Wyatt Worldwide.

Because of this 60-basis-point decline, these Fortune 1000 companies will have to report an aggregate projected $106 billion actuarial loss for 2008. The projection as of Oct. 15, 2008, was for a $257 billion actuarial gain for plan sponsors. So the drastic decline in corporate bond yields over November and December increased liabilities in aggregate by $363 billion.

According to a recent Watson Wyatt survey of sponsors’ plan assumptions, companies are expecting to realize an 11-basis-point decline in discount rates from year-end 2007 to year-end 2008.⁴ Given the smaller reduction in discount rate assumptions relative to the decline in the Citigroup Pension Discount Rate Curve and Liability Index, sponsors are probably seeking other methods and techniques to determine their rates. Using an 11-basis-point reduction in interest rates instead of the 60-basis-point reduction in the Citigroup curve produces a better funding result for plan sponsors, but the outcome remains grim. Under this scenario, funding levels are projected to be an average of 71 percent (versus 67 percent) and 78 percent on an aggregate level (versus 74 percent) at the end of 2008.

Equity returns stay consistent but bond returns pick up
Return projections used to calculate plan assets realized minor changes since mid-October. By the end of the year, plan assets were up slightly from our previous study. This gain was mostly owing to an improvement in the bond market in the last few months of the year, as returns on equity realized little net movement. Returns on bonds were roughly 5 percent by the end of the year,⁵ a 6 percent gain since our previous analysis, which projected returns on bonds at roughly -1 percent. In contrast, the performance of hedge funds actually worsened by the end of 2008. Our earlier analysis projected returns as of October 15 at roughly -11 percent. At year-end, however, returns were roughly -22 percent. Overall, these changes in market assumptions increased plan asset values by 2 percent from our previous study, thereby reducing the asset loss from 26 percent to 24 percent.

Funding levels fall for Fortune 1000 firms in this analysis
Due to the decline in the value of discount rates used to measure pension obligations, most plan sponsors will realize major declines in plan funding levels. At the end of 2007, 46 percent of plan sponsors realized funding levels between 90 percent and 110 percent (see Figure 3). Only 5 percent of plan sponsors had funding levels between 50 percent and 70 percent. In contrast, for 2008, we project that only 5 percent of plan sponsors will have funding levels between 90 percent and 110 percent, and funding for 61 percent of sponsors will fall between 50 and 70 percent.

Figure 3
Distribution in plan funding status (year-end 2007 vs. projections for year-end 2008)

Source: Watson Wyatt Worldwide.

On an aggregate level — total assets over total projected benefit obligations (PBO) for firms in this analysis — we project an average decline of 32 percentage points in funding status for the Fortune 1000 — from 106 percent to 74 percent. At the end of 2007, these firms had a pension surplus of $78 billion. We project that this group will slip into a $366 billion deficit by the end of 2008, representing a total loss of $445 billion in funding over the past year. Figure 4 shows the projected aggregate funding components for year-end 2008.

Figure 4
Estimated changes in PBO and asset values during 2008 ($ billion)

*Actuarial loss due to interest rate change.
+ Change since previous study.
Source: Watson Wyatt Worldwide.

Conclusion
The significant drop in interest rates over the past months has created another perfect storm for plan sponsors. Funding levels for accounting purposes are expected to drop to historically low levels.

It should be noted that funding status is calculated on a different basis to determine required cash contributions. Under regulatory requirements, sponsors can use a smoothed approach in selecting their interest rate to measure plan liabilities, and most sponsors choose this method versus a current spot rate, which is closer to the method used for accounting purposes. Sponsors also may want to use a smoothed approach to value plan assets, which will help to mitigate the 24 percent loss in assets.

Unfortunately, due to historically low market returns during 2008, current law will require plan sponsors to contribute more than twice the cash to their pension plans this year as last year, precisely when they can least afford the higher contributions.⁶ In the past, volatility in cash contributions was a major factor in the freezing and closing of defined benefit plans. The pension community is lobbying Congress and the new administration for further temporary funding relief. Otherwise, we could be in for another round of plan freezes and closings. We are already witnessing some firms suspending the match components of their defined contribution plans due to cash constraints.

¹ Plan assets over the plan’s projected benefit obligations (PBO) equals the funding status.

² Watson Wyatt analyzed data for 450 Fortune 1000 firms whose fiscal years ended in December. See “Year-End Pension Accounting Declines Might Be Milder Than Expected,” Watson Wyatt Insider, November/December 2008.

³ For methodology and previous results, refer to “Year-End Pension Accounting Declines Might Be Milder Than Expected,” Watson Wyatt Insider, November/December 2008. The majority of assumptions are the same for this article. Changes in projected obligations from the October projections are largely owing to actuarial loss arising from lower interest rate assumptions. Changes in the value of plan assets since the last analysis are relatively insignificant.

⁴ According to Watson Wyatt’s Real-Time FAS Assumption Survey, the average discount rate for sponsors that measure their pension plans at the end of 2008 was 6.23 percent. The average discount rate used by plan sponsors at the end of 2007 was 6.34 percent.

⁵ According to Barclays Capital U.S. Aggregate Index.

⁶ See “The Future of DB Plan Funding Under PPA and Relief Legislation Proposals,” Watson Wyatt Insider, January 2009.