If the stock market doesn't recover this year, defined benefit plan sponsors could see their pension surpluses diminish, and their contributions increase or, in many cases, resume.
In recent years, many defined benefit plans have basked in the luxury of being so overfunded that they have contributed to operating profits in many companies. A booming economy and strong employment growth kept pension liabilities stable while surplus assets swelled, allowing many plans to enjoy contribution holidays while investment returns more than made up for benefit payouts.
Among the 200 largest employee benefit plans, 116 made contributions to their defined benefit in 1995, according to the Pensions & Investments survey of the largest pension plans. That had declined to 107 last year (P&I, Jan. 22).
Meanwhile, according to the P&I survey, total benefit payouts by the defined benefit plans among the top 200 grew 144% to $122 billion in 2000 from $49.9 billion in 1991, while employer contributions grew just 40% to $41.5 billion between 1991 and last year.
But the party soon could be over. If stock prices continue to decline for another year, surplus pension assets will start to evaporate and many plan sponsors will have to dust off their contribution policies and kick in for the first time in years.
According to actuaries, some companies' pension liabilities are growing even faster than projected as layoffs result in increased lump-sum payouts to departing employees.
"A lot of things are coming together at maybe the worst time," said Mike Young, actuary at William M. Mercer Inc., Minneapolis.
Rates and returns
The combination of declining interest rates and disappointing equity returns has increased pension liabilities and shrunk assets for most plans. The fallout could be significant, he said.
That doesn't mean all overfunded plans will have to start making contributions soon, said Mr. Young. Most plans use an averaging or "smoothing" technique to account for pension gains, and many plans still are recognizing market gains from prior years.
But, he said, smoothing is also used to recognize losses. And if the market continues to deteriorate, those losses will begin to eat away at the funded status at the same time pension liabilities are rising.
Pension liabilities are valued using an assumed interest rate. As interest rates decline, as they have for the past year, liabilities increase faster. "A lot depends on how plans are smoothing their asset fluctuations," said Mr. Young. "A lot of companies used actuarial values that have lagged the decrease in market value of their assets. Downsizing, lump-sum payouts, early retirements - all cause the funded status to go down even faster. If you are downsizing and you agree to take on additional (pension) obligations for those who are leaving, you would expect to see further deterioration in funded status."
That being the case, even if asset values had remained unchanged over the last 12 months, liabilities still would have increased, he said.
Not until 2002
Matt Siegel, principal and consulting actuary at Unifi Network, a subsidiary of PricewaterhouseCoopers, Teaneck, N.J., said the pension funding holiday is not going to be over for most plans based on one year's market decline. However, he said, if the stock market remains volatile and continues to drop, the funding holiday could end.
"A lot of things could tend to drive contributions in different ways," said Mr. Siegel, "For some companies, as lump-sum payouts are paid, the opportunity to have asset growth exceed liabilities is reduced or limited. For example, actuaries may discount plan liabilities at 6% to 7% while plan sponsors expect 10% return on assets. Over the last 10 years, that hasn't been overly optimistic. But the increasing number of companies offering lump sums has limited their ability to grow their surplus.
"Since companies haven't been contributing to their plans while employees have been accruing benefits, the lack of contributions has helped erode the surplus. Benefit accruals have eaten into the surplus.
"I think you will find some companies are so far overfunded that the level of accruals won't significantly eat into surplus. I'd say for a minority, though, the holiday may be over. Not now but as early as 2002."
Mr. Siegel expects the tanking stock market to have a delayed impact on pension fund contribution requirements because of the use of smoothing. "Just as outperformance has been spread over several years, any losses would be spread out. It may be two to three years before the market decline would have any impact on contributions, assuming that the market stays down or becomes even more volatile," he said.
Mr. Siegel said the weak economy and layoffs actually could improve the funded status of some plans. In most cases, projected increases in final-average-pay salaries are linked to increases in funding. If more people than expected leave a company, projected benefit payouts also drop.
Funding factor
Then again, minimum funding requirements start to enter the picture as plan assets decline and pension liabilities increase. "Depending on plan design and the relative weighting of active and inactive liabilities, (funding requirements) could affect companies in different ways," said Mr. Siegel.
In 1994 Congress changed the minimum funding requirement, which "was a non-event" at the time, said Mr. Young. "The IRS was concerned about underfunding at the time. They looked at existing funding and wanted to create a mechanism to accelerate funding for plans that were underfunded. A lot of companies weren't affected because they were well-funded at the time. The rules said that when a plan's funded status dropped to less than 90% of current liabilities it required larger contributions to get back to at least 90% in a short period of time."
Now as the decline in the equity markets eats away at pension assets "many plans will confront these new rules for the first time," he said.
