Corporate pension plans in for more funding woes in 2012

U.S. corporate pension plans will have an uphill climb through continuing volatility to improve funding ratios in 2012, after a slew of reports released last week showed considerable declines last year.

Officials from BNY Mellon Asset Management, Mercer, UBS Global Asset Management, Milliman and Legal & General Investment Management America all expect another volatile year for both equity markets and funding ratios, similar to 2011 where funded status plummeted below 80% in large part because of minimal investment returns and a significant drop in the corporate discount rate.

“The markets have been choppy, and the recovery outlook is uncertain,” said Jeffrey B. Saef, Boston-based managing director at BNY Mellon Asset Management and head of the investment strategy and solutions group. “We need a firming of economic growth and then a positive trend in that firming. ... We need a credible and transparent plan from Europe that will create confidence in investors.”

According to BNY Mellon's Pension Summary Report, the funded status of a typical pension plan in 2011 declined 12.7 percentage points to 72.4%. In December, the funded status was down 2.7%. A 0.8% increase in assets was overshadowed by a 4.6% rise in liabilities, driven by a decrease in the Aa corporate discount rate. The discount rate fell 30 basis points to a historic low of 4.36% after starting the year at 5.64%.

Corporate plans are trying to move to safer assets as funding ratio volatility will continue in the early months of 2012, said Mr. Saef in a telephone interview.

December saw the second-lowest funded status of 2011; plans were 70.1% funded in September, according to BNY Mellon's report. Assets for the typical corporate pension plan increased 2.7% for the year, but liabilities increased 20%.

In a report by Mercer LLC, the aggregate deficit in pension plans sponsored by S&P 1500companies increased $169 billion to $484 billion in 2011, dropping the funding ratio to 75% from 81% at the start of the year. The funding ratio was 78% at the end of November, said Jonathan Barry, a Boston-based partner with Mercer's retirement risk and finance consulting group.

Long-maturity bonds saw double-digit returns while U.S. equity markets were up about 1% in 2011. But decreasing discount rates caused liabilities to soar, according to Mercer. Overall funded status would have been even worse last year if not for the estimated $50 billion that S&P 1500 companies disclosed they expected to contribute during 2011.

“The biggest takeaway is how many sponsors are exposed to significant funded status risk and how not much has been done to mitigate this,” Mr. Barry said in a telephone interview.

Corporate plan funding widely fluctuated throughout the year, peaking at 88% at the end of April with a low of 71% at the end of September, the largest month-end deficit since Mercer started tracking the information more than 10 years ago.

Mr. Barry said corporate plans have two options to address a low funded status. They can change to higher allocations of fixed income — and longer-duration fixed income — as well as some derivatives to match the liabilities, or employ risk transfer, either through annuitization or offering lump-sum cash distributions to former employees.

A separate survey conducted by Mercer with CFO Research Services showed that many plan sponsors have risk management on their agendas for 2012. “I do think we will see more activity in that space than in the last couple years,” Mr. Barry said. “Sponsors need a formal plan in place so they know what they need to do and when, and have the ability to do it.”

In the past five years, 68% of respondents had closed or frozen defined benefit plans, while 30% to 40% were somewhat or very likely to do so in the next two years, Mr. Barry said.

According to UBS Global Asset Management's U.S. Pension Fund Fitness Tracker, the typical corporate plan's funding ratio improved two percentage points in the quarter ended Dec. 31 to 73%, but that meant 2011 ended with a funding level an estimated 11 percentage points below the start of the year.

“The volatility last quarter was upwards, but there is no way of guessing if the next month is upward or downward,” Francois Pellerin, New York-based head of asset liability investment solutions-Americas at UBS Global Asset Management, said in a telephone interview. “It's the equivalent of going to Las Vegas and playing roulette — one month you're lucky and one month you're not.”

Fixed-income assets were flat to slightly up in the last quarter, while equity markets returned about 5%, according to UBS. Liability values increased moderately because of a fall in discount rates, increasing pension obligations by 2%.

Mr. Pellerin said corporate plans could improve their funded status by extending the duration of their investment portfolio or mitigating equity exposure by trading for long-duration fixed income or diversifying with alternatives and real estate. He also expects large contributions in 2012 to help increase funding ratios.

“Most importantly, (sponsors) should have a plan of attack,” Mr. Pellerin said. “If they believe funding ratios will bounce up and down, it will have consequences on contributions and cash balance sheets.”

Mr. Pellerin said plan sponsors are “spooked” in the current market and are showing patience in hopes that interest rates and funding ratios will increase before turning to liability-driven investing.

“I hope markets rally and interest rates go up, but I'm not sure if it will happen,” Mr. Pellerin said. “The only certainty is uncertainty. I don't see the volatility experienced in 2011 coming down much in 2012.”

In Milliman's study, the combined funded status of the 100 largest U.S. corporate defined benefit pension plans decreased $59.7 billion in December to 72.4%, from 75% at the end of November.

The plans' cumulative deficit for 2011 was $464.4 billion, the largest in the 11-year history of the Milliman 100 Pension Funding Index and more than double the $228 billion deficit at the end of 2010. December's funding ratio was the fourth-lowest month in the history of the Milliman 100; May 2003 was the lowest month, with a funding ratio of 70.5%.

The plans' cumulative investment return was 3%, or $12.3 billion, but the projected benefit obligation increase was 22.1%, resulting in an increase of $248.7 billion.

John Ehrhardt, New York-based principal, consulting actuary and co-author of the study, said funded status could be improved based on “higher-than expected” employer contributions. The study's calculations are based on 2010's record level of $60 billion in employer contributions.

“I wouldn't be surprised if (that level is) closer to $80 billion last year and close to $100 billion this year,” Mr. Ehrhardt said in a telephone interview. “The only relief is going to be positive asset performance.”

Mr. Ehrhardt said interest rates w ill remain low over the next two years. If the discount rate remains the same in 2012 and 2013 and companies achieve the expected 8% investment return, funding ratios would end this year and next at 75.9% and 79.6%, respectively.

The aggregate assets of the plans last month totaled $1.22 trillion, up from $1.212 trillion at the end of November. Pension liabilities increased by $68 billion in December to $1.685 trillion, up from $1.617 trillion at the end of November.

Legal & General Investment Management America's Pension Fiscal Fitness Monitor saw its typical corporate plan funding ratio actually rise about one percentage point in the fourth quarter, but fall about 20 percentage points for the year, “an unprecedented drop,” said Aaron Meder, Chicago-based head of U.S. pension solutions at LGIMA. That left a typical U.S. corporate pension plan with an estimated average funding ratio of 75% to 80%, taking into account unknown employer contributions and other factors. Tracking data from the last 16 years, 2008 was the only year that had a larger drop in funded status.

“We expect the uncertainty to remain across the global economy, which means continued volatility,” Mr. Meder said in a telephone interview.

Funding ratios dropped nearly 21 percentage points in the second and third quarters, the LGIMA report said. Assets modestly outperformed liabilities in the fourth quarter, but 2011 saw an increase in liabilities close to 20%. You would need huge equity returns to balance that out and the typical 60/40 split of equity and fixed income is not going to cover that, Mr. Meder said.

The biggest recommendation LGIMA takes to its clients is being “nimble and flexible” in finding the best ways to hedge liability, whether it is long-duration credit or a balance between Treasuries and credit, depending on the health of the plan, Mr. Meder said. He added that many clients started adopting LDI approaches in 2011.