Corporate pension funded status not rising despite contributions

Corporations have added $1 trillion in assets to their defined benefit pension plans in the last four years, only to see their average funded status remain essentially static and their aggregate unfunded level grow 15% to an estimated $441 billion, according to a J.P. Morgan Asset Management Inc. executive analyst.

Corporations run up against a “90% glass ceiling” trying to raise their funding level, said Karin Franceries, executive director at J.P. Morgan Asset Management in New York. Corporations face an almost insurmountable obstacle, even with a bright outlook in investment markets and further large contributions, Ms. Franceries said. The continuing low discount rate for valuing liabilities wipes out gains in assets from investments and contributions, Ms. Franceries said.

The average corporate funded status now ranges between 74% and 81%, according to Mercer LLC and J.P. Morgan data, respectively.

“To improve funded status to 85%, a plan would need growth assets to return 15%,” Ms. Franceries said.

For funded status to exceed 90%, a plan would need both a 15% increase in growth assets and a discount rate increase to 4.67% from the current rate of about 4.1%, Ms. Franceries said. The positive correlation between equity returns and corporate debt credit spreads, a key metric in determining the interest rate to discount pension liabilities, makes this scenario of both rising equity returns and interest rates unlikely, she added.

“Many sponsors are tired of the volatility that they've seen in the last several years in their plans,” said Jonathan Barry, principal with Mercer in Boston.

As a result, Ms. Franceries, Mr. Barry and others interviewed said pension sponsors will be taking more action to reduce risk in their portfolios.

“Asset returns were reasonably good in 2012 ... between 10% and 15% for most plans,” and contributions, while dampened because of funding relief enacted in 2012, are estimated to total possibly $80 billion, or about $10 billion to $20 billion more than in 2011, Mr. Barry said. Ms. Franceries estimates 2012 contributions were $70 billion.

Even so, “the combination of all those things actually ended up with an overall decline in the funded status,” because of a fall in interest rates in 2012, driving liabilities up about an average 10%, Mr. Barry said. By Mercer's calculations, the funding level fell to 74% at the end of 2012 from 75% a year earlier.

The bleak funding prospect is forcing corporate plan sponsors into stepping up derisking and risk transfer strategies, including annuitizations, such as the pension liability buyouts General Motors Co. and Verizon Telecommunications Inc. initiated in 2012, all moves that are transforming defined benefit pension plan management, consultants and managers said.

“If we look at all the 10-Ks (of companies) 10 years from now, if (corporate plan sponsors) ... or even a decent fraction does what they say they are going to do, we'll see a significant amount of liability move through risk transfers” — lump-sum distributions and annuitizations of pension liabilities — “over the next 10 years,” Mr. Barry said.

“Absolutely, it will be a much different picture 10 years from now,” with corporate plans having to a large extent reduced their pension assets and liabilities, he added.

Alison Salka, corporate vice president and director of retirement research at LIMRA, Windsor, Conn., sees annuitizations growing.

Pension plan sponsors have more understanding and feel more comfortable with annuitizations, Ms. Salka said. The move to annuitization “is part of the trend” to move to defined contribution from defined benefit plans, she said.

Pension group annuity sales, including the GM and Verizon deals, totaled $35.9 billion in 2012, according to data from LIMRA, a global association whose focus includes research and other assistance to help its member insurance and financial services companies improve their marketing. The previous year the total was only $920 million.

The capacity of insurance companies and the bond market to handle derisking strategies and annuitizations will be a challenge.

JPMAM's Ms. Franceries expects more companies to seek to do annuitizations, but notes such increasing activity could create a long-bond shortage. “Everyone is putting it (annuitizations) on their agenda; everyone is analyzing it,” she said.

“It does appear we are close to being at capacity for the time being” for annuitization, she added.

The GM and Verizon transactions that transferred $26 billion and $7.5 billion, respectively, in pension obligations to Prudential Insurance Co. of America “might have taken about ... 10% of the new issuance in long credit bonds,” if the related assets transferred were invested in a 40% allocation to fixed income, Ms. Franceries said.

That 10% “is a very large figure,” Ms. Franceries added. “If you have more companies (seeking to annuitize pension liabilities), there would be less opportunity to invest” and possibly causing insurance companies to raise rates to complete such transactions, she said.

In addition, if Russell 3000 index companies with defined benefit plans raise their long-duration credit bond allocations by two percentage points across their $1.9 trillion in pension assets, that $38 billion “would soak up another 30%” of the estimated $137 billion in new issuance of such fixed-income securities in 2013, according to a February report, “Pension Pulse,” Ms. Franceries co-authored.

But Scott Robinson, senior vice president, Moody's Investors Service Inc., New York, said, “I don't see (annuitizations) having a major disruption in the bond market.”

“In a lot of these deals (pension) assets are transferred along with the liability,” Mr. Robinson said. “So (insurance companies) aren't necessarily buying a new bond,” although they might make some change in the transferred allocation.