Human Capital & Careers

Pension Plan Quality Is Withering

A Mercer study finds that deterioriation in the ratio of assets to liabilities has quickly produced an underfunding of plans.
Stephen TaubOctober 7, 2008

A new study finds that the ratio of pension plan assets to liabilities has moved from overfunded to underfunded.

According to an analysis by Mercer, the overall plan ratio was 104 percent at the end of 2007, but fell to 97 percent at the end of the third quarter. As a result, the $60 billion surplus at the end of 2007 has turned into a deficit of $35 billion.

However, during the third quarter, despite the falls in global equity markets, the financial position improved, due to the increase in “high-quality” corporate bond yields, according by Mercer.

Mercer’s study analyzes the pension plans operated by S&P 1500 companies.

On Monday, we reported that a separate Merrill Lynch study found that the average funded status of pension plans for U.S.-based S&P-500 companies fell to 92 percent from 99 percent at the beginning of the year.

The Mercer study had a slightly different thrust. It found that without a significant increase in high-quality corporate bond yields, which most companies use to measure the value of plan liabilities, the financial position would be significantly worse. Further, were credit spreads to return to levels typically observed over the last three to four years, without a recovery in equity values, the deficit would exceed $400 billion.

How does Mercer figure this? “It is important to understand the relationship between corporate bond yields and pension plan liabilities,” said Adrian Hartshorn, a member of Mercer’s Financial Strategy Group. “Pension plan liabilities are a promise of payments in the future, and are therefore similar to bonds, albeit with a more complex structure. Also, like all bonds, an increase in the discount rate — in this case the yield on corporate bonds–reduces the present value of pension plan liabilities.”

Hartshorn explained that although there has been a significant reduction in the funded status of pension plans over the year — from 104 percent to 97 percent — had there not been an increase in credit spreads the position would be worse.

He noted that between 2003 and 2007, credit spreads between AA corporate bonds and U.S. Treasuries were typically 1 percent to 1½ percent, but at the end of September they stood at over 3.3 percent. If markets settle and credit spreads contract to previous levels without a recovery in the equity markets and without any other external events, the funded status of pension plans would fall to 77 percent, equivalent to a deficit of over $400 billion. “This would clearly be bad news for sponsors of defined benefit plans, and would lead to higher pension costs in financial statements and higher cash contribution requirements,” Hartshorn added.

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