With estimated defined-benefit pension plan deficits for Standard & Poor’s 1500 companies hitting a record of $409 billion for 2008, companies are likely to find themselves with added constraints on capital spending, loan covenants, and other potential outlays this year, pension advisers report.
Indeed, the overall pension expense of the 772 corporations in the S&P index that sponsor traditional plans is likely to increase from $10 billion in 2008 to $70 billion in 2009, according to projections released by Mercer, a big pension-consulting firm.
While aggregate 2008 year-end net-income figures for the companies aren’t yet available, in 2007, the last full calendar year for which data is complete, the S&P 1500 recorded a cumulative $727 billion profit, Adrian Hartshorn, a Mercer retirement plan consultant, noted at a press briefing on Wednesday. Thus, the $60 million hike in pension expenses the firm is estimating for 2009 represents 8 per cent of the profits the companies reported two years earlier. “So it is a fairly substantial number,” he said, noting that “the deficit will be shown on company balance sheets.”
With the stock market tanking, companies will be hard pressed to simply invest themselves out of their pension deficits–meaning that hefty cash contributions will be required. While the deficit number “has been bouncing around during the year,” Hartshorn, said, “what’s important now is that this figure will be capitalized, because about two-thirds of the companies had their financial year-end on Dec. 31.”
To be sure, much of the deficit stems from a familiar cause: the awful performance of the equities most defined-benefit plans are heavily invested in. That performance can be blamed for the huge swing Mercer calculated in the funded status (assets minus liabilities) of the plans over 2008 from 104 percent to 75 percent, or from a surplus of $60 billion to a deficit of $409 billion. For the year, the S&P 500 index was down almost 40 percent.
Not as well understood, however, is the impact that the performance of the bond market has had on pension liabilities, Hartshorn pointed out. To determine the value of a plan’s liabilities, pension experts apply a discount rate based on the yield of AA-rated corporate bonds. Thus, the higher the yield is on such high-quality bonds, the lower will be the value placed on the liabilities.
During 2008, the yield started off at around 6.4 percent, rose to about 8.5 percent by the end of October, and then finished the year at 6.3 percent, according to Hartshorn. The many corporate plan sponsors with Dec. 31 year-ends will thus have to lock in the highest amounts of liability reached for the year. (The yields are based on Mercer’s yield curve, for which the company looks at a portfolio of bonds and calculates their yield over an 11-year duration.)
Having incurred such whopping losses over 2008, companies will have to revamp their funding strategies to restore their plans to fully funded status, Mercer consultants said. A big part of that may involve retooling the balance between the two ways of funding the plans: investments and cash contributions. That allocation “will need to be revisited,” Hartshorn said, “because the deficits come at a time when there are needs for other competing resources within the business.”
Such shifts are likely to involve changes in corporate risk tolerance and a move from stocks to long-duration bonds and other more conservative investments, according to David A. Kelly, another Mercer consultant, who noted that current high-yields on long-term bonds mean that plan sponsors will be able to buy them at lower prices.
Kelly was asked by a reporter, however, if such a move to long bonds wouldn’t lock companies into their current pension shortfalls. “Certainly, if you make a move to a more conservative investment strategy, especially one in which you move in lockstep with your liabilities, you’re giving up the opportunity for excess return,” he replied.
Before the current downturn, companies were happy to live with an investment policy in which there was a fairly high risk that the assets might not match the plan’s benefit liabilities “because it could provide that excess return that would subsidize the cost of benefits,” he went on.
Now, however, investors are balking at any volatility they see in corporate financial statements, Kelly said. Because of that, companies have become more prone to bring their investment strategies into closer alignment with plan liabilities, he added.