Free Special Resources
Get Your FREE
Special Report. Download Any One Of These FREE
Special Resources, Instantly!
Featured Special Report
Claim Your Free
Cost Per Hire Calculator
This handy calculator lets you plug in your expenses for recruiting, benefits, salaries, and more.
Graphs automatically generate to show you your annual cost per hire and a breakdown of where you are spending the most money.
February 21, 2002
Pension Plans Hit by Combination of Events
"We know what drove these results," said Bill Gulliver, chief actuary for the firm. "This was caused by large drops in equity markets from their spring 2000 peaks, along with a fall in the key Moody's Aa bond yield from 7.9 percent at year-end 1999 to 7.1 percent two years later."
The most recent two-year period follows four exceptional years over which portfolio returns for the benchmark portfolio averaged 15.7 percent, while the Moody's Aa yield increased from 6.9 percent to 7.9 percent.
Plan sponsors who received the benefit of this performance typically remain well ahead of their starting points at year-end 1995. For example, the Towers Perrin benchmark plan was 85 percent funded for PBO (projected benefit obligation) six years ago versus 100 percent today.
"This review of history indicates that the 2000 to 2001 experience may reflect a unique combination of conditions and events that are perhaps unlikely to recur," said Gulliver.
A Towers Perrin report entitled "Capital Market Update: Review of Year 2001 Results for Pension Plans," analyzes portfolio return, pension liability changes and their combined impact on the funded status of a benchmark plan established by Towers Perrin.
It tracks the asset and liability performance of a model benchmark pension plan with an investment portfolio comprised of 60 percent equity and 40 percent fixed income. This diversified asset allocation approximates the average portfolio for the 280 large companies included in the Towers Perrin Retirement Financial Management Benchmarking Database.
The Towers Perrin benchmark plan's portfolio reported a -3.6 percent return for 2001, following a -0.3 percent return for the prior year. A more conservative 40 percent equity portfolio reported positive performance for 2001 at 0.2 percent, while a more aggressive 80 percent equity portfolio reported a -7.5 percent return.
Since 1990, Towers Perrin has tracked monthly changes in its benchmark plan's funded ratio. Similar to bond values, liability values move in the opposite direction of interest rates. The PBO liability index reported an 11.4 percent increase for 2001, reflecting the combined effects of interest accumulation and the drop in the discount rate. The combination of unfavorable asset and liability performance reduced the PBO funded ratio for the benchmark plan by 15 percentage points during 2001, dropping from 115 percent at the start of the year to 100 percent at its finish. At year-end 1999, the benchmark plan had achieved a 131 percent PBO-funded ratio.
The most recent 30-year period (1972 to 2001) is especially relevant for evaluating pension plan financial performance, since the rate of pension plan funding accelerated with the passage of ERISA (Employee Retirement Income Security Act) in 1974, and pension accounting was modernized with the promulgation of FAS 87 (accounting standard for pension plans) in 1985. With these two landmarks, pension plan sponsors were required to advance fund their plans and to set accounting costs in light of current capital market conditions.
The analysis of this most recent 30-year period is significant because it shows that:
- The benchmark portfolio (60 percent equity/40 percent fixed income) Towers Perrin tracks shows a two-year return of -3.9 percent. There was only one other period - 1973 to 1974, which experienced a -21.6 percent return - where returns on this portfolio were lower over two consecutive calendar years.
- The period 2000 to 2001 is a significant "outlier" in that there is no other two-year period where plan sponsors experienced a similar combination of negative investment return and declining interest rates.
- Interest rates increased during each of the four prior periods with the most unfavorable two-year investment returns, thus acting as a buffer to protect plan funded ratios.
- Declining interest rates, rather than unfavorable investment returns, typically drove prior periods of adverse asset/liability experience. There were declining interest rates in six of the worst seven financial periods for the benchmark plan, while only two periods show negative investment returns.
"With few exceptions, global equity returns disappointed during 2001, while lower interest rates resulted in higher pension plan liabilities," said Gulliver. "But recent years' results have to be taken in the context of earlier years, when strong returns in capital markets helped boost plan funded levels and enhanced the overall security of company-sponsored plans."
Implications for plan sponsors
For the typical plan sponsor, the implications of recent capital market events and the resulting decline in plan funded ratios will include increasing pension expense and the return of required contributions, with the full effects in many cases spread over the next few years. Some companies may also see large additional liabilities charged to their balance sheets.
Results for individual company plans, however, may vary significantly, depending on such factors as:
- Initial funded position of the plan.
- Interest sensitivity of benefit obligations.
- Asset allocation and manager performance.
- Use of long-duration fixed income strategies.
- Offsetting effects of other actuarial assumption changes.
- Use of asset smoothing approaches that defer asset gains from prior years.
In some cases, companies have employed risk management and smoothing strategies that enable them to weather the current storm with reduced impact to their P&L and to cash flow.
What companies should do
Plan sponsors should rethink their financial strategies and review performance in light of recent capital market events. Specifically, they will want to:
- Update their expectations for 2002 pension expense and cash flow requirements, and determine the potential for additional balance sheet charges
- Review the selection of financial assumptions used in valuing the plan, given recent experience and the current financial outlook, along with other assumptions such as salary increases and demographic assumptions
- Review pension plan asset allocations to ensure that they are consistent with plan liability profiles and business objectives
- Analyze year 2001 investment results and assess performance in light of objectives and benchmark comparisons.
"Many plan sponsors routinely use dynamic modeling of future economic conditions and stress testing to evaluate the effectiveness of their funding, accounting and investment strategies," said Gulliver. "The capital market results of the last two years should serve as a wake-up call for those who don't. We believe that plan sponsors should assess funded levels, expense and contributions under a broad range of future economic conditions as they reset these strategies this year."
Participate in this week's HR.BLR.com poll and discussion!
typical pension plan saw a funded ratio decline of more than 20 percent over the past two years, according to consulting firm Towers Perrin.