A Return to Better Funding for Pensions in 2006

Pension plan funding has been up and down during the last six years. In many firms, formerly fully funded defined benefit plans became significantly underfunded early in the decade, as the stock market plummeted and falling interest rates pushed up present-value measures of liabilities. These trends are cyclical and, fortunately, the trend for 2006 is up. To track the latest developments, Watson Wyatt projected 2006 year-end aggregate financial status for firms that have made the FORTUNE 1000 list during the last six years.¹

Watson Wyatt has been tracking plan funding levels for several years. Between 2002 and 2005, aggregate funding status for large pension plans increased from 82 percent to 92 percent.² For 2006, pension funding at these companies will continue to improve, reaching a projected aggregate funding level of roughly 100 percent for the first time since 2001 (Figure 1).³

Figure 1 | FORTUNE 1000 Companies' Pension Assets Versus Liabilities and Aggregate Funding Status, 2000 - Projected 2006

Source: Watson Wyatt Worldwide

Higher funding levels are mostly a result of higher discount rates coupled with a year of strong market returns. After four years of widespread underfunding, these advantageous financial conditions combined with ample plan contributions have restored many plans to full funding.

Table 1 depicts projected aggregate funding ratios and funding components for fiscal year 2006.

Table 1 | Projected Changes in Pension Benefit Obligations and Assets During 2006 for FORTUNE 1000 Sponsors ($ billions)

Source: Watson Wyatt Worldwide

Lower Pension Liabilities

As shown in Table 1, aggregate pension liabilities are projected to decrease 1 percent during 2006 - from $1,313 billion to $1,297 billion. This decrease is mostly due to higher discount rates - the first year-over-year increase since 2000 (see Figure 2). Variations in the discount rate significantly affect plan liabilities. Liabilities move in the opposite direction of interest rates and a 20-basis-point change in rates can move liabilities by roughly 3 percent (assuming a typical plan with a 15-year duration.)

Figure 2 | Discount Rates, 2000 - 2006

* The projected discount rate is based on results from Watson Wyatt's Real Time FAS Assumption Survey for December 2006.

Source: Watson Wyatt Worldwide

We projected service cost - the actuarial present value of pension benefits earned by employees during the period - by examining the rate of increase for the sample of firms in the FORTUNE 1000 during the last six years.

We measured interest cost by multiplying the beginning of the year discount rate of 5.60 percent by the projected benefit obligation (PBO) for the same period, adjusted for current-year expected benefit payments.

For the first time in several years, many firms are reporting actuarial gains on their balance sheets. To calculate the actuarial gain on the liabilities, we applied a 20-basis-point increase in the discount rate. We assumed an average duration of 15 years for liabilities. To derive the value of benefits paid out to employees for 2006, we used expected benefit payments over the next plan year from SEC 10-K pension footnotes.

Rising Plan Assets

For 2006, we project a 7 percent increase in pension plan assets. Increases in plan assets generally come from two sources: returns on plan assets and employer contributions. These are offset by benefit payments and expenses. During the last six years, when asset returns were high, employer contributions were correspondingly lower. When the markets underperformed, funding ratios dropped significantly, which required most employers to contribute significantly more to their plans.

Because we expect sponsors to contribute to their plans at roughly the same rate in 2006 as they did in 2005, we multiplied sponsors・projected service cost by last year's contribution-to-service-cost ratio, calculating aggregate pension contributions for 2006 of $50 billion. Our analysis focused on a six-year history of employer contributions and service cost (see Table 2). In years of strong market performance, firms contributed roughly 50 percent of their service costs. But when funding ratios dipped, sponsors upped their contributions by as much as five times.

Table 2 | Ratio of Employer Contributions to Service Cost by Year

Source: Watson Wyatt Worldwide

Expected contributions from the 2005 pension footnotes for these firms show only $27 billion in contributions for 2006, since most firms project their minimum required contributions for the coming year. Clearly, this value is significantly lower than our projected value of $50 billion. However, even substituting this lower value would only decrease the aggregate funding ratio for these sponsors by two percentage points - from 100 percent to 98 percent - still close to full funding.

For 2006, we project a 10 percent rate of return on plan assets. Investment returns have declined for the FORTUNE 1000 defined benefit plan sponsors during the last several years, from 20.7 percent in 2003, to 12.2 percent in 2004, all the way down to (a still healthy) 9 percent in 2005. We based our prediction for 2006 on one year of returns from equity and bond markets, using the S&P 500 Index for stocks and the Lehman Long A Credit Index for bonds. To derive the equity/bond split, we examined the aggregate dollar amount invested in equities from last year's disclosures and arrived at a 62/38 equity/bond split. For 2006, our equity calculations yielded a 13.62 percent return, while the bond return was 3.95 percent. This estimate could be considered conservative, since some pension plans will beat the equity and bond indices.

A Brighter Funding Future

For the first time in five years, aggregate pension funding has caught up to liabilities, thanks to fortuitous market conditions and responsible management by plan sponsors.

Now that pension funding has regained lost ground, plan sponsors might also consider adopting new investment policies, such as liability-driven investment strategies to help lock in current funding levels. Such strategies utilize bond and derivative markets, which would help firms better hedge against their long-term pension liabilities.

The new funding requirements mandated by the Pension Protection Act of 2006 (PPA) should keep future plan funding stable. The PPA also allows sponsors to build up an extra cushion of contributions. Thus, those that want to can build up some reserves and reduce the volatility of future required contributions ・which was a factor in some earlier funding shortfalls.

¹ Our analysis included the 426 firms that have been in the FORTUNE 1000 for the last six years. In 2005, 627 pension sponsors were in the FORTUNE 1000, so the analysis focuses on a subset of the total universe of FORTUNE 1000 sponsors.

² Funding status is the ratio of the market value of assets to the projected benefit obligation.

³ Many of the pension liability values in the 10-K disclosures incorporate nonqualified plans, which are typically not funded, suggesting that the aggregate funding ratio for qualified plans is actually higher than 100 percent for these firms.

Watson Wyatt - INSIDER - January 2007