Falling interest rates cause further damage to the pension world s $20 billion club in 2012

Transcription

1 Falling interest rates cause further damage to the pension world s $2 billion club in 212 Liabilities once again grow faster than assets FEBRUARY 213 Bob Collie, FIA Chief Research Strategist Two years ago, we introduced the $2 billion club, made up of the U.S.-listed corporations that have worldwide pension liabilities in excess of $2 billion. 1 These corporations represent roughly 4% of the pension assets and liabilities of all U.S.-listed corporations, and give a window into the condition of the wider corporate pension plan universe. Despite strong asset performance, the funded status of these plans deteriorated in 212: the combined net pension shortfall rising from $182 billion to $22 billion. There were 19 U.S.-listed corporations whose 211 SEC filings revealed worldwide pension liabilities in excess of $2 billion. Their combined liabilities in 211 were roughly $86 billion, and all bar one of these corporations started 212 with a shortfall of assets below liabilities. Four filings on February 28, 213 completed the set for 212. Although most of these reports show an increase in the value of pension assets, liabilities went up even faster; 17 out of the 19 corporations saw shortfalls increase over the year, with the combined net shortfall rising from $182 billion to $22 billion. The biggest positives were strong performance from asset portfolios and contributions by the 19 plan sponsors totaling some $28 billion. These positives were more than outweighed by a reduction in interest rates, which caused a large jump in the value placed on liabilities. Exhibit 1 summarizes the development of assets and liabilities in 212. Exhibit 1: How the combined worldwide pension assets and liabilities of the $2 billion club developed in 212 Liabilities Liability (Projected Benefit Obligation) at Start of Year Accrual of new benefits (Service Cost) Benefits paid Interest payable on liability (Interest Cost) Impact of change in interest rates and in actuarial assumptions (Actuarial loss) Liability (Projected Benefit Obligation) at End of Year Collie (211). Russell Investments // Falling interest rates cause further damage to the pension world s $2 billion club in 212

2 Assets Assets (Fair Value) at Start of Year Employer contributions Benefits paid Investment return on plan assets Assets (Fair Value) at End of Year Surplus (Deficit) Excess (Shortfall) of assets below liabilities at Start of Year Excess of employer contributions over service cost Investment return less interest cost and actuarial loss Excess (Shortfall) of assets below liabilities at End of Year Source: Corporate 1-K Filings, Russell Investments * Miscellaneous other includes a combined reduction of roughly $4 billion in both assets and liabilities, at GM, Ford, and Verizon Communications, as a result of the settlement of retiree liabilities through the payment of lump sums and the purchase of annuity contracts. See Collie (212b). So, once again, the gap between assets and liabilities has failed to narrow. The single biggest factor contributing to this result was the reduction in the discount rates used to value liabilities. Whereas the discount rates used a year ago for U.S plans ranged from 4.15% to 5.64%, the rates used this year ranged from 3.59% to 4.42%, with the median discount rate falling by 89 basis points. This 89 basis point fall is larger than the fall in the yield on high-quality corporate bonds in general (those yields fell by -6 basis points). That is because many actuaries calculate discount rates based not on the characteristics of the whole set of qualifying bonds, but on the highest-yielding subset. 2 This allows them to place a lower value on liabilities. In 212, that subset of bonds saw a bigger drop in yields than high-quality bonds in general did. This difference technical though it is means that what otherwise might have been a reasonably flat year has turned out to be a bad one. Meanwhile, plan sponsor contributions exceeded the accrual of new benefits by some $14 billion; MAP-21 3 does not appear to have had a big impact on contributions in 212 in most cases, with only one club member choosing to significantly change their plans and most others electing to make discretionary contributions in excess of the MAP-21- mandated minimum. 4 However, as we highlighted a year ago 5, it will take a long time for contributions alone to seriously dent the $2bn shortfall if they remain at their current levels. If a significant increase in contributions is to be avoided, then help is needed from the markets. 2 While the actuary performs the calculation, responsibility for the choice of discount rate rests with the corporation. 3 MAP-21: Moving Ahead for Progress in the 21st Century Act 4 Tax considerations and the increase in the PBGC variable rate premium create incentives to maintain a strong funding policy, notwithstanding the flexibility given by MAP-21 to defer contributions. See Harvey (213) for more details. 5 Collie (212). Russell Investments // Falling interest rates cause further damage to the pension world s $2 billion club in 212 / p 2

3 A longer look at history A look back over the past eight years 6 tells us a great deal about what exactly it is that causes the overall picture to improve or deteriorate, and just how important the discount rate is. Exhibits 2, 3 and 4 show the breakdown of the change in value of (respectively) the liabilities, assets and net surplus of the 19 club members. Exhibit 2: A breakdown of the change in the value of the liabilities of the $2 billion club, Interest cost Actuarial losses/(gains) Benefit accruals Benefit payments and other flows value of liabilities Exhibit 3: breakdown of the change in the value of the assets of the $2 billion club, Investment return earned Contributions Benefits paid & by plan sponsor other flows value of assets This takes us back to the adoption of Statement of Financial Accounting Standard no Earlier data is not marked to market and hence not comparable. Russell Investments // Falling interest rates cause further damage to the pension world s $2 billion club in 212 / p 3

4 Exhibit 4: breakdown of the change in the value of the net pension surplus of the $2 billion club, Investment return net of interest cost and gains/losses Contributions less benefit accruals Net other effects value of surplus Looking first at the liabilities, the main source of variation in the year-to-year results is the actuarial gain/loss, which is mainly the result of changes in interest rates. Variations in benefit payments and other flows are mainly due to settlements, mergers, acquisitions or divestitures and tend to be balanced by similar variation on the asset side. Benefit accruals and interest cost change relatively little each year. On the asset side, we note an increase in contributions in recent years, but this increase is dwarfed by the year-to-year variation in the asset return. The asset return should ideally cover the interest cost plus the effect of actuarial gains or losses (a perfectly matched investment strategy would lead to these components of the assets and liabilities moving in lockstep). 7 So the net position, shown in exhibit 4, reveals just how important both the asset experience and the effect of changes in interest rates have been. The big losses of 28 have not been recovered despite subsequent strong asset performance: 29 and 21 were essentially flat on a net basis, while 211 and 212 have both seen the shortfall widen. Membership of the $2 billion club The sixteen corporations who made up the original $2 billion club are: AT&T General Electric Northrop Grumman Boeing General Motors Pfizer Dow Chemical Hewlett-Packard United Parcel Service E.I. DuPont de Nemours IBM United Technologies Exxon Mobil Lockheed Martin Verizon Communications Ford 7 See Owens (212) for a discussion of the steps taken so far by these corporations to tie their asset strategies closer to the liabilities. Russell Investments // Falling interest rates cause further damage to the pension world s $2 billion club in 212 / p 4

5 Last year, we added three corporations whose liabilities crossed the $2 billion threshold during the course of 211: Bank of America Honeywell Raytheon In 212, at least five other U.S. listed corporations saw their worldwide pension liability pass the $2 billion mark (Federal Express, Johnson & Johnson, 3M, Caterpillar, and Delta Air Lines.) While adding these corporations to the club would widen representation (and would satisfy those who like the rules of admittance to a club to be clear and consistent), we have opted instead for stability this year, and decided not to make any changes to the club s membership at this time. We will revisit this question again next year. REFERENCES: Collie, R. (211). Sharp increase in both assets and liabilities for the pension world's $2 billion club. Russell Investments Collie, R. (212). Shortfalls increase for the pension world's $2 billion club; cash contributions on the rise. Russell Investments Collie, R. (212). A busy year so far for the $2 billion club. Russell Investments Harvey, J. (213). To fund now or to fund later? That is the question. Russell Practice Note Owens, J. (212). Large U.S. corporations begin to favor LDI strategies. Russell Practice Note. For more information: Call Russell at or visit Important information Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional. These views are subject to change at any time based upon market or other conditions and are current as of the date at the beginning of the document. The opinions expressed in this material are not necessarily those held by Russell Investments, its affiliates or subsidiaries. While all material is deemed to be reliable, accuracy and completeness cannot be guaranteed. The information, analysis and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Russell Investment Group, a Washington USA corporation, operates through subsidiaries worldwide, including Russell Investments, and is a subsidiary of The Northwestern Mutual Life Insurance Company. The Russell logo is a trademark and service mark of Russell Investments. Copyright Russell Investments 213. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty. First used: February 213 USI Russell Investments // Falling interest rates cause further damage to the pension world s $2 billion club in 212 / p 5