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Pension Sponsors Grapple with the Fallout of a Three-Year Bear Market

The bear market that enveloped Wall Street from 2000 to 2002 dramatically worsened the funding outlook for defined benefit pension plans, and the gains posted by the stock market this year have not been sufficient to reverse the damage. Many plans that entered the new millennium comfortably over-funded are now under-funded, just as the baby boomer generation approaches retirement age and pension payouts promise to increase. That leaves plan sponsors with a real challenge as they seek to ensure their pension assets grow fast enough to keep pace with their swelling liabilities.

The outlook is not pretty. "We do not see the assets keeping up," says Karen McQuiston, Head of JPMorgan Fleming Asset Management's Strategic Investment Advisory Group. "There is a dramatic shortfall." McQuiston told attendees at the SVIA's 2003 National Forum that the greatest corporate pension funding shortfalls can be found among the 200 largest plans. In 1997, the median plan in that group was 112 percent funded; in 2002, she estimates, it was 80 percent funded.

McQuiston says that while most ongoing defined benefit plans will see their liabilities grow by 8.5 percent to 11 percent, before benefit payouts, in a neutral rate environment, a passively managed diversified portfolio of stocks and bonds might be expected to earn long-term returns of only about 7.3 percent to 7.5 percent. To counter this disparity, she indicated, sponsors will have to depend to some extent on active management of their investment portfolios to outpace passive returns. Where that does not work, or where conservative plans are not willing to try to outsmart the market, sponsors will have to resign themselves to making additional contributions to their plans. The size of those contributions will depend, of course, on the current funded status of the plan. A plan that is 100 percent funded, has liabilities growing at a ten percent pace, and manages to squeeze 8.5 percent investment returns from the financial markets, would have a 150-basis-point difference to make up with contributions if it wanted to keep asset growth in line with liability growth. A similar plan that is only 80 percent funded right now would have to grow its assets 16 percent a year, leaving it with a 750-basis-point shortfall to make up with contributions.

Depending upon their tolerance for risk, different plan sponsors may legitimately choose different ways to attack their funding problems. Some can be expected to take a more aggressive investment stance in an effort to make up their funding shortfalls through market gains, McQuiston said, while others will take a more conservative stance and resign themselves to higher contribution levels. "There are a lot of ways to think about this, which is why not all plans are invested the same way," she concluded.

To get by with lower contribution levels over time, some plan sponsors might lower their benefit accruals, McQuiston added. That is, they might offer less generous benefits. In addition, they could stretch out the time they give themselves to meet their funding goals. On the other hand, cosmetic changes plans might consider-such as reducing expected inflation adjustments and future salary increases in liability calculations-would only paper over the real promise those plans have made to participants. In other words, they would not actually reduce the benefits due at some later date.

There are measures afoot in Washington to ease the pension funding crisis. For example, federal lawmakers have introduced proposals to increase the discount rate plan sponsors must use to calculate the present value of their future pension liabilities. Current law requires they use a rate linked to the 30-year Treasury bond rate, even though the Treasury stopped issuing 30-year bonds years ago and the interest now paid on those bonds has fallen to levels substantially and consistently below those for other conservative long-term bonds. Some proposals that have been floated in Washington could reduce the typical pension liability by ten percent, McQuiston said.

Here again, though, the changes would be somewhat cosmetic, as raising the discount rate would not actually reduce the amount plan sponsors must pay to pension plan participants in the future, but merely delay the timing of when those benefits must be funded. As a consequence, McQuiston said, many plan sponsors are planning to make contributions to their plans, regardless of what happens in Washington.

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