Friday, January 6, 2012

Will Job Gains Help Pensions' Funding?

As I expected, the December jobs report smashed expectations, confirming yesterday's strong ADP report. With 200,000 new jobs added, including 23,000 factory jobs, the unemployment rate fell to 8.5%. Importantly, gains in transportation, warehousing, retail, and construction were all encouraging, as was the increase in average hours worked.

But while the labor market is on the mend, pension funding is deteriorating across the globe. Janet McFarland of the Globe and Mail reports, Pension plans’ funding plummets:

Canadian pension plans saw their funding plummet in the first nine months of 2011 but the bleeding was stanched in the final quarter of the year.

Surveys by two pension consulting firms – both tracking hypothetical pension plans with typical investments – show pension funding fell by almost 15 percentage points throughout 2011, leaving plans facing a severe financing shortfall.

Towers Watson said its pension index fell to 72 per cent by the end of December from 86 per cent at the beginning of 2011, while Mercer said its index dropped to 60 per cent from 73 per cent at the start of the year. The index measures the proportion of assets held by the pension plan compared with its estimated pension liability.

Paul Forestell, senior partner at Mercer, said the only good news is that pension health remained flat in the fourth quarter as stock markets posted modest gains.

“I think that’s the best you can say this year – it’s the only quarter that didn’t do any damage,” he said.

Canada’s benchmark S&P/TSX composite index fell 11 per cent in 2011, posting a decline of 13.5 per cent in the first nine months but recording a gain of 2.8 per cent in the final quarter.

Towers Watson said its model pension plan – with a typical asset mix of 60 per cent stocks and 40 per cent bonds – earned a meagre 0.5 per cent rate of return on its assets in 2011. But its financing was eroded by a 20-per-cent increase in the liability to pay pensions to members.

That’s because pension liabilities are calculated based on long-term bond yields, which fell in 2011, driving funding costs far higher.

Both surveys look at the impact on pension plan health based solely on changes in interest rates and investment performance during the year. Real pension plans may have a different funded status because companies often add extra cash to their plans to make up shortfalls.

Nevertheless, the impact of the market turmoil means companies are facing sharply higher pension costs and growing obligations to put extra cash into their traditional defined-benefit (DB) pension plans, which pay a guaranteed level of income in retirement.

“DB plan sponsors will continue to feel the impact of the double whammy we experienced in 2011 – a combination of declining long-term interest rates and poor equity-market performance,” Towers Watson pension consultant Ian Markham said.

“For many organizations, these conditions have resulted in larger plan deficits at the end of 2011 and will lead to higher pension costs in 2012 and beyond.”

Many large companies announced plans to add extra cash to their pension plans in 2011 or to reorganize their plans to lower liabilities. Royal Bank of Canada, for example, said it will no longer allow new hires to join its traditional DB pension plan as of Jan. 1, while Air Canada faced labour turmoil in June over its plans to close its DB plans to new hires.

Canadian Pacific Railway Ltd. said in November it will borrow $500-million to inject more cash into its pension plan – the third such lump sum payment in three years. Phone giant BCE Inc. said it would make an extra $750-million payment to its pension plan in December.

“There was a fair bit of press in December around companies making special contributions … and they were big amounts,” Mr. Forestell said.

“I think what they were doing is anticipating the results that we’re seeing here. So it will be a cash drain again this year.”

According to according to Towers Watson, the deteriorating health of Canadian pensions in 2011 is likely to convince more employers to shift burdens to employees this year and force an increase in retirement ages.

Funding woes are also impacting US corporations where the funded status of pension plans fell for second year:

For the second consecutive year, the funded status of pension plans sponsored by large employers has dropped, according to an analysis released Wednesday.

On average, pension plans sponsored by companies in the S&P 1500 were 75% funded at year-end 2011, according to Mercer L.L.C. of New York. That's down from year-end 2010, when plans were an average of 81% funded; and year-end 2009, when plans on average were 84% funded.

In the aggregate, the plans' funding deficit hit $484 billion as of Dec. 31, 2011, up from $315 billion a year earlier and $229 billion as of Dec. 31, 2009.

Decline in interest rates

The drop in plans' funding status was largely fueled by the decline in interest rates, which drove up the value of plan liabilities, Mercer executives say.

“With U.S. and non-U.S. equity indices underperforming expectations and interest rates on high-quality corporate bonds declining upwards of 100 basis points, driving discount rates down and plan liabilities up significantly, we saw a marked decline in funded status,” Jonathan Barry, a partner with Mercer's Retirement Risk and Finance Group in Boston, said in a statement.

The damage to plans' funding levels would have been even greater had it not been for the roughly $50 billion in contributions employers disclosed that they expected to make to their plans in 2011.

“Many plan sponsors are merely treading water, or even moving backward on funded status, despite significant cash contributions to their plans,” Mr. Barry said.

Volatile year

And for 2012, the deterioration in plan funding will mean big increases in how much they are required to contribute to their plans, Mercer said.

While plans' funded status slumped in 2011, funding levels were extraordinarily volatile during the year. The aggregate funded status peaked at about 88% at the end of April, only to fall to 71% at the end of September, which was the biggest month-end deficit since Mercer began to track such information.

The Mercer study is based on the 721 companies in the S&P 1500 that sponsor defined benefit plans with enough data for analysis.

And in the UK, pension fund returns saw the first dip since 2008, and according to Mercer, pension deficits up by nearly a third in 2011:

Pension scheme accounting deficits were £84bn at the end of December 2011 compared to £64bn at December 31st 2010, representing a 3% fall in funding levels over the year from 88% to 85%. Funding levels also deteriorated through December, despite an increase in asset values.

Mercer’s latest Pensions Risk Survey data shows that the accounting deficit of defined benefit (DB) pension schemes in the UK has increased for the second consecutive month. According to Mercer’s latest data, the aggregate FTSE350 IAS19 defined benefit pension deficit, adjusted for market conditions, stood at £84bn at the end of 2011. The total is equivalent to a funding ratio of 85%. This compares to an £80bn deficit (and a funding ratio of 86%) at the end of November 2011, describing a worsening over the month. The change is most evident however, compared with a funding ratio at 88% corresponding to an aggregate deficit of £64bn at the end of 2010.

Mercer estimates the aggregate combined funded ratio of plans operated by FTSE350 companies on a monthly basis. This is based on projections of their reported financial statements adjusted from each company’s financial year end to December 31st in line with financial indices. This includes UK domestic funded and unfunded plans and all non-domestic plans. The estimated aggregate value of pension plan assets of the FTSE350 companies at December 31st 2010 was £463bn, compared with estimated aggregate liabilities of £527bn.

Allowing for changes in financial markets through to the end of December 2011, changes to the FTSE350 constituents, and newly released financial disclosures, the estimated aggregate assets were £478bn, compared with the estimated value of the aggregate liabilities of £562bn.

According to Adrian Hartshorn, partner in Mercer’s Financial Strategy Group, “2011 was a defining year with a clear bifurcation taking place amongst schemes. Companies and trustees that have taken action to hedge liability risks have seen their deficits hold steady or increase only moderately. However, companies or trustees who have not hedged liability risks have been more adversely affected.

Looking forward into 2012, managing liability risk will continue to be an important focus for many organisations and we expect to see the implementation of both traditional and non-traditional risk management strategies including interest rate and inflation hedging, longevity hedging, liability management exercises or the use of non-cash funding options to smooth cash contribution requirements.”

Corporate bond yields, which are used to discount liabilities, fell again over December 2011 increasing liability values. The effect of this was partly offset by a small reduction in long-term inflation expectations. The net effect was to increase liability values by approximately 2% over the month to £562bn by year end. Over the same period, asset values increased from £473bn to £478bn, says Mercer.

“At the start of 2011 the yield on sterling AA rated corporate bonds was nearly 1% per annum higher than the corresponding Eurobonds, whereas at the year-end the yields were virtually identical. As the European sovereign debt crisis intensified in the autumn, UK government bonds became a relative safe haven. It looks like this back-handed compliment has now extended to UK corporates as well over the last couple of months. The flip side of this is that it has increased the notional cost of the debt owed to their own DB pension schemes and means that 2011 ends on a bleak note despite asset values showing an increase over the year, and long term inflation expectations being much lower now than they were at the start of the year," explains Ali Tayyebi, senior partner and pension risk group leader at Mercer.

Some UK corporations are already taking action. Shell announced it will close its final salary pension scheme to new employees from 2013, heralding the end of an era as it was the last of the FTSE 100 companies to offer the scheme to employees.

So what is the bottom line on pensions' funding? While pensions didn't get clobbered in 2011 on assets, their funded status deteriorated because real rates plunged in 2011. The volatility in 2011 didn't help, but with job growths coming back in the US economy, expects bond yields to creep up and stock markets to keep grinding higher.

In other words, funded status should improve in 2012 but it won't be enough to make a material difference in the long-term structural trend. Pensions are in trouble and unless we address this problem on all fronts, we are only delaying the inevitable.

Below, a CNBC interview with Steve Leblanc of the Teachers Retirement System of Texas (TRS), discussing the success of their pension portfolio. It was the top performing fund in the US over the last year. Listen to his comments on anticipating investment opportunities and their strategic partnership with Apollo.

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