Pension plan deficit hits record $409 billion for S&P 1500 companies; pension expense may rise to $70 billion in 2009, a significant drain on corporate earnings

The chaos that has been observed in the world’s financial markets over the last 12 months has had a major adverse impact on pension plan funding and will negatively impact corporate earnings in 2009, according to the latest estimates by Mercer. According to Mercer, pension plans sponsored by the largest US companies have seen a decline in funded status (the ratio of assets to liabilities) from 104 percent at year-end 2007 to 75 percent as of December 31, 2008. This equates to losses of an estimated $469 billion over 2008, causing an aggregate surplus of $60 billion at the end of 2007 to be replaced an estimated aggregate deficit of $409 billion at the end of 2008. The study by Mercer also shows that pension expense is likely to increase from $10 billion in 2008 to an estimated $70 billion in 2009.

Moreover, the trend in recent months has been one of alarming deterioration. The aggregate funded status fell by $129 billion in December, $130 billion in November and $110 billion in October, while the aggregate deficit for the first nine months of 2008 was $100 billion.

"The majority of US companies have their financial year-ends at December 31. The decline in funded status will be capitalized and reflected in corporate balance sheets for many companies. This will reduce balance sheet strength, which leads to consequences for several areas of the business, including capital expenditure decisions, loan covenants and credit rating decisions,” said Adrian Hartshorn, a member of Mercer’s Financial Strategy Group, which helps companies manage financial risk in their retirement programs.

"Additionally, the pension expense that companies report in their financial statements is likely to be significantly higher in 2009, despite the smoothing options available to companies under the Financial Accounting Standards. This will reduce corporate profitability and reported 2009 earnings. Mercer’s estimates show that pension expense is likely to increase from approximately $10 billion in 2008 to approximately $70 billion in 2009. To put this into context, net income for S&P 1500 companies in 2007 (the last year that full information is available) was $727 billion, so an increase in pension expense of $60 billion (from $10 billion to $70 billion) would equate to an 8 percent reduction in profits,” said Mr. Hartshorn.

The decline in pension plan funding levels comes from adverse trends in both equity and bond markets. The S&P 500 index was down almost 40 percent through 2008, a decline typical of nearly all of the world’s major equity indices. In the bond markets, 10-year Treasury yields have fallen from 4.1 percent to 2.3 percent and AA bond yields were at 6.1 percent, practically unchanged from the start of the year. The divergence of Treasury yields and AA yields is a result of widening credit spreads (the difference between AA corporate bond yields and treasury yields). Declining equity markets have been the main driver behind asset losses for the pension plans sponsored by S&P 1500 companies. Although rising corporate bond yields benefited pension plans through much of 2008 by reducing the value placed on plan liabilities, a rapid reduction in yields in the fourth quarter, particularly in the last few weeks of December, has largely eliminated this gain.

Mercer estimates the total combined funded status position of plans operated by S&P 1500 companies on a monthly basis. The total value of pension plan assets at December 31, 2007, was $1.66 trillion, compared to the total value of the liabilities of $1.60 trillion. At December 31, 2008, the estimated assets had declined to $1.21 trillion, compared with estimated liabilities of $1.62 trillion.

Figures in pension disclosures that appear in a plan’s financial statements are calculated differently than for purposes of the pension plan funding rules under the Pension Protection Act (PPA). In particular there are several options available under PPA to determine the value of plan assets and liabilities which are not available for financial reporting purposes.

"Given the sponsor options available under PPA, based on current and publicly disclosed information, it is not possible to set a reasonable estimate for the absolute level of contributions that will be required in 2009 and beyond. However, companies are likely to have to make higher cash contributions to their pension plans,” said Mr. Hartshorn. "The Worker, Retiree, and Employer Recovery Act of 2008, which was signed into law on December 23 by President Bush, granted some relief to the funding requirements. In addition, further relief may become available as part of the economic stimulus plan currently being worked on by Congress. However, despite this uncertainty and the potential for additional relief, we believe that a significant number of companies could fall under the 80 percent funded status trigger that could result in additional funding, benefit restrictions or plan freezes.”

Mr. Hartshorn added, "Although there has been a significant reduction in the funded status of pension plans over the year from 104 percent to 75 percent, had there not been an increase in credit spreads the position would be worse. Between 2003 and 2007 credit spreads between AA corporate bonds and US Treasuries were typically 1–1½ percent, but at the end of December the spread stood at 3.8 percent. If markets settle and credit spreads contract to previous levels without a recovery in the equity markets or an increase in US Treasury yields, the funded status of pension plans would fall to 58 percent, equivalent to a deficit of over $880 billion. Of course, this is speculative – the widening of credit spreads is linked to the economic conditions that have driven down Treasury yields and equity markets. Credit spreads are therefore unlikely to contract in isolation, but there is no guarantee of an orderly normalization in all three areas.”

Mr. Hartshorn continued, "What is clear from the last 12 months, and particularly so in the last quarter, is that markets have not only created a significant change in pension plans’ funded status, but that markets have been more volatile and the funded status of plans has been more difficult to project. Similar levels of volatility have not been observed since 2000–2002, and since then both the accounting standards and the funding standards have changed, moving towards a more mark to market methodology. This means that rather than being able to smooth volatility in pension plan finances, the market volatility is more directly reflected in company financial statements and in contribution requirements. In itself, this should lead corporate sponsors to review their ability to tolerate risk from their pension plans.

"Aside from the volatility itself, there are three factors which make it imperative that plan sponsors reevaluate the financial risks they are taking in their pension plans, and their tolerance for doing so. First, the significant change in funded status over the last 12 months results in a different risk profile. Second, plan sponsors themselves are likely facing different business challenges; pension plan risk tolerances need to be reviewed in the new business environment. Finally, the capital market outlook has changed significantly; investment decisions taken need to be revisited to ensure the current investment strategy is appropriate given the current capital market outlook,” said Mr. Hartshorn.

Notes for Editors

Unless otherwise stated, the calculations are based on the Financial Accounting Standard (FAS) funding position and include analysis of the S&P 1500 companies.

About Mercer

Mercer is a leading global provider of consulting, outsourcing and investment services. Mercer works with clients to solve their most complex benefit and human capital issues, designing and helping manage health, retirement and other benefits. It is a leader in benefit outsourcing. Mercer’s investment services include investment consulting and multi-manager investment management. Mercer’s 18,000 employees are based in more than 40 countries. The company is a wholly owned subsidiary of Marsh & McLennan Companies, Inc., which lists its stock (ticker symbol: MMC) on the New York, Chicago and London stock exchanges. For more information, visit www.mercer.com