Declining discount rates reduced funded ratio of pension plans

Pension asset portfolios gained 9.3 percent in 2012, but declining discount rates drove the funded ratio of pension plans lower. The good news is that for the past four years, pension fund returns have exceeded their expectations, even as funded status worsened due to lower discount rates, according to new research by Milliman.

The funded status increased by $53.7 billion during December 2012, ending a volatile year on a positive note for the 100 largest corporate defined benefit pension plans measured by the Milliman 100 Pension Funding Index.

Historically low interest rates were the dominant factor in the $74.4 billion deficit increase during 2012. While higher-than-expected investment returns produced a solid $90.4 billion gain, pension liabilities increased by $164.8 billion. The funded ratio was 76.4 percent as of Dec. 31, 2012, down from 78.7 percent at the beginning of the year but still above the historical low funded ratio of 70.5 percent set in May 2003. Improvements in the December 2012 metrics may be realized by higher-than-expected cash contributions, which will be disclosed as the 100 companies publish annual SEC filings in the first quarter of 2013.

During 2012, the cumulative investment return was 9.3 percent while the cumulative liability return was 14.4 percent. The discount rate for the December 2012 funded status plunged 49 basis points to 4.18 percent from 4.67 percent at the end of 2011, and the median expected investment return for 2012 was 7.8 percent, as reported in the Milliman 2012 Pension Funding Study, published in March 2012.

The $74.4 billion deficit increase during 2012 resulted in a yearend funded status deficit of $411.8 billion, the largest deficit at year-end in the 12 year history of the Milliman 100 PFI. The loss in funded status during 2012 resulted in a charge to corporate balance sheets at the end of the 2012 fiscal year and is expected to produce an estimated increase of $9.2 billion in pension expense for 2013.

While 2012 ended on a positive note, the road ahead appears shaky as Federal Reserve Chairman Ben Bernanke has indicated the Fed’s intention to keep interest rates unchanged from the current lows until the unemployment rate reaches 6.5 percent. If low discount rates are sustained, the only two ways for the funded status to improve are by exceptional investment returns and/or higher cash contributions by plan sponsors.

The funded status increased by $53.7 billion during December. The deficit decreased to $411.8 billion from a deficit of $465.5 billion at the end of November. The funded status improvement for the month of December was due to lower liabilities based on an increase in corporate bond interest rates that are the benchmarks used to value pension liabilities. The funded status increase was partially aided by positive investment performance during December. As of Dec. 31, the funded ratio increased to 76.4 percent from 74 percent at the end of November.

December’s $8 billion increase in market value brings the Milliman 100 PFI asset value to $1.336 trillion, up from $1.328 trillion at the end of November 2012, an investment gain of 0.8 percent for the month. Pension liabilities decreased by $46 billion during December, lowering the Milliman 100 PFI value to $1.748 trillion from $1.794 trillion at the end of November 2012. The change resulted from an increase of 13 basis points in the monthly discount rate, to 4.18 percent for December from 4.05 percent for November.

If the Milliman 100 PFI companies were to achieve the expected 7.8 percent (as per the 2012 pension funding study) median asset return for their pension plan portfolios and the current discount rate of 4.18 percent were to be maintained during 2013 and 2014, it forecasts the funded status of the surveyed plans would increase. This would result in a projected pension deficit of $336 billion (funded ratio of 81 percent) by the end of 2013 and a projected pension deficit of $255 billion (funded ratio of 85.7 percent) by the end of 2014. For purposes of this forecast, Milliman assumed 2012 aggregate contributions of $67 billion and 2013 and 2014 aggregate contributions of $81 billion.

Under an optimistic forecast with rising interest rates (reaching 4.78 percent by the end of 2013 and 5.38 percent by the end of 2014) and asset gains (11.8 percent annual returns), the funded ratio would climb to 94 percent by the end of 2013 and 115 percent by the end of 2014. Under a pessimistic forecast with similar interest rate and asset movements (3.58 percent discount rate at the end of 2013 and 2.98 percent by the end of 2014 and 3.8 percent annual returns), the funded ratio would decline to 69 percent by the end of 2013 and 63 percent by the end of 2014.

For the past 12 years, Milliman has conducted an annual study of the 100 largest defined benefit pension plans sponsored by U.S. public companies. The Milliman 100 Pension Funding Index projects the funded status for pension plans included in its study, reflecting the impact of market returns and interest rate changes on pension funded status, utilizing the actual reported asset values, liabilities, and asset allocations of the companies’ pension plans.

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