The balance sheets of large US companies deteriorated by in excess of $70 billion during the first quarter of 2008 as a result of changes in the value of the assets and liabilities of their pension plans, according to Mercer.
The extent of these losses will not be included in earnings reported for 2008 because, under US accounting rules, pension costs are generally determined using market data at the end of the prior reporting period. For most companies this means that the 2008 pension expense was based on December 31, 2007, market conditions – prior to the market declines of the year’s first quarter.
“The full extent of the turnaround in the fortunes of pension plans operated by US companies can be seen by the change in their funded status since October 31, 2007,” said Adrian Hartshorn, a member of Mercer’s Financial Strategy Group, which helps companies manage financial risk in their retirement programs, in an announcement of the findings. “Using US accounting rules to place a value on the liabilities of S&P 1500 companies that sponsor pension plans, we estimate there was a net surplus of almost US$120 billion as of October 31 last year; this has now been replaced by a deficit of around US$20 billion. However, the reality is that the accounting cost understates the true cost of settling the plan liabilities, so the real deficit is much higher.”
Mercer estimates the funded status position of plans operated by S&P 1500 companies on a monthly basis.
Looking back further, there was overall favorable experience in 2006 and 2007, but fortunes in the first quarter of 2008 have deteriorated significantly as equity markets have declined, according to the report.
"Rises in high-quality corporate bond yields flowing from the credit crunch have somewhat softened the decline in equity values," said Hartshorn. "The current higher yields on AA bonds mean that pension liabilities have declined over the last three months, but generally not by as much as the fall in the value of plan assets, leaving pension plans worse off overall. The ultimate reality may be more painful, as the funded status position could deteriorate even further if credit spreads revert to more normal levels, and equity markets do not rebound."
Mercer suggests that the full impact of the credit crunch may not be realized for several months, and plan sponsors should not rush to take precipitous action in the middle of highly turbulent markets. Mercer notes that many companies have made changes to their investment strategies in an attempt to reduce the impact of pension plan volatility on the company's financial statements.
Typically, companies are seeking to reduce the impact of changes by better matching fixed income durations to their liability durations, investing more heavily in bonds, or for some more sophisticated plan sponsors, by entering into interest rate swaps. However, these actions often leave the risk of equity market volatility unaddressed, according to the firm.
Desire to Manage Risk
"The desire to manage interest rate risk is a step in the right direction," said Hartshorn. "However, companies need to implement risk management strategies carefully and consider which risk they are seeking to mitigate. For example, putting in place LIBOR-based swap contracts may result in increased volatility in the AA credit-based accounting costs. It is only by considering the investment strategy in tandem with the behavior of the liabilities under different economic scenarios that the true nature of the risk can be understood. This represents a change from traditional asset-only investment strategies followed by many plan sponsors in the past, and emphasizes the need to involve the plan actuaries when setting the investment strategy."
The chart below shows the estimated surplus/deficit position and the funded status (ratio of assets to liabilities) of all plans operated by companies in the S&P 1500 as reported in their financial statements. This includes US domestic qualified and non-qualified plans and all non-domestic plans. The figures provided in the chart are estimates based on financial indices.
The calculations are based on the Financial Accounting Standard (FAS) funding position.
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