Watson Wyatt: Pension Crisis Tied to Regulatory Restraints

October 1, 2003 (PLANSPONSOR.com) - Pension underfunding may be prevalent, but as a percentage of total corporate assets the mountain looks more like a mole hill.

Two-thirds of the nation’s 1,000 largest companies report an underfunded pension plan.   Much of this increased underfunding can be traced back to three primary factors:   declining discount rates that lead to rising pension liabilities, the stock market’s well publicized drop and an aging workforce, according to Watson Wyatt’s Pensions in Crisis report.

However, the ratio of unfounded pension obligations to total corporate assets is less than 4% for the average plan, suggesting the current problem in the pension system may be in the regulations rather than the math.  “Relative to total corporate assets, the unfunded pension liabilities of most large companies are not excessive,” says Sylvester Schieber, director of research at Watson Wyatt, in a statement. “Unfunded liabilities should always be monitored. But the real problem with the pension system is a regulatory environment that actively discourages not only the full funding of future liabilities but the very idea of pension plan sponsorship at all.”

80s Redux

Specifically, the report points to moves made in the mid-1980’s that placed new limits on funding requirements and established a slew of other restrictions.   For example, Watson fingers the Tax Equity and Fiscal Responsibility Act of 1982 and Omnibus Budget Reconciliation Act of 1987 (OBRA87).   These plans changed the focus of plan sponsors by restricting the level of pension underfunding allowed and tying the limit of the current liability – the accrued benefit obligation – instead of the actuarial accrued benefit – the projected benefit obligation.

Thus plan sponsors were suddenly focused on a funding standard based on current liability and were unable to recoup excess pension assets. Watson says that by 1993, the number of fully funded plans started to diminish for the first time since the passage of the Employee Retirement Income Security Act (ERISA), partly the result of falling interest rates, but also due to this changing mindset among plan sponsors. Further, between 1993 and 1995, when the decline in interest rates was sharpest and liabilities began a sharp increase, annual contributions fell by more than 20% and the funding ratios went with them. By the mid-1990s, the percentage of plans that were fully funded dropped 15% points in only three years.

The end result is the current environment of big pension headlines that began in the 1990s and was only magnified at the onset of the recent bear market.   Especially dramatic was the drop noted between 1998 and 2002, when the percentage of fully funded pension plans went from 84% to 37%.  

Further illustrating that point, Schieber points to an increase in contribution amounts made by Fortune 1000 companies between 1999 ($11 billion) to 2002 ($44 billion).   Yet, despite this infusion of dollars – more cash than had been contributed over the previous three years combined – plan funding continues to deteriorate.   Further, at the current rate, plan sponsors at these plans will contribute at least $83 billion to their plans this year. Even assuming annual returns of 8% this year and next, these same employers would have to contribute roughly another $80 billion for 2004 if current law is not changed.

“Growing costs have undoubtedly contributed to the demise of some plans,” said Schieber. “But recent plan curtailments will likely pale in comparison to future terminations if the remaining plans have to face the cash call that current law portends. Unfortunately, without changes, the worst may be yet to come.”

That is to say if it has not already arrived.   Due primarily to terminations, the total number of defined benefit pension plans has declined by about 20% in the past three years.

Recovery Idea

“Today’s underfunding can be resolved,” said Schieber, who points to the barren pension landscape of the late 1970s.   In 1978, the number of fully funded plans was only about 25%, but by 1985 that number soared to 78%.

To accomplish a recovery the report says it is time for the rubber to hit the road.   Already, attempts are being made to improve the current system.   The Senate Finance Committee recently approved a proposal to
use a bond yield curve to calculate pension liabilities (See  Pension Partisianship Set Aside in 30-Year Treasury Rate Compromise ).  However, theoutlook for this proposal is unclear as competing proposals are beingconsidered.

Also, Watson Wyatt alludes to a solution in the current fixation on minimizing tax losses that evolved in the 1980s.   Instead, the report suggests shifting the focus to funding the benefits as the best way to secure them and points to a steady rise in the number of plans between 1978 (25%) and 1986 (79%) that reported accrued benefit security ratios about 100%.

This is because the current system does not offer a significant enough buffer to weather the bad times after reaping the good times.   However, hope may be on the horizon, as the Financial Accounting Standards Board (FASB) has agreed to look at the current rule governing pension accounting standards, FAS No 87, and specifically t he regulations that govern “smoothing” (See  Smooth Move ).

A copy of the full report is available at  Pensions in Crisis .