Pension plan investment returns hit double digits in 2004 for the second straight year following the 2000-2002 market downturn. Although this strong investment performance has spurred a modest improvement in the funded status of plans at major US companies, the gains have not translated into lower pension plan costs. In fact, plan liabilities also rose during the period, according to an analysis by Mercer Human Resource Consulting and Mercer Investment Consulting entitled, “How Does Your Retirement Program Stack Up?”
Mercer analyzed retirement plan data disclosed by companies in the S&P 500 in their 2004 10-K reports. The Mercer analysis enables companies to compare their pension costs with peer groups of competitors or with companies in the same industry group, thereby better understanding how pension costs affect their own overall cost structure, risk profile, and competitive position.
“As employers seek to manage costs in an increasingly competitive business environment, pension costs will continue to be closely scrutinized. Over time, this scrutiny will result in changes, both in employers_ financial management and design of these programs and in the role employees play in planning for their retirement needs,” says Mercer HR consultant Mike Young, an author of the study.
In the areas of plan benefit design, funding policy, accounting options, and investment policy, Mercer has provided clients with the critical advice that employers rely upon. The objective is to provide optimal benefits to employees while controlling costs and, especially, managing risk, Mr. Young explains. Recommendations may include creating funding strategies to minimize contribution volatility, or to avoid charges against equity and protect against violations of loan covenants.
About 70% of the S&P 500 companies maintain traditional pension (defined benefit) plans. Investment returns for these companies_ plans barely kept up with liability growth, although new contributions helped produce some improvement in the overall financial health of such plans.
From the beginning of 2003 through 2004, the median plan’s funded status (the ratio of plan assets to plan liabilities) improved somewhat, from 75% to 81%. But during the same two-year period, median plan costs remained at 0.5% of corporate revenue, according to Mercer’s analysis. Looking forward, funded ratios as of the beginning of 2005 had improved slightly, to 83%.
Investment returns are just one of several factors that affect a retirement plans overall financial picture. Changes in the assumptions used to calculate a plans liabilities also have an effect. Other factors relate to current pension accounting standards. For example, “smoothing mechanisms” provided under current accounting rules mean that gains or losses in prior years can affect plan costs for several years into the future. And changes in target asset allocation and market outlook can influence the assumptions used to predict the return on plan assets, which in turn affects plan costs.
“To understand retirement plan costs, you need to examine the performance of both the plans assets and its liabilities, as well as the consequences of accounting rules,” says Mr. Young. “Understanding the component drivers of these costs is a first step in enabling employers to better manage them – and to assess the financial costs and risks against the significant value to both employees and employers of traditional defined benefit pension promises.”
PENSION EXPENSES RISE DUE TO ASSUMPTIONS REGARDING INVESTMENT RETURNS At the median, the investment return on plan assets was 18.1% for 2003 and 12.2% for 2004. These investment results helped plans regain some of the ground lost during the 2000-2002 stock market decline. However, plan liabilities also increased during 2003 and 2004, primarily due to the lower interest rates used to value those liabilities. The discount rate used in the median plan decreased from 6.75% to 6.23% to 5.80% between the end of the 2002, 2003, and 2004 fiscal years, respectively, as long-term interest rates fell. According to Mr. Young, as the discount rate decreases, the cost of each dollar of past and future benefit accrual becomes more expensive and causes pension expense to increase.
“Most companies are also reviewing assumptions about the expected return on plan assets, especially since in recent years the Securities and Exchange Commission has asked companies to justify expected returns of 9% or more,” observes Mr. Young. “In reaction, most companies have reduced their assumed rate to a level below 9%. Reductions in this rate, of course, directly increase pension cost.”
The expected return for 2004 remained 8.5% at the median and dropped at most other percentiles, helping to further explain the absence of a decrease in pension plan costs. Among companies in the study that disclosed what rate they intended to use for 2005, most indicated they would use the same rate as in 2004.
With the help of Mercer, and consistent with prudent investment policy, companies are taking a fresh look at strategies to optimize expected return for a given level of risk. Mercer has been able to help its clients adopt investment policies to hedge against interest rate risk, or to adopt strategies to minimize the chances of a spike in expense or contributions.
CARRYOVER OF OLD LOSSES ARTIFICIALLY BOOST PENSION EXPENSE BY 47% Finally, pension expense continues to be artificially boosted by the incorporation of past unrecognized losses into the pension expense calculation. At the median, amortization of these unrecognized losses increased dramatically, from 0.10% of revenue in 2003 to 0.15% in 2004. Looked at another way, recognition of past losses added, at the median, a whopping 47% to what the expense would have been without the loss amortization. A significant portion of these past losses stems from the adverse experience during the market downturn of 2000-2002.
Some users of financial statements have criticized incorporating past unrecognized losses into the pension expense calculation, which is one of the “smoothing mechanisms” in the current accounting standard. Calls for reform include immediately recognizing these losses, so that the financial status of the pension plan is more faithfully represented on the corporate balance sheet. This is the essence of “mark-to-market” accounting as applied to pension plans.
Consistent with the unchanging cost pattern seen with pension expense, cash contributions made to pension plans also remained level. The median amount contributed to pension plans, when expressed as a percentage of revenue, remained at 0.7% between 2003 and 2004.