Corporates walk funding tightrope as DB plans falter

An analysis of defined benefit schemes around the world reveal they all face the same issues of severe underfunding, but what should they do about it? In recent weeks, some of the world’s largest consultants have warned of the liability blow outs facing corporates with defined benefit (DB) pension plans.

Suffering from the dual impact of falling interest rates and falling asset values, companies are under pressure to throw more money into their DB plans to plug the growing funding deficit – precisely at a time when they cannot afford to do so.

The tough economic environment has seen many companies issue profit warnings, and those that are in reasonable health are looking to preserve their capital in order to steer their way through the remainder of the crisis.

However in some countries, particularly the US and UK, corporates have little choice but to increase contributions to meet the stringent funding requirements under which they operate.

And this has already begun to happen. According to Wilshire Consulting’s 2009 Report on Corporate Pension Funding Levels, S&P 500 Index companies contributed $30 billion to their DB plans in 2008, versus only $25.2 billion in 2007.

Yet the impact of the extra funding has been wiped out by adverse investment markets, which have caused assets to fall and liabilities to skyrocket; DB pension assets of S&P 500 Index companies declined by $310.2 billion in 2008, while liabilities increased $21.9 billion – from $1199.7 billion to $1221.6 billion.

As a result, the aggregate funding ratio for all plans decreased from 107.9 per cent to 80.6 per cent, and a $94.6 billion surplus at the beginning of the year became a $237.5 billion deficit.

“In light of the funding targets set out by the Pension Protection Act, company contributions will have to increase substantially to achieve full funding by 2011,” the report notes.

“If the deflating technology bubble at the turn of the century is viewed as an analogous event, positive market returns for several years forward will have to be experienced, five years in the case of the technology bubble, to grow out of the current funding deficit.

“Yet market growth assumptions did not do all the work in the past” companies today will at minimum face steeper contribution schedules to meet full funding requirements under the targets of the Pension Protection Act.”

This week, Continental Airlines announced it had contributed an additional $50 million in cash to its DB pension plans, bringing its total year-to-date contribution to $100 million. Continental expects to contribute around $150 million to its DB pension plans in 2009.

Oil group Royal Dutch Shell last month revealed an $8.3 billion shortfall in its pension fund at the end of 2008, and has reportedly unveiled a multi-million euro plan to raise contributions in a bid to close the gap.

Even Australia, which is largely a defined contribution market, has not been immune to the DB phenomenon.

A survey by Watson Wyatt of Australian listed companies released this week revealed a modest funding shortfall of less than A$2 billion (US$1.46 billion) six months ago is now an estimated $18.2 billion black hole.

Recently, Qantas announced it would tip $48 million into its $3.6 billion DB superannuation plan, while the $4.15 billion Local Government Superannuation Scheme has been forced to increase contribution rates for its DB scheme from July 1, 2009 until June 30, 2010.

David McNeice, principal at Watson Wyatt, said many Australian listed companies were being forced to make extra contributions at a time when they should ideally be hoarding cash.

“The financial strength of funds has weakened obviously, quite substantially over the last six months, and it is requiring top-up contributions to be made,” he said.

“It’s exactly at this time when corporates may need to preserve their capital and preserve their cash, simply to get through the crisis, and yet they need to be topping up their superannuation plans, so it’s a very difficult balancing act.”

The Wilshire report, which covers 323 companies in the S&P 500 Index that maintain DB plans, reveals that 92 per cent of corporate pension plans in the US are underfunded – notably higher than the 62 per cent reported for the previous year.

In the UK, defined benefit pension schemes are also in dire straits, with the combined shortfall of those schemes in deficit now exceeding £250 billion (US$372.7 billion).

The UK Pension Protection Fund (PPF), which acts as the pension guarantee fund for UK DB schemes, publishes a monthly PPF 7800 Index. The index compares pension scheme assets with the approximate cost of paying an insurance company to provide the benefit levels that scheme members would expect to receive if their employer went bust and the scheme passed into the PPF.

The latest update revealed scheme liabilities increased by 15.5 per cent over the year to March 2009, to around £990 billion, while assets total just £748 billion.

John Ball, head of defined benefit pension consulting at Watson Wyatt, said the assets in DB schemes are now sufficient to cover just three quarters of the benefits that the PPF aims to provide, while 90 per cent of schemes would be a drain on the PPF if their employers went bust tomorrow.

“Large deficits mean companies will either have to increase contributions when many cannot afford it or persuade trustees to accept that it will be a long time before their plans become fully funded,” Ball said.

“Everything indicates that paying for pensions promised in the past will remain a major drain on company finances for years to come.”