US pension plan liabilities rose last year, despite investment returns hitting double digits in 2004 for the second consecutive year following the 2000-2002 market downturn.
A survey by Mercer Human Resource Consulting of the retirement schemes sponsored by S&P 500 companies found that investment performance barely kept pace with liability growth. Median returns of 18.1 per cent for 2003 and 12.2 per cent for 2004 surpassed median liability returns of 17.9 per cent and 12.2 per cent for the corresponding years. But, although the funded status of schemes improved slightly, from 75 per cent to 81 per cent during the same two-year period, median plan costs remained at 0.5 per cent of corporate revenue.
Mercer said the increase in plan liabilities was mainly due to the lower interest rates used to value those liabilities. The discount rate used in the median plan decreased from 6.75 per cent to 6.23 per cent to 5.80 per cent between the end of the 2002, 2003, and 2004 fiscal years, respectively, as long-term interest rates fell. According to Mercer, as the discount rate decreases, the cost of each dollar of past and future benefit accrual becomes more expensive, therefore causing pension costs to increase.
Reviewing assumptions
Another reason, added the consultancy firm, is that most companies are also reviewing assumptions about the expected return on plan assets. In recent years, the Securities and Exchanges Commission has forced companies to justify expected returns of 9 per cent or more. Companies have reacted by reducing their assumed rate of return to a level below 9 per cent, which directly increases pension cost.
The expected return for 2004 remained at 8.5 per cent at the median and dropped at most other percentiles, which helped, said Mercer, to further explain the lack of a decrease in pension plan costs.
The incorporation of past losses into the pension expense calculation also served to artificially boost pension expenses. At the median, amortisation payments against these unrecognised losses increased dramatically from 0.10 per cent to 0.15 per cent of revenue between 2003 and 2004.
Mercer said that recognition of past losses at the median added a massive 47 per cent to what the expense would have been without the loss amortisation. The biggest contributor to these unrecognised accumulated losses was the bear market of 2000-2002.
Mercer pointed out that the amount of unrecognised loss carried by the plan can increase costs for years after the actual occurrence of the loss. Such ‘smoothing mechanisms’ of the current accounting standard have come under fire by users of financial statements. Calls for reform include immediately recognising these losses so that the financial status of the pension plan is more faithfully represented on the corporate balance sheet.
Under new standards adopted by the Financial Accounting Standards Board (FASB), companies must disclose their actual and target pension plan asset allocations in their annual 10-k reports. US pension plans maintained an allocation to equities of about 65 per cent in both 2003 and 2004. Mercer said this meant that asset allocation does not explain any of the change in the level of pension expense because expected return assumptions would have been developed from the same 65 per cent allocation to equities.
The report said the stockmarket downturn has caused sponsors to take a long, hard look at their current investment strategies both to determine whether a change in asset allocation would help to avoid future bear markets and also in order to manage assets in a lower-return environment.
Mercer says that by investing in equities, companies have mismatched plan assets and liabilities.
Less attractive
Another source of investment risk is the ‘typical’ decision to invest the fixed-income portfolio in bonds that have a duration mismatch with plan liabilities. Mercer said that under current accounting standards, such an investment strategy makes sense because much of the risk is amortised, or ‘smoothed out’ over a number of years. But the firm warned that a mark-to-market accounting standard would make equity investing less attractive for pension plans as well as create a greater incentive to protect against inflation risk.
Mike Young, Mercer HR consultant and an author of the study, commented that there is no firm timeline for the introduction of a new mark-to-market accounting standard in the US. Until new accounting rules are introduced, he said plan sponsors are unlikely to seriously consider reducing their equity portfolios and addressing bond duration mismatch with liabilities.
He also contended that many plan sponsors are not worried about the possibly of another prolonged bear market in the short-term. Rather they did not envisage another severe downturn for a long time to come.
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