The largest corporate pension plans are in a bind—an underfunding bind in which projected benefit obligations exceed assets’ market value by a cumulative $398 billion as of the end of October, according to John Ehrhardt. Ehrhardt, a principal and consulting actuary at Milliman, Inc., has focused on defined benefit plans for more than 30 years, and has worked with dozens of corporate clients on redesigning traditional pension plans, such as a conversion to cash-balance plans. Eleven years ago Ehrhardt started the Milliman 100 Pension Funding Index, which tracks the 100 largest U.S. corporate defined benefit plans and was the first publicly released index based on corporations’ actual pension reports rather than estimates. Ehrhardt recently spoke with Institutional Investor contributing writer Judy Ward.
Institutional Investor: The funded status for these 100 plans has deteriorated by a total of $170 billion this year alone. Why?
Ehrhardt: It is all about interest rates. If you break down that $170 billion, it equals a $179 billion increase in liabilities due to declining interest rates plus a $41 billion decrease in assets due to a falling market, less $50 billion in new money that companies have contributed.
How big are the contribution increases for these corporations?
We don’t have the numbers for this year yet, but contributions doubled from $29 billion in 2008 to almost $60 billion in 2010. There were seven companies in our database whose annual contributions increased by more than $1 billion from 2008 to 2010: General Motors, UPS, Lockheed Martin, PepsiCo, International Paper, Citigroup, and United Technologies. I cannot imagine any of these companies will have a decrease in contributions in 2011. Funding those is going to be a little bit of both using cash on hand and tightening up spending in other parts of the company. The thing that is different now than in ’09 is that at least there is cash on these companies’ balance sheets.
Is this underfunding and volatility in funded status likely to remain for the long term?
We expect that almost $60 billion in total contributions to hit $100 billion if not this year, next year. With what [Federal Reserve Chairman Ben] Bernanke said a while back—that interest rates will stay low for at least 18 months—plan sponsors can plan on significant contributions for the next few years. Because of low interest rates, I do not think they will get any liability relief. And I think volatility is here to stay in equity markets.
How are companies changing their pension strategies to deal with underfunding?
I do not think we will see many more freezes, because it does not reduce the near-term funding cost. If you were 75 percent funded before a freeze, you are 75 percent funded after a freeze. A freeze does not reduce your liabilities: It just stops the bleeding.
Some companies are taking steps with liability-driven investing (a strategy focused on investing in assets with characteristics akin to its liabilities, such as bonds with a similar duration), but it is hard to make a long-term commitment to bonds when interest rates are at a historic low. We are starting to see some sponsors use equity hedging, which removes 75 percent of the downside risk while keeping 80 percent of the upside potential. The Milliman Protection Strategy uses futures contracts to employ a combination of volatility management and capital protection to keep 80 percent of the upside while eliminating 75 percent of the downside—much more efficient than collar strategies. It is new with pension plans, but it already is used by Milliman with large insurance companies to help their variable-annuity contract portfolios.
Do we need regulatory changes for pension funding to work better?
The thing that has caused the volatility in pension liabilities has been the very rapid decline in interest rates, and the very immediate recognition of those rates in required pension contributions. If you take the volatility out of the interest rates used in calculating liabilities, you take the volatility out of liabilities. The American Benefits Council has proposed continuing to use the two-year average of interest rates, but disregarding rates within those two years that do not fall within 10 percent of the average for the past 25 years.
There should be fewer penalties associated with overfunding a plan. We need to encourage companies to fund above the minimum required. They should not be targeting 100 percent funded status—they should be funded to at least 110 percent. The problem is that they are worried that interest rates will come back up, and all of a sudden they will be at 125 percent, which would trigger an excise tax on any asset reversion to the company in the event of a plan termination. There have to be restrictions so that companies are not playing games with surplus assets.