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Corporate Pension Funding Gap Widens as Interest Rates Remain Low

The Federal Reserve Board’s effort to keep interest rates low is forcing Fortune 500 companies to dip into cash reserves for pension funding.

Low interest rates translate into higher required pension payments in order to maintain compliance with pension accounting rules. United Parcel Service (UPS), for example, recently announced a pension-accounting related charge of $3 billion, causing the delivery service to report a fourth quarter loss.

As public companies file their 2012 annual reports in 2013, many are expected to reveal pension payments of at least $1 billion. Coca-Cola recently reported a $1.1 billion payment to its defined benefit pension plans in 2012, as another example.

Ford and Exxon-Mobil expect their 2012 pension contributions to be approximately $3.8 and $2.9 billion, respectively, according to actuarial firm Milliman. Caterpillar, GE, Honeywell, Lockheed-Martin, Pepsi, Raytheon, and Verizon also expect to spend at least $1 billion in 2012 pension funding payments.

Pension Plan Payments Climb as Interest Rates Fall

Pension plan sponsors, through their actuaries, rely on assumed rates of return (also known as “discount rates”) to determine the amount of money they must contribute to a pension system to adequately fund future obligations.

As the assumed rate of return increases, current funding requirements decrease. Conversely, a lower assumed rate of return requires a higher current funding level in order to meet future obligations.

By one industry estimate, each 1 point reduction in the discount rate means 10 percent more in current contributions. When there are funding gaps due to lower interest rates and other factors, employers and employees will be required to contribute more to the plan.

Airplane manufacturer Boeing saw a decline in its discount rate from 6.2% in 2007 to 3.8% in 2012, according to a Wall Street Journal report. Boeing reported in an SEC filing that pension obligations increase $3.1 billion for every 0.25 percentage point decrease in its discount rate.

Median discount rates for corporate pension plans fell to 4.80% at the end of 2011, from 5.42% in 2010 and 5.50% in 2005, continuing the decline from 7.5% at the end of 1999, according to the Milliman 2012 Corporate Pension Funding Study.

Looking at the brighter side, if interest rates rise, plan sponsors can breathe a sigh of relief.

Pension Terminal Funding Gains Momentum

One increasingly popular way that corporate plan sponsors are trying to reduce pension-related balance sheet volatility is to transfer pension payment obligations to a third party using a technique known as “pension terminal funding.”

Under pension terminal funding, a plan sponsor transfers a defined amount of outstanding pension obligations to an insurance company in exchange for an advance premium and administrative costs. The insurer then assumes liability for the payments, and the transferred pension obligations are removed from the balance sheet of the original plan sponsor.

General Motors outsourced pension administration for 76,000 U.S. salaried retirees to Prudential Financial Inc. last year, for example. GM was expected to pay between $3.5 and $4.5 billion as a cash contribution to its U.S. salaried pension plans in order to purchase a group annuity contract and increase pension plan funding levels.

Pension payments for approximately $7.5 billion owed under The Verizon Management Pension Plan, which covers almost 41,000 current management retirees, are also being fulfilled by Prudential under an agreement announced in October 2012.

Liability-Driven Investing Strategies Remain Popular

Another popular pension management strategy is “liability-driven investing” (“LDI”), now in use by over a quarter of the country's largest pension funds according to Pensions & Investments. LDI is a structured investment program designed to finance a predictable stream of future pension payments.

Pension plan administrators with responsibility for defined benefit plans can reduce their exposure to the equity markets by using more predictable investments, such as bonds, to fund future obligations under an LDI strategy.

Hewlett-Packard Co. has adopted many LDI strategies, according to a June 2011 article in Pensions & Investments magazine. The company successfully structured an LDI program for a defined benefit plan that was frozen in 2007.

Liability-driven investing strategies in use by pension plans increased 35% between 2007 and 2010, according to a 2011 report by Booz & Company.

Summary: Pension Plan Funding to Remain a Challenge

Overall, J.P. Morgan Asset Management estimates that corporate pension plans only hold an estimated $81 for every $100 in pension benefits promised to plan participants.

Looking at the cumulative corporate pension deficit, the Milliman Pension Funding Study reports that plan deficits for the leading 100 corporate pension plans grew by almost $95 billion between fiscal years 2011 and 2012 (from $232.1 billion to $326.8 billion, respectively).

As corporations continue to face funding pressures due to low discount rates, increasing life spans, and other factors, watch for the continued adoption of new funding strategies.

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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