Mercer: In the Wake of Interest Rate Lows, Pension Plan Sponsors Foresee Soaring Contributions

(October 27, 2011) — Pension plan sponsors are anticipating soaring 2011 contributions as interest rates hit record lows, a new analysis by Mercer reveals.

“Falling interest rates have created an environment in which plan sponsors that have taken steps to de-risk — incorporating a liability-driven investing approach — have fared better than those who haven’t,” Craig Rosenthal, a partner in Mercer’s retirement, risk and finance business, tells aiCIO. Rosenthal describes the current market environment as a ‘pension perfect storm,’ characterized by declines in asset values, driven mainly by equities, coupled with growing liabilities due to falling interest rates. Amid the turbulent environment, the trajectory for cash contributions continues to point skyward, according to Rosenthal. “These dramatically increasing contributions could drive some employers out of the pension system,” he says.

In anticipation of a worsening pension perfect storm, Rosenthal adds that many of Mercer’s clients with the luxury of available cash have made additional voluntary contributions for the 2010 plan year so that their 2011 funded ratios would avoid further threshold tests and scrutiny, as mandated by the Pension Protection Act (PPA).

According to the consulting firm, the funded status for most pensions is anticipated to drop significantly in the wake of higher expected contributions for 2011, with about 50% of surveyed plans needing 2010 contributions in excess of the minimum required amount to prevent 2011 funded ratios from falling below 80%. This would potentially trigger benefit restrictions and onerous “at risk” funding rules, the consulting firm reveals.

Low interest rates have been driven largely by US economic policy, and Mercer notes that “the full effects of this one-two punch won’t be fully felt until 2012 and beyond.” Huge and continuing cash calls, the slow economic recovery, and big potential increases in Pension Benefit Guaranty Corporation (PBGC) premiums under consideration in Congress could place many plan sponsors in a difficult position, the firm states in a release, adding that without changes to pension funding rules, the funded status for many plans in 2011 and subsequent years will likely continue to decline significantly, with the following implications:

1) Funded ratios fall

2) Required contributions soar

3) Credit balances wither

4) Cash contributions skyrocket – up eightfold in just two years

5) Additional contribution increases expected in 2012

Mercer’s study was based on an analysis of 849 private-sector single-employer plans subject to the PPA, with more than $191 billion in combined assets as of January 1, 2010, and covering more than 4 million participants.

The consulting firm’s analysis follows a research paper published in August by UBS’s Francois Pellerin, which showed that between 2003 and 2007, the funded status of plans in the US ballooned from 77% to 96%. According to Pellerin, a heightened level of contributions made by plan sponsors — fueled by the PPA — largely drove the increase – highlighting a prevalent misperception among sponsors that a pure increase in equities got them out of their rut, when the real driver was contributions.

“In analyzing the liabilities of 500 publically-traded companies with the highest pension exposure, I found that on average, the pension plan was 46% of the size of the company,” Pellerin notes, adding that “liability-driven investment has flourished to control volatility so that plan sponsors can worry about what they’re good at – whether its building cars, making widgets, or whatnot.” Thus, once a plan reaches a funded status it deems appropriate, it should be heavily committed to a de-risking program, the paper claims.