Interest rates undermine investment returns and pension plan infusions

Annual study of DB plan funding looks at key finanical results

Over the last two years, plan sponsors have made record levels of contributions to pension plans and the typical pension fund has experienced double-digit investment returns.

In spite of this, the average funded status of large Canadian corporate pension plans remained stuck at about 84 per cent of obligations at the end of 2004. Why? While pension fund assets have grown dramatically from large contributions and good returns, pension fund obligations have grown even faster.

That is what Towers Perrin found in its fifth annual review of defined benefit (DB) pension plan funding at major Canadian corporations. The review covered the 90 largest Canadian companies traded on the Toronto Stock Exchange. The study compared a number of key financial results for 2004, as disclosed in each company’s annual report. Excluded were companies with no DB pension arrangements, as well as financial institutions, since their financial structure looks quite different from others’.

Funded status measures the extent to which pension assets cover obligations. According to the review, pension obligations exceeded assets by $20 billion. The average deficit was about $221 million. This was despite pension contributions of more than $5 billion in aggregate and $57 million on average. Contributions for the 90 companies in the review have soared 171 per cent over three years. The 10 largest companies increased their average contribution by 158 per cent over just two years, from $70 million in 2002 to $181 million in 2004.

The funding status stall

In addition to substantial inflows from sponsors, pension funds did well on their investments. A separate Towers Perrin survey of results for diversified investment managers found that balanced funds averaged 10.3 per cent last year following a 14.2-per-cent gain for 2003. Yet funded status still hovered about the 84-per-cent level for the second straight year.

This stall was due to falling interest rates, which have a disproportionate impact when valuing pension obligations. Pension fund valuations use a rate that is based on Canadian long-term interest rates at the date of the valuation. This rate is based on a combination of bond yields, government or corporate, that have been in a long-term decline since the early 1980s. The average interest rate used for financial reporting purposes dropped from seven per cent in 2000 to 6.25 per cent in 2003 and then 5.95 per cent in 2004.

A decline in long-term interest rates drives up the current value of pension obligations. At seven per cent, $362,446 must be set aside today to fully cover $1 million in obligations due 15 years from now. At 5.95 per cent, $420,229 must be set aside. In this case, an interest rate decline of 105 basis points has increased the plan’s obligations by 16 per cent.

While declining interest rates increase the current value of the future obligations, they also increase the value of bonds or other debt securities held in the fund. But stocks and other equity investments are considerably less correlated to interest rates. In 2004, the average Canadian pension fund held just 37 per cent of its portfolio in bonds. Therefore, interest rate slippage affected 100 per cent of the plan’s obligation calculation, but just 37 per cent of its assets. This mismatch overpowered the positive effects of record sponsor contributions and strong investment returns. Sponsors need to think very carefully whether they should accept the degree of financial risk inherent with such a large mismatch.

If a sponsor decides that the degree of mismatch risk is too large, they can increase their allocation to bonds with a similar degree of interest sensitivity as their obligations. This will reduce the chance that the funded ratio will fall dramatically. But this risk reduction comes at a price. The price is that they will expect to contribute more to the plan over time because bonds are expected to achieve a lower investment return than equities.

Sponsors will need to keep in mind that as we enter the second half of 2005, the situation has deteriorated since the beginning of the year. Interest rates have continued their downward trend. Without a significant increase in long-term interest rates or the combination of stable rates and very high asset returns, sponsors should expect a continuation of the large contributions they have been making and the high pension expense eating away at the net income they report.

Steve Bonnar is a principal in the Toronto offices of Towers Perrin. He may be reached at (416) 960-2735 or [email protected].

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