As Congress searches for solutions to the economic crisis, it should not overlook the impact on pension plans – and the millions of American workers covered by them, according to experts at Watson Wyatt, a leading global consulting firm. If nothing is done to provide funding relief, many defined benefit plans could be frozen, placing participants at additional financial risk.
“No one could have predicted the disruption that has occurred in our financial markets and the resulting impact on defined benefit plan sponsors,” said Gene Wickes, global director of benefits consulting at Watson Wyatt. “New pension funding rules will squeeze pensions at exactly the wrong time, and both companies and workers will bear the consequences. When Congress reconvenes, we urge them to take a common-sense approach to pension funding that reflects current economic conditions, not one based on theoretical models. Workers’ retirement benefits are at stake.”
Congress is expected to reconvene on November 17 to address the economic crisis, and business groups are urging that a number of pension issues be addressed. The business community is not seeking an overhaul of the Pension Protection Act (PPA) funding rules. Instead, they are advocating temporary provisions and technical corrections to soften the transition from the old rules to the new ones, which were passed in 2006 but take effect this year.
Companies fund their pensions based on the value of plan assets relative to future retirement payouts. Reflecting the long-term nature of pension plans, old funding rules allowed pension sponsors to smooth their asset values based on market returns over a four-year period. The PPA reduced this to a two-year period and changed the "smoothing" method permitted under the old law to an "averaging" method. Smoothing allows sponsors to take expected investment returns into account when calculating asset values, while averaging does not. The use of the averaging method is expected to produce values that are less than market value, while the use of the smoothing method is expected to produce values that are approximately equal to market value.
On top of that, under the new rules averaged assets cannot exceed (or trail) current market value by more than 10 percent. Prior rules allowed for 20 percent. When asset values drop sharply as they have in recent months, this tight limit around market value creates considerable funding challenges for pension plan sponsors.
The new law generally requires sponsors to make additional contributions over a seven-year period to make up any investment losses. However, current circumstances could force sponsors to fund these losses on a much more rapid basis. For example, under the new law, a plan may be prohibited from paying full lump sum benefits if its funded status falls below 80 percent. For the many plans expected to fall below this threshold as a result of the recent economic crisis, this new requirement could effectively force the sponsors to fund the investment losses on a dollar-for-dollar basis to raise the funded status back above 80 percent in order to continue to pay plan benefits.
The end result is that new pension funding changes can significantly increase the year-to-year volatility of required pension contributions and create a situation where large cash contributions are required at the same time that cash is both scarce and needed for other business purposes.
“Marking-to-market at the end of every day might make sense for day traders, but it creates chaos for a plan sponsor trying to budget the costs of retirement plans being funded over 30- or 40- year time horizons,” said Wickes. “Without some relief, a sustained downturn in asset values will noticeably increase required contributions to pension plans starting next year, when plan sponsors will also be facing significant business pressure.”
In other situations, the Financial Accounting Standards Board, realizing that current market forces may be misrepresenting asset values, has provided some leeway in interpreting mark-to-market rules in light of the financial crisis, allowing companies to avoid pricing hard-to-value assets at “fire sale” prices. And the Emergency Economic Stabilization Act of 2008 instructed the Securities and Exchange Commission to review mark-to-market accounting generally. However, neither will provide relief for pensions.
“Pension plan sponsors face a number of unique issues that need to be addressed, most importantly permitting asset smoothing and suspending the 10 percent corridor rule in the short term,” said Kevin Wagner, a senior retirement consultant at Watson Wyatt. “If lawmakers implement just a few key temporary changes, it will ease the transition to new funding rules and help pension plans and their sponsors weather the storm.”
About Watson Wyatt Worldwide
Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organisations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,200 associates in 32 countries and is located on the Web at www.watsonwyatt.com.