Underfunded Pensions Could Spark Wave of ‘Precedent Setting’ Reforms

Underfunded pensions plans are possibly one of the most significant headwinds facing companies and public-sector bodies today.

Despite record high stock markets and a bond bull market that has lasted for many decades, corporate pension plans are still chronically underfunded as fees and poor investment performance have eroded gains. Furthermore, pension trustees have struggled to keep up with funding requirements for over-generous schemes.

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According to an analysis by Willis Towers Watson at the beginning of this year, pension plan data for 410 of the Fortune 1000 companies with a defined-benefit pension plan, had an aggregate pension funded status of 80% at the end of 2016. The average pension deficit is 5 billion, up from 8 billion at the end of 2015.

Pension funding levels have fallen steadily over the past decade from around 99% in 2006. Companies contributed billion their pension plans during the year and benefited from an average investment return of 6.7%. However, a 28 basis point decline in discount rates pushed liability values up 3.4%.

Proposed tax changes, as well as a healthy demand for corporate debt, has inspired some treasurers to try and fill their pension gaps this year by issuing debt. According to the Financial Times, International Paper, the paper and packaging group, motor oil maker Valvoline, and grocer Kroger have all issued debt to top up underfunded pension plans in recent weeks. Companies have also decided to take this action ahead of a premium hike from the Pension Benefit Guaranty Corporation, which provides a backstop for underfunded pension plans. According to Bank of America, the annual fee charged is expected to rise to 4.2% by 2019, that’s compared to the average investment grade corporate bond yield of 3.11% today.

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Companies are not facing pension problems alone. US public pension funds are chronically underfunded with the shortfall between assets and liabilities estimated at just under .9 trillion. The gap jumped by 4 billion last year alone.

Research shows the underfunded pensions problem is only going to get worse. The Financial Times reports that according to research from Stanford, analysis of the finances of 649 public pension plans for the 12 months to June 2015 shows that no city or state is running a balanced budget for their underfunded pensions.

Underfunded Pensions Woes to Lead to Radical Changes?

Trying to balance the books is going to be an uphill struggle for pension trustees. For example, Chicago estimates that underfunded pension liabilities equal 19 years of city tax revenues.

To try and balance the books, pension reform proposals are starting to emerge, but public bodies are having to navigate complex legal protections for employee benefits, which can limit reform options.

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However, according to Moody’s litigation on a variety of pension reforms continues to work its way through courts across the country, offering the potential for precedent-setting decisions.

California is a prime example. California provides the strongest level of legal protection for public pension benefits according to Moody’s, as a series of state Supreme Court decisions have created a strict legal protection framework. Not only are accrued benefits for past service legally protected from impairment, but future benefit accrual formulas may not be weakened once employees are hired.

If investment return targets are met, CalPERS projects average government contributions to public safety plans will peak at 40% of payroll in fiscal 2020, up from approximately 32% in fiscal 2015. To help manage the situation, CalPERS looks set to lower its discount rate further over time, although more severe reforms may be needed. The ratio of active employees to benefit recipients is declining for both CalSTRS and CalPERS, although at 1.5, CalSTRS is very close to the national level of 1.6.

A similar situation is unfolding in New York with its underfunded pension woes, where the city already faces much higher contribution requirements for pensioners than years as public safety plans have fewer active employees than retirees. Nonetheless, New York’s constitution explicitly protects the pension benefits of current employees and retirees from impairment, so reforms have been limited.

By Rupert Hargreaves

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