The unfunded liabilities of the US’s 19 largest pension plans rose to $189 billion, an increase of $12 billion from last year, according to a new report from Russell Investments. The shortfalls from the 19 pension funds of the nation’s largest publicly-traded corporations in the healthcare, aerospace, automotive, technology, oil and gas, logistics, and chemical sectors, rose due to a fall in the discount rates used to value liabilities.

While these large corporations, which Russell calls the “$20 Billion Club,” saw an increase in liabilities, the long-term liability trend is going lower, the report found. The 2016 total of $902 billion is below the high point of $933 billion reached in 2014. “Unless there is a substantial fall in interest rates this year, 2014 may well prove to be “peak pension,” the point at which defined benefit plan liabilities reached their high,” the report said.

Yet as liabilities rose, the report found that assets continued to grow. Asset growth would allow plan sponsors to address their collective $189 billion pension fund deficit. This would mean that with 2016 total assets less than 5% below 2014’s level, strong investment performance in 2017 could see a new high, the report said.

Pension funds were also negatively affected by mark-to-market accounting which accelerated gains and losses and contributed to higher pension costs in 2016. The fall in the discount rate and other market factors were all realized more quickly as a result of mark-to-market accounting.

“The total loss recognized by the six corporations who use a mark-to-market approach was $9.9 billion, approximately 4% of year-end liability value. The loss recognized by the 13 corporations who do not mark to market averaged less than 2% of their liability value,” the report said.

According to Bob Collie, chief research strategist, the main reason for the decline in 2016 was a decrease of about 0.25% in the discount rate used to value liabilities. However, this decline was offset by a slight increase in plan sponsor contributions and a slight rise in investment returns.

The biggest force affecting the underfunding was interest rates, specifically the median discount rate used to value liabilities.  His accounted for the actuarial loss of $38.7 billion among the pension plans of the largest corporations.

On the asset size, the report said investment returns “were solid,” with returns ranging from 4.7% to 12% from the 18 corporations that reported returns on a calendar basis. “This was more than enough” to cover the interest cost of $31.9 billion in liability growth, the report said.

Pension contributions were another story. These varied widely among the 19 corporations, with about half making discretionary contributions in 2016 and the rest failing to make them. One reason for the differences in voluntary contributions was due to increases in the PBGC’s variable rate contribution schedule. This change gave pans a few more choices in how they addressed their underfunding situations. These changes, Collie said, meant “sponsors will increasingly choose to make discretionary contributions above the required minimum in order to reduce their funding shortfalls.”  

Looking ahead to 2017, Collie said “while the past few years have shown that interest rates have been the biggest factor driving changes in interest rates (even more than investment returns),  if we enter a rising rate environment, we could see substantial improvement in funded status. If we look, for example, at 2013’s improvement that was mainly caused by the median discount rate used to value liabilities rising from 4.0% to 4.89%. If rates rise in 2016, we’d expect to see a similar effect. The other cause of year-to-year variation is, of course, investment returns. Those are the big two.”

Collie also said contributions are important,” especially when you look at the longer term. Currently, contributions are still fairly low as many corporations continue to take advantage of the flexibility offered by funding relief to defer contributions. But, we expect to see discretionary contributions tick up as a result of PBGC premium increases, and there are signs that’s starting to happen. Overall, the pension fund situation really comes down to interest rates and investment returns,” Collie said.

When Should a Pension Plan Borrow to Fund its Liabilities?

In contrast to Russell’s latest 2016 report, pension plans in 2015 started to borrow money rather than continue with a pension deficit. In a paper written by Russell’s Jim Gannon, changes in the way the Pension Benefit Guaranty Corporation (PBGC) gave underfunded plans more flexibility in how they corrected their shortfalls. This change, which was part of the in the Bipartisan Budget Act of 2015, gave sponsors more options in determining their contribution schedules, including a reduction in  their minimum contributions to correct underfunding. But it also meant they could face higher costs from the PBGC’s variable funding option, which is a high costs for underfunded plans.

In a scenario modeling “amortization of unfunded liabilities,” Gannon used key variables (such as credit rating, interest rates, PBGC premiums) to calculate whether  the “breakeven rate” makes more sense for the corporation to either borrow or continue to fund the plan annually.

By Chuck Epstein