The Case of Unfunded Liabilities

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The Case of Unfunded Liabilities

• Obie L. McKenzie
• Managing Director

November 15, 2002
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Retirement Plans Under Attack By Rising
Liabilities
Retirement Stool
Liabilities
Social Security
Pension Plans
Savings
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What is the problem?

• Extraordinary market decline coupled with lower
  interest rates has created serious unfunded
  pension liabilities for both corporate and public
  retirement plans

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Pension Plan Funding Level

• Plan funding level is determined by comparing the
  assets supporting the benefit obligations of a
  pension plan with the actuarial liabilities of
  the plan

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A Primer on Pension Funding
Retirement
Today
Salary Scale
Salary
Final Salary
ActuarialLiability
ProjectedBenefit
Discount Rate
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Plan Assets

• Plan assets are funded by the sponsor and
  contributed to based upon periodic valuations of
  the plan made by the plan actuary

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Actuarial Liabilities

• The liability of a plan is the present value of
  benefits that have been accrued for service

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Stock Market / Assets

• Worst Bear Market since WWII
• SP 500 down almost 50 from last year
• NASDAQ is down to less than one fourth of its
  2001 peak
• Resulting in asset levels being down 15 from
  year end 2001

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Bond Market / Liabilities

• The liability side has inflicted greater damage
  than the asset side
• Long bonds are up about 12
• Yields are down 80 basis points
• 15 year strips have soared by 23
• The true economic liability of plans has soared
  by 20 dwarfing the 15 from the asset side

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Equity versus Fixed Income Cumulative Returns
All periods ended 9/30/02
Percent
Benchmarks Russell 3000, LB Aggregate
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Actuarial Liability and Interest Rate Sensitivity

• The actuarial liability is sensitive to changes
  in interest rates similar to that of the rate of
  a bond

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Corporate Bond Yields Key Measure for Determining
Corporate Plan Liability
Moodys Corporate AA Long Bond Yields
Percent
Month
Source Callan Associates, Inc.
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Present Value of LiabilitiesIncreases as
Interest Rates Decline
Treasury Yield Curves
10.5 9.5 8.5 7.5 6.5 5.5 4.5 3.5 2.5 1.5
12/31/85 12/31/90 12/31/98 12/31/01 6/30/02
Yield (Percent)
1 2 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Duration
Source Callan Associates, Inc.
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Standard Poor's Survey

• US Corporate Pension Funding at 94 Credit
  Ratings Unaffected for Now (Sept. 24, 2002)
• "Average funding ratio declined to 94, from
  100 at the end of 2001"
• "So far not identified any US companies for
  which rating downgrades are warranted solely on
  the basis of pension fundingcompanies still have
  sufficient leeway"

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Standard Poor's Survey

• Public Pension Funds Under Stress (Sept. 24,2002)
• "Expect average fiscal 2002 actuarial funding
  levels to drop to between 95 to 100, down from
  103"
• "Increasing contribution rates on top of fixed
  pension obligation bond's debt service costs can
  spell trouble for the sponsor"

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Merrill Lynch Survey Fidelity Survey

• Merrill survey reported by Reuters Fundfire
• 346 companies in the SP 500 were "overfunded" by
  215 billion as of 12/00
• 98 of those companies expect to be underfunded
  at 12/02
• expected underfunding 640 billion
• Fidelity conducted a very comprehensive survey of
  corporate plans and found similar results
• huge change in funded status
• expect tremendous increase in funding

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What are the funding issues facing corporate
plan sponsors?

• Growing unfunded actuarial liability
• Solvency issues with implications for higher
  contributions and PBGC variable premiums
• Pressure to lower assumptions
• Additional minimum liability and charges to
  shareholder equity

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What are the funding issues facing public plan
sponsors? (contd)

• Pressure to lower discount rate assumption
• Uncertainty about future wage increases

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What can we do?

• Understand current financial condition and
  monitor the changes to the financial condition of
  the plan and understand their implications
• Re-evaluate funding investment policies and
  assumptions in light of the level of current and
  future costs and tolerance for risk
• Assess pension cost and funding needs for next
  several years
• Consider a broad range of possible outcomes and
  risk management

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What can we do? (cont'd)

• Educate those who need to know legislators,
  participants and executives
• Maintain a long-term focus and recognize that we
  have been here before