By John Hintze
Fitch says progress made in funding ratios could be reversed amid prolonged low-rate period.
Corporate pension plan funding ratios have improved in recent years due to an increase in employer contributions, motivated by tax law changes, low borrowing costs and efforts to de-risk plans. However, long-term interest rates remaining low for an extended period and lower investment returns could reverse that progress.
“If you’re a corporate treasurer that has a 7% bogey for an assumed return on plan assets but actual gains are 2% or 3% while the discount rate assumption is also lower, funding gaps will rise,” said William Warlick, group credit officer at Fitch Ratings.
Return on assets falls. Mr. Warlick said a critical factor is the path of interest rates, which have been historically low for years but took a sudden dive in July and August—10-year Treasurys fell below 2%, and by early September yielded just above 1.5%. That potentially creates a “double whammy,” he said, in part because yields remaining low for an extended period will eventually reduce returns on pension funds’ fixed-income portfolios, which have been growing in recent years as pension-fund managers have shifted away from riskier equities.
While liabilities grow. As the return on assets shrinks, pension-fund liabilities are likely to increase, also potentially widening plan funding gaps. When Treasury and high-grade corporate bond yields fall, plan administrators’ discount rates fall along with them, so a given set of future cash flows related to plan-participant liabilities is discounted back at a lower interest rate.
“That means the present value of the liabilities is higher and the pension’s funded status could worsen,” Mr. Warlick said. “So the pension fund could either have a deficiency of asset returns or higher liabilities than expected.”
Either way, it could widen a pension plan’s funding gap.
“We could be entering an environment where, despite a recent period of voluntary contributions, required contribution could go up,” he said.
Good behavior lowers risk. Fortunately, the recent tax reform’s shift to a lower corporate tax rate and persistently solid investment returns have enabled most companies with large pension plus to significantly improve their funded status. The 150 companies Fitch reviews saw their median funded status improve to 85% from 81% between 2014 and 2018.
“We see a funded status between 80% and 90% as generally manageable for corporate America in terms of the cash contribution burden,” Mr. Warlick said.
Companies with projected benefit obligations of at least $5 billion that are substantially underfunded include Delta Airlines, with a 68% funded ratio, and United Airlines Holdings, with a 71% ratio. However, the Pension Protection Act of 2006 allows commercial airlines to elect alternative funding rules for DB plans that are frozen so the credit implications are limited.
Several large defense contractors, including Lockheed Martin, Raytheon, Northrop Grumman and Boeing, also have funding ratios below 80%. However, they can recover a portion of their pension costs from the US government, notes a Fitch report co-authored by Mr. Warlick. This is because defense contractors often are able to include contributions as allowable costs in their US government contracts.
Most of these plans are also fully funded on an ERISA basis and require minimal mandatory cash contributions over the next couple of years.
“We believe this somewhat reduces the long-term cash flow risks associated with underfunded plans of such contractors,” Fitch says.