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The Case of Unfunded Liabilities

The Case of Unfunded Liabilities. Obie L. McKenzie Managing Director. November 15, 2002. Retirement Plans Under Attack By Rising Liabilities. Retirement Stool. Liabilities. Social Security. Pension Plans. Savings. What is the problem?.

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The Case of Unfunded Liabilities

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  1. The Case of Unfunded Liabilities Obie L. McKenzie Managing Director November 15, 2002

  2. Retirement Plans Under Attack By Rising Liabilities Retirement Stool Liabilities Social Security Pension Plans Savings 1625_nj

  3. 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 1625_nj

  4. 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 1625_nj

  5. A Primer on Pension Funding Retirement Today Salary Scale Salary Final Salary ActuarialLiability ProjectedBenefit Discount Rate 1625_nj

  6. Plan Assets • Plan assets are funded by the sponsor and contributed to based upon periodic valuations of the plan made by the plan actuary 1625_nj

  7. Actuarial Liabilities • The liability of a plan is the present value of benefits that have been accrued for service 1625_nj

  8. Stock Market / Assets • Worst Bear Market since WWII • S&P 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 1625_nj

  9. 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 1625_nj

  10. Equity versus Fixed Income – Cumulative Returns All periods ended 9/30/02 Percent Benchmarks: Russell 3000, LB Aggregate 1625_nj

  11. Interest Rates Actuarial Liability 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 1625_nj

  12. 9.0 8.5 8.0 7.5 7.0 6.5 6.0 01/1993 01/1994 01/1995 01/1996 01/1997 01/1998 01/1999 01/2000 01/2001 01/2002 Corporate Bond Yields Key Measure for Determining Corporate Plan Liability Moody’s Corporate AA Long Bond Yields Percent Month Source: Callan Associates, Inc. 1625_nj

  13. 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. 1625_nj

  14. 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 funding…companies still have sufficient leeway" 1625_nj

  15. 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" 1625_nj

  16. Merrill Lynch Survey – Fidelity Survey • Merrill survey reported by Reuters & Fundfire • 346 companies in the S&P 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 1625_nj

  17. 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 1625_nj

  18. What are the funding issues facing public plan sponsors? (cont’d) • Pressure to lower discount rate assumption • Uncertainty about future wage increases 1625_nj

  19. 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 1625_nj

  20. 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 1625_nj

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