The ratio of plan assets to plan liabilities, which was 104 percent at the end of 2007, was 97 percent at the end of the third quarter. The surplus at the end of 2007 of $60 billion has been replaced by a deficit of $35 billion. However, Mercer’s analysis shows that without a significant increase in high-quality corporate bond yields, which are used by most companies to measure the value of plan liabilities, the financial position would be significantly worse. Furthermore, if credit spreads return to levels typically observed over the last three to four years, without a recovery in equity values, the deficit could open up to over $400 billion.

Mercer estimates the total combined funded status position of plans operated by S&P 1500 companies on a monthly basis. Figure 1 shows the estimated surplus/deficit position and the funded status (ratio of assets to liabilities) of all plans operated by companies in the S&P 1500 as reported in their financial statements. This includes US domestic qualified and nonqualified plans and all non-domestic plans. The figures provided in the chart are estimates based on financial indices.

FIGURE 1

"It is important to understand the relationship between corporate bond yields and pension plan liabilities," said Adrian Hartshorn, a member of Mercer’s Financial Strategy Group, which helps companies manage financial risk in their retirement programs. "Pension plan liabilities are a promise of payments in the future, and are therefore similar to bonds, albeit with a more complex structure. Also, like all bonds, an increase in the discount rate – in this case the yield on corporate bonds -- reduces the present value of pension plan liabilities."
 
Mr. Hartshorn continued:  "Although there has been a significant reduction in the funded status of pension plans over the year -- from 104 percent to 97 percent -- had there not been an increase in credit spreads the position would be worse. Between 2003 and 2007, credit spreads between AA corporate bonds and US Treasuries were typically 1-1½ percent, but are currently [at the end of September] standing at over 3.3 percent. If markets settle and credit spreads contract to previous levels without a recovery in the equity markets and without any other external events, the funded status of pension plans would fall to 77 percent, equivalent to a deficit of over $400 billion. This would clearly be bad news for sponsors of defined benefit plans, and would lead to higher pension costs in financial statements and higher cash contribution requirements."

Mr. Hartshorn outlined several steps plan sponsors should take in response to the current market conditions.

"Plan sponsors should continue to educate themselves on the risks they are exposed to with their pension plans," Mr. Hartshorn said. "Those who have quantified and can withstand short-term volatility are being encouraged to sit tight and maintain a longer term focus. Others may be revisiting their current program financial management policies and considering opportunities to mitigate risk or better position themselves moving forward. While it is difficult to take short-term action, it is also important for plan sponsors to monitor the ever-changing environment and be prepared to take action at the appropriate time."

Mr. Hartshorn added, "As we approach the financial year end for many companies, continued market volatility could result in substantial, unplanned and potentially unwelcome outcomes for plan sponsors in terms of accounting figures and future cash flow requirements. This would suggest updating budget forecasts for 2009 expense and cash, and then monitoring the position closely until the end of the year."