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US pension funds face funding gap, says report

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US defined-benefit pension schemes could be in jeopardy as funds predict sharply reduced investment returns from major asset classes up to 2013, according to research from Greenwich Ass

US defined-benefit pension schemes could be in jeopardy as funds predict sharply reduced investment returns from major asset classes up to 2013, according to research from Greenwich Associates.

Overall, corporate pension funds interviewed from July to October 2008 said they had reduced investment returns on plan assets to an annual 7.4 per cent in 2008 from 8.2 per cent in 2007 and public funds cut overall portfolio return expectations to 7.6 per cent from 8.5 per cent.

‘US pension funds are not expecting a quick recovery in investment markets,’ says Greenwich Associates consultant William Wechsler. ‘To the contrary, they are planning for a slow-growth environment for asset valuations that they expect to continue for the next five years.’

Pension funds have dramatically reduced return expectations for US equities, with projections for annual rates of return dropping to 7.8 per cent in 2008 from 8.6 per cent in 2007 among corporate plans and to 7.9 per cent from 9.1 per cent among public plans.

Both groups also cut return expectations on fixed income, with public plans reducing annual expectations to 5.0 per cent from 5.8 per cent and corporate plans reducing expected returns to 5.2 per cent from 5.6 per cent.

Pension funds also reported substantial reductions in expected returns on international equity, equity real estate, private equity and hedge funds.

Both groups expected private equity to generate the highest returns of any asset class over the next five years, with public funds projecting an annual 11.3 per cent return from their private equity investments and corporate funds expecting 10.1 per cent.

‘It is important to remember the extent to which markets have deteriorated since these interviews were completed in September,’ says Greenwich Associates consultant Dev Clifford. ‘If anything, these expectations for private equity and other asset classes might prove overly optimistic.’

Declines in investment returns have produced a gap between pension funds’ actuarial earnings rate and their actual expectations for returns on plan assets. The average actuarial earnings rate reported by corporate pension plans increased modestly to 8.3 per cent in 2008 from 8.2 per cent in 2007 despite the decline in expected returns for all asset classes. The discrepancy results in an expected gap of 90 basis points. Although the average actuarial rate for public plans declined to 8.0 per cent in 2008 from 8.2 per cent, the bigger drop in expected investment returns has produced a gap of 40 basis points.

‘These gaps can only be made up in one of two ways: through higher investment returns or new contributions,’ says Greenwich Associates consultant Chris McNickle. ‘At the present moment, neither option seems particularly likely. So we are facing a growing problem.’

The results of the annual Greenwich Associates study suggest that institutions believe a low return environment will persist for some time to come. Meanwhile, companies, states, municipalities and other plan sponsors are facing severe resource constraints.

Rather than being in a position to increase contributions, many plan sponsors are reducing or delaying contributions as part of actions that will save them money in the short term, but these actions could serve to increase pension funding shortfalls over the long term. Some will be at risk of violating regulatory requirements, and in the current environment may seek relief from the government.

‘We might look back at this crisis as being the final stake in the heart of corporate defined benefit pension plans in the US,’ says Wechsler. ‘Recent volatility in pension asset valuations is bringing home the risks these plans can pose to the bottom line, and unfortunately closing plans to new employees is a relatively easy way for companies to reduce pension costs.’

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