S&P 500® Corporate Pensions and Other Post-Employment ...

RESEARCH Retirement

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Howard Silverblatt Senior Index Analyst Index Investment Strategy howard.silverblatt@

S&P 500? Corporate Pensions and Other Post-Employment Benefits (OPEB) in 2017

Providing Americans with adequate retirement income and affordable medical care was one of the country's most hotly debated social and political topics of the 20th century. However, the times have changed, along with longevity, as the medical cost of that prolonged longevity has risen, and corporations' ability to absorb the risks associated with multidecade portfolios to finance those commitments has fallen. Over the past three decades, corporations in the private sector have successfully shifted the responsibility of retirement to individuals, as programs have been frozen or closed to new employees, with 401(k)-type saving programs acting as substitutes. What remains is a lingering program of the past that will slowly decline in size and number of covered retirees over the coming decades. For now, both S&P 500 pensions and OPEB remain a manageable cost with sufficient resources and cash flow to support them-- as slowly increasing interest rates could improve funding via lower discounted liabilities for 2018. For 2017, corporate pension underfunding stood at USD 304 billion--22.1% lower than the USD 391 billion level of 2016, as markets posted a second year of impressive double-digit gains. The funding level increased to 85.62% in 2017 from 80.75% in 2016, 81.14% in 2015, and 81.12% in 2014. The most recent low-funding level was in 2012, at 77.26%, with the last full-funding level occurring in 2007, at 104.40%.

Clearly, the traditional defined-benefit corporate pension has become a relic of an earlier age, one that dates back to World War II, when the average American's life expectancy was 65 years. By 1974, when Congress passed the Employee Retirement Income Security Act (ERISA; the federal law that sets minimum standards for most voluntarily established pensions in the private industry), Americans' average life expectancy had risen to 72 years. Today (according to the Center for Disease Control), the average life expectancy in the U.S. is 78 years (76 years for men and 81 years for women). In 1983, when the life expectancy was 74, the official Social Security age of "full retirement" was scaled forward from 65 years to 67 years, depending on the year of birth, as longevity continues to move up. Medicare eligibility, however, has remained at 65. As a result, post-employment medical costs associated with longevity have skyrocketed, as have the costs of prescription drugs and elder care.

S&P 500 Corporate Pensions and Other Post-Employment Benefits (OPEB) in 2017

August 2018

TABLE OF CONTENTS

Overview

3

Today's Pension Situation Didn't Happen Overnight

6

OPEB: Easily Surviving Day-to-Day, but Not Living

10

Pension Funding Remains Manageable, as Coverage and Obligations Will Eventually Sunset

13

Conclusion: Traditional Pensions and OPEB Are a Dying Breed

15

Appendix: Company Listings?2017 and 2016 Comparisons

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Appendix: Sector Listings?2017 and 2016 Comparisons

27

Note the data for this report is as of July 10, 2018, unless otherwise noted. Regarding the Appendix: Excluding the Appendix, the tables and charts in this paper are based on S&P 500 historical memberships. The alphabetical and sector listings in the Appendix are based on the S&P 500 current membership to permit comparisons with the same issues' 2016 data; the aggregates for 2016 in these two tables therefore could vary from the actual 2016 membership data, and data in the other tables and charts.

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S&P 500 Corporate Pensions and Other Post-Employment Benefits (OPEB) in 2017

August 2018

OVERVIEW

Equity markets continued to set new highs last year, posting double-digit returns and outpacing the cost of lower interest rates, which have pushed up discounted liabilities, resulting in a 22.1% improvement in underfunding for 2017.

Interest rates utilized for discounted pension liabilities again declined in 2017, after 2015's significant increase, and are less than half of those used in 2001.

Expected pension return rates declined for the 17th year in a row. Most corporations have successfully shifted the burden of risk for retirement to the employee, as

401(k)-type savings accounts have become the norm, and active defined-benefit pensions in the private sector have become few and far between. Given the dwindling coverage, the current obligations of pensions and OPEB are a manageable expense for most companies. OPEB coverage continues to decline, as fewer covered retirees cost more per person, but are a quantifiable cost with a declining obligation.

The regulated pension system in the U.S. continues to suffer from antiquated accounting regulations that can sometimes distort the financial position of pension funds and their sponsors. The problem with OPEB is that the mostly pay-as-you-go system has been hampered by low funding rates, few incentives, and few legal guarantees.

In 2017, pension and OPEB assets set aside for issues in the S&P 500 amounted to USD 1.88 trillion, a 10.0% increase from the USD 1.71 trillion held at year-end 2016, setting a record level for assets. Obligations posted a 3.2% increase to USD 2.34 trillion from 2016's 2.26 trillion, also setting a new record for liabilities. These records combined to form an underfunding decrease to USD 453.6 billion from last year's USD 552.5 billion. The combined coverage ratio (theoretical, since the funds cannot be legally comingled) increased to 80.6% from last year's 75.6% (it was 70.0% in 2012).

For private companies, the long-term reality is that, thanks to shrinking programs and fewer employees who are covered, the end of onerous retirement obligations is on the horizon, although it may be decades away. In the short term, lower interest rates have worsened funding requirements, as higher eventual interest rates should improve pension funding, even with minimal corporate contributions.

For many Americans, early retirement remains a common occurrence, sometimes by choice but often due to job loss or job change. Given the financial burden associated with longevity, many people are unable to completely retire and find they must supplement their retirement income with part-time jobs or postpone retirement for as long as possible.

One of the primary reasons U.S. corporations have given for the cutbacks in traditional pensions and OPEB has been the dramatic growth in the globalization of markets in the past 30 years. This has eroded U.S. economic dominance and has shown up in the current tepid global recovery. As a result, U.S. companies are less able to pass retirement-associated costs--which many foreign competitors do not have--through to consumers.

Still, the U.S. private sector remains in a much better financial condition to meet its pension obligations than the U.S. public sector, due mostly to stricter funding regulations and the massive shifts over the past 30 years from traditional defined-benefit pensions to enhanced, 401(k)-type saving accounts. After the bear markets of 2000-2002 and 2007-2008 drastically reduced private pension fund reserves, the bull markets of 2003-2007 and 2009-to-present (with the current bull market scheduled to become

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S&P 500 Corporate Pensions and Other Post-Employment Benefits (OPEB) in 2017

August 2018

the longest in S&P 500 history on Aug. 22, 2018) helped them recoup somewhat. However, due to historically low interest rates and increases in longevity, pension underfunding remains substantial in absolute terms. The current record level of assets for 2017 stands 20.5% higher than it was in 2007, while the record liabilities stand 47.0% higher, with the result being that current pensions are underfunded by USD 304.6 billion, a 22.1% improvement from the 2016 underfunding of USD 391.2 billion, and as compared with being overfunded by USD 63.4 billion in 2007. The increase in 2017 funding appears to be more of a product of higher equity returns, up 10.5%, than discounted obligations, which increased 4.2%. For 2017, global markets excluding the U.S. posted a weighted 24.93% gain, as measured by the S&P Global Ex-US BMI (versus 1.79% in 2016), as U.S. markets, where S&P 500 funds are more invested, posted an 18.90% gain (6.10% in 2016), with the S&P 500 up 19.42% (9.54% for 2016). Historically, companies have failed to add additional discretionary funds to their required contribution, with the result being that underfunding remained prevalent. For 2017, there are some indications that companies made additional contributions ahead of the lower 2018 tax rates (a higher tax rate reduces the net income impact), which technically could continue until Sept. 15, 2018. The bottom line for the prior five years was that funding had become more of a product of liabilities, which are a product of interest rates, but as interest rates have started to trend up (with a lagging impact), discounted liabilities should decline, reducing underfunding. At this point, equity returns have been one-sided; the U.S. set records earlier in the year (Jan. 26, 2018), but it has remained in a trading range for most of the year, with the U.S. annualized return approaching double-digits.

While funding levels remain low, the ability of companies to support them remains relatively high, as earnings reached an all-time high in Q1 2018 and are projected to set a record in Q2 2018, and lower tax rates have resulted in record margins. The available resources (and cash flow) remain sufficient to support funding requirements. Additionally, cash levels and the availability of low-cost financing (especially abroad) remain high.

This means that the current underfunding and S&P 500 pension costs have become a reasonably controlled expense for corporations. Pension costs and outflows fit well within income and asset levels, and they remain compatible with cash flow levels. Also helping corporations cope are the declining benefits for newly covered employees, as those expenditures represent a shrinking obligation base, even as short-term costs and longevity increase for those covered (grandfathered). As interest rates rise and are incorporated into the pension funding forecasts, liability will likely decline, and the funding ration will most likely improve (subject to market returns). Of note is that these levels are "on paper" and do not change any of the actual payments to be made.

Another factor allowing most companies to keep pensions as an acceptable expense is employees' grudging acceptance of lower levels of pension growth and benefits, for those who still have them. As companies continue to shift more of the risks associated with defined-benefit programs to definedcontribution programs--and have extended that to medical benefits as well--the result is that legacy pension and benefit programs may largely disappear over the next several decades, as current and dwindling future recipients die.

For individuals, the impact of personal wealth depletion--via diminished home equity, low-yield savings and fixed income investments, prolonged high unemployment, lower-paying jobs, and reduced pension and OPEB--has left potential retirees with little ability to retire. While household wealth has climbed well above its prerecession level (to a record USD 100.8 trillion at the end of 2017), the distribution of that wealth has been uneven, making retirement even more difficult. Even with unemployment at levels not seen since 2000 and with U.S. equity markets posting new highs in 2017 and early 2018, the current economic reality for retirement is painful. Strained government programs, the need for

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S&P 500 Corporate Pensions and Other Post-Employment Benefits (OPEB) in 2017

August 2018

additional tax revenue, reduced spending on entitlement programs, and higher social costs have heralded a return to the retirement of prior generations. That is, you work for most of your (now-longer) life and spend your remaining years in retirement with a reduced lifestyle.

For what's left of the middle class, this reality replaces the American dream of a golden retirement for current retirees and baby boomers. Instead, with resources that are mostly strained, it leaves few options for a comfortable retirement. Simply put, time has run out for most boomers to add significant income to their retirement resources. Their primary option is to work longer. Younger workers, who now appear to be left on their own to plan for their retirement, will need to start saving early, allowing time to compound their returns. Their ability to do so, however, remains unclear.

The increase in fund status came as strong equity market returns overpowered lower interest rates (see Exhibit 1).

Exhibit 1: S&P 500 2017 Pension and OPEB Funding Stats

CATEGORY

PENSIONS 2017 PENSIONS 2016 OPEB 2017 OPEB 2016 COMBINED 2017 COMBINED 2016

Assets (USD Billions)

1,813.35

1,640.94

69.62

70.71

1,882.97

1,711.64

Obligations (USD Billions)

2,117.98

2,032.09

218.59

232.08

2,336.56

2,264.16

Funding Status (USD Billions)

-304.62

-391.15

-148.97

-161.37

-453.59

-552.52

Funding Ratio (%)

85.62

80.75

31.85

30.47

80.59

75.60

Source: Compiled by S&P DJI from data provided by S&P Capital IQ. Data as of each issue's 2017 and 2016 fiscal year-end. Table is provided for illustrative purposes.

Funding has improved, as more issues have higher rations, but the vast majority of companies remain underfunded (see Exhibit 2).

Exhibit 2: S&P 500 Pension and OPEB Funding Stats

CATEGORY

NUMBER OF ISSUES

PENSIONS

OPEB COMBINED

PERCENTAGE OF TOTAL (%)

PENSIONS

OPEB COMBINED

2017

Fully Funded

43

21

28

13.27

8.11

8.51

Funded 90%-100%

78

12

72

24.07

4.63

21.88

Funded 80%-90%

83

7

76

25.62

2.70

23.10

Funded 70%-80%

57

9

63

17.59

3.47

19.15

Funded 60%-70%

33

9

50

10.19

3.47

15.20

Funded < 60%

30

59

40

9.26

22.78

12.16

No Assets (OPEB: included in ................
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