The funding situation in defined benefit pension plans is continuing to improve across most industries, according to study released yesterday by Dominion Bond Rating Service.

The DBRS study finds just a handful of companies and industries are still in a large underfunded position.

The sectors most seriously affected are auto parts and a wide range of manufacturing companies, which tend to be more labour-intensive, DBRS notes.

But, DBRS says that the worst appears to be over for most companies. Mining, forest products, and auto manufacturers all saw their pension classification changed from middle exposure to insignificant exposure, relative to 2003, indicating reduced pension risk for these industries. This leaves only auto parts suppliers still in the “significant exposure“ category, although there are still individual companies with pension difficulties.

Since underfunding for defined benefit plans is only issue for some industries/companies, DBRS suggests that it is generally being over-emphasized as an issue in credit ratings. It concludes that most industries’ pension situations are manageable. Most pension plans have narrowed their underfunded position; Canadian pension plans continue to have significantly more conservative assumptions than U.S. Plans; and, pension deficiencies are cyclical.

In the study, DBRS examined 324 plans across 16 industries and noted that 63% were funded 80% or better at the end of 2004. “This compares to 58% at the end of 2003 and 51% at the end of 2002,” says DBRS vice president and study author, Francesco Sorbara.

“The improvement occurred despite two major issues,” Sorbara notes. “Firstly, assumed return on investments continued to decline such that 46.3% of the plans had assumed rates of return less than 8%, versus 42.9% in 2003, and secondly, discount rates on plans were reduced, with 47.8% of discount rates below 6.0% in 2004, versus 11.8% in 2003.”

The impairment in the funding position of pension plans in 2004 was mainly helped by: a relatively lower drop in the discount rate in 2003; modest investment returns for the second straight year; and, additional contributions by major companies.

Sorbara adds, “The pension deficiency is most sensitive to the discount rate which is based on average rates of interest on long-term debt paid by AA-rated companies. With short-term interest rates rising, it is only a matter of time before long-term rates increase. When they do, the present value of pension liabilities will decrease, thereby decreasing the pension deficiency.”

However, the study also found that the accounting for pension fund liabilities continues to be somewhat flawed. Of 309 companies, 12.6% continued to record pension income (not pension expense) despite the fact that they often had deficiencies in their pension funding, with plan liabilities exceeding assets. “In the U.S. and Canada, there have been new additional disclosure requirements with respect to discount factors used, plan assets, underlying assumptions, and estimated future benefit payments but the critical issue of the measurement of the pension obligation remains to be addressed,” DBRS says.