Fixing pension deficits
Is the worst over? The sky over American pension funds looks a bit less cloudy, after some good news arrived both from Wall Street and from the bond market. Analysts at Merrill Lynch even calculate that the huge deficit hanging over DB pension plans – as big as $300bn (e266bn) according to some estimates – could be completely eliminated by the year-end, if the positive trends keep going. Specifically, if long-term high quality corporate bond rates were to rise to 7.5% and if the S&P500 returned to 1,056.
In fact these bond rates are used by companies for discounting pension and post retirement healthcare liabilities from their balance sheets, according to GAAP (Generally Accepted Accounting Principles): the higher they are, the lighter liabilities are. Meanwhile the stock market rally lifts the value of pension fund assets.
So far 2003 has been a good year for Wall Street: the S&P500 index has risen 15% and some gurus, like Prudential chief strategist Ed Yardeni, forecast it will close December at 1,140. On the other hand, the bond sell-off since mid-June has increased yields and, says a Merrill Lynch analyst, Crispin Southgate, “has reduced accounting measures of pension plan deficits by 40%, undoing nearly all the damage done by falling bond yields until then”.
At 31 December 2002 most big US companies used a rate of between 6.5% and 7% – the one relative to long AA corporate bonds – for discounting pension liabilities. The big rise in bond markets from January to mid-June 2003 increased the value of these liabilities by around 15%. Luckily since 13 June the opposite happened: falling bond prices and rising yields have chopped liabilities to the previous level.
Good news comes also for avoiding paying penalties to the Pension Benefit Guarantee Corporation (PBGC), the public agency that insures US pension funds. The PBGC discounts pension fund liabilities using the 30-year Treasury yield and it can force employers with big deficits to pay extra premiums. The PBGC rate was around 4.9% for 2003 and “if rates stay the way they are,” says Southgate, “it could well be around 5.5% for 2004, reducing PBGC liability measures by around 10%. This would lift some pressure from employers with the worst deficits”.
A different story regards ERISA rules, which can force companies with big pension deficits to make top up contributions to plans. The yield used for ERISA calculations of liabilities is based on the four-year weighted average of 30-year US Treasury bond yields and it is still falling. Besides, there is a big uncertainty about what will happen next year. The consulting company Watson Wyatt has figured out three different scenarios for 2004/05. First, the current concession (due to the discontinuance of the 30-year T-bond issuance) can be extended and actuaries will still be allowed to use up to 120% of the ERISA rate for funding purposes: Fortune 1000 companies will have to contribute $47.5bn to their pension plans. Second, if the concession is withdrawn, companies will be able to use only up to 105% of the ERISA rate and they will have to contribute $80bn. Third, the US Congress passes the ‘Pension Preservation and Savings Expansion Act of 2003’ proposed by representatives Rob Portman and Benjamin Cardin: the ERISA rate will be based on long-term high-quality corporate bond yields, which are consistent with the discount rate used for GAAP pension calculations. The latter would be a very positive change for companies that will have to contribute only $22.5bn. Employers are lobbying Congress to approve the bill.
This uncertainty is not the only problem US pension plans have to face. The New York-based consulting firm Ryan Labs reminds them about their long-term asset/liability mismatch. It is true that the latest Ryan Labs bulletin registered some improvement in the average US pension fund (invested 60% in US stocks, 5% in international stocks, 30% in bonds, 5% in cash). The asset allocation model performed 10.61% in the first eight months of 2003 against a 2.96% decline in liabilities, improving the asset/liability ratio to a 13.57% gain. “But it is the cumulative performance since 1999 that remains the key problem,” says Ronald Ryan. “The deficit gap since then has now been reduced to –54.26%, suggesting funding ratios below 60% for most pensions.”
Another sceptical analyst is Robert Arnott, chairman of Californian investment firm First Quadrant. He was the first to ring the alarm bell about pension fund deficits amounting to a “trillion-dollar time bomb”. He insists the bomb is still ticking, because companies maintain unrealistic assumptions of 8.5–9% returns on their pension assets.