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How to shrink the liabilities

US pension fund sponsors can breathe with relief after the Pension Funding Equity Act of 2004 was signed by the president George W Bush in April. According to the Pension Benefit Guaranty Corporation (the quasi-federal agency that insures pension plans) the new law will save them $80bn (e117.8bn) in contributions over the next two years. But not everybody is happy.
The most important feature of the legislation is a new benchmark for calculating benefit obligations of defined benefit (DB) plans. The old one, which expired at the end of 2003, was tied to the 30-year Treasury bond, which the government stopped issuing in 2001. The new benchmark is an index of long-term upper-medium-grade corporate bonds, which includes AAA, AA and A bonds. The average yield of this kind of corporate bonds is around 6%, one percentage point higher than the rate on the 30-year bond. The higher the yield, the lighter the burden of benefit obligations on companies’ balance sheets, because their current value is calculated discounting interest rates. That is why the new benchmark will shrink US pension funds’ liabilities for the next two years. In 2006 the rules will be discussed again.
For the time being, DB plans appear better funded and companies have welcomed the new law. “This is the landmark pension legislation of the past 15 years; it’s a big deal,” says Mark Ugoretz, president of the Erisa Industry Committee (ERIC), a lobbying group for big employers.
According to ERIC, if the legislation didn’t pass employers would have been forced to freeze or terminate traditional pension funds, whose assets were severely affected by the 2000-2002 stock market downturn, while the liabilities ballooned because of the dramatic drop in interest rates.
Luckily, also last year stock market recovery has improved pension fund situation. It is true that most of the 358 companies in the S&P500 that pay out pensions still have underfunded plans. But according to S&P, 18 of those companies’ pension plans moved to overfunded status in 2003 from a deficit in 2002; another 26 companies’ pensions reported big gains and even the 256 companies that had underfunded pensions in 2003 grew their assets by 21%. “We believe the market will return 12% in 2004 and we think 2005 is going to continue with a positive return, so we project further pension improvement,” says Howard Silverblatt, an S&P equity market analyst.
But some critics point out that the new law could have adverse repercussions. Zvi Bodie, a professor of finance at Boston University, says that by giving companies relief from strict pension fund requirements, the government is greatly increasing the magnitude of a potential taxpayer bailout of the Pension Benefit Guaranty Corporation. David Zion, an accounting analyst at Credit Suisse First Boston who is an expert on pension issues, added: “It’s a temporary solution. I’ve described it as a Hail Mary pass: you throw something up and really hope someone catches it.
“The Hail Mary is hoping that the stock market moves up. If it doesn’t, companies may end up having to make even bigger contributions than they had expected initially.
“The new pension bill does not solve the most important problems and adds a new one,” says Ronald Ryan, president of the research firm Ryan Labs. “First of all it still allows smoothing accounting: it is obvious that interest rates are volatile, so why the new benchmark is based on four year averages?” In fact 40% of the benchmark is made of the current year rates; 30% is made of last year rates; 20% of the year before rates; 10% of the previous year rates. “If the rates go up quickly, they won’t benefit immediately the pension funds. The paradox is that the 30 year T-bond rate may become higher than the new benchmark,” says Ryan. “Second, the new bill has adopted a single discount rate, which means that pension funds are going to write all liabilities with the same rate, which is non realistic. Pension benefits must be paid at different dates and if you want to match the true liabilities you should be able to buy on the market bonds with different durations. Finally, the new benchmark introduces a new problem.”
Says Ryan: “It blends three different types of corporate bonds, from AAA to A bonds and the latter do not qualify for high quality bonds. The companies feel happy, because usually their asset allocations do not consider liabilities. But the ripple effect of mispricing liabilities can be very bad.”

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