Wednesday, March 7, 2012

Energy Independence, U.S. Dollar, Interest Rates and Pension Plan Assumptions

Oil is priced worldwide in U.S. dollars. Accordingly, a higher dollar means lower fuel prices for U.S. citizens and companies, and a depreciating dollar means higher oil prices for the U.S. economy.

All other things being equal, low interest rates mean a less valuable dollar. That's because investors prefer currencies where cash returns are higher than lower. That said, increasing interest rates tend to slow the economy, and stability is the desired end game. That state of stability in turn requires a stable economy.

A weak economy, such as we have today, means lower interest rates as policy makers attempt to stimulate investment and improved economic growth. Besides, debt levels, both private and public, become more difficult to service if interest rates are elevated. So when efforts by monetary policy makers are implemented to get the economy moving again when times are tough, increasing interest rates isn't a realistic option.

Now let's switch to pension plan contributions and investments.

With pension plan investing, a lower assumed investment return means higher future contributions are required to meet plan payout promises. There's a very simple reason for that.

If the plan invests $1 and only earns 1% annually on that investment, it will take 72 years to double the amount of money invested to $2. On the other hand, if the plan earns 4% annually on the initial $1 invested, it will grow to $16 in 72 years. Hence, the less earned on money invested, the more money it takes to meet future payout obligations.

Now let's put all this together and include Congressional rules for pension plan funding in the private sector. To my knowledge, no such rules exist for public sector funds.

In any event, Companies' Pension Plea provides an interesting example of the impact of interest rates and investment returns on the future financial requirements of any plan, rules or no rules. Here's an excerpt:

"Business groups are urging Congress to let employers put less money into their pension funds, saying that exceptionally low interest rates are forcing them to set aside too much cash. . . .

Though its chances of becoming law aren't clear, the measure holds appeal in Congress because it would increase the government's near-term revenues . . . . Setting aside less for pensions would leave companies with smaller tax deductions, requiring them to pay about $7.1 billion more in taxes over 10 years than under current law, according to Congress's Joint Committee on Taxation.


The proposed change would apply to private-sector defined-benefit pension plans, which promise a specified amount of retirement pay. Though millions of Americans are covered by such plans, their prevalence has declined in past decades as companies have shifted to 401(k)s and other retirement plans that don't guarantee payouts.

Labor unions are open to changing the contribution formula, but say that Congress shouldn't allow companies to underfund their pension plans, as has happened already in some cases.

{NOTE: If unions are concerned about underfunding, why don't the public sector unions recommend adequate mandatory funding requirements for public sector employees? Are they content to let sleeping dogs lie (i.e., taxpayers) instead of hastening the day when 401(k) plans replace public sector pension plans?}

Companies with defined-benefit plans are required to use a "discount rate," based on a specific mix of corporate bond yields over the past two years, to help determine how much to contribute to their plans each year to meet their obligations. The rate varies by company.

Since the company uses the rate to help estimate the returns it can expect on its pension assets over time, the lower the rate, the more the company must contribute to its plans. . . .

Business groups argue that the two-year window used in the current discount-rate formula is too narrow, leaving companies vulnerable to short-term swings in interest rates. . . .

The business groups argue that with U.S. interest rates near historic lows, companies are diverting money into pension funds that could be otherwise used to hire new workers or make other investments. . . .

The AFL-CIO, the nation's biggest labor federation, said it could support changing the pension fund formula if it is paired with protection for the pension plans' participants. . . ."

Discussion and Analysis

Pension plans generally include an assumption that sponsors will earn a blended annual rate of return of ~8%. That assumption is not an issue for discussion today, although in fact it's a very big issue in need of a solution. We'll save it for another time.

What's at issue today is the governmental requirement to force private sector companies to contribute to their pension plans based on a "discount rate" tied to two year maturity interest rates. Of course, current two year borrowing rates are quite low.

Thus, the congressional funding mandate requires that companies contribute more to their pension plans than they would have to if fixed income borrowing rates were higher. In other words, the higher the assumed borrowing or interest rate, the lower the cash amount required to be contributed to the pension plan.

But on the whole, private sector pension plans are generally much better funded than are public sector plans. And annual contributions are much higher as well.

In the private sector, the strong trend is that companies are replacing their pension plans with defined contribution plans. Companies are doing this to avoid the risky and often unaffordable obligation to provide guaranteed benefits to employees upon retirement, regardless of the money available and the returns realized on funds previously invested.

Companies are putting the decisions with respect to investment alternatives and employee contributions, as well as all investing rewards, into the hands of employees.

In the public sector, however, no such widespread trend away from paternalism is occurring. And here's a big reason why. Public sector pensions have essentially no funding requirements.

Isn't that interesting? Private companies are obligated to fund and public sector plan sponsors aren't.

Neither are Social Security benefits funded and invested. Current workers in essence write checks to Social Security recipients out of their current paychecks.

And the reason for the astounding difference between private and public sector funding obligations for retirees is both simple and straightforward--the taxpayer is directly on the hook for public sector pensions. Notice the word directly. Now let's look at what too often is the rest of the story.

Taxpayers Are Always On the Hook

In the end, the taxpayer is on the hook for any shortfall in private sector pension promises as well. The government, through its agency the Pension Benefit Guaranty Corporation (PBGC), backstops private plan benefits.

Thus, if the private sector plan sponsor goes broke and has insufficient assets to pay all the claims, the PBGC picks up most of the tab. After adding up what the plan sponsor and the government cover, the employee then forfeits the remainder of what he thought he would receive.

And, of course, companies that do end up in bankruptcy generally don't have adequately funded pension plans, especially if the economy is in tough shape, as it is during difficult economic periods. Like today.

So why should Congress give companies a break today? For one thing, politicians reason that government will get more tax dollars since companies not making contributions will post higher profits, and hence owe more income taxes. Meanwhile, companies making lower or no cash contributions will expose their employees to a greater likelihood of pension payment shortfalls should the companies later not be able to meet their retiree pay obligations. Then the taxpayer gets the bill.

Putting It All together ..... The Oil Factor

But what's this pension plan stuff have to do with low interest rates, oil and the U.S. dollar? Well, that's the most interesting and important part of today's story.

Our economy appears to be at or near stall speed, jobs are hard to find, the U.S. dollar is weak, and oil prices are on the rise.

When that set of circumstances develops, the economy often proceeds to struggle indefinitely, as it did in the 1970s when OPEC raised oil prices severalfold. And when the economy struggles for years, many companies and individuals go broke. Many more suffer the consequences of that weakened economy.

And the Federal Reserve maintains low interest rates in an effort to help both the economy and individuals get back on their feet. But a normal recovery isn't likely to occur as long as oil prices remain elevated. And they now appear to be at a high level for a sustained period.

And since over the past several decades we have made no serious North American effort to achieve energy independence, we've grown far too dependent on countries like Iran, Russia, Venezuela and OPEC members for oil.

As a result, high oil prices will continue to postpone the U.S. economy's recovery. And those high prices, along with heavy debt and ongoing deficits, are a heavy load to bear.

I don't know which straw will break the economy's back, if it ever breaks, but the more straws that are piled on higher and higher, the bigger the risk of such a breakdown.

Summing Up ..... The Remedy

My view is simple. Unless and until we get serious about achieving energy independence, oil prices will be too high, the economy will be too weak, unemployment will be too elevated, deficits and debt will be too burdensome, and interest rates will remain too low-- unless, that is, inflation takes hold, rates rise and then a whole new set of even more serious problems arise.

The remedy is simple if not easy. We must immediately take all available steps to become energy independent. And keep at it until we've succeeded.

So for now, we must proceed to discover, extract and use lots of our own oil and natural gas, along with nuclear energy and coal in an all-out effort to regain economic prosperity and national security for our citizens.

We can't sit by and wait several more decades hoping that Iran and other rogue nations will choose to behave responsibly.

Nor can we wait for our own government sponsored solar or wind projects to "save the middle class." The time to act is now.

So unions, companies and Congress are talking about the wrong things while they debate pension plan funding deferrals and await the November election results.

If we don't quickly get to work on achieving North American energy independence, we'll need to tell the kids and grandkids that the good old days are gone. And that they're gone only because we didn't fight the good fight for energy independence.

And that by failing to act, we squandered their rightful inheritance.

That's my view. Bob.

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