Thursday, December 27, 2012

Attempting to Quantify the Unquantifiable in Pension Funding Requirements


Retirement underfunding is a huge issue facing Americans and American taxpayers as well. Whether it's the lack of money for private sector or public sector pensions, private or public sector 401(k)s, Social Security, Medicare or now ObamaCare, we have a "public education" problem and it's a biggie.

When we combine this lack of necessary knowledge with the added difficulty of funding adequately for an aging society and also for a citizenry not accustomed to self reliance as a method of providing for our own old age security, the big problem gets even bigger.

And finally, if we throw in a general lack of understanding of the financial issues involved with saving and investment versus the effects of current consumption and borrowing, it's perhaps the biggest factor, other than government ineptitude and private sector led future economic growth, facing the nation.

So let's tackle the specific issue of pension plan underfunding today.


We hear lots of chatter, but no serious remedial action, about the tens, hundreds of billions and even trillions of dollars in pension plan underfunding.

And we also frequently hear about the roughly one hundred trillion dollars in Social Security and Medicare unfunded promised benefits as well.

But what's the real number? Is there one? Well, that's where things get interesting. There is no one accurate number. It all depends on what happens down the road.

The problem is huge but largely unquantifiable without making assumptions about future developments and which almost certainly will prove to be significantly inaccurate. The only question is how inaccurate they will turn out to be.

In 2013, An Antidote for Poison Pensions? says this about the unquantifiable nature of the problem. Or as Donald Rumsfeld might say, the known unknown of pension fund liabilities:

"When you have just come through a hurricane, some rain doesn't seem such a big deal.

For corporate pension plans, that may sum up 2013. Although many are still dealing with the aftereffects of the financial crisis, they seem to have weathered the worst of the storm.

That may not be readily apparent. Pension deficits are still near record levels. Companies in the Standard & Poor's 1500-stock index with pension plans showed a combined deficit of $607 billion at the end of November, according to Mercer. Although this is down from a peak of $689 billion at the end of July, it is still up sharply from $484 billion at the end of 2011.

And one of the big factors weighing on pension plans—superlow interest rates—isn't likely to lift anytime soon. . . .

Low rates are tough on pension plans because they swell calculations of liabilities, and deficits. High-quality corporate bond yields, as measured by one index and an example of the rate companies would use to calculate those liabilities, stood at 3.57% at the end of November, versus 6.4% at the end of 2007, according to Mercer.

Meanwhile, although stock markets have recovered from crisis lows, the large-cap S&P 500 has basically gone nowhere over the past five years. So longer term, pension funds have had trouble meeting return expectations, which have generally averaged about 8%.

Going into next year, though, funds can hope interest rates don't fall much further. Barring unforeseen shocks, economic growth should be enough to keep rates around current levels, even if the Fed will try to prevent them from rising sharply. Should the Fed's latest measures help buck up the economic recovery, any improvement in stock markets will provide additional relief by helping funds to boost assets.

What is more, some companies will see some pension expenses fall, which could benefit cash flow. In mid-2012, Congress passed changes to interest-rate assumptions that corporate plans can use for calculating liabilities. Rather than base these on recent rates, companies will be able to use a 25-year average of rates. That will generally produce a higher rate, which will lead to a lower overall liability.

This won't affect the size of pension deficits or pension expense for accounting purposes. But it will shrink deficits for funding purposes under federal law. And the effects could be dramatic.

David Zion, accounting and tax analyst at Credit Suisse, estimated earlier this year that the change could reduce pension obligations, for funding purposes under federal rules, by more than 20% for S&P 500 companies. That in turn could cause a 90% drop in the required contributions these companies must make in 2013.

The catch is that this is a game of smoke and mirrors. The actual pension obligation hasn't changed. And by putting less into their plans today, companies may end up facing a bigger bill in the future. "Pension funding relief is just kicking the can down the road," Mr. Zion noted.

That is why some companies may choose to contribute more than is required. Others may look to turn low interest rates in their favor by borrowing cheaply to make up funding gaps in their plans."

Summing Up

If interest rates are 3% and the pension plan assumes they'll be 6%, the reality is still 3%.

And if the plan assumes an overall return of 8% and 50% of the plan's assets are invested in bonds at 3%, that would require a rate of return on stocks of 13% to hit the overall 8% rate of return as assumed in the plan. Not 10% as would be the case if interest rates were 6%.

All of which is to say simply that future ACTUAL investment returns will have an enormous, albeit unknown, impact on how well or poorly the plan is able to meet its future benefit obligations, regardless of what RATE OF RETURN assumptions are made by plan sponsors.

Hitting 8% overall almost certainly would necessitate something approximating an investment portfolio of 100% in stocks, but pension plans won't dare to invest that way, even though they should.

That said, they aren't going to have the guts to reduce their overall rate of return assumption to 5.5% from its current level of 8% either.

Going from an assumed rate of 8% to 5.5% would cause necessary contributions to skyrocket, which they should anyway, regardless of the assumptions used. There's a lot of catching-up to do.

Unless, of course, future benefits are going to be reduced, which will be very hard for pension sponsors to pull off, too.

It's indeed a tough spot to be in for pension plans, their sponsors, union leaders and employees.

No easy road lies ahead.

Thanks. Bob.

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