Kicking the pension can down the road

Tucked away in the transportation bill passed almost two years ago is a small provision that has little to do with transportation. The bill is called Moving Ahead for Progress in the 21st Century Act or MAP-21 and buried deep within it is a law that deals with defined benefits corporate pension plans.

... MAP-21 modified the method for determining the interest rates used to determine the actuarial value of benefits earned under the plan, providing for a 25-year average of interest rates to be taken into account in addition to a 2-year average ...

For those of us who grew up on the concept of "discounted cashflows" this law is particularly absurd. The basics of finance tell us that the net worth of any long-only portfolio is the market value of its assets less the present value of its liabilities. And the present value of liabilities should be determined by discounting future liabilities with current interest rates.

Of course in the current low interest rate environment the present value of liabilities for many pension plans is much greater than the value of the assets, making these plans insolvent. That would mean companies need to inject cash into these pension plans each year to keep them afloat. But here comes MAP-21 to the rescue. Let's allow pensions to use interest rates averaged over the past 25 years to discount the liabilities. That makes the discount rates much higher and the discounted liabilities much lower. It's not mark to market but rather mark to the past 25 years. All of a sudden companies don't have to pony up large amounts to keep these pensions afloat. Magic.

It's all interesting in theory, but what does it look like in practice? Here is a 2013 statement from a mid-size US company that discloses the difference between the traditional discount methodology and the new MAP-21.

The value of this pension plan is negative $219 million (funding shortfall), but under MAP-21 it's only $34 million under water. It's like telling a homeowner that her house doesn't really have negative equity because we've devised a clever way of discounting the mortgage. However it's the law of the land, and defunct corporate pensions will stay underfunded for years. But no worries, eventually the federal government will bail out many of these pensions at taxpayers' expense (see post). For now, MAP-21 and the higher rates over the past 25 years have allowed companies to kick the pension can down the road.

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Low rates pushing pensions deeper into underfunded territory; liability "smoothing" goes global

The corporate pension lobby is increasingly energized to have the US Congress approve the 25-year "smoothing" for pensions. With interest rates falling, defined benefits corporate pensions are once again becoming severely underfunded.

Source: JPMorgan

Increasing the discount rate would lower the net present value of pension liabilities making them look less underfunded. The assets however will be growing at the current extremely low rate of return and will likely be insufficient to meet pension obligations in the future.

NCPA:  - Private corporations are asking Congress to change how they calculate their annual pension contributions, which could create a huge unfunded liability for taxpayers, say Jason J. Fichtner and Eileen Norcross, senior research fellows with the Mercatus Center.

The law requires corporate plans to measure their liabilities, and determine annual contributions to fund them, using the rate of return on corporate bonds -- the discount rate. Now, corporations are lobbying for Congress to allow them to increase the discount rate. This allows accountants to assume better investment performance, setting aside fewer dollars for future pension obligations.

• The provision in the Senate-passed version of the transportation bill currently under consideration in the House would allow corporations to use a 25 year average rate as opposed to the current 2 year average.

• This would increase the current discount rate from the 4 percent range to roughly 6 percent.

• Since liabilities are sensitive to discount rate assumptions, the plan's liability will change roughly 15 percent for every one percentage point change in the discount rate.

• For example, Boeing reports that a mere quarter of a point increase in the discount rate could cut its pension liability by $1.7 billion.

Not surprisingly this lobbying effort is not limited to the US.

FT: - Pressure is growing on the UK government and Pensions Regulator to follow their US and European counterparts and give corporate pension funds more flexibility in how they calculate their level of funding for setting company contributions.

Accounting rules in many countries require pension funds to mark their liabilities to market by discounting them at current bond rates. The low level of interest rates has put pressure on scheme funding by inflating liabilities, and authorities in some countries have decided to help scheme sponsors by moving away from the mark-to-market approach.

Governments in the US and the Netherlands are extending “smoothing”, which allows funds to discount their liabilities with an average rate over a set time period. Elsewhere, Sweden has put a lower limit on rates, and Denmark has set a higher rate for long-term liabilities

Out of sight, out of mind. 

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Politicians snuck a pension provision into the transportation bill

With all the talk about mark to market accounting, nobody seems to care that US pensions do not use these accounting principles when determining the present value of their liabilities. Pensions mark to market their bond portfolio based on current rates and spread levels (i.e. current yield/spread curve). However liabilities are discounted using a 2-year average of the investment grade corporate curve (see attached document for the latest rates). That means that pension liabilities are currently undervalued relative to pension assets because rates have come down so sharply in the past two years.

One would think however that in the next two years this problem should correct itself as low rates get reflected in the average. As the 2-year average starts including these low rates and liabilities become worth more on a present value basis, an increasing number of pensions will become underfunded and corporations will be required to inject more capital. And that in fact has already been taking place.

Treasury and Risk: - Corporate contributions to defined-benefit pension plans have been rising, reflecting the damage done to plan assets by the financial crisis and recession and the boost to plan liabilities that results from record low interest rates. A study published last fall by the Society of Actuaries showed that in the decade that ended in 2009, companies’ cash contributions to their plans averaged about $66 billion a year. The study estimates that minimum required contributions will average $90 billion a year in the decade that started in 2010 and hit a peak of about $140 billion in 2016. 

But no worries - the corporate pension lobby was able to get to the US politicians before the really low rates got into the average. And the politicians snuck in a little provision into (of all places) the Transportation Spending bill that was recently passed by the US Senate changing the rolling 2-year averaging into a 25 (twenty five) - year average. Rates of course were significantly higher in the past 25 years than they are now and will likely be in the next few years.

MERCATUS CENTER AT GEORGE MASON UNIVERSITY: - The provision in the Senate-passed version of the Transportation bill currently under consideration in the House would allow corporations to use a 25-year average rate as opposed to the current 2-year average, increasing the current discount rate from the 4 percent range to roughly 6 percent. Since liabilities are sensitive to discount rate assumptions, the plan's liability will change roughly 15 percent for every one percentage point change in the discount rate. For example, Boeing reports that a mere quarter of a point increase in the discount rate could cut its pension liability by $1.7 billion. Apply a small discount rate hike across all private plans and it's easy to see why corporations are lobbying Congress for a discount rate boost.

All of a sudden pensions will no longer look underfunded. Accounting magic!

JPMorgan: - This artificially low sensitivity [the two-year smoothing] of US pension liabilities to market rates is set to decline even further under new rules being proposed by Congress as part of the Transportation Spending bill passed by the Senate in March (S. 1813) and now being considered by the House. Buried on page 1472 of the bill are new rules on “Pension Funding Stabilization” that effectively put a corridor on the discount rate used to value pension liabilities. The upper bound of this corridor is equal to a rolling 25-year average of the IRS published corporate bond yield scaled up by a factor (110% for 2012, 115% for 2013, trending up to 130% for 2016 and beyond); the lower bound equals a rolling 25-year average of the IRS published corporate bond yield scaled down by a factor (90% for 2012, 85% for 2013 and trending down to 70% for 2016 and beyond). The 25-year average greatly increases the smoothing effect, further reducing the reported sensitivity of pension fund liabilities to changes in market interest rates.
...
While the House has thus far failed to bring the Transportation bill to the floor for a vote, our best guess is that Congress approves a bill that includes these pension funding rules in the next month. Congress considers the Transportation bill “must-pass” legislation; part of the funding for it in the Senate bill comes from increasing employer premiums to the Pension Benefits Guaranty Corporation and there has been limited pushback on this in the House. This makes it likely pensions will be a component of any Transportation bill that is passed. With the current funding authorization expiring at the end of this month, therefore, we view it likely that a bill is passed that includes new rules on

Why do we care? Again, the taxpayer is very much at risk here. As discussed before, the US pension bailout fund PBGC is already stretched and may require more taxpayer money. Now it would be taking over pensions that will be even more underfunded, with asset values way below the present value of the liabilities. And more of taxpayers' money will be used to fund the benefit payments.



Current discount rules for pensions

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US pensions' equity holdings the highest among OECD nations

US pension funds are still heavily invested in equities - close to 50% of assets. In fact US pensions have the highest concentration of equities among all OECD nations.

Source: DB (click to enlarge)

This is somewhat troubling, particularly for defined benefits corporate pensions. That's because there are risks of a feedback loop. When equities decline, pension funds become underfunded, forcing some companies to inject cash into their pension accounts. And that in turn may add to the declines in equity prices.

But no worries. Corporations are shifting to defined contributions plans, letting their employees take this equity risk. And for the remaining defined benefits plans, the pension managers will use corporate bonds to discount pension liabilities - the wider the spread, the lower the "present value" of what they owe to future retirees.

Good luck with your retirement plans.

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As population ages, institutions reduce equity holdings

The last census had shown one unmistakable trend - the US population is aging. It's not nearly as bad as the situation in Japan or Western Europe for that matter, but troubling nevertheless.

US age distribution in 2000 and 2010 (Source: The US Census Bureau)

The growth in retirement age population is not only severely pressuring the US fiscal situation, but is also creating a visible asset reallocation away from equities. We've seen this trend at the retail level with equity fund outflows. A similar situation is now developing on the institutional side. For the first time US pensions have allocated more to fixed income than to equities.

Source: JPMorgan

The "Other" category includes assets such as commercial real estate, commodities, resource investments (for example forest land), alternatives, etc. But as yields and spreads compress, pension performance will deteriorate further, making it that much more difficult to meet growing liabilities from increasing numbers of retirees. With population aging, pensions are chasing a limited supply of "safe assets" (also see research from IMF) which produce diminishing returns. State employee pensions (such as teachers' pensions) for example are struggling with this issue, undermining state budget balancing efforts.

It is particularly troublesome for corporate pensions, as companies are required to contribute ever larger amounts of cash per current of future retiree to keep their pensions from becoming underfunded. That in turn will pressure corporate profits (for companies that have these types of retirement plans), reducing equity returns and further lowering allocations to the equities asset class. It's a vicious circle and over time some of these pensions will either become the responsibility of the US tax payer or will need to negotiate down the amounts payable to retirees. Going forward there is little reason to believe that this trend will reverse, making equities a less attractive asset class over the long term.

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Wider spreads in financials help with pension liabilities

Here is an informative e-mail exchange discussing the discount rate used for pension liabilities:
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Hey Kevin,

Did you see the Milliman study about underfunded pensions? Rates coming down is killing them as discounted liabilities explode.

Sacramento Bee: Milliman, Inc., a premier global consulting and actuarial firm, today released the results of its latest Pension Funding Index, which consists of 100 of the nation's largest defined benefit pension plans. In November, these plans experienced a $7 billion decline in market value and a $1 billion increase in pension liabilities. While declining assets drove the deficit growth, the 4.53% discount rate—the lowest in the 11-year history of this study—continues to be the big story.

"So long as we have low discount rates we'll have no choice but to hope for improved asset performance," said John Ehrhardt, co-author of the Milliman Pension Funding Study. "As 2011 draws to a close it seems increasingly likely that this will be a lost year for pension funding. In the coming weeks, plan sponsors will be closely monitoring both the discount rate and the market value of these assets, with the hope of starting off 2012 with at least some upward momentum."

How's that impacting you guys?  As treasurer you must be freaking out.

All the best,
Ron
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Hi Ron,

Thanks for sending this.  It's really no big deal for us - our pension discount rate has not changed.  In fact it's actually a little higher this year.  So we don't need to kick in additional cash into our pension.

See you next week.
Kevin

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Kevin - are you serious about the discount rate?  10-y treasury yield is lower by 114bp from a year ago.  How is that possible?  Everyone is telling me that pensions are struggling because the NPV of the liabilities is exploding due to massively lower discount rates.

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Ron- we use the 10-year AA corporate composite yield as the discount rate. And that hasn't changed much.

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Kev - I am still having trouble wrapping my head around this.  Do you have a chart?

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Sure.  Check this out - it's pretty cool.  We measure our discount rate once a year in mid-October.  Treasury yields came off but AA spreads blew out, keeping our discount rate stable.

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Kevin - that's crazy.  AA spreads blew out that much?  Obviously enough to compensate for the falling treasury yields.  Why?

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Well Ron, how many corporations do you know that are AA?  Not many.  So a big chunk of the "AA Index" are financials.  And as you know with the madness in Europe, US financial spreads blew out, really moving out the whole AA spread.

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Amazing. Who could have thought that all the mess in Europe will actually help with your pension liabilities. So you guys are all set with your pension.
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Yes.  Until next October.

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Bailout this - PBGC pension takeovers

Was the AMR (American Airlines) bankruptcy filing really necessary? Analysts are speculating that if AMR hadn’t pursued an orderly restructuring, they would likely be forced to go through this process in about a year (Bloomberg radio). This will allow AMR to come out of the restructuring swinging, with cash reserves and airplane leases in place.

Great. But one thing that remains uncertain is the AMR pension. Typically pension liabilities for a US firm constitute unsecured subordinated debt. That means that legally AMR could walk away from their pension obligations. And if they decide to do so, the US government would be on the hook. More precisely it is the Pension Benefit Guarantee Corporation (PBGC), a government agency.

From PBGC: American Airlines sponsors four traditional pension plans that cover almost 130,000 participants. As of today, the plans collectively had about $8.3 billion in assets to cover about $18.5 billion in benefits. If American Airlines were to end their plans, the agency would be responsible for paying about $17 billion in benefits; about $1 billion in benefits would be lost.

So PBGC would cut benefits some, but with $8.3 billion in the AMR pension assets, the taxpayer would be responsible for about $9 billion. And this is just a drop in the bucket relative to the amounts of obligations PBGC may be assuming.  Below is a table by industry showing changes in assumed pensions:

2011 will see an increase of 33% in pension liabilities over the previous year.  The agency is already running a $26 billion deficit. Talk about a bailout.

The hope of course is that AMR will reach a deal with the union in which it would keep the pension, while the union would agree to accept pay cuts. Otherwise there will be more financial pain for PBGC and the taxpayer.

PBGC 2011 Annual Report

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