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As the recovery stalls in advanced countries, central banks are leaning more and more toward quantitative easing, a form of monetary stimulus that could provide a tool to help the economy as public opinion turns against more government spending. Japan implemented its plan in early October, and in the United Kingdom Adam Posen, senior fellow at the Peterson Institute for International Economics, has forcefully advocated a similar approach as a member of the Bank of England's Monetary Policy Committee. In the United States, the Chicago Fed governor is also now in favor.1
Quantitative easing would take the form of central banks expanding their balance sheets and buying assets or securities, as they did at the height of the crisis in 2008 and 2009. Among the objectives would be lower interest rates on medium-term government and corporate securities. The natural next questions become: What type of assets should central banks buy; at what maturities; and, naturally, how many?
With short-term interest rates already near zero, the general idea of so-called quantitative easing is to have central banks seek to lower longer-term interest rates to stimulate the broader economy by expanding credit and reducing investment costs. At times of much slack in the economy and high unemployment rates, this is generally a laudable goal for monetary policy.
At the same time, however, directly intervening in longer-term financial asset markets is a complex endeavor with potentially unintended consequences. One such consequence might be an adverse impact on the solvency of public and private defined benefit pension funds.
In recent years, accounting and fiduciary rules and regulations governing public and private corporate pensions have shifted toward mark-to-market standards and stricter funding requirements. Tougher mark-to-market rules for pension funds imply greater volatility in the value of their assets and liabilities. Stricter funding requirements would force pension plan sponsors to increase their cash contributions when the systems are deemed to be underfunded.
It is both sensible and fair to make pension plan sponsors increase their contributions more quickly to avoid large-scale underfunding and to protect retirees' pension benefits. By definition, however, pension funding levels are sensitive in a procyclical way to economic fundamentals, as asset investments rise in value during periods of economic growth, while similarly discounted expected future liabilities for the pension fund decline with higher interest rates.
During a recession, meanwhile, it is well known that pension funds suffer losses on their asset holdings because of bear markets. Less well known is the other side of pension funds' balance sheet—the value of projected liabilities to pay for future retirees' benefits, which are often responsible for underfunding during recessions. This phenomenon results from the complicated accounting rules regulating how the size of pension plans' projected future liabilities is estimated at the end of an accounting reporting period.2
The most important factor here is the discount interest rate used to generate "net present values" (NPVs) for future obligations. The lower the discount rate, the larger projected future pension obligations of a pension fund will be. Some leeway exists in pension accounting for the permissible discount interest rate, but generally it must reflect "market yields on high quality corporate bonds"—usually determined to be AA-rated corporate bonds. Consequently, when the yields on AA-rated corporate bonds decline, pension funds' future liabilities go up and, without additional sponsor contributions, their funding level goes down. Unfortunately for pension fund sponsors, this is precisely what has happened in both the United Kingdom and United States during 2010, as illustrated in figure 1. (Note that Japanese corporate bond yields have similarly declined by about 40 basis points during 2010, but 10-year AA-rated bonds were already extremely low at just about 1.4 percent at the beginning of 2010 because of Japan's extremely low interest environment).
As can be seen, US AA-rated 10-year corporate bond yields have dropped by more than 1 percentage point during 2010 to just below 4 percent recently, while UK rates have dropped slightly less. This is very bad news for all defined benefit pension plan sponsors (especially in the United States) whether they are private corporations or US state and local governments.
At a time when the US and UK economies cry out for more private investment and government expenditure, such declines in corporate bond yields and the associated increase in liabilities look likely to neutralize any investment value increases in pension funds' assets—and quite possibly add to a pension plan's existing underfunding. Correspondingly, private businesses and state and local governments may be forced to divert more money in to their defined benefit pension funds rather than invest them in the economy.
Given the scale of underfunding in defined benefit plans in the United States, where corporate pension plans are funded at only 80 percent,3 and state and local governments are even more underfunded (see figure 2), the required additional pension contributions by state and local governments are likely to be substantial.
Other strategies exist to address defined benefit pension underfunding levels, though they would pose political challenges. Such steps could include tax increases or reductions in pension benefit levels of public worker retirees. But what of the effect on AA-corporate bond yields of potential additional quantitative easing (or purchasing of corporate and government securities) by the Bank of England and the Federal Reserve?
Central banks typically refrain from buying specific private bond categories to avoid favoring individual private debtors over others. But quantitative easing is generally thought to lower all bonds yields roughly by the same amount.4 If effective, additional quantitative easing may actually increase defined benefit pension plan underfunding levels.
Given the declining number of defined benefit pension plans, especially in the private sector, the overall private sector impact may be limited. The impact seems likely to be more pronounced among state and local governments. For quantitative easing in the United States to have the maximum effect, it may have to be accompanied by additional forbearance regarding funding requirements for state and local government pension plans.
Notes
1. This policy for the Federal Reserve was advocated as early as 2009 by Joe Gagnon.
2. See details hereof in Zion, David, and Bill Carcache. 2002. The Magic of Pension Accounting. Credit Suisse First Boston. September.
3. See Milliman 2010 Pension Funding Study.
4. I am indebted to Joe Gagnon for walking me through the empirical research and central bank regulations on this issue.
