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As the financial crisis deepens, the world's central banks and financial authorities have gained broad support for their efforts to reintroduce liquidity to the credit markets, get banks to lend again and bring down spreads and bond yields. But these sensible and indeed required steps to avoid a repeat of the 1930s may come with a drawback: a rapid decline in corporate bond yields, which threaten to produce rapidly rising funding shortfalls in defined benefit (DB) pension funds.
Many US corporate and state and local government defined benefit pension funds—retirement systems in which the benefit is governed by formula and not by a return on investments—found themselves in severe financial stress following the bursting of the internet and stock market bubbles in 2001. The acute problems then for pension plans in the steel and airline industries and with the Pension Benefit Guarantee Corporation (PBGC) are well known. After 2001, pension plan sponsors were hit not just by the internet bust, but by a triple-whammy—first, declining stock markets, reducing the value of the assets; second, declining interest rates and high-quality (AA) bond-yields, increasing the value of their pension liabilities; and third, the gradual introduction of (much required) transparency in the accounting standards for the balance sheets and income statements of sponsors' pension funds. As a result, increased sponsor contributions and rising asset prices brought US DB pension plans back to about full funding levels on average only by 2006-07.
In today's financial crisis, US corporations and state and local governments with a DB pension plan have so far been hit in different ways. The large recent declines in global stock markets have hit pension plan asset valuations hard,1 and without doubt the Pension Protection Act (PPA) of 2006 (for corporations) as well as the gradual introduction of accrual accounting methods for state and local government pension funds by the Governmental Accounting Standards Board (GASB) will require future increases in pension plan sponsors' pension contribution levels. In late 2008, we will therefore see the first recessionary "political stress-test" of America's pension laws so painstakingly reformed by Congress and federal regulators after 2001. In fact, on November 13, the first letter from DB pension plan sponsors to Congress was sent, requesting that the Pension Protection Act be watered down in response to the credit crisis.2
However, and not without irony, the credit crisis has temporarily helped the DB pension funds' balance sheet, too, by improving at least one side of the balance sheet. On the asset side, valuations have declined dramatically, while on the liability side, the financial crisis has—via the intricacies of accrual pension accounting—also produced a significant decline in pension plan liabilities. As a result, pension plan net funding levels have not so far seen the full dramatic declines experienced after the bust in 2001.
This might seem counterintuitive—i.e., that a financial crisis can actually lower pension plans' future liabilities, so let's go through the individual steps of this process.
Much simplified, a DB pension fund first has a future total vested benefit obligation to its members—in other words, what it needs to pay its members in retirement benefits each month until they (and/or their dependents) die. The precise size of a pension fund's future total vested obligation is affected by many things, like the benefit estimation formula, the number of years of employment, future projected salary increases and the life expectancy of retirees.
Second, the accumulated benefit obligation is a liability that the pension fund must pay out over many years in the future. As such, what we are really interested in knowing today (and putting on the liability side of the balance sheet of pension funds) is the amount of money that the pension fund should have available today in order to have enough assets to pay all its future obligations to its members. That is what is called the "present value" of the pension fund's future liabilities.
Third, there are essentially two ways of determining what the "present value" of a pension fund's future total obligation is today. A pension fund sponsor may look at current market prices of annuity contracts,3 similar in size and duration to its future total obligation. That is, a sponsor may simply pay somebody else today (typically an insurance company) what they charge to take care of the fund's future obligation. This, however, is usually a prohibitively expensive option for pension fund sponsors, because of the often decade-long nature of the obligation and related uncertainties, which causes suppliers to charge very high risk premia on such contracts.
Instead, present accounting rules provide pension fund sponsors with another and usually cheaper option, which allows them to look instead at the rates of return on high-quality fixed-income investments. The idea here is to find the amount that, if invested today in a portfolio of such high-quality instruments—defined by the SEC as at least corporate AA-rated bonds—would in a secure manner provide the pension fund with the necessary future cash flows to pay its members' benefits when these come due. In other words, the pension fund sponsor here, rather than simply outright pay someone else to take care of its future liability, is assumed today to own a reasonably secure portfolio of assets that will yield enough cash in the future to pay retirees. Hence, the higher the yield on AA-rated bonds, the fewer of them are pension funds required to own under this assumption in order to generate future cash flows and lower the present value of its future pension liabilities.
In conclusion, the large increases in AA-bond yields, producing a rise in credit spreads with US Treasury bonds, have reduced the present-day value of many of their pension liabilities.4 As a result, unlike the period after 2001, the declining value of assets in DB pension plans has been offset to some degree by the declining estimated present-day value of their liabilities.
It will be necessary to wait for the full-year 2008 financial reporting to get a more complete and detailed picture of the net impact of these countervailing forces on the balance sheets and income statements of DB plan sponsoring corporations and state and local governments.5 However, one thing is clear. Should the combined multitrillion dollar efforts of the world's central banks and treasuries be successful in rapidly bringing down credit spreads to precrisis levels—but without simultaneously boosting stock markets and broader asset prices back to precrisis levels, too, and that is a big IF—the financial impact on DB plan sponsors could be dramatic at the end of 2008.
With the US and global economy heading into a potentially severe recession, US corporations could soon find their DB pension plans severely underfunded and be compelled by the Pension Protection Act of 2006 to pay—out of their declining profits—both additional premiums into the Pension Benefit Guarantee Corporation and increase their pension plan contributions. State and local governments, already under budgetary pressure from declining tax revenues, could similarly be obliged to increase their contributions to suddenly underfunded DB pension plans.
American workers' have earned their pensions. If DB pension plan sponsors are required to increase their contributions at this inopportune time, it would be a welcome sign that the pension safeguard system works as intended. But don't be surprised if DB pension plan sponsoring companies and state and local governments—pointing a blaming finger at the success of earlier bailouts and liquidity injections for banks, insurance companies and the like—come to Congress in a few months with their hats in hand asking for a bailout, too.
And don't be surprised either, if the government sponsored reintroduction of liquidity into the credit markets and associated declines in AA-bond yields further accelerates the long-term switch away from DB pension plans and towards defined contribution (DC) plans among US corporations and state and local governments. A successful bailout of the credit markets may just end up making defined benefit pensions an increasingly rare species.
Jacob Funk Kirkegaard is coauthor of the forthcoming book US Pension Reform: Lessons from Other Countries.
Notes
1. According to S&P, the S&P500 DB pension plans at the end of 2007 had over 60 percent of their investments in equities, an incidentally far higher average equity weighting than DB pension funds in other OECD countries. As such, US DB pension plans are likely to be disproportionally affected by the decline in global stock markets.
2. Washington Post, November 12, "Business Groups Pushing For Relief of Pension Laws," page A02.
3. An annuity is a contract that typically pays out a fixed amount every month until the death of the benefit recipient.
4. Note that rising discount rates have no impact on DC plans or individual IRA/401-K type plans.
5. Mercer LLC recently estimated that were corporate AA bond yields to drop back to their 3-year average without a corresponding rally in the stock markets, the present DB plan funding deficits of the S&P1500 companies would increase from a manageable $35 billion to $400 billion.
