Corporate optimism datapoint of the day

By Felix Salmon
August 25, 2010
Randall Forsyth reports on the magical math of corporate defined-benefit pension plans:

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Randall Forsyth reports on the magical math of corporate defined-benefit pension plans:

Fitch’s analysts find the mean assumed return for corporate pension plans in 2008 and 2009 was 8%. That’s with an allocation to fixed-income assets of 34% of the total.

Obviously, there’s no way that fixed-income assets can return 8% going forwards from here. There’s also little sign that pension plans are reducing their fixed-income exposure. And I can’t imagine that fund managers genuinely believe that long-term stock returns are going to be somewhere in the teens.

As a result, any intellectually honest plan is going to have to start cutting the interest rate it’s using to calculate the net present value of its future defined liabilities. And every percentage point by which they cut that discount rate means that the present value of their liabilities soars by between 10% and 20%. Cut by two or three percentage points, and suddenly all those cash-heavy corporate balance sheets start looking a lot lighter:

That’s the thing about deflation; it’s like a neutron bomb for corporate, public-sector and consumer balance sheets. Asset values and returns get decimated while liabilities remain standing.

There’s no news here, of course. Inflation is painful for the poor, but much easier for the rich, whose wealth is tied up in things like stocks and houses which tend to retain their real value. Deflation makes goods more affordable for the poor, but is horrible for anybody counting the days until their future liabilities come due.

Still, for the time being, I’m going to place my faith in the continued ability of corporations and pension-plan trustees to delude themselves about future returns and prudent current discount rates. The 8% return assumption didn’t make much sense in 2008 or 2009 either, and so the fact that it makes even less sense in 2010 is hardly a reason to think it’ll be reduced. It’s much easier for the current tranche of executives to leave this problem to their hapless successors.


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Can’t activist stockholders force honesty on the company? It may hurt the stock price now, but the future is bleak if nothing is done.

Posted by MarkWolfinger | Report as abusive

I think you and Randall are confusing two things in the pension calculation:
1. The assumed return on plan assets, which influences the periodic pension expense recorded on the firm’s Income Statement. This would be influenced by the composition of the firm’s pension portfolio and the expected returns on those assets. The assumed long-term rate of return on plan assets doesn’t affect the firm’s funded status because the assets are already at present value.

2. The discount rate used to convert expected future liabilities into present value dollars. This shouldn’t have anything to do with how the firm’s pension portfolio is allocated (except to the extent that they might try to match the duration of the assets with the expected duration of the liabilities) or the expected return on assets.

The rate used for assets will be different (and higher, I would expect) than the right used for PVing liabilities. As an example, in its most recent annual filing (12/31/2009), Kodak estimates an 8.49% long-run rate of return on U.S. pension assets and uses a 5.75% discount rate to PV its liabilities. That 5.75% at 12/31/2009 compares to a 7.0% discount rate at 12/31/2008, so they’ve taken quite a hit on their funded status.

A decrease in the discount rate used to PV liabilities will make their funded status look worse (because the PV of future obligations is higher), but will make their future expenses lower as that discount rate accretes into earnings.

Posted by Beer_numbers | Report as abusive

Corporate Pensions were doomed to failure when companies were allowed to assume that plan assets would grow at a faster rate than future liabilities were discounted.

That mathmatical mismatch assures that all plans will be underfunded almost all the time. It also means that companies get hit when they are down… IE oh the stock market is down 20% due to recession… your pension plan is now underfunded and you need to do something about that when capital is scarce and expensive.

No wonder companies hate DB plans with a passion. Corporate DB plans are already 75% dead from where they were 20 years ago and 20 years from now they will be 99.5% dead. The problem is no one told the stupid workers (by which I mean the 65% of people who belive their company will pay them income in reirement when no such plan is offered.)

This is why even in a “free country” it should be mandatory to contribute 10% of your wages to a privately managed 401k plan. Because with private DB plans vanashing there will be an even greater retirement crisis in this country in 25 years than exists today.

And make no mistake today is already a crisis… the median income of Americans over 65 is $18,000. Even if your house is paid off and you’re in good health that’s not an lifestyle I’d aspire too.

Posted by y2kurtus | Report as abusive

I don’t understand your first comment. The mathematical “mismatch” doesn’t have anything to do with the funded status of a pension. The funded status is based on the plan assets (at fair values) relative to the firm’s benefit obligation. There’s no mechanism that virtually guarantees pension plans will be underfunded all the time.

While the benefit obligation is based on an estimated discount rate, the plan assets are not – they’re just the current market value of the firm’s pension fund. If the firm estimates a discount rate of 5% for liabilities, it doesn’t matter whether they estimate return on plan assets as 3%, 5%, or 7%. The estimated return on plan assets does not affect the the asset value, nor does it affect the plan’s funded status.

Corporations hate DB plans because they bear the financial market risk on the funding side as well as the actuarial risk on the payout side. Individuals hate DC plans because those risks are transferred from the employer to the employee. Someone has to bear the risk, though.

Posted by Beer_numbers | Report as abusive