Negative rates and pension pain
By Jim Saft
(Reuters) – One of the overlooked victims of the fall and fall of interest rates are corporate pension plans which are facing a ballooning liability even as returns stay tepid.
That’s because market rates play a key role in valuing pension plan liabilities, and the lower they go the tougher things get for underfunded plans.
This may, over time, become a real issue for equity markets, as investors realize that purchases of shares bring not just a right to benefit from future streams of earnings but also the responsibility to meet potentially huge future streams of retiree payouts.
This is a big and growing problem, and a widespread one, with companies in the mature economies like the U.S. and Britain among the worst affected. The combined pension fund deficit of 1500 leading U.S. companies hit a record $689 billion in July, according to consultants Mercer, rising by $146 billion in that month alone. That leaves the companies just 70 percent funded.
Similarly, defined benefit pension plans in Britain, those which promise a certain payout, had a combined deficit of $416 billion, according to the UK Pension Protection Fund. Nearly 84 percent of such plans have a funding deficit.
The deficits have a number of common drivers. Investment returns have been terrible for a decade or more, even as pension funds, as they almost inevitably do, have loaded up on what just went up in price, adding bonds and selling equities. As well, retirees are simply living longer, a happy outcome, but one which means there are more payments for a given fund to meet.
Companies have also been guilty, where possible, of skimping on pension contributions, as boards rationalize that recent developments are an aberration and we will soon return to “normal”.
In terms of valuing liabilities, the big driver has been interest rates, which have fallen sharply in recent years, and especially this past year. Pension funds measure their future liability by applying a discount rate, usually tied to a market interest rate. As those rates fall, the present value of future payments the fund must make rises. The widely-cited Mercer yield curve for pensions showed a discount rate of 3.71 percent in July for an average pension fund, down from 5.3 percent a year ago.
To give an idea of exactly how powerful the effect of falling rates is on pension liabilities, consider that, according to Mercer, through US shares rose 1.4 percent in July, the 30-55 basis point fall in discount rates drove an increase in liability of between 3 and 11 percent. In a single month.
CHANGING RULES Those sorts of moves are capturing investor attention, and indeed may have been driving share performance in recent years. Morgan Stanley strategist Krupa Patel, constructed a basket of British and European shares all of which have pension liabilities of at least 15 percent of their stock market value and found they have underperformed by a whopping 27 percentage points since September of 2009.
U.S. lawmakers recently passed a bill which will allow companies there to use a longer-term rate to calculate their liabilities, a move which may in future flatter their pension deficits. It will also, obviously, allow them to report higher profits and pay out higher taxes, higher dividends and make more executive share awards. The impact on long-term shareholder value is far less sure.
This change may in part be offset by a new accounting standard, called IAS 19, which will come into effect in January. Under IAS 19, companies will be forced to reflect pension losses on their balance sheets. As well, for accounting purposes, companies will have to assume that long-term pension fund returns are in line with discount rates. That’s a striking change, because many funds project 7 and 8 percent returns now, rather than the sub 4 percent discount rates the market produces.
In truth, as with everything in markets and investments, this boils down to an argument about what the future holds. If you believe that current super low, and sometimes negative, interest rates are a central bank-engineered phenomenon, a bit of cough medicine for markets, than you might just ignore the huge liabilities. Rates may shoot back up if a recovery comes, and market returns could surge.
Unfortunately, most pension funds have spent the past decade buying bonds, which would fall in that scenario, and selling stocks, which would rise.
If, on the other hand, we are in a new era of low rates and low returns, somebody is going to have to make good these pension deficits. Equity holders should be first in line.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at email@example.com and find more columns atblogs.reuters.com/james-saft)
(James Saft is a Reuters columnist. The opinions expressed are his own.)