The rising interest rates of 1994 will bring many companies reduced pension expenses in 1995, despite lower than expected returns on assets this year.
Companies also will see increased reported corporate earnings as early as the first quarter, according to some actuaries.
General Motors Corp. and Chrysler Corp., for example, should see their liabilities drop at least $5 billion and $1 billion, respectively.
The Federal Reserve's latest 75 basis-point increase in short-term rates Nov. 15 only increased the likelihood that pension fund liabilities and costs will be reduced in 1995 as companies increase their pension discount rates. Some analysts think the Fed will increase rates again in January if the economy does not show significant signs of slower growth.
The average discount rate used by pension funds to calculate the present value of future benefits dropped to 7.3% at the end of 1993 from 8.74% in 1990, according to a survey by The Wyatt Co.
Lower discount rates generally coincide with lower interest rates. But thanks to five increases by the Federal Reserve Board this year, interest rates are about 200 basis points higher than a year ago.
Even if long-term rates remain at current levels through the end of 1994, most - if not all - pension funds will increase the discount rate used to calculate pension liabilities generating actuarial gains and resulting in enhanced funded status for many plans.
This will come as welcome relief to pension funds that have been battered by lower-than-expected investment returns. That's because each one percentage-point increase in the discount rate will reduce liabilities 10% to 25% and, in turn, result in lower 1995 pension expenses.
In September 1993, the Securities and Exchange Commission established strict guidelines for determining discount rates. Companies are required to recognize the full impact of the 1993 rate decline as well as future rate fluctuations.
The SEC said discount rates should reflect the yield of cash-matched portfolios of securities "that receive one of the two highest ratings given by a recognized ratings agency."
The SEC now is reviewing filings of corporations using a market rate greater than 7%, according to Goldman, Sachs & Co.'s Gabrielle Napolitano.
"Pension funds will be raising discount rates at the end of this year and will be happy to do it," said Mark Maselli, principal at Kwasha Lipton, Fort Lee, N.J. "If everything else remains the same, we will see discount rates now at 7.3% going to something like 8.25% or 8.5%."
Gerald Paul, automobile analyst at Sanford C. Bernstein & Co., New York, said Chrysler Corp. could shave nearly $1 billion from its unfunded liability by increasing its discount rate by 100 basis points. He said the Chrysler plan, with assets of about $10 billion, will be fully funded by the end of 1994 even if investment returns are flat.
Chrysler had a $2.2 billion unfunded liability at the end of 1993 and made a $700 million contribution to the plan in the first quarter.
Mr. Paul said the General Motors Corp. plan would cut its $22 billion unfunded liability by $5 billion for each 100 basis-point increase in its discount rate, which was 7.1% at the end of 1993.
GM announced it plans to contribute $10 billion in cash and stock to its U.S. hourly pension plan over the next two years in an effort to cut its unfunded liability (Pensions & Investments, May 30).
Mr. Paul said a 100 basis-point increase in the discount rate at GM will reduce its 1995 pension expense by $600 million to $800 million; Chrysler's pension expense will be reduced $100 million to $150 million. The reductions also flow through to the income statement and will help improve reported earnings for the both companies.
The Ford Motor Co. plan already is overfunded by about $800 million.
R.P. Flynn, manager-pension fund investments at Chrysler, said the discount rate will be increased but the rate will not be established until year end. "We will follow the market rate, but with rates changing so much we don't know what rates will be at Dec. 31," he said.
Mr. Flynn agreed an increase in the discount rate will be "good news" for Chrysler in reducing its unfunded liability. But "it's not good news in that asset returns haven't been as much as in the past. ... Asset returns this year have been hard to come by."
Larry Bader, vice president-asset allocation research at Salomon Brothers Inc., New York, said overall investment returns for the typical pension fund with a 60/40 equity/bond mix were only 0.8% through the first nine months of the year. But the increase in interest rates has more than offset the sour investment returns by slashing pension liabilities dramatically.
The discount rate for the Salomon Brothers Pension Liability Index, which represents a typical pension liability, increased to 8.91% at the end of October from 7.36% at year-end 1993.
As a result, the Pension Liability Index is about 12.8% below its level nine months earlier, said Mr. Bader, while the funding ratio would have increased 15.6%, he said.
A Salomon Brothers report co-authored by Mr. Bader points out the potential rewards associated with boosting discount rates, as well as the increased volatility in funding ratios.
"The volatility of funding ratios highlights how far most plan sponsors are from having their assets matched to their liabilities," the Salomon report said. "This mismatch has served them well so far during 1994, but poorly over the preceding years, when liability growth outpaced even the outstanding investment returns that most funds produced."
At the same time, Messrs. Maselli and Bader point out most pension funds probably will not attain their assumed rate of return on assets in 1994 but the magnitude of anticipated boosts in the discount rate should overshadow poor investment returns for the year for the average pension plan.
"For most plans, the increase in the discount rate will be larger than any expected shortfalls in projected rates of return on assets," said Mr. Maselli. "But the year-end bottom line may not be quite as rosy as if they had reached their expected rates of return and the discount rate is increased. the liability is still going to be lower."
A one percentage-point shift in the discount rate "has an enormous impact" on corporate financial disclosure and pension expenses, said Dick Joss, resource actuary with Wyatt in Seattle. He said the change affects liabilities without affecting assets, "which means the full impact of the change gets leveraged into the sponsors' expense calculation."
For some companies with a young work force and fewer retirees, a 100 basis-point increase in the discount rate could translate into a 25% reduction in liabilities and up to a 50% reduction in pension expense. More typically, however, the liability would be reduced by 10% to 15%.
"So, a plan could go from an unfunded position to a fully funded position," Mr. Joss said.
He noted the ups and downs of the average discount rate in recent years and related shifts in disclosures is something the Financial Accounting Standards Board was trying to avoid by implementing FAS 87, which requires the adoption of long-term market interest rate assumptions. He said it might be time for the FASB to "reconsider its discount rate selection process."
The FASB "may want to re-evaluate" the requirement that discount rates reflect current market rates annually in favor of a "five-year average" to reduce discount rate volatility, Mr. Joss said.
Mr. Maselli at Kwasha Lipton said the Pension Benefit Guaranty Corp. uses more conservative rate assumptions (5.65% at the end of 1993) to compile its list of most underfunded plans. Still, sources said even the PBGC will have to increase its rate; but its top 50 list probably will not reflect increased rates until 1995.
Some plan sponsors have expressed their concerns to the PBGC regarding the large differential between its conservative assumptions and the market-oriented discount rates being adopted by the industry in response to the recent SEC guidance on selecting pension liability discount rates.
Charles A. Service, corporate director-capital management and trust investments at Unisys Corp., Blue Bell, Pa., said the 7.375% discount rate used at the end of 1993 will "most certainly" be raised to reflect market conditions at the end of 1994.
He said the difference between the $59 million surplus reported by Unisys using its market-related discount rate and the $155 million unfunded liability reported by the PBGC "reflects the difference in discount rates."
He said Unisys expressed its concern directly to the PBGC about its "unduly conservative" 5.65% discount rate.
"We don't think it (the PBGC assumption) reflects reality," said Mr. Service. He expects Unisys to appear on the PBGC list again.
Martin B. Tolep, assistant treasurer and director-pension asset management at Woolworth Corp., said he does not expect Woolworth to be eliminated from the PBGC's top list even with the favorable impact of rising rates on the unfunded liability.
The PBGC says Woolworth has unfunded liabilities of $103 million. He would not disclose the amount of underfunding based on FAS 87 and internal accounting, but said "it is not much."
Mr. Tolep said the current discount rate of 7.25% will be increased to reflect current market rates at year end; "as rates go up we will either be fully funded or only slightly underfunded."
He is chagrined about the lower discount rate assumptions used by the PBGC.
A government source said the new PBGC top 50 list, expected to be published before year end, will not reflect the recent rise in rates but will be based on the 1993 year-end rate; next year's list will reflect 1994 year-end rates.
