Many companies will face increased pension expenses in 1996, despite 1995's extraordinary investment returns.
That's because declining interest rates during 1995 boosted pension liabilities faster than they lifted asset values, so pension funds lost ground.
While stocks, as measured by the Standard & Poor's 500 Stock Index, returned 37.6% and the bellwether Salomon Broad Bond Index was up 18.55% in 1995, asset growth in a typical pension fund still lagged the growth in the liabilities by about 13%, according to data compiled by Ryan Labs Inc., a New York fixed-income research and management firm.
The drop in interest rates during 1995 is responsible for the large upward move in liabilities. Liabilities perform like bonds when interest rates fluctuate.
Contributing to increased pension expenses this year is the fact that companies will have to reduce the rate at which assets are assumed to grow, to conform with accounting rules. Many pension funds already have reduced the rate used to calculate the present value of future benefits to reflect current market rates.
A small but vociferous group of pension experts, characterized by Ron Ryan, president of Ryan Labs, claims 1995 should serve as a "wakeup call" for pension executives, consultants and money managers. They say pension funds are "mispricing" liabilities by focusing most of their attention on investment returns while essentially ignoring the liability side of the pension equation.
These financial experts advocate matching or managing the relationship between plan assets and liabilities. This would not only minimize the effects of market and interest rate swings on funding levels, but also save money.
They claim that by extending the duration of the plan's fixed-income portfolio so its value tracks the value of pension liabilities, a plan may neutralize interest rate risk and reduce or eliminate the need for pension contributions.
The concept has been applied by a few pension funds, but has not gained broad acceptance. American Airlines Inc., Fort Worth, Texas; Sears, Roebuck and Co., Chicago; and TRINOVA Corp. Maumee, Ohio, use the approach, according to Mr. Ryan.
The asset and liability matching strategy worked nicely in 1995 for American Airlines. Its $2.2 billion long duration bond portfolio soared 57% for the year, while plan liabilities increased by about 26%. Nancy A. Eckl, vice president at AMR Investment Services, which oversees the airline's pension fund, said the duration on the long bond portfolio, which correlates with liabilities, ranged from 19 to 26 years in 1995. American lowered its discount rate to 7.25% at the end of 1995 from 8.25% the year before.
"Just because a fund or money manager outperformed the S&P 500 doesn't affect liabilities," said Mr. Ryan. "The asset side has been managing pension money against the wrong objective. Assets are being managed against an objective known once a year and is three months behind.
"Until liabilities are made into a frequent, clear liability index, how can the asset side manage money properly? Market indexes have nothing to do with liabilities," said Mr. Ryan.
"The liability side should dictate asset allocation by matching long liabilities with long duration bonds, shorter liabilities with shorter duration assets and intermediate duration liabilities with intermediate assets. Then and only then can the asset side function to allocate assets properly. You can tear apart liabilities piece by piece so you can understand them. Then asset allocation, performance measurement and investment management can function together," said Mr. Ryan.
He noted pension fund asset allocations have remained relatively constant, and "unfortunately most asset allocation models have no input for a client's liability characteristics....Without a client's liability structure, all clients get about the same asset allocation," he said.
There is a "surprising lack of attention and obedience" to accounting rules, he said, adding Financial Accounting Standard 87 is clear in requiring pension liabilities be priced as if they were high-qua
