Pension funds suffered a double whammy when the U.S. stock market plunged 7.18% late last month.
Not only did total pension fund assets skid 2.47% compared with the previous month, but pension fund liabilities grew more than 5 percentage points, according to Ron Ryan, president of Ryan Labs Inc., New York.
As of Oct. 31, the Ryan Labs Liability Index for 1997 stood at 14.69%, up from 9.62% as of Sept. 30. This means liabilities grew by 14.69% since the beginning of the year.
But thanks to a turnabout in the stock market Nov. 3, when the Dow Jones industrial average surged 232.31 points or 3.12%, pension funds recouped most of their losses. And because interest rates had climbed slightly, liabilities had dropped a little and were up only 13.8% from the beginning of the year.
The average fund returned 19.92% for the year through Nov. 3, off only 0.52% from the 20.44% return posted as of Sept. 30, according to Ryan Labs data.
But pension liabilities didn't fare as well. Through Nov. 3, pension liabilities had increased about 4.2 percentage points since Sept. 30.
Mr. Ryan, who views the relationship between assets and liabilities as a horse race, observed that while assets have been winning the race in 1997, the October market correction reduced the margin of victory of assets over liabilities by 43.34%.
As of the end of September, assets were beating liabilities by 10.82%. But by Nov. 3, they were ahead by only 6.13%.
Falling interest rates are causing the uptick in liabilities, because liabilities perform like bonds when interest rates bounce around, Mr. Ryan explained. As rates fall, pension funds have to put aside more money to pay off their fixed future obligation.
If interest rates continue to decline throughout the rest of 1997, pension funds could be hit with funding problems, he said.
So far, assets have outperformed liabilities, Mr. Ryan said. Long-term interest rates began the year at 6.64%, rising to a high of 7.18% in mid-April, but are now at 6.25%.
While there is no way to predict what interest rates - as measured by 30-year Treasury bonds - will do the rest of the year, many economists have said they don't expect rates to rise much above current levels of 6.2%.
Until 1995, most pension fund managers miscalculated liabilities, preferring to zero in on how well assets were performing, Mr. Ryan said.
But that year, his firm's liability index jumped 41.16%, far more than pension fund assets, which gained 29.08%. There was a reversal in 1996, as the liability index fell 3.70%, while assets grew 15.23%.
Nevertheless, the growth of liabilities in 1995 spurred many pension fund executives to focus more on them, rather than just watching investment returns, Mr. Ryan said.
Managers believed that because their portfolios performed so well, they wouldn't have a problem paying obligations.
But because their liabilities increased so sharply, expenses and corporate contributions also rose, he said.
But old habits die hard. Many pension funds continue to use the traditional actuarial method, calculating obligations only once a year, said Mr. Ryan.
Mr.Ryan recommends calculating the obligations once a month, to avoid a shortfall at the end of the year.
"If you know in advance that your obligations are going to be higher than the money you have put aside, you can change your strategy," he said.
Sean McShea, Ryan Labs' vice president, said at times of great market volatility, pension fund officials should not try to time the market.
"If assets are properly structured, whether interest rates are up or down should not affect the strategy," Mr. McShea said.
Mr. Ryan computes pension liabilities using his index for corporate and public pension funds. It is based on FASB Statement 87, which requires pension funds to price each liability at a different yield.
"We take the future value of cash flow from the pension actuary and weight it to the U.S. Treasury strip curve to look like the liabilities," Mr. McShea said.