The sky may be falling for pension plans

BETHESDA, Md. — Three-quarters of the nation's largest corporate pension plans could cut their equity exposure while half would double or triple their bond duration if a series of accounting, regulatory and legislative proposals is adopted, the Committee on Investment of Employee Benefit Assets warned in a new study.

The cumulative effect could be sharp declines in the U.S. stock market, trimmed real economic growth and short-term job losses.

The study also predicted that roughly half of the big corporate funds must reduce pension benefits if the proposals are adopted, with many expected to freeze accruals on existing defined benefit plans or require new hires to join defined contribution plans, the study found.

CIEBA members invest $1 trillion in pension assets and their plans comprise more than one-quarter of Americans covered by defined benefit plans.

Officials of CIEBA, a committee of the Association for Financial Professionals, plan to take their message to Congress and regulators. They hope to convene a forum of key policy-makers, plan sponsors and participants to address these issues, said T. Britton Harris, CIEBA vice chairman and president of Verizon Investment Management Corp., which manages $65 billion, mostly for the Verizon Communications Inc. retirement plans.

If adopted, the proposals could seriously erode corporate support for defined benefit pension plans, Mr. Harris said.

"We've operated under stable rules for the last 20 years," he said. The proposals represent "significant and unprecedented change, (they would) remove a significant proportion of support for investing on a long-term basis through stocks."

The problem is these proposals are being examined individually, but the collective impact is being ignored, he said.

Up to $650 billion could be shifted from domestic and international stocks to bonds if the proposals were adopted. That would cause an 8% to 12% decline in U.S. equity prices and a flattening of the yield curve by 35 to 60 basis points in the first few months following implementation, based on a phased implementation, according to research provided to CIEBA by Morgan Stanley, New York.

A more abrupt rebalancing would have more dramatic effect, temporarily reducing stock prices by 10% to 15% and flattening the yield curve by 75 to 150 basis points, the Morgan Stanley report said.

The Morgan Stanley scenario assumes public pension funds would copy corporate plans.

"If both reallocated 22.2% of their equity holdings into bonds, such sales would amount to nearly $600 billion, or 3.7% of U.S. equity market capitalization," the report said.

Morgan Stanley analysts also noted that nearly half the CIEBA respondents would more than double the duration of their bond portions "by a whopping 6.4 years," from the current average duration of 5.75 years. This type of shift could swamp the limited supply of long-duration bonds, the report added.

But similar research conducted for CIEBA by Goldman, Sachs & Co., New York, was less alarming.

For one thing, the Goldman Sachs research dismissed notions that public funds would mimic corporate plan shifts out of bonds.

Thus, Goldman researchers estimated that corporate defined benefit pension funds might reduce their equity holdings by about $250 billion. Given U.S. stock market capitalization of about $12 trillion at year-end 2002, the impact of all regulatory proposals occurring "would be negligible," the researchers wrote.

Goldman researchers William C. Dudley and Michael A. Moran added that shifting $250 billion into bonds over a two-year period would have little effect on the huge U.S. bond market. "Thus, we would be surprised if the increase in demand would push down long-dated yields by more than 10 basis points," they wrote.

Neither firm thought the effects of a major shift out of equities into bonds would have a big impact on the U.S. economy.

The CIEBA report cited Morgan Stanley as predicting a reduction in real gross domestic product of between 0.3% and 0.5% a year between 2005 and 2007. The Morgan Stanley research said the impact would be minimal for two reasons: a drop in equity prices "would only nick the economy;" and "lower bond yields would offset the impact of lower stock prices on economic activity."

What's more, Morgan Stanley noted the drop in real GDP growth would be temporary, with the change in asset mix actually producing a positive effect starting in 2008.

Unemployment would rise by up to 0.2% to 0.3%, resulting in job losses of 290,000 to 440,000, between 2005 and 2008, but the job growth rate would rebound in 2009, the Morgan Stanley research found.

Nevertheless, both firms said the defined benefit system is in trouble, and needs an improved regulatory environment to survive.

CIEBA's Mr. Harris previously had identified seven proposals, or "missiles," that he said represent a threat to the U.S. defined benefit system (Pensions & Investments, Oct. 13). The study marks the first effort at quantifying the cumulative effective of those proposals.

Of those proposals, three represent the greatest danger to the defined benefit system, and should be opposed, Mr. Harris said. They are:

Eliminating smoothing of gains and losses in pension accounting. While the Financial Accounting Standards Board has not placed a "mark-to-market" proposal formally on its agenda, many observers think the board might follow Europe's example, Mr. Harris said.

Adopting an unsmoothed corporate yield curve to calculate pension contributions. This "would potentially double or triple the expected volatility in annual funding," the report said. Nearly half of CIEBA members surveyed said this Treasury proposal alone would significantly alter their asset mix and possibly result in lower benefits.

Changing the Pension Benefit Guaranty Corp.'s premium structure. Adopting a premium system based solely on a pension fund's equity exposure, regardless of funded status or the sponsoring corporation's financial health, could push pension funds further toward bonds.

Other proposals concerning CIEBA member: broadly defining core earnings, as Standard & Poor's has done; and including pension obligations as part of corporate debt. CIEBA members were more supportive of new accounting rules requiring greater disclosure and use of a discount rate based on high-quality, long-term bonds.

The collective effect of the proposals on pension benefits also would be dire, the report said. If all of the proposals were adopted, 47% of survey respondents said it was possible or very likely they would freeze benefit accruals to existing participants, while 53% said it was possible or very likely they would not allow new employees join the plans.

Also, 39% said it was possible or very likely they would switch to a cash balance plan from a defined benefit plan.

CIEBA surveyed more than 60 corporate pension executives, representing about $500 billion in pension assets.