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February 20, 2012 12:00 AM

The cost of low rates

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    Roger Schillerstrom

    Corporate pension plan sponsors are putting billions of dollars more into their defined benefit plans this year. Eleven major corporations, including Ford Motor Co., Boeing Co. and Verizon Communications Inc., recently announced plans to contribute a combined $10.8 billion to their plans in 2012.

    While the contributions reflect the financial strength of companies, the amounts show the costly impact of making up for continuing unfavorable market trends, both in the investment of plan assets and the valuing of liabilities.

    Companies might have to contribute similar large amounts for at least the next several years because of weak markets and the Federal Reserve's monetary policy, which will keep interest rates low and liability values high. Mercer LLC expects the pressure on companies to make large contributions to continue into 2013.

    BlackRock Inc. projects aggregate corporate pension contributions will more than double from what they were last year, averaging about $90 billion a year for the next 10 years and peaking at $140 billion in 2016. In 2011, aggregate contributions were about $42 billion.

    Pension sponsors can't sustain having to make large contributions year after year to finance their pension plans; they have to depend also on favorable investment markets and reasonable interest rates to contribute toward funding.

    In addition, the market environment challenges those sponsors that intend to move toward derisking their pension plans and liability-driven investing. Because the plans are so underfunded, they still need to take investment risk through return-seeking assets in hopes of earning returns closer to their assumptions.

    The median U.S. corporate pension plan funding ratio fell to 67.4% in 2011, down from 80.2% a year earlier, according to a BlackRock report, largely because of low and declining interest rates.

    Such an unfavorable environment and the demands of pension funding regulations that step up requirements for fully funding plans have put more pressure on sponsors to curtail pension benefits to keep costs competitive in their business operations.

    The economy is likely to stay weak and rates low, according to Ben S. Bernanke, chairman, Federal Reserve board of governors. Testifying Feb. 7 before the Senate House Committee on the Budget, Mr. Bernanke said the Federal Open Market Committee “now anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate at least through late 2014.”

    The low-interest rate policy so far hasn't produced a booming rebound in the economy as hoped, as Mr. Bernanke acknowledged. But it has damaged pension plans, worsening funding ratios.

    The recent large pension contributions demonstrate the negative effect of keeping interest rates low in support of a fiscal policy of expanding federal budget deficits.

    The policy of keeping rates low appears to be designed, in part, to aid the federal deficit by keeping its interest payments low, and to drive investors to equities, adding to pension sponsors' concerns about derisking plans by tilting asset allocations more into fixed income.

    “Uncertainty is here to stay,” Jim Kaitz, Association for Financial Professionals president and CEO, said in a statement about an AFP risk survey. “One way organizations can take control of rising uncertainty in their earnings is by adopting a new mindset and making more risk-adjusted decisions. The ones that do this effectively will have a competitive advantage.”

    Among companies, for example, Ford Motor intends to lower the risk level of its pension plans, while fully funding them in the “next few years,” eliminating the $9.4 billion underfunding in its U.S. plans.

    It plans to do so through discretionary contributions, including $2 billion this year to its U.S. plans, as well as closing participation to new entrantsand progressively rebalancing assets to more fixed-income investments, although the company provided no details.

    In addition, Ford lowered its assumed rate of return on pension investments to 7.5% from 8%. Yet, Ford didn't even earn that on its U.S. pension plan investments in 2011, returning just 7%, putting more pressure on its pension funding level.

    Making funding worse, its weighted average discount rate for its U.S. plans decreased by 62 basis points, resulting in pension losses of about $2 billion, according to its 10-K report for 2010, its latest available. For its U.S. plans, every one-percentage point decrease in the discount rate would result in a $5.59 billion increase in its pension liabilities, while every one percentage point increase in the rate would result in a $4.6 billion decrease in pension liabilities, according to the report.

    Other companies generally report similar significant sensitivity to changes in discount rates.

    But as Michael Schlachter, Denver-based managing director at Wilshire Associates Inc., noted in an interview, the problem of “derisking into a more conservative asset mix ... is you aren't getting a whole lot for it in terms of return.”

    In the next few years, pension plans will face immense challenges not only with the markets, but monetary policy and continuing large federal budget deficits. If the Obama administration and the Federal Reserve are not careful, by the time their monetary and fiscal policies work, corporate defined benefit plans might be damaged beyond repair.

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