For corporations, the pension contribution "holiday" is almost over.
The decade or more in which many corporations have been free of making contributions to their defined benefit pension plans will end by 2000.
Gordon L. Gould, chief actuary at Towers Perrin, calls the phenomenon the "vanishing pension wealth."
In his view, this new situation "holds sobering implications for corporate financial performance."
It will mean a decline in net income reported to shareholders by many corporations, whose earnings received boosts in recent years from the hefty returns of their pension fund investments.
"A continuation of recent stock market and interest rate trends through 1999 could easily erase $200 billion in shareholder equity" from all publicly traded companies, he estimates.
For the 100 largest publicly traded companies alone -- 90 of which have defined benefit plans -- lower stock market returns and interest rates will erase $100 billion in shareholder equity, Mr. Gould said. That's 6% of total shareholder equity for those companies, he added.
The reason: Many corporations will have to resume making pension contributions; and those that weren't on a "holiday" will have to increase their contributions.
The culprit is plunging interest rates, according to Mr. Gould, who is based in the firm's Denver office. The sharp correction this year in the long bull market shares some of the blame as well, he added.
Rio Tinto America Inc., Valencia, Calif., expects it may have to resume funding two of its pension plans and increase funding in three others. Glenn I. Swartz, director-investments, said Rio Tinto America has some $600 million in eight pension plans.
Mr. Swartz expects the contribution holiday to continue for two very overfunded plans, to which the company hasn't made contributions in eight to 12 years.
Baxter International Inc., Deerfield, Ill., doubts it will have to contribute to its $1.1 billion pension plan because it is so well funded.
Charles W. Thurman, assistant treasurer, said the company hasn't contributed for two years.
The overfunding stems "from a combination of pretty aggressive contributions we made in the early 1990s and good market returns on investments," he said.
The overfunding allowed it also to reduce its pension expense, he said, although this hasn't been enough to generate pension income for the corporation.
The company bases its pension calculations on year-end figures, he said. He doesn't expect the decline in interest rates or lower investment returns to force major change.
WORSE IN AUGUST
In August, the situation looked worse for corporations when the market fell steeply from its lofty 9000-plus height. But the more recent rebound has mitigated the effect on pension funds.
Ethan E. Kra, chief actuary-retirement, William M. Mercer Inc., New York, agreed with Mr. Gould that lower interest rates and lower stock market returns have had an adverse impact on corporations and their pension funds.
"Corporations with plans at the fully funded limit and on a contribution holiday may not have a contribution holiday any longer," Mr. Kra said. "Plans that have been overfunded may not be overfunded."
A new report for clients by Mr. Gould lays out what he considers a realistic projection for an increase in pension contributions corporations will have to make.
"This is not an alarmist message," Mr. Gould said. "This is a wake-up call to corporations. We have to keep an eye on it (the trend to unfavorable pension rates).
"If the trend continues, it could drive contributions up."
The contribution calculation is "based on a four-year average of interest rates, so cash contributions won't go up a lot in 1999, but could in 2000," he said.
Michael J. Gulotta, president and chief executive officer, ASA Inc., Somerset, N.J., disagreed with this distressing prognosis.
"The decline in interest rates won't have too much of an impact on pension contributions," he said.
"A decline in the market will have more of an impact. But from the beginning of the year, despite the drop in late summer, the market is up."
The Standard & Poor's 500 is up more than 10% so far this year.
"Interest rates going down won't increase contributions because it will cause an increase in the value of bond portfolios" pension funds hold, he added.
That's why in general, he said, the decline in interest rates and the volatile stock market "won't be a big event."
"None of my clients is going to have a problem," he added.
But, Mr. Gulotta acknowledged, "If a plan is at a 100% funded level now, then you might have some trouble," possibly requiring an increase in pension contributions.
A DIFFERENT Y2K WOE
"By the year 2000, contributions will catch up with a real vengeance," Mr. Kra said, agreeing with Mr. Gould.
Mr. Gould said 1999 "doesn't look like things will be too bad on the balance sheet." But in 2000, contributions will increase noticeably. "How noticeable will depend on the U.S. equity market."
"Companies lower the discount rate for their annual reports," Mr. Gould said. "One year in lower equity returns may not be enough to lower return assumptions. But if you have two years of lower returns, it might have a bigger impact."
With two months remaining in the year, Mr. Kra said, the market could go up or down by as much as 2,000 points.
"There is a great deal of uncertainty in the remainder of the year," he said.
"I'm giving a heads up so corporations can be ready to deal with" the potential problem.
Of the 100 largest companies Towers Perrin surveyed, "very few (he estimated fewer than 10) are making meaningful contributions," Mr. Gould said. By the year 2000, however, that could rise to about 50 companies making a total of $4 billion in contributions, he said.
The top 100 companies "had $200 billion in net income in 1997," Mr. Gould said. "So is $4 billion in contributions meaningful?" Mr. Gould suggests the answer is "yes."
Contributions could rise to between $8 billion and $12 billion in the immediate ensuing years, he said, if adverse capital market trends continue.
Mr. Kra also believes contributions will increase "for a fair number of plans," but couldn't say how many.
Corporations make two sets of estimates for pension liabilities.
One, reported in its shareholder financial reports, uses corporate bond rates to discount liabilities and determine pension expenses under Financial Accounting Statement 87. That rate now on average is 7.16%.
The Towers Perrin report projects the FAS 87 rate will be 6.5% to 6.75% by year end.
The other set uses, as required by the IRS, a four-year average of the 30-year Treasury bond rate. Corporations use that as a basis to figure their pension contributions.
That rate was 7.1% at the beginning of this year. At the beginning of next year, Towers Perrin projects it will be 6.5%.
The high returns in the stock market may have made corporate executives complacent about the impact of interest rates on the funding status of pension plans.
"We found it was somewhat overlooked, just how important the discount rate is in determining pension expense and contributions," Mr. Gould said. "Too many were looking mostly at investment returns.
"We need to point out the need to pay attention to interest rates and plan ahead" for the possible need to make pension contributions.
Mr. Kra agreed.
"Everyone seems focused on the volatility of the stock market, while ignoring the volatility of interest rates," he said.
INCREASE BOND EXPOSURE
Both Messrs. Gould and Kra suggest pension funds tilt more toward bonds to try to offset the decline in interest rates.
"Pension funds could put a heavier weighting to corporate bonds," Mr. Gould said. "As bond yields go down, they would make a gain (on their investment portfolio) to offset the lower discount rate that would raise their pension liabilities."
Mr. Kra said: "Companies might consider setting up a dedicated bond portfolio for half their pension assets, and put the other half in the stock market."
The dedicated portfolio would match the duration of its bonds with the duration of the pension liabilities. With any downward change in interest rates, Mr. Kra said, "liabilities would go up but the bond portfolio would go up equally" to offset the rise in pension obligations.
Discounting pension liabilities by the lower interest rates will raise the present value of those liabilities.
Lower stock market returns won't offset the increase in pension liabilities. As a result, pension funds will face resuming or making additional pension contributions to their pension plans.
The IRS discount formula for determining pension contributions is 105% of the weighted average of the past four years of 30-year Treasury bond rates. It is skewed to make the current year count the most in the weighting. Under the formula, the current-year rate counts 40%, 1997's rate counts 30%, 1996's rate counts 20%; and 1995's rate counts 10%.