From the October 2010 issue of Treasury & Risk magazine

Plans Wallow in Low Rates

The Federal Reserve's strategy of keeping interest rates low to coax the economy back on track has proved costly for corporate defined-benefit pension plans, whose funding is deteriorating as a result of the low rates. Actuarial consulting company Milliman calculates that the total combined deficit of the 100 biggest corporate pension plans grew by $106 billion in August, with $91 billion, or 84% of that increase, reflecting the expansion in the plans' liabilities caused by lower rates.

The double-A corporate bond rate used to estimate corporate plans' liabilities "is very low right now, and that's probably the number one driver of a low funded status," says Gordon Young, integrated retirement financial management leader at HR consultancy Mercer.

The double-A corporate rate was 4.94% in August, its lowest level in a decade. Young says the equilibrium level is probably around 6%. "It's going to go up eventually," he says. "But we don't have a view of how quickly it will go up, or whether it might go down first, and then go up."

And if the U.S. were to experience a spell of deflation, as some fear, "that would be tough on pension plans," Young says. He estimates that a rate move from 5% down to 4.5% could increase plan liabilities by 5%.

The deterioration in funded status suggests companies may have to boost their contributions. As businesses work to recover from the recession, "funding their plan competes with other needs for capital," Young says.

An August report by Fitch Ratings warns investors about the potential claim on companies' cash flow posed by the worsening underfunding. The Fitch report also questions corporate pension plans' assumed rates of return, which averaged 8% in 2008 and 2009, in light of current rates. "Current assumed returns may prove to be optimistic and will likely warrant a discussion of whether these assumptions will need to be ratcheted down," says the report, written by Fitch's Mark Oline, John Culver and James Rizzo.

Consultants have recently advised sponsors to guard against volatility by extending the duration of a plan's assets, often by holding more fixed-income securities. But the current rate environment makes that strategy, known as liability-driven investing, seem less attractive.

Investing in long-duration bonds now means the risk of a capital loss on those bonds when rates start to head higher, Young notes. "That creates a situation where you have to ask yourself, should I go ahead and invest in long-duration bonds now and hedge? Or set my strategy to say, I want to invest more in bonds, but I want to wait until rates go up a bit?"