The financial markets’ poor showing in August left U.S. corporations’ defined-benefit pension plans even deeper in the red. And there are additional challenges on the horizon for DB plan funding, including the prospect that the Federal Reserve will try to bolster growth by pushing long-term rates lower. That could lower the discount rates companies use to measure pension obligations and increase the size of those obligations.
Mercer, the HR consulting company, estimates the aggregate pension deficit at S&P 1500 companies grew by $73 billion in August to total $378 billion. Pension plans took a double hit last month, with the sell-off in stocks eroding their assets at the same time the decline in interest rate caused their liabilities to grow.
The aggregate funded ratio of the S&P 1500 plans was 79% at the end of August, according to Mercer, down from 83% at the end of July and 81% at the end of 2010.
Fed policy makers pledged in August to keep their target for short-term rates at the current low level through mid-2013. Speculation now is that policy makers could announce that they will try to lower longer rates by adding more long-term Treasuries to the central bank’s portfolio, in what would be the Fed’s third round of quantitative easing, or QE3.
“Just a few weeks ago, funds were saying: ‘We don’t think yields can go any lower,’” says David Kelly, a principal in Mercer’s financial strategy group. “Now we have speculation on QE3 that says yields could go lower.”
Such a move “could be a substantial negative” for many pension plans, Kelly says. Pension plans generally measure their liabilities using a discount rate derived from longer corporate bonds; lower bond yields mean bigger liabilities. Kelly estimates that a 25-basis-point decline in yields causes pension funding to worsen by about 2%.
“The big question is, if the Fed is buying down Treasuries at the end of the curve, will corporates follow them down or will spreads widen?” Kelly says.
The spread between Treasury and corporate yields has widened recently as investors exited riskier assets and gravitated toward the safety of Treasuries, he notes. “It is likely, you would think, that if [yields on] Treasuries do go down extremely low, that corporates spreads will not blow out all of the way to compensate,” he adds.
Analysts say the deterioration in pension plans’ funded status underscores the importance of considering strategies, such as liability driven investing, that shield plans from market volatility.
Kelly says that while a few plans implemented liability-driven investing strategies a few years ago, those that didn’t have been reluctant to make the move while rates are so low. He says once yields begin to rise again, the demand from pension plans moving more assets into fixed-income securities may limit the increase in yields.
“Once yields go up, there’s going to be a strong bid,” he says. “That probably puts some pressure on the ability for yields to get very high.”
Mercer also notes that funding relief that Congress enacted in 2008, in the wake of the financial crisis, is expiring, which means plan sponsors may have to make significantly larger contributions to their plans starting next year.