The stock market’s 15% leap in the third quarter helped out companies on two fronts: their share prices rose, and they got a good return on their own equity investments. But one thing the bull run did not do was trigger a rise in the funded status of defined-benefit pension plans.
Counterintuitively, the average funding level for plan sponsors among the S&P 1,500 companies actually fell one percentage point in the quarter, to 81% of what would be needed to pay for expected future pension obligations, according to an analysis by the consulting firm Mercer.
The stock gains did help push up those companies’ pension assets by about 15%. But a plan’s funded status is the ratio of its assets to its liabilities, and the value of a typical company’s liabilities also grew by 15% in the quarter, said Mercer. That was because average interest rates on the high-rated corporate bonds in which pension plans typically invest plunged by almost 100 basis points, from 6.87% to 5.90%, while Treasury bond rates fell by only 28 basis points. The difference between bond rates and Treasuries, or the credit-risk spread, thus narrowed from 2.57% to 1.88%. (In its calculation of bond rates, Mercer included all bonds rated double-A or higher in Barclays Capital’s corporate bond-index.)
Pension liabilities grow when the credit-risk spread narrows because, under both pension-funding rules and generally accepted accounting principles, plan sponsors must then discount the present value of money to be used for paying off future obligations at a lower percentage of its face value. For example, if a company expects to pay $1 million in pension obligations a year from now and declares a discount rate of 10%, it needs only about $900,000 in present money to cover that. But if it picks a discount rate of 5%, it needs to carry roughly $950,000, so its liability is $50,000 higher.
Although plan sponsors set their discount rates, the methodology they use must be reasonable to their independent auditors, says Scott Allen, a Mercer actuary.
Meanwhile, the extreme volatility in bond rates and stock prices during the past year is of particular significance to plan sponsors with shorter investment horizons, such as companies in the portfolios of private-equity firms.
Typically there is a disconnect between the long-term financial objectives that a portfolio company sets for its pension plan before being acquired and the short-term goals of the private-equity owner, Mercer noted in a recent white paper. Since private-equity firms generally seek to divest their acquisitions within a few years, at any point in time they should strongly consider “derisking” their pension investments by reallocating assets more toward bonds and less toward stocks, Allen tells CFO.com.
But this year has been marked by especially strong opportunities for private-equity firms to shed risk from their pension plans. After the interest rates on bonds held by an “average sample plan” peaked above 8% in September 2008, according to Mercer, they crashed to 6.11% by year-end, causing pension-plan liabilities to soar. But there was significant recovery in bond rates in the first half of 2009, to 6.87% — nowhere near the peak, but still high by historical norms.
It would be understandable that even pension plans with short investment horizons would have hesitated a few months ago to sell out of equity positions — even when doing so would have locked in good bond rates — given how much stock prices had fallen in the previous 18 months. But in its white paper, which addressed the investment market as of June 30, Mercer wrote that “plan sponsors reluctant to ‘sell at the bottom’ may wish to reconsider when taking a holistic view of plan management and accounting for the impact of interest rates on plan liabilities.”
By September 30, one quarter later, there was still a rationale for offloading risk — but a different one, says Allen. Plan sponsors that viewed the stock market as overvalued following the spike in prices and considered their plan’s funded status to be satisfactory could take their profits and move more into fixed-income instruments, even though they would be locking in a relatively low bond interest rate.
Such machinations are less relevant to plan sponsors with long investment horizons. Their asset allocation is likely to be weighted more toward equities, since there is an expectation that the passage of time will smooth out the effects of short-term volatilities.