Pension-plan sponsors may be in for a rude surprise as they meet with actuaries and go about the annual exercise of valuing plan liabilities over the next few weeks.
The majority of sponsors that use the calendar year as their fiscal year will, on December 31, lock in the interest rate used to calculate a plan’s liabilities. That rate — generally based on average rates for “AA”-rated corporate bonds — will be used for valuing liabilities as reflected on plan-sponsoring companies’ year-end 2012 balance sheets.
It’s likely that for plans sponsored by S&P 500 companies, the aggregate year-end funding deficit — the shortfall between plan liabilities and the assets to satisfy them — will surpass the record of $484 billion set on December 31, 2011, according to consulting firm Mercer.
But an easy-to-miss subtlety is likely to have a major impact on the “discount” interest rate — so called because plan sponsors discount current liabilities to account for expected future interest payments on plan investments — that sponsors will select at the end of this year, says Evan Inglis, chief actuary for Vanguard.
Most bonds issued by major banks such as JPMorgan, Bank of America, Citigroup, and Goldman Sachs historically have been rated AA and made up a large portion of the universe of bonds used to measure pension-plan liabilities. During 2011 markets perceived that bank bonds had become riskier, so their yields went up. But typically, according to Inglis, debt-rating agencies don’t get around to dropping ratings on bonds until well after the markets sense changes in their riskiness. So even though it was hardly a banner year for pension-plan valuations, plans did benefit from high yields on AA bonds that weren’t really AA quality.
But then, in 2012, most of the bank bonds finally got bumped below AA. “So, not only was there a general drop in interest rates and corporate bond yields this year, there’s this double-whammy effect that’s making the drop in AA bond yields even bigger,” says Inglis.
The effect is that while average interest rates within the entire universe of investment-grade bonds fell from about 5.0% to 4.5% this year, the decline just for AA-rated bonds was twice as steep, from about 4.8% to 3.8%, Inglis notes. “It will come as a surprise to some that their discount rate will be less than 4%, and it will make things a bit more painful than they would have been otherwise,” he says.
But knowing all of that, what can plan sponsors do to mitigate the effects of the downward-spiraling bond yields?
Unfortunately, not a lot. Their best bet, says Richard McEvoy, a senior pension consultant with Mercer, may be to determine now how to derisk plan investments when interest rates pick up, whether that happens next year or several years down the road. “That will allow them to derisk in a disciplined way, rather than waiting to make those decisions when the time comes,” he says.
For most plans, it would be unwise to derisk now, since at this point it appears that the only direction rates can go is up.
A perhaps even longer-term strategy, and one with dubious chances for success, would be to persuade regulators to set a new standard for selecting discount rates — a standard more favorable to plan sponsors. Some CFOs have been supporting lobbying efforts in that direction, according to Inglis.
It was in 1993 that the Financial Accounting Standards Board codified some public statements by the Securities and Exchange Commission that bonds with AA or AAA ratings would be appropriate for setting discount rates. That standard is now well ingrained.
But, says Inglis, “When it was first pronounced that you should use AA bonds to set discount rates, there were a lot of them, and a lot of variety, and it made sense. Now, because so many bonds have been downgraded and the AA bond space is very different, it seems less and less useful as a standard.”
Plan sponsors do have significant discretion in selecting a discount rate, but some are more conservative than others. That’s been especially so since 2005, when the SEC publicly investigated six companies — Boeing, Delphi, Ford, General Motors, Navistar, and Northwest Airlines — over their selection of discount rates for valuing pension liabilities. In the end no charges were brought, but those and many other companies then developed more robust and systematic methods for setting their rates.