The possibility that their actions could hurt corporate pension-plan sponsors probably wasn’t top of mind for members of the Federal Reserve’s Open Market Committee when they announced last week that the Fed would forge ahead with a second round of quantitative easing by buying $600 billion of longer-term Treasuries by the end of the second quarter of 2011.
But if pumping money into the economy fulfills the Fed’s goal of lowering long-term interest rates, that could force sponsors of defined-benefit plans to record higher pension costs on their income statements at the end of this year, benefit consultants say. That, in turn, could lower those companies’ reported earnings. The cash on corporate balance sheets could also dwindle as the need to fund pension plans grows.
While government interest rates aren’t directly used to measure private pensions, the rates’ movements can have a powerful effect on the rates used to calculate plan assets. If the government’s action drives such interest rates down, plan liabilities will rise, notes Jonathan Barry, a partner in the retirement, risk, and finance group at Mercer, a big employee-benefit consulting firm.
That’s because a pension liability is like a bond issuance, says Barry. “There’s a reasonably predictable stream of payments that are going to be made out to the beneficiaries of the plan, which is like the coupons being paid out by the bond issuer to the investor,” he says. When bond coupons decrease, bond prices rise, and vice versa. In the same way, when interest rates used to gauge the value of a pension’s liability decrease, the price of the liability increases.
In other words, the cost of a plan sponsor’s pension obligations will rise, creating an expense on its income statement that reduces reported earnings. Although reported earnings can have a huge effect on a company’s share price, however, a rise in pension expense is an accounting demerit rather than a loss of real money.
But if quantitative easing does end up lowering pension interest rates, real money could be lost, too. A pension sponsor’s funded status (the plan’s assets minus its liabilities) must be recorded on the company’s balance sheet. And if the Fed’s actions cause a plan’s liabilities to grow until the plan is excessively underfunded, the sponsor is required under federal pension rules to contribute more dollars to the plan.
To be sure, if the Fed’s moves stimulate the economy, that could have a positive effect on plan assets by boosting the price of the stocks held in pension portfolios. “But generally speaking, liability movements tend to swamp asset movements on the pension plan,” says Barry. In a plan that has liabilities with a duration of 10 years, for example, a mere 1% drop in interest rates could produce a 10% rise in liability in the first year. Achieving a balancing 10% annual asset rise in today’s stock markets, by contrast, would be tough sledding indeed.