Imagine if you knew you owed a dollar to your friend but you didn’t have to pay it back for 10 years. Using the time value of money, you could assume an interest rate and then invest some amount (say 60 cents) so you could build up to have that dollar when you needed it. Now imagine what you would do if you knew that you could only earn half the interest on your 60 cents that you thought that you could. You would have reached 80 cents instead of a dollar. What would you do?
Multiplied to add several zeros, this is the status of the typical U.S. corporate defined benefit pension plan right now according to Bank of New York Mellon.
Corporations contribute assets into the pension plans of their employees each year. The administrators of these retirement plans use actuarial tables and average investment return scenarios—primarily of high quality bonds—to project how much they will earn on their pension investments. They then determine how much they could potentially owe to their pension recipients. Finally they compare these amounts to determine how much to invest on behalf of each employee to be able to fully fund their expected pension payouts.
At the end of each year, the actuaries review the growth in expected retirement plan payouts and the growth (or loss) of the investments in the plan as well as the new contribution that the company has made to the plan and they determine if the plan is over or under-funded.
Right now, the average corporate defined benefit retirement plan has about 72% of the money that it needs to be fully funded. For companies in the S&P 500 Index that still have pension plans, the funding gap increased from $250 billion to $450 billion in 2011 according to Credit Suisse.
The problem is that most of these pension plan managers expected investment markets, not their contributions, to do the heavy lifting required to fulfill their obligations. Even if they have used a very conservative expected return when making decisions about how much to contribute to their pension plans, the actual rates have been below that.
That means that these plan managers have four basic choices about how to proceed:
- Lower their expected market returns for many years and get the leaders of their businesses to approve much higher payments into their retirement plans until these plans are more fully funded. Many publicly-traded U.S. companies are holding record amounts of cash. But investing it in their pension plans prevents them from reinvesting in their business for growth or paying dividends to shareholders.
- Hope that market returns increase soon. At the same time they will also increase the risk that they take with the investments in the plan and hope that their returns will help bring the pension plan liabilities and assets into equilibrium.
- Issue bonds to raise money to meet their pension obligations.
- Weigh the costs and benefits of continuing to offer a defined benefit plan for employees. If the costs are too high, they will have to distribute the assets of the underfunded plan to employees so they can be used to fund a defined contribution plan(401k, etc.).
None of these seem very appealing, so our guess is that choice number four will continue to be popular with many companies in the next couple years.
~ Brooks, Hughes & Jones, Partners in Wealth Management, Tacoma, WA