Pensions Can't Win

Author: Peter C. Beller

Both stock and bond markets have been rising in fits and starts since March but corporate and public pension plans haven't seen much benefit. Indeed, the recovery in prices for high yield debt, seen by some as an indication of an improving economy and low future defaults, has actually hurt the pensions.

With the exception of pundits now making a fat living by predicting the doomsday of our financial system, most people have reason to smile about the markets' recent rally. The S&P 500, after dropping to 1997 levels this spring, gained almost 40% by June. Not only stocks came roaring back, from April through June corporate bonds of long duration returned about 15% as fears that credit markets would cease to exist dissipated.

Among the biggest holders of corporate debt are company pension plans but, perversely, what should be a windfall return for retirement plans is making a bad situation even worse, according to pension consultant Mercer. Pensions, unlike 401(k) plans, guarantee benefits to retired workers. Because of the way pension plans are accounted for, the bond rally actually widened the deficit between what companies own, and what they owe their workers. As a result, the shortfall in the nation's corporate pensions went from 13%, or $167 billion, in April to 18%, or $245 billion, in June, says Mercer, using the S&P 1500 index for its calculations.

The reason for the paradox lies in the tricky accounting of company pension plans. Plan sponsors must estimate how much money they need to invest now to meet obligations decades away. Estimating the obligations requires its own guesswork—how long retirees will live, how much they'll be making when they retire -- but the tougher trick is figuring whether a plan's investments will return enough to meet its promises.

To do that, plan sponsors use a "discount rate" to estimate returns years into the future, explains Adrian Hartshorn, a principal at Mercer. Accounting rules require nearly all pension plans to base their discount rate on the yield of high quality corporate bonds. A higher rate of return means companies must invest less today and vice versa. As bond yields go down, liabilities go up. While the market for bonds has rallied, yields on corporate bonds have fallen about 1%, which in turn has forced pensions to reduce their discount rate from 7.74% to 6.79%, says Hartshorn.

If pensions held only the corporate bonds they use to calculate the discount rate, the rise in bond values in their portfolios would nearly offset those higher liabilities. But most corporate plans choose to invest heavily in U.S. stocks to generate higher returns and reduce the need for the parent company to contribute earnings to the pension, says Hartshorn. (See "Indexers Love Suffering Pensions") That creates a mismatch between their portfolios and the way they calculate what they will owe retirees. The growing gap will show up on companies' financial statements at the end of the year.

The bond rally predicament comes at a bad time for firms with big retirement plans. Most corporate pensions took a beating in the stock market last year. The average plan, which invests a majority of its assets in U.S. stocks, lost 27% last year while liabilities rose 15%, says Robert Penter of consultant firm Hewitt. Accounting rules once allowed companies to hold off recording those deficits on their financial statements but recent changes forced the red ink onto corporate balance sheets at year-end. Several large companies saw their shareholder equity plummet or, in Boeing ( BA - news - people )'s case, get totally wiped out as a result of stock markets losses.