Pension Relief Bill Presents Risks

July 6, 2012 (PLANSPONSOR.com) - New pension rules may provide relief for underfunded pension plans but they can also increase risk, according to Karin Franceries, an executive director in J.P. Morgan Asset Management’s Strategy Group.

“Most people hope that interest rates will go up so the value of liabilities goes down,” Franceries told PLANSPONSOR. “But with the funding relief, the discount rate is so smoothed (over 25 years) that the liability value is known over the next three years. Liabilities will not be sensitive to rates anymore. This could raise a question if you are in fixed-income investments: if rates go up, your fixed income investments will lose in value, but your liabilities will not move at all.”

That means plan sponsors might have to increase contributions when they could have decreased them had their liabilities been timely marked to market. But the new law could cloud sponsors’ judgment, tempting them to choose very short fixed-income investments to remove interest rate risk, a move that Franceries strongly discourages.

Franceries said a pension fund which appears to be 100% funded due to the new regulations, but is actually 80% funded, might say, “‘Let me switch all my assets to cash.  I won’t lose money with cash.’” Franceries does not agree with that logic. “The assets will not appreciate in value, your deficit could stay constant or even increase once the effects of the new bill disappear in a few years," she stated.

The bill presents a problem in the case of decreasing interest rates. Sponsors can now calculate their liabilities based on benchmark bond rates for the 25-year-preceeding period. Because interest rates were much higher before the 2008 financial crisis, the use of higher interest rates lowers pension liability calculations (see “Despite Funding Relief, DB Contributions May Stay Above Minimum”).    

But should interest rates decline in subsequent years, the jig will be up – sponsors will eventually have to increase their contributions to match the increase in liabilities, according to Franceries. “With a small decrease in rates, deficits could go through the roof once the effects of the new Bill wear off,” she said. “[Plan sponsors] would be really hurt.”

Franceries equated the bill to Botox, the popular cosmetic treatment that smoothes out wrinkles. Botox wears off with time. So do the effects of the bill. It makes pensions funds look much better in the short term,” Franceries said. “But the effects will disappear in four to five-year period.”

This begs the question: why did the government change the rules and why now?

One possible explanation is that the government was pressured by pension plans that have to contribute much more than they did than last year due to the low interest rate environment, Franceries contended.

Another possible explanation is that the government wanted to increase tax revenue. “If sponsors contribute less, there are less tax-deductible expenses, and more tax paid to the government,” Franceries said.

However, the government might not ultimately collect more tax revenue. Unless rates increase, sponsors will eventually have to increase their contributions, and therefore their tax-deductible expenses, she noted.

Despite the risks, Franceries said most of her clients have underfunded pension plans and probably will take advantage of the regulations. “I would assume they’ll be happy to go with the new bill,” she concluded.