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Already in trouble, corporate pension plans are doomed by low interest rates

Allison Schrager
The logo of the GE Money Bank is seen behind a traffic light in Prague May 29, 2012. REUTERS/David W Cerny (CZECH REPUBLIC - Tags: BUSINESS LOGO) - LR2E85U1LTJRP

This week General Electric announced its plans to freeze its defined-benefit pension plan. Its pension obligation are the company’s largest liability, with future benefits are estimated to be worth about $92 billion and second in size only to IBM’s, which froze its plan in 2008 at $93.5 billion. (A frozen pension plan means new employees aren’t enrolled and workers already in the plan won’t accrue future benefits.) GE’s pension assets only cover about 75% of its liability and it must contribute about $6 billion each year to fund the benefits of its current and future retirees. As it faces more financial troubles, GE is offloading all the liabilities it can. But the problem is not unique to GE. The conglomerate was among the 16 remaining Fortune 500 companies to offer defined benefits plans. The number of large pension plans has been falling since the 1980s and the remaining few will probably soon follow GE’s lead.

 

Corporations struggling to finance their pensions are not unique to the United States. Historically low interest rates around the globe are making defined benefit plans untenable. Even Denmark’s pension plans—famously the best run and well-funded in the world—needed their government in 2012 to change the regulations on how pension liabilities (based on interest rates) are calculated. Since then, rates have fallen further, and Danish regulations may be revised again. Economists and commentators usually like to talk up the benefits of low interest rates, which are presumed to expand employment and economic activity. But there are always costs, and one is that when low rates make work-place pensions too expensive, companies end up transferring the risk—and the cost—to their employees.

What killed pension plans?

In the US, initially, it was the Employee Retirement Income Security Act of 1974 which forced corporate plans to fully recognize the cost of their pensions and fund them accordingly. As a result, many companies—especially smaller ones—dropped their pensions. There were a few hold outs, mostly large firms willing and able to take on their employees’ retirement risk and offer it as a benefit to retain long-term staff. But persistently low and falling interest rates have further increased the costs of pensions, making defined benefits unaffordable for firms of any size.

When a firm puts a value on the benefits they’ve promised, they estimate future pay-outs using current (or some average of recent) interest rates.American firms use a corporate rate, while European pensions use some combinations of derivatives based on government rates. The lower the interest rates, the higher the value of their liabilities and the more they must contribute. Worse, if pension fund managers want to reduce their risk and invest in bonds—which ensure they have money to make payouts when liabilities are due—they’ll get a lower return. This is why even well-managed pension funds are now in trouble.

It is notable the only employers still offering defined benefit pensions in America are states and municipalities. They face different accounting standards which don’t require them to use interest rates (or any measure of risk) when the calculate their “funded” liabilities.

Moving risk around

Companies have dropped their pensions plans, but that doesn’t mean the risk disappeared; it was just transferred to individuals. The costs involved with financing a low-risk retirement are the same, but many employees don’t realize they have to bear this cost because individual pension account statements, like those provided with a 401(k), usually only show an asset balance, not how much income the assets will need to provide, as pension plans do. But that doesn’t mean retirees won’t need income from drawing on their asset balances when they retire. Stable income comes from shifting their assets into fixed income or annuities., where low interest rates are a liability and lower rates makes retirement more expensive for individuals and big pensions. As a result, retirees could spend less, speculates Robert Merton, the financial economist and Nobel prize winner, which could undermine the supposed benefits of low interest rates.

 

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