Pension funding hit hard by new proposal

Snapshot for July 23, 2003.

Pension funding hit hard by new proposal
Pension funds are facing financial trouble because interest rates have declined. Current funding rules require pension plans to use a four-year average of the 30-year treasury rate to determine funding contributions. When these rates rise, pension plan liabilities and required contributions fall because less money is needed today to meet future obligations.

But because the Treasury Department no longer issues 30-year bonds, policy makers need to define new rules. The Bush Administration has proposed to replace the treasury rate with the higher corporate bond rate for the next two years. Thereafter, it would be replaced with a current yield curve* of interest rates. The use of the yield curve would mean that there are different interest rates for different liabilities.

At any point in time, the yield curve is composed of interest rates for short-term, medium-term, and long-term liabilities. Under a yield curve, liabilities that will come due at different times would be discounted by different rates. For example, a benefit payable in five years would be discounted by the interest rate on five-year bonds, while a benefit due in 20 years would be discounted by a 20-year bond rate. The effect of this rule change is to make earlier benefits, such as pensions to older workers, more expensive.

The administration's proposal to use yield curves for calculating pension plan funding makes these plans hugely vulnerable to recessions for two reasons. First, the change eliminates the averaging of interest rates. If averaging is eliminated, then the discount rate for pension liabilities is likely to fall rather than to rise in a recession. For example, the four-year average rose in recessions, while the actual rate fell (see figure). If the four-year average had been used in all post-war recessions, pension plans would have been helped rather than hurt by rising interest rates because a 1% increase in interest rates lowers pension liabilities by about 10% to 15%, requiring fewer contributions in a recession.

Second, yield curves rose in recessions because short-term rates fell faster than long-term rates. This would make some benefits—such as pensions covering older workers—more expensive than others. Pension plans covering an older workforce, particularly in manufacturing, would see costs rise faster than other plans, providing incentives to employers to reduce or eliminate these pension plans.

* The yield curve is the ratio of the long-term treasury bond rate to the one-year treasury bond rate. As commonly done, the 20-year treasury bond yield is used as the long-term rate for bonds issued prior to the introduction of the 30-year bond in 1977.

This week's snapshot was written by Christian E. Weller.

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