Blogging Employee Benefits

January 25, 2006

Chilling Discussion on Pension Ice Age

Filed under: Pensions — Fuguerre @ 4:08 pm

[A]s stock market prices and interest rates picked up slightly at the end of 2005, some funds were able to come closer into balance than they had for several years. That creates an opportunity to close the fund down and cash out before another funding gap arises.

Actually, that return to near-balance, cited in an excellent article posted by the Wharton School of the University of Pennsylvania, very probably has little or even nothing to do with the current avalance of pension plan freezes. But it is an extremely critical point nonetheless, and for a far more potentially disruptive rush for the door that is yet to come: not the pension plan closures or freezes, but rather the coming wave of pension plan terminations. When a company such as IBM only freezes its defined benefit pension plan, premiums continue to be paid to the PBGC, among numerous other implications important to the system as a whole, to the company, and to the individual participant. But take a frozen plan and actually terminate it, and the PBGC loses premium income, and numerous other things irrevocably change. Meanwhile, back to the nuance of the balance between interest rate levels and pension fund assets: although there are certain aspects of the current accounting that may feel more comfortable with freezing at the equilibrium point, in actual practice there is nothing inherent in that point that pushes toward freeze. With plan termination, though, it’s an entirely different story. Plans can and do freeze at any funded status, but there are serious impediments to terminating an underfunded plan. Rather than ramble on about the distinctions, let’s just say that as equilibrium emerges, we will be seeing more and more pension plans actually terminating. Indeed, until interest rates turned back around late last year and the equity markets failed to continue momentum past their 5-year highs, we were very close to the magic moment for many plans, perhaps even now still close enough for one final employer contribution to reach the point where the DB burden can be dropped entirely.

For the freezes, the potential volatility looming in the pending pension funding legislation and in the new accounting standards that will take effect later this year are more the story than the funded status itself.  Bringing me to the next paragraph in the Wharton article, which states, “To curb pension-fund volatility, the Financial Accounting Standards Board (FASB) is now studying accounting changes that could eliminate smoothing and make pension assets and liabilities a part of the corporate balance sheet.” Nope, the first clause in that sentence is completely wrong on at least two major points. First, volatility is not in any way whatsoever the reason why FASB is taking up its pension accounting project.  Perhaps in a very distant way of seeing things, the lack of volatility over recent years has led to the clamor for accounting reform – for instance, sustained pension income reported on corporate P&Ls despite sustained declines in the pension funded status. But even there, it’s too much of a reach to characterize that as a reason behind the FASB project. But more to the point, the FASB project will have precisely the opposite effect suggested by that sentence in the Wharton article. Phase 1 of the FASB project will introduce material volatility to the balance sheets of DB pension plan sponsors by the end of 2006; and Phase 2 of the project will FASB project will dispense with most or all of the current GAAP’s smoothing techniques, thereby introducing even more volatility to corporate income statements. And although not the only reason for sticking the pension plan in the refrigerator, it is precisely that threat of volatility that is one of the forces behind the increase in abandoned pension plans.

OK, just a few thoughts on two scraps from a far more extensive discussion, one thought very highly praising the insight on the interest-investment equilibrium (albeit for slightly different reasons than those suggested in the article), the other thought disputing the article on the issue of volatility vis a vis the FASB project. I could go so much further: this article is by and large well thought through and well written, and belongs on the reading list of any observer or practitioner of what remains of the DB pension plan universe.

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