Opinion and Investing Column

SKARBECK: Observers cry foul over pension fund proposal

March 24, 2012

Ken Skarbeck InvestingAs is often the case in Washington, the highway bill our Senate approved this month isn’t just about provisions for repairing bridges and roads. The measure was amended to provide relief to companies that now find themselves facing large pension-fund contributions.

Both private and public pension costs have ballooned in recent years. Big U.S. companies will make a record $100 billion in pension contributions in 2012, up 67 percent from two years ago. Through 2015, contributions at the 100 largest pension plans will amount to an estimated $400 billion. The legislation would change the formula used to calculate pension costs and effectively allow companies to lower their annual contributions.

Pension costs have mushroomed due to a few factors. Laws that took effect in 2008 gave employers only seven years to catch up on their underfunded pension plans. That law also required pensions to use market-based rates of returns to calculate the amount of their contributions, instead of internal projections. The historic low interest rates of recent years have meant pension funding needed to rise dramatically to meet future retiree payments.

Before the 2008 law change, companies had greater leeway in setting the interest rates they used to make their pension plan calculations. The way pension math works, higher assumed interest rates generally reduce the amount of contributions needed to keep the plan healthy, which is why many pension plans have kept projected rates within their plans higher than logic would dictate.

The Senate bill, now being considered by the House, allows companies to lower pension obligations by pretending interest rates today are closer to their 25-year average. In effect, this negates the impact of the 2008 law, which was intended to bolster the health of corporate pension plans.

Many observers are crying foul. Congress already has eased the rules on pension funding six times since 2002, and critics view the current bill as letting them off the hook again. Companies have argued that the heavy pension costs are diverting money they could be using to hire workers and expand their businesses.

In the realm of public pensions, the California Public Employees’ Retirement System—the country’s largest pension fund with 1.6 million members—recently lowered its assumed rate of return from 7.75 percent to 7.5 percent. Its chief actuary had recommended a reduction of one-half a percent, leading one board member to comment, “We’re still kicking the can.”

To demonstrate CalPERS’ quandary, lowering rates to the recommended 7.25 percent would have cost taxpayers an additional $425 million next year. However, despite its $236 billion in assets, CalPERS remains underfunded with only about 65 percent of the money it is projected to need to pay future retirees. CalPERS earned 1.1 percent on its investments in 2011 and 5.1 percent over the past decade—well short of its prior 7.75-percent projection.

A final concern is that pension funds may take actions within their investment portfolios that are ill-advised as they stretch for returns. Perplexingly, some appear to be expanding their allocations to long-term fixed income. With today’s interest rates, returns from long-term bonds are unlikely to keep pace with rising pension liabilities. Other plans may succumb to Wall Street’s complex derivative strategies, a move we have seen before and one that only increases the risk for permanent capital loss.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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