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What to look for in 2012: Discount rates

March 12th, 2012 Leave a comment Go to comments

By Tim Connor, Genny Sedgwick

As we are now under way with the 2012 calendar year, it’s time to look at the issues we expect to generate heavy interest during the year. For one thing, the federal deficit has attracted a lot of attention lately and will likely continue to do so. The upcoming presidential election is likely to feature plans on reducing deficits, and these plans will undoubtedly reach the world of employee benefits in some fashion. In addition, the economic environment of recent times, both globally and locally, has been unstable to put it kindly. Pressure on employee benefit plan sponsors is coming from a lot of different directions. In this series, we look at a few of the potential headliners that may affect defined benefit and defined contribution plans in 2012.

The year that just passed saw some extraordinary events take place. Those that are unforeseen are what make predictions impossible, complicating matters and leaving their mark on the global economy and political landscape. The European debt crisis, political revolutions, an earthquake and tsunami in Japan, and the downgrade of U.S. debt, to name just a few, were major events that dictated the direction of economic and regulatory policies. What will 2012 hold? First, we’ll look at defined benefit (DB) plans.

Defined benefit plans: Discount rates
First and foremost on the minds of defined benefit sponsors are interest rates. How low can they go? It seems like DB plans have already circled around the limbo stick of interest rates several times and are now faced with rates so low that not even the retirement plan of double-jointed contortionists could slide under without buckling. Bend don’t break has been the unfortunate reality for DB sponsor’s balance sheets and funding requirements. The rate on the Citigroup Pension Liability Index, a common benchmark used to discount pension liabilities, hit a record low in December of 4.40%. That was the lowest rate reported by the index in its history.

Since 2008, the Federal Reserve has done what it can to keep interest rates low in an effort to offer cheap rates to homeowners and businesses with the hopes of eventually reviving the economy. Federal Reserve Chairman Ben Bernanke said last month that the plan would be to keep rates “exceptionally low” through 2014. One unfortunate consequence of these actions has been to increase the cost of insurance and annuities to individuals and plan sponsors. This wreaks havoc in the retirement industry. At the individual level, the cost of annuities has dramatically increased. At the same time, the returns under fixed income instruments are potentially inadequate to meet retirement needs. In the DB arena, today’s estimates for the values of the liabilities have skyrocketed as interest rates have dropped. If a plan was both fully funded and immunized with investments in a dedicated bond portfolio, the increase in liability wouldn’t matter because the underlying asset investment backing the liability promise would increase equally. However, such an investment strategy is the exception not the rule. The inflated liabilities showing up in actuarial reports and financial statements are leading to historically high contribution and expense requirements.

The Milliman Pension Funding Index (PFI), which measures pension requirements for the 100 largest defined benefit pension plans sponsored by publicly traded corporations, expects significant increases in 2012 and 2013 fiscal year contributions. The PFI includes different funding projections, and for the years 2012 and 2013 includes an assumption of $91 billion annually in order to fill the funding gap. This forecast agrees with the results of a recent research project led by the Society of Actuaries, “The Rising Tide of Pension Contributions Post-2008: How Much and When?” The report predicted that the average aggregate contribution to private sector pension plans would increase from $70 billion per year over the five years in 2004-2008 to about $90 billion per year over the next 10 years, peaking at $140 billion in 2016. Says John Ehrhardt, co-author of the Milliman Pension Study, “It’s all about having to cope with low rates right now.”

Next we’ll look at financial statements.

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