November 12, 2010

Fed’s QE2 Generates Pension Plan Uncertainty, Mercer Says

The Fed's policy could cause further deterioration in U.S. pension plan funding

After the midterm elections, the Federal Reserve passed a quantitative easing program (QE2) that could potentially cause further deterioration in U.S. pension plan funding, especially if it lowers long-term interest rates, according to Mercer in a news release on Tuesday.

Benefit plan sponsors are looking for ways to lessen the impact of pension volatility on their balance sheets and income statements so that they can focus on their core businesses. However, Mercer advises that many companies are contending with significant pension deficits and struggling with balancing risk reduction and increasing cost during a time of profitability challenges and expenses reduction pressures.

For the new round of quantitative easing, the Fed’s primary tool is their commitment to purchase roughly $600 billion in Treasuries over a nine-month period. These purchases are designed to lower long-term interest rates for the near term, and reduce the potential for relief on the pension equation liability side. Typically, pension plan liabilities are valued using yields in high-quality corporate bonds, not Treasuries. If the purchase doesn’t change the spread between corporates and treasuries, then pension discount rates are expected to stay at all time lows for the short term.

As for longer term, the Fed’s actions could cause inflation to creep upward, drive interest rates higher, and potentially lower liabilities. However, significant movement before late 2011 or early 2012 is highly unlikely. "The short run effect is a greater demand for Treasuries, which will pressure short and intermediate rates to remain low. The longer term impact of QE2 is to risk higher actual inflation than the market is currently pricing." said Louis Finney, chief economist for Mercer, in a statement.

On the equity side, QE2 can stimulate economic growth and rally the equity markets. There were favorable reactions from Wall Street after the Fed’s announcement.  Fifty percent  to 70% of pension plans assets come from equities, so this could provide a favorable tailwind for pension funding.

“Over the long term, if the Fed hits the mark with QE2, the funded position of pension plans, and the associated level of contributions, could improve,” said Jonathan Barry, Partner in Mercer’s Retirement, Risk and Finance Group, in a statement. “Higher interest rates, resulting primarily from a moderately higher inflation rate, would decrease pension liabilities. At the same time, in a positive scenario, the value of plan assets could increase if the equities market improves as a result of improved business conditions and profitability. However, in the short term, it is likely that the low discount rate environment we are in will persist for those plan sponsors with December 31, 2010 fiscal year-ends, putting pension funded status pressure on corporate balance sheets at year-end.” 

Sponsors remain concerned with the market’s volatility which is associated with the level of interest and market exposure.  They are looking for prudent risk management. “A growing number of pension plan sponsors are tired of being subject to economic factors beyond their control, and are seeking to reduce the impact of defined benefit pension volatility on their balance sheets,” Barry noted. “While QE2 is yet another factor to consider in devising a pension risk reduction strategy, there are an increasing number of strategies to achieve pension risk reduction, including insurer buy-outs, lump-sum cash outs and  dynamic asset allocation, which allows for plan sponsors to systematically take risk off the table as their funded status improves. Plan sponsors really need to take some time to understand the risks that they are exposed to, and decide whether or not those risks are acceptable to their organizations.“

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