The not-so-welcome trend of low interest rates continuing to liquidate the funded status of the nation’s defined-benefit plans seems unlikely to end, according to experts with Vanguard.
The first big drop in funded status took place a year ago when corporate bond interest rates began to head south, and have continued to stay at historically low levels.
Now, downgrades in some corporate bond issues — whose higher rates had been used in the past by plan sponsors to fix discount rates and better estimate liabilities and funded status — are continuing to plummet.
“For financial reporting, accounting rules require the use of an AA corporate bond yield curve to value pension liabilities,” explained Jeff Sparling, an investment consultant in Vanguard’s Insititutional Advisory Services, in a recent commentary from the company.
“The SEC provides guidelines on picking a discount rate but allows plan sponsors some flexibility in selecting a discount rate among these bonds,” he said. “So when it came time for the annual accounting for plan liabilities at the end of 2011, some sponsors chose bonds along the yield curve that justified a discount rate of around 5 percent — the rate for the highest-yielding AA-rated issues.”
Because of the perception of risk, the bonds had higher yields — and tended to come from still-embattled financial institutions. But when Moody’s and Standard and Poor’s aligned their thinking with the market perception, the bonds were downgraded and are no longer the best choice to use as a benchmark for accounting purposes.
“A lot of sponsors prepare their budgets in the fall,” Sparling added. “And some were unprepared for what they’re now seeing.” Interest rates as high as 5 percent in 2011 have now slipped as low as 3.5 percent.
Analyists say a significant disconnect exists between the liability reported on a plan’s financial statements and the liability used to determine the contributions necessary to keep the plan afloat.
Plan sponsors are, as a result, being encouraged to view their plan liability as their market liability — and think about the real, long-term costs of actually paying out benefits to plan participants. This makes the notion of investing in long bonds a better idea for the very long haul.