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Marvelous medicine of ECB’s Draghi is poison for pensions

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(Bloomberg) — Mario Draghi’s latest batch of measures to boost the euro-area economy comes with a sting in the tail for companies and anyone hoping to retire comfortably one day.

Extending quantitative easing to include non-bank corporate bonds is poised to make life even tougher for company pension plans. Record-low interest rates had already depressed bond yields, making it harder for companies to finance retirement promises made to employees. The ECB’s move is likely to send company debt prices up and yields even lower, worsening their struggle.

It’s a huge problem. The first stress test of European defined-benefit and hybrid pension plans in January found a combined 428 billion-euro ($484 billion) funding shortfall euros across 17 countries. To give but one example: Lufthansa’s 6.6 billion-euro pension plan deficit is roughly the same as its market capitalization.

Rising prices boost the value of the assets pension plans use to fund retirement obligations — a good thing. But those gains have been swamped in recent years by problems on the liability side.

Accountancy rules require companies to assess projected pension liabilities using a discount rate based on the prevailing yield of investment-grade corporate bonds. The calculations determine how much companies must set aside now to fund future obligations. 

Falling bond yields result in a lower discount rate, which in turn increases the costs of meeting those obligations. In short: pension deficits get bigger.

Paul Watters, credit analyst at Standard & Poor’s, estimates that a 1 percentage-point decline in the discount rate tends to increase pension obligations by about 16 percent at large companies with the most-exposed pension plans.

The ECB’s timing is unfortunate as its intervention followed a period of relative respite for pension plan managers last year, when discount rates rose and deficits therefore narrowed somewhat.

Total pension obligations for companies in Germany’s Dax had increased 24 percent to 372 billion euros in 2014, but declined by about 10 billion euros in 2015, according to Mercer, a consultancy. The funding ratio (of pension assets to obligations) improved to 65 percent from 61 percent last year.

This may all sound a bit dull, but it has important consequences for companies, investors, the economy and, of course, employees.

If companies divert capital to plug a hole in the pension fund, they have less cash to fund capital investments. A big pension deficit hanging over a company means employees are also less likely to be able to win pay increases. Widening pension deficits could therefore create a headwind to QE’s effectiveness.

Credit-rating companies pay attention to pension deficits. And bigger shortfalls might prompt them to raise a flag that could feed into higher borrowing costs — another drain on cash. Ballooning gaps also make equity investors nervous because dividend payments can come under pressure. These can counteract QE’s beneficial effect of cutting bond yields and boosting equities.

What can be done, besides closing defined benefit plans to new entrants? Companies could move liabilities to an insurer via a buyout, but this would cost it money, reducing reported profit.

Regulators could create a bit of breathing space for companies by allowing them to take a less rigid approach to setting pension discount rates. Where permitted, corporate pension plans should also consider diversifying further into riskier assets like property and infrastructure. That would help in particular in Germany, where pension funds are often weighted heavily towards low-yielding bonds. 

Yet until interest rates rise materially, which seems very unlikely, the fundamental problem isn’t going to go away.

It’s true that corporate pension plans would also be in serious trouble if the ECB had refused to act, creating a deflationary spiral and pushing the continent back into recession. Nevertheless, investors cheering Draghi’s latest injection of adrenaline into the region’s economy need to be alert to its side effects.

See also:

Top European pension opts for roads as hedge funds left behind

Biggest private fund in Finland says QE kills price signals

Trudeau reverses Harper policy on pension-eligibility age

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