When Low Interest Rates are Anti-Stimulus
We have heard about the difficulty folks who are retired are having with low interest rates. But low interest rates are having a huge impact on corporations that still have defined-benefit pensions.
Across America's business landscape, the gap between the amount that companies expect to owe retirees and what they have on hand to pay them was an estimated $347 billion at the end of 2012. That is better than the $386 billion gap recorded at the end of 2011, but the two years represent the worst deficits ever, according to J.P. Morgan Asset Management.
The firm estimates that companies now hold only $81 of every $100 promised to pensioners.
In general, everything happening on the liability side of the pension equation is working against companies. A big source of the problem: persistently low interest rates, set largely by the Federal Reserve....
Pension liabilities change over time as employees enter and leave a pension plan. For financial-reporting purposes, companies use a so-called discount rate to calculate the present value of payments they expect to make over the life of their plan.
The discount rate serves as a proxy for the hypothetical interest rate that an insurance company would expect on a bond today to fund a company's future pension payments. The lower the discount rate, the greater the company's pension liabilities.
Boeing's discount rate, for example, fell to 3.8% last year from 6.2% in 2007. The aircraft manufacturer said in a securities filing that a 0.25-percentage-point decrease in its discount rate would add $3.1 billion to its projected pension obligations.
Boeing reported a net pension deficit of $19.7 billion at the end of 2012.
The discount rate is based on the yields of highly rated corporate bonds—double-A or higher—with maturities equal to the expected schedule of pension-benefit payouts.
Moody's decision last summer to lower the credit rating of big banks hurt UPS and other companies by booting those banks out of the calculation. And because bonds issued by some of those banks carried higher yields than other bonds used in the calculation, UPS's discount rate fell 1.20 percentage points.
This is obviously not a wildly productive use of corporate funds, to divert ever-increasing amounts of money to pay people who are no longer producing. But at least corporations are acknowledged the problem (I will give credit where it is due -- thanks to accounting rules and government regulations that force a fair amount of transparency here).
It is interesting to note the Boeing example, where their expected rate of return on pension funds fell from 6.2% to 3.8%. Compare that to corrupt government entities like Calpers, which bravely faced this new reality by cutting its discount rate from an absurd 7.75% to a still absurd 7.5%. This despite returns last year around 1%. By keeping the number artificially high, Calpers is hiding its underfunding problem. An interesting reform would be to force Calpers to use a discount rate equal to the average of that used by the 10 largest private pension funds.
a_random_guy:
Just a minor point, on a related topic: Having the pension funds managed by the same companies that pay into them is a huge risk. This isn't done in other countries. For example: if compane X goes belly up while owning billions to its pension fund, the pensions of people who (no longer) have anything to do with the company will be drastically affected. Even worse, company X may find a way to raid the pension fund, while attempting to stay financially afloat - in which case the pensions disappear in a magical puff of smoke.
Really, when a company or a government organization pays a pension benefit, this should be to a pension fund managed by a completely independent organization. A trust fund, if you will. This would prevent shenanigans like the CalPers idiocy, because the independent entity will not be interested in appeasing unions by pretending to things that it simply cannot deliver. In fact, pretending otherwise would surely be fraud, if done by any organization other than the government!
February 26, 2013, 9:50 amLarryGross:
not just defined benefit - but defined contribution also. People saving for their own retirement are not getting the returns that were originally counted on to determine how much money to save towards retirement so now those folks are having to put aside more and/or work longer.
And this is also affecting people who have self-directed pension investments that they count on generating their annual pension distributions from..
not sure who doesn't get hurt... but it's not just defined-benefit plans.
February 26, 2013, 9:55 amChris Kahrhoff:
Or you know, let people manage their own retirement without getting more and more parties involved with ever increasing costs for management and regulatory compliance BS.
February 26, 2013, 10:07 amNL7:
Otherwise stated: bondholders are hurt by lower rates of return, and pension funds hold lots of bonds.
February 26, 2013, 12:05 pmNL7:
DB retirees do not share in most of the decline and other parties (current employees, prospective employees, DC retirees, customers, vendors, shareholders, taxpayers/PBGC) can be made to feel the pain before DB pensioners will. DC beneficiaries will share the pain of the general market. So it's much more relevant to non-pensioners what is going on with DB beneficiaries, to the extent that their fate will be averted by sacrificing others around them.
February 26, 2013, 12:10 pmmarque2:
It also has an unintended effect on banks. Because the QE interest rates are lower than treasury rates, banks will borrow and purchase Federal government debt and still make some money. They don't want to take the risk of making private loans to businesses.
If QE rates go above treasury rates, than banks will be forced to lend privately again.
The whole QE strategy is really designed to allow the government to continue massive deficit spending. Once the rates rise, where will the treasury get money, unless Treasury interest rates go up precipitously.
February 26, 2013, 2:21 pmmarque2:
I share in almost 60% of the increase and decline since that is the retirement savings I have in 401K and similar retirement devices. the 40% will come from SSA, and is a ponzi scheme anyway so doesn't really reflect real interest rates of return.
February 26, 2013, 2:23 pmTorontonian:
Not quite. Bond values increase as interest rates decline. The magnitude of the increase is proportional to the duration of the bond. Short duration bonds see minimal price impact. Long duration (i.e. 30 year treasuries) are highly sensitive to interest rates.
So, long duration bondholders have done exceptionally well over the last 5 years.
However, going forward is a different story.
February 26, 2013, 2:24 pmmarque2:
There is a federal insurance program that covers bankrupt plans. If the Fed requires insurance they should make it private insurance - and then the funding issues will go away. The only reason companies can raid funds and pull other shenanigans is because the federal program just doesn't look all that closely at the underlying solvency of the plans.
February 26, 2013, 2:28 pmmesaeconoguy:
See also: Financial repression.
February 26, 2013, 4:30 pmbigmaq1980:
Actually, it is worse...there is evidence, because of the fungibility of money, that the banks have been using the extra funding for their "house" investments. In other words, those QE deposits from the Fed are turning into the equity (stock or derivatives) investments, boosting earnings beyond the differential on deposits vs loans, and it is easier profits.
In a seemingly unrelated news story, I heard today that "Wall Street" bonuses will be up 8% this year on average.
Part of the Fed strategy is the hope that a buoyant stock market would create a "wealth effect" and thereby boost the economy (consumer/business confidence to spend/invest), while keeping rates low for the federal government debt (a 1% increase in rates on a $16T debt would have interest expense rival welfare expenditures, a 3% increase would have it rival pension or healthcare expenditures).
So, we are left with the fact that they are deliberately attempting (successfully) to distort the market pricing mechanism for debt and equity. As Bernanke alluded to in Jackson Hole, we are in "experimental territory".
Not sure how it will work out, but we hear lots of cheering from much of the popular media. Too bad these smart folks didn't let us know of the pending crisis back in 2008.
February 26, 2013, 5:30 pmbigmaq1980:
The new Consumer Financial watchdog appointed (illegally) by Obama was just legally "renewed". I read that he has been talking about exploring the legal boundaries of their abilities regarding today's collection of retirement plans - this is in context of "protecting" consumers from the Wall Street sharks and the vagaries of the markets (translation: Federal government access to individual retirement savings money in return for "guaranteed" income provided to retirees).
This rationale played out in Argentina where people found their (already devalued) savings turned into government bonds.
February 26, 2013, 6:54 pmmesaeconoguy:
That’s correct, the idea of private retirement asset seizure has been floated several times by Democrats.
In the name of “safety,” of course.
So not only are they suppressing rate of return, they may seize your retirement funds outright.
They will also dip into your bank accounts and remove funds at will, as they do currently in Italy (and other backward countries).
Outcome: violence.
February 26, 2013, 7:01 pmmesaeconoguy:
The media have ceased being merely ignorant & biased, and are now active participants in the farce - extensions of the state.
The state is officially your enemy.
February 26, 2013, 7:03 pmbigmaq1980:
"The media have ceased being merely ignorant & biased, and are now active participants"
Man, you don't know how right you are.
My thinking on that had changed some years ago after I had personally witnessed an event and seen it expressed on TV that night in a way completely different than what I know I saw.
It was completely accidental. I was not part of it, nor did I know what was going on until I heard the news report. Then once I understood, I had a "that's not right! Why are they saying that?" moment.
Until then, like everyone else, I was "too busy to notice", even though I had my suspicions and could point to examples of "bias" from a so called "objective" media. But, when it goes beyond bias into doing the spinning itself (leaving a false impression), then its like a chapter out of 1984. It is rather unsettling.
All I can say is know or try to take an educated guess from what you see as to the motivation from the people/organizations providing you the information. Know that every source is biased anyway, but are they distorting the truth as well vs just providing a point of view? Make your own decision to accept or not. Don't just look for confirmation bias, but consider various view points from sources you can "trust".
We are living in some challenging times with much of the media hardly asking the tough questions that need to be asked, made worse by some who ARE participants.
February 26, 2013, 7:40 pmbigmaq1980:
Once the LA Times runs an Op Ed on the idea, you know it is only a matter of time before the "thinking" in DC starts to veer in that direction.
February 26, 2013, 7:42 pmBurn_the_Witch:
Look up Gell-Mann Amnesia effect.
February 27, 2013, 6:32 pmbannedforselfcensorship:
My newest thought experiment: with bank rates at around 1%, and the poverty line at $23,500, someone with 2 million in the bank would be considered poor.
February 27, 2013, 8:27 pmLarryGross:
well if you lived forever perhaps and the govt did not consider assets when determining poverty thresholds. Interestingly enough they don't for Medicare means-testing, ... apparently - you can have a lot of assets but only have to pay 100 a month premiums.
but for 2 million dollars, you could buy a pretty good life annuity that would pay you much more per year until you croaked. that's essentially how many defined benefit plans actually work. They're annuities, as is social security.
since the talk is about public debt - you might find this interesting:
http://en.wikipedia.org/wiki/File:Holders_of_the_National_Debt_of_the_United_States.gif
it basically shows who the govt currently owes - public and self. All the "self" are Trust Funds.
February 28, 2013, 4:32 ambigmaq1980:
Thanks for the reference...will keep it in mind for future reference...definitely fits our behavior, probably a form of cognitive dissonance response.
I especially liked the mock headline "Wet Streets Cause Rain" to illustrate how the media can distort the news.
February 28, 2013, 8:51 am