As private pension funds struggle to meet their obligations in a low-yield environment, companies are making their plight even worse by pushing for unrealistically high discount rates, MFS Investment Management Chairman Emeritus Bob Pozen warns.
In an Aug. 20 opinion for the Brookings Institution co-written with Theresa Hamacher, president of the National Investment Company Service Association, Pozen argues that Congress’ recent decision to use a discount rate based on bond yields averaged over 25 years rather than the previous two years does a major disservice to private pensions.
The authors note that the discount rate, meaning the interest rate on high-quality corporate bonds that is used to determine a pension plan’s expected future return, plays a key role in calculating pension plan obligations. And with the unrealistically higher rate now in place, pension plans will suffer, they warn.
“While an averaging period of five to 10 years might better reflect more ‘normal’ conditions, a 25-year averaging period, as enacted in the U.S., clearly goes too far. Interest rates in 1988 are unlikely to have much predictive value for the next 10 to 20 years,” Pozen and Hamacher write in their opinion piece, “A Realistic Discount Rate for Pensions.”
Corporate pension funds’ current plight is the result of several factors: poor stock market returns over the past five years, a shift from stocks to bonds, and historically low interest rates over the past year, the authors write. At the same time, they say, private pension funds across the world are having a harder time meeting their obligations to future retirees: “In July 2012, the 100 largest U.S. private pension funds faced a $533 billion shortfall, according to the consulting firm Milliman.”
Pozen and Hamacher recommend instead a discount rate that uses expectations about the future, rather than data from the past, arguing that forward rates are a reasonable reflection of expected risk-free returns.
“Policymakers must be careful when considering what the ‘correct’ discount rate should be,” the authors conclude. “What if today’s historically low interest rates are not some aberration that will quickly disappear? If so, temporary increases in the discount rate will only delay, rather than prevent, the day or reckoning for pensions.”
In May, Investment Advisor magazine named Pozen to its 2012 IA 25 list of most influential people in the advisor universe. Pozen and Hamacher are also co-authors of “The Fund Industry: How Your Money Is Managed.”