Fed Feeling States' Pension Pain?

MarketWatch reports, Pension Funding Relief Could Provide Between $19 Billion and $63 Billion Reduction in Required Contributions Over Five Years:

Employers that sponsor defined benefit (DB) pension plans have the potential to receive billions of dollars in temporary pension funding relief as a result of legislation recently signed into law, according to a new analysis by Towers Watson), a global professional services company. However, while the law may significantly ease financial pressures for some sponsors for at least two years, employers face potentially larger funding obligations after 2011.

Under the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act of 2010 (the Act), employers with underfunded DB plans may elect to amortize funding shortfalls for any two plan years between 2008 and 2011 either over a 15-year period or by making interest-only payments for two years followed by seven years of amortization. Generally, DB sponsors are required to amortize shortfalls over seven years.

"The federal government has given employers the much-needed and welcome funding relief they were seeking," said Mark Warshawsky, director of retirement research at Towers Watson. "Despite some improvement in the overall health of pension plans since the depths of the financial crisis, employers had been bracing for sharp increases in their DB funding obligations. Now, with the new law, employers can breathe a collective, albeit temporary, sigh of relief."

The Towers Watson analysis projected funded status and minimum required contributions for single-employer DB plans under three scenarios for the five plan years from 2009 through 2013: the pre-Act provisions and the two funding options under the new law. It did not consider the impact of the law's so-called cash-flow rules, which require extra pension contributions if executive compensation or dividend payments are too large, and could cause some employers to forgo the relief offered. The two funding options were tested for all potential two years of relief over the 2009 to 2011 period.

The analysis found that, under the pre-Act provisions, the minimum required contributions in aggregate would be $78.4 billion for plan year 2010, and would escalate to $131 billion for 2011 and approximately $159 billion for both 2012 and 2013.

Under the new law, however, required contributions would be reduced between $19 billion and $63 billion, depending on which of the two provisions and which plan years employers choose. The 15-year amortization for 2010 and 2011 funding shortfalls offers employers the maximum aggregate funding relief for employers over the 2009 through 2013 projection period; the seven-plus-two-year option for 2009 and 2010 funding shortfalls provides the least amount of relief. The analysis noted that for employers with immediate cash-flow concerns, the seven-plus-two-year option for 2010 and 2011 may be the better choice to concentrate the relief, while the 15-year amortization rule spreads the relief more evenly over a longer period.

"The pension funding relief law significantly eases some of the financial pressures employers had been facing, at least for two years," said Mike Archer, senior consultant at Towers Watson. "However, the choices that employers make now will have an impact on the magnitude of their future pension funding obligations. In addition, the new law's cash-flow rule included in the legislation has the potential to make contribution requirements more volatile for companies that avail themselves of the relief."

In a separate survey earlier this month of 137 Towers Watson consultants on behalf of 367 employers, only one-quarter (25%) of plans are likely to elect the relief. Many employers have concerns about the application of the cash-flow rule and uncertainties around details of the new law; others are pursuing aggressive funding policies, have good funded positions or otherwise do not need relief. For those likely to elect the relief, most employers intend to reflect it for plan years 2010 and 2011 and use the 15-year amortization option.

More information on the analysis can be found at: http://www.towerswatson.com/fundingrelief.

These measures are just going to buy some time for US corporate DB plans, many of which are de-risking while public plans are taking on more risk to deal with their shortfalls.

But have no fear, Fed Chairman Bernanke feels states' pension pain:

As commentators chew over the odds of a double-dip recession, the Fed chief is focusing on a bigger problem: the ticking time bomb of state pension and retiree healthcare obligations.

Bernanke's speech Monday revealed nothing we didn't already know about the health of the U.S. economy. It has a "considerable way to go to achieve a full recovery," he told members of the Southern Legislative Conference in Charleston, S.C.

But Bernanke was much more emphatic in sketching out the troubles facing states whose finances have been hit hard by the recession. He cited recent studies that put unfunded state pension liabilities as high as $2 trillion and retiree health benefit liabilities at $600 billion.

The states are running up these huge tabs at a time when many of them are struggling to put together a budget for this year, let alone plan for next year or a decade from now.

"This daunting problem has no easy solution," Bernanke said, referring to the pension shortfalls. "In particular, proposals that include modifications of benefits schedules must take into account that accrued pension benefits of state and local workers in many jurisdictions are accorded strong legal protection, including, in some states, constitutional protection."

But the pressure on governors and state legislatures to take control of their financial futures is only building, Bernanke said. He urged state government officials to begin making hard choices now, because they are likely to get little help from a federal government hamstrung by a "structural budget gap that is both large relative to the size of the economy and increasing over time."

As grim as this picture is, Bernanke sees a silver lining for those who find ways to solve this monstrous problem. "The states have the opportunity to serve as role models for effective long-term fiscal planning," Bernanke said. It's a vacuum someone is going to have to fill one of these days.

Let me repeat what I've often stated, the Fed's policy is geared towards banks, keeping rates low so they can borrow cheap and invest in risk assets all around the world. The Fed is hoping that reflation will translate into mild economic inflation, thus avoiding any prolonged deflationary episode which will hit banks' and pensions' balance sheets.

The reflation trade is alive & kicking, which is why smart money continues to buy the dips in equity markets. The doomsayers keep warning us that another disaster far worse than 2008 is on its way, but they've been wrong.

Something tells me that this is just another cyclical recovery but with one important caveat. I was talking with a sharp senior portfolio manager this morning who told me investors remain "far too focused on the US economy when in reality, it's the Emerging Markets that are leading global growth this time around."

According to him, this is a "new post-war phenomena" that is propelling the global economy ahead. His comment made me think that perhaps I should revisit Galton's fallacy and the myth of decoupling. If structural decoupling is taking place, then it will have profound implications for the way investors are currently pricing risk.