According to economists, the current low-interest-rate environment is primarily intended to bolster business activity by making it easier for companies to invest in growth-producing projects. That’s been hard on savers, but increasingly, one factor has made major corporations want interest rates to rise as well: the growing problem of pension liability.
What low rates have done to pensions
For years, companies have been doing everything they can to minimize or eliminate their pension liabilities. Just last year, for instance, General Motors Company (NYSE:GM) and Verizon Communications Inc. (NYSE:VZ) took major steps toward outsourcing their liabilities to an insurance company, Prudential Financial Inc (NYSE:PRU), in order to get rid of the risk of long-lived pensioners beating the actuarial odds and draining corporate coffers to a greater extent than expected. Dozens of major companies have shuttered pension plans, forcing new employees to make do with 401(k) defined-contribution plans and the profit-sharing and matching contributions that employers have in many cases made on their behalf.
Yet low interest rates have caused problems for legacy pension plans and their funding status. As an article in The Wall Street Journal Monday noted, many companies with big pension plans will have to make substantial contributions this year in order to boost their funding levels. Ford Motor Company (NYSE:F) will divert $5 billion in profits to go toward its pension funds, sapping its ability to make capital expenditures to grow its business. Similarly, The Dow Chemical Company (NYSE:DOW) said that lower rates added $2.2 billion to its pension liabilities, forcing it to add an extra $250 million to $300 million in pension expenses this year to start on making up the difference.
Why do rates matter so much?
It may seem surprising that low interest rates have such a huge effect on pensions. But the simple explanation is that, as with ordinary people investing for a long-term financial goal, assumptions on what interest rates and rates of return will prevail over the decades can make huge differences to how much money you have to save in order to achieve the best results.
For pension funds, rate assumptions have to stretch far into the future — half a century or more for those companies that still let new employees participate. For brand-new workers, the time horizon is the longest, but the benefits are also the smallest. As workers stay longer in their careers and earn more benefits, what an employer needs to set aside gets a lot bigger — and it becomes much more sensitive to rate risk.