The calm before a storm? Funding levels have recovered strongly, and the Pension Protection Act has provided new certainty on key rules for plan sponsors. But accounting issues and volatility remain major concerns.

After several years of stormy seas, the pension waters are considerably calmer these days. Funding levels have risen sharply in the past couple of years, goosed by a rising stock market and higher interest rates, and legislation has provided new certainty for pension plan sponsors--albeit with a stern mandate that under-funded plan sponsors provide for full funding over time.

[ILLUSTRATION OMITTED]

Certainty is a good thing, especially in an area as potentially unpredictable as pension funding. The Pension Protection Act of 2006 (PPA) did a lot to clarify and provide certainly around pension rules, experts say, even as troubling questions remain about pension accounting.

To be sure, there are still headlines about big companies putting "freezes" or "soft freezes" on their defined-benefit DB plans (ending accumulation of benefits to all plan members, or just closing the plan to new hires, respectively). But pension consultants say the impression of a steady erosion of DB plans is exaggerated.

"My experience is that when you explain plan design, and the various alternatives, you get different answers," says Alan R. Glickstein, a senior retirement consultant in the Dallas office of Watson Wyatt Worldwide. "A significant number of companies see the worth of defined-benefit plans.

"For the employer, DB plans are fundamentally less expensive," he adds. "They allow more investment efficiency," and employers can also offer features like early retirement windows that can't be done with a defined-contribution (DC) plan like a 401(k).

Glickstein and others see a resurgence of interest in what he calls LDI, or liability-driven investing. The idea is to better match the returns of assets and liabilities, to ensure that the portfolio maximizes the funding surplus, while reducing overall volatility. Glickstein says that "organizations are looking at the duration of bond-like instruments, which can be much longer than equity-based investments. They're asking, 'How can we better link the movements [of assets and liabilities] together?'"

Such strategies utilize bond and derivative markets, he adds, which would help firms better hedge against their long-term pension liabilities.

"Plan sponsors in both the public and corporate sectors have begun investigating a series of investment and management strategies, some new and some not-so-new, that are designed to achieve some combination of increasing investment returns, limiting portfolio volatility and managing liabilities down over time," says Greenwich Associates consultant Dev Clifford.

Seven-Year Window

As the most sweeping pension reform in many years, the PPA has been the subject of reams of analysis. One of its explicit goals was to help preserve the integrity of the Pension Benefit Guaranty Corp. (PBGC), which had been buffeted by sizable bankruptcies in the airline and automotive industries and the threat of others; the PBGC has had to make large payments when under-funded plans failed to make retirees whole. Now, companies will be required to reach fully funded status, though they have seven years to do so.

Some sponsors have voiced concerns about financial statement concepts like transparency and "smoothing," the ability of companies to average asset changes over time, rather than recognize them annually. By limiting smoothing terms to two years, rather than to four or more, as had been the case, the PPA would seem likely to accentuate the swings in pension accounts.

Indeed, many believe the new rules will increase volatility. Stewart Lawrence, senior vice president and National Retirement Practice leader at the Segal Co., in New York, says, "Minimum funding requirements will be more volatile than in the past. They will sometimes be higher than in the past and sometimes lower, put they will always be more volatile."

Mary Ann DiMaggio, director of fixed income for Evaluation Associates, wrote in a report published last year that "because plans will now be required to use asset and liability valuation procedures that more closely resemble mark-to-market valuations, within a narrower valuation band, and with limited smoothing, plan status will be subject to greater levels of volatility."

"The way they are going to handle smoothing, by shortening it to two years from four or even five, will materially increase funding volatility, especially for plans that have made heavy use of equities," says Douglas A. Dachille, CEO of First Principles Capital Management LLC, an investment management adviser in New York. "The consequences are quite troubling for regulated institutions. For banks, it's really quite problematic. Highly leveraged industrials also have a significant problem--it dwarfs anything else on their balance sheets. Ratings could be impacted.

"On the positive side," Dachille adds, "the new rules do allow tax advantages--you have the ability, if you can over-fund the plan, to enjoy all of the earnings tax-free. You can now pre-fund up to 150 percent of the liability. That's a significant benefit."

The new law established a new discount rate, a blended yield on higher-quality investment grade corporate bonds (rated A or better), but it will also have a yield curve component to it, notes DiMaggio. "Under normal-term structure environments, where the yield curve is upward sloping, the new methodology is expected to lead to an increase in the present value of liabilities," DiMaggio wrote in a research note last year.

For "hybrid" or cash-balance plans, which combine features of DB and DC plans, the PPA has been a blessing: it specifically affirms their status, defines them and concludes that they are not age-discriminatory, which had been a common complaint, Glickstein notes.

"The law fully opened the door to confidently designing these plans," which have been around for more than 20 years, he says. "The changes are really effective in '08, but we have seen several large companies saying they are converting to or are expanding existing cash-balance plans."

Segal's Lawrence says that "the prospective 'green light' on cash-balance plans has created a financially viable alternative to DC plans for employers that want to move away from the traditional DB promise." In recent months, he notes, Mead Westvaco Corp., SunTrust Banks Inc. and FedEx Corp. have announced the conversion of their conventional DB plans to cash-balance plans.

Where Are Things Headed?

While companies are still adjusting to the PPA rules, and the PBO accounting issues loom on the horizon, crises are no longer shaking up the pension area. Greenwich Associates says this time could be called "the calm before the liability storm."

Watson Wyatt's Glickstein doesn't expect the smoother waters to make companies complacent, however. "There will be ups and downs," he says. "There may be a time in the future where interest rates rise, and, with good returns, funding levels are up to around 120 percent--that might turn companies' focus to other areas."

Says Greenwich Associates consultant Chris McNickle: "Even if such favorable market conditions persist, plan sponsors will continue to seek a different risk/return tradeoff in their portfolios and new approaches and products will continue to gain adherents. Simply put, the two forces driving this change--under-funding and accounting reform--are not going away."

RELATED ARTICLE: Pension Accounting Rears Its Head

It isn't just the Pension Protection Act that worries benefit administrators and senior executives. There's the accounting side, which really hits harder on finance areas, and there, the Financial Accounting Standards Board (FASB) has created some real reasons for concern.

In Phase 1 of its pension project, FASB issued FAS 158, which says that the funding status of a plan must be reflected on the balance sheet, no longer just described in footnotes to the financial statements. As Mary Ann DiMaggio, director of fixed income for Evaluation Associates, notes, the changes will have a direct impact on shareholder equity, and could boost book value volatility "if asset values do not move in tandem with liabilities."

More important, arguably, is Phase 2. While still undetermined, and scheduled to take effect next year or in 2009, this phase will address more fundamental questions of how pension obligations will be recorded. FASB has announced its preference for "projected benefit obligation," or PBO, versus the conventional "accumulated benefit obligation" (ABO).

Watson Wyatt's Alan Glickstein says his firm favors ABO rather than PBO, which would use projected pay and benefit increases to establish obligation values. "The idea of having to project future pay increases seems like a bit of a stretch," Glickstein says. He adds that "using different rates creates comparability issues" among companies.

Douglas Dachille of First Principles Capital Management says this PBO calculation inflates the size of the liability, as reflected on the balance sheet, "but it doesn't reflect the full economics. If you terminated the plan now, you would use only ABO." Forcing companies to calculate a projected obligation, he believes, "will motivate some sponsors to consider freezing their plans."

Then there is the general trend in FASB pronouncements to move toward mark-to-market accounting of financial instruments. "The transition to mark-to-market accounting rules in the United States is reducing the ability and willingness of corporate plan sponsors to tolerate market volatility within their pension funds, and thereby their ability to generate much-needed investment returns," noted Greenwich Associates in a recent report.

RELATED ARTICLE: TAKE AWAYS

* The Pension Protection Act did a lot to clarify and provide certainly around pension rules, even as troubling questions remain about pension accounting.

* There's been a resurgence of interest in strategies like liability-driven investing, which aim to better match the returns of assets and liabilities.

* Many experts believe the restrictions on asset "smoothing" are likely to accentuate the swings in pension accounts.

* The Act has been a boon for cash-balance plans: it specifically affirms their status, defines them and concludes that they are not age-discriminatory.

Distribution of Retirement Plans Among FORTUNE 100 Companies

Type of Plan                      1985  1998  2002  2004  2005

Traditional Pension Plan*         89%   68%   50%   42%   37%
Hybrid Pension Plan*               1%   22%   33%   33%   27%
Defined Contribution/401(k) only  10%   10%   17%   25%   36%

*Most of these firms also have a 401(k)
Source: Watson Wyatt Worldwide