Inflation is both friend and foe to private pension plans
Boston — In planning for retirement, inflation is the worker's enemy but the company's friend. US companies have recently been trimming the amount of money they set aside to provide retirement benefits. The reason: Inflation has pushed up the interest a pension fund can earn on its money.
The higher the return a company earns now, the smaller the pile of dollars it must invest to provide a given retirement stipend in the future.
A number of companies have increased the interest rate assumptions used to set their contributions to the corporate pension, says Patrick Davey, the Conference Board's project manager for financial management research. ''This has enabled them to lower their pension fund contributions,'' he adds.
While inflation is making retirement planning somewhat easier for corporations, it is making it tougher for individuals. In essence, a pension is a debt the company owes a worker. And the faster the pace of inflation, the lower the real value of the dollars the company uses to pay a pension.
As a result, the pensions workers have been promised ''have gone down quite a bit in value,'' says Jeremy I. Bulow, an assistant professor of economics at Stanford University Business School.
Corporations do not have to make radical changes in the interest they assume their fund will earn to reap major gains. The changes in assumptions ''have been modest,'' says Robert Berin, director of professional studies for William M. Mercer Inc., a benefit consulting firm.
Still, General Motors Corporation was able to save $60 million in the third quarter of 1981 by increasing its interest rate assumption from 6 to 7 percent.
The Price Waterhouse accounting firm estimates that a 1 percent change in investment results translates into a 20 to 24 percent change in the ultimate cost of the plan to the sponsor.
''I haven't seen a case where raising the assumption did not produce a gain for the company,'' says Kathy Condon, a Bankers Trust Company vice-president.
The high rates of return now available to pension plan sponsors have made corporate benefit planners smile. One effect of the high rates has been to wipe out some companies' unfunded pension liabilities. (An unfunded liability is money a company has promised to pay workers in the future but has not set aside.)
''Many pension plans which felt they had unfunded liabilities have recently reevaluated based on the current high rates of return,'' says Robin G. Holloway, vice-president of the management consulting firm Towers, Perrin, Forster & Crosby. ''They have concluded that they could cover all of their current liabilities with current assets if they could lock up these high rates of return.''
In 1980 the top 100 US corporations had set aside almost $11 billion more than they needed to meet basic pension obligations, a study conducted by Standard & Poor's Compustat Services discovered. The study, which was prepared for Business Week magazine, found that in 1979 the same corporations reported an underfunding of $22 billion.
Due to changes in financial reporting standards, however, pension funding figures for the two years are not directly comparable.
While companies may have the option of revising return assumptions and cutting their pension fund contributions, not all of them will do so. Since pension fund contributions reduce a company's taxable income, management may decide to put aside more money than strictly necessary, given current rates of return.
''I would expect that companies like International Business Machines with large tax liabilities and pension plans in good shape will continue to contribute quite a bit'' more than necessary, says Mr. Bulow at Stanford.
One indication of this conservative approach is the fact that IBM assumes its pension funds earn only a 4.75 percent rate of return. Of course, IBM may be glad to have assumed such a low rate of return if interest rates plunge unexpectedly.
Although well-heeled companies such as IBM may not change their pension contributions, those facing hard times, like General Motors, probably will. ''I would expect those companies not paying taxes because of losses would have an incentive to reduce (pension) fund contributions,'' Mr. Bulow notes. ''Why contribute this year if you are in the zero tax bracket?''
And some pension plan sponsors may decide that rather than have more in their pension plan than is necessary, they will close the fund and put the extra cash to work elsewhere.
The Great Atlantic & Pacific Tea Company has already announced plans to pursue such a strategy. A&P plans to terminate an existing plan and create a new one for employees who are covered. The combined effect of higher interest rates and a reduction in the number of employees will give A&P $200 million to invest elsewhere in the business.
Relatively few pension plans are expected to be shuttered as a result of the extra cash they now contain. ''But A&P is not unique in contemplating'' its plan shutdown, notes Mr. Holloway at Towers, Perrin. ''Other companies are exploring this possibility.''Most companies looking at folding up their pension plans to recover excess cash have run into financial woes. ''But a second group of companies - like Grumman - may be looking at surplus pension assets to avoid takeovers,'' Holloway says.For example, a company could close its pension plan and buy stock for a profit-sharing plan, using the excess cash. Because a relatively large block of stock would be held by an employees, hostile takeover attempts would be more difficult.Of course, the excess funds that companies now see in their pension plans could evaporate if the return fell on pension investments. So a number of companies have taken steps to ''lock up'' high interest rates.''We are seeing a lot of interest in locking up a portion of the portfolio and 'immunizing','' says Ms. Condon at Bankers Trust. ''Many companies have bought contracts from insurance companies which offer high interest rates, and others have sought 'immunization' through a bond approach,'' Holloway adds.The insurance contracts guarantee a specified return on the pension fund's investment for a specified period of years. An immunized bond fund is one in which the bond's maturity and coupon rate of interest are selected to provide a stream of income that will match the checks that a pension fund will have to write in a given period to retired employees.When an employer decides to boost the interest rate assumptions for his pension fund, he should also adjust his estimates of employee pay and benefits in the future, Ms. Condon says. ''If you are going to make explicit interest rate assumptions, you should be explicit about future salary and cost-of-living benefits,'' she states.Adjusting for the higher benefits workers will get in the future may reduce the extra funds in a firm's pension fund. ''A fund may find it does not have as much excess cash'' as it thought, Ms. Condon says.And businesses may find they need the excess cash if the Reagan administration succeeds in reducing social security benefits. Some 86 percent of the pension plans covering nonunion employees have benefits tied to social security payments. And if social security payments were reduced, there would be pressure on companies to make up the difference in pension payments.''I don't think the pressure would be limited to those plans which are integrated with social security,'' Holloway notes. ''Even non integrated plans have been designed with social security in mind.''
Median performance of retirement funds Annualized percent return
15 yrs. 10 yrs. 5 yrs. 3 yrs. 1 yr. 1966-80 1971-80 1976-80 1978-80 1980 Equities 5.5 7.0 13.6 19.9 32.7 Bonds 4.7 5.7 4.6 1.3 1.1 Cash equivalents NA 8.1 8.9 10.9 13.5 Total fund 5.1 6.3 10.3 13.2 20.0 Source: A.G. Becker Inc.
The largest corporate pension funds
In millions of dollars 1. AT&T $20,369 2. General Motors 13,354 3. General Electric 6,580 4. Ford Motor 6,200 5. U.S. Steel 6,100 6. Exxon 5,961 7. IBM 5,712 8. Du Pont 5,537 9. General Telephone 2,500 10. Mobil 2,488 Source: Standard & Poor's Compustat Services Inc.
The largest unfunded pension liabilities
millions of as percent dollars of net worth 1. General Motors $4,085 23% 2. Chrysler 1,275 278 3.Westinghouse 457 18 4. Bethlehem Steel 420 16 5. Caterpillar 384 11 6. Trans World 312 45 7. Sears, Roebuck 233 3 8. Conoco 193 4 9. American Can 139 13 10. Allied Corp. 121 6 Source: Standard & Poor's Compustat Services Inc.