Smoothing Corporate Pension Plan Discount Rates

There’s a controversial cost-offset provision in the highway bill currently being debated in the Senate; it would effectively allow corporations to make smaller contributions to their pension plans. And since a smaller contribution means a smaller tax write-off, tax revenue would increase by $7 billion over ten years. Although the bill itself is certainly not headed for an easy passage, this provision has raised some interesting—and complex—issues related to pension accounting.

Currently, corporate pension funds account for the present value of their liabilities using a discount rate based on high-quality corporate bond yields, averaged over the preceding two years. When these yields fall, the present value of liabilities increases. So, because the discount rate fell by about 100 basis points between year-end 2010 and year-end 2011, the total value of S&P 500 companies’ pension shortfalls increased by $200 billion.

The provision in the highway bill would allow corporations to use a discount rate averaged over a longer period. The Wall Street Journal reported on Tuesday:

“The provision in the highway bill would extend the window, keeping the discount rate within 15% of an average of corporate bond rates over the preceding ten years.”

As the discount rate is designed to represent the long-term low-risk return that a pension plan could realize, this idea is not totally unreasonable.  There is a case to be made that the current interest rate environment does not reflect longer-term expectations, especially because the Federal Reserve is actively holding down long-term interest rates through a stimulus measure known as Operation Twist. Because of these temporary measures, a modestly longer averaging period could more accurately reflect return expectations.

Personally, I would advocate an averaging period of no longer than five years—more than the two years under current law, and less than the ten years currently being proposed. By contrast, some corporate lobbyists have advocated an even longer averaging period. Again, from the WSJ:

“A coalition including the U.S. Chamber of Commerce, National Association of Manufacturers, American Benefits Council and the ERISA Industry Committee is pushing to calculate the discount rate over a longer time frame, keeping it within 10% of a 25-year average.”

This would go too far. The interest rate in 1987 doesn’t predict investment returns in the future in the same way that the interest rate in, say, 2006 might. Too much can change over 25 years—growth expectations, demographic trends, technological developments, etc.

In short, averaging over a slightly longer period than current law allows could help insulate corporations from short-term rate fluctuations. A five-year period for averaging high-quality corporate yields seems particularly justified at this time because the Fed is explicitly suppressing interest rates through the end of 2014. However, averaging over 25 years would not reflect reality. Such a radical proposal could allow corporations to significantly underfund their pensions.

Bob Pozen is a Senior Lecturer at Harvard Business School and a Senior Fellow at the Brookings Institution. His latest book, Extreme Productivity, is now available at your favorite local or online bookstore.

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