Op-Ed: Congress’ Temporary Pension Relief Is Hardly Relief At All

As legislators grapple over another highway bill funded on pension smoothing, former PBGC Director Charles Millard calls for the measure to be made permanent.

At the eleventh hour, the US Senate has voted to keep federal money flowing to highways, but rejected the bill's funding source. This $10.8 billion package was to be paid for through a budget maneuver called temporary pension smoothing. As a budgetary matter, this is just a gimmick. Yet as a pension matter, it makes perfect sense—if it is permanent. Regardless of what one thinks about the highway bill, as far as pensions are concerned, Congress should stop the gimmickry and enshrine this change in permanent law.

When Congress wants to increase spending, it must come up with the funds. This is called a "pay-for." Two years ago, Congress "paid-for" the Highway Bill with a temporary pension smoothing amendment. More recently, the Senate attempted to use pension smoothing as a pay-for to extend unemployment benefits, but that bill never passed the House of Representatives.

Pension smoothing is a sensible way to allow corporations to maintain and fund their pension plans. It allows plan sponsors to align their funding to the long-term horizon of their liabilities, not the short-term nature of market volatility. Pensions value their liabilities using a discount rate similar to the rate of interest paid on high-grade corporate bonds—essentially, those rated AA. Even though pension liabilities are paid out over decades, current rules require that they be valued with a two-year average discount rate.

Since 2005, US corporations have terminated 5,000 pension plans. Two million fewer Americans are covered by a defined benefit plan.

Never miss a story — sign up for CIO newsletters to stay up-to-date on the latest institutional investment industry news. 

Interest rates have been very low for years. The lower the interest rate, the higher the present value of the liabilities. Corporations are required to pay down approximately one-seventh of their underfunded pension liabilities each year. They are not, however, required to have pension plans in the first place. And after years facing this volatility, fewer of them do. Since 2005, the year before current pension legislation was passed, corporations in the United States have terminated 5,000 pension plans. Today, two million fewer Americans are covered by a defined benefit plan.

If Congress would like to keep the remaining pensions plans in place, it must make pension smoothing permanent. As the name suggests, this would smooth the burden (and pain) of funding plans across all rate environments rather than concentrating it on low-rate periods. Over time, it will make pension funding would become more predictable. That will allow more corporations to keep their plans intact.

Some argue that the only way to value liabilities is by marking them sharply to market. For the security of members’ retirements, these liabilities must be fully funded. But think about this: If interest rates were to rise by less than two points, almost every pension in America would be "fully funded." Would we want corporations to forego any pension contributions in those years? What we should want—if we want to keep the defined benefit system alive—are predictable contributions that rise and fall over the long term (just like the liabilities they are responsible to meet).

Unfortunately, Congress has used temporary pension smoothing as a sort of budgetary piggy bank. Need to fund a $10 billion project? Bingo! Pension smoothing. The fact is, lower near-term contributions mean higher ones in coming years. When Congress only counts the budgetary effect in the next few years, it is hiding the long-term reality instead of addressing it. But many plan sponsors—desperate for stability—won’t fall in line if only offered temporary smoothing.

Two years ago, the Congressional Budget Office’s “pay-for” revenue estimate proved too high thanks to pension smoothing. Many corporations chose not to take advantage of it, due to the short timeframe and Congress’ unreliability and unpredictability. This year, the office has lowered its estimate. Lawmakers know that temporary pension smoothing will not deliver the long-term funding stability corporations need to keep their pensions in place. So lawmakers should act.

Charles Millard is the global head of pension relations at Citigroup. He also served as the director of the US Pension Benefit Guaranty Corporation (2007-2009) in the administration of President George W. Bush.

Now is the time to “scale down risk” due to high valuations in equities and fixed income, according to a report by UBS.

“Stretched” valuations have made the recent momentum of equity indices such as the S&P 500 “difficult to justify”, the Swiss bank’s strategists said, adding that inflows into exchange-traded funds were “consistent with a ‘risk on’ trend”.

UBS highlighted the recent difficulties faced by Portuguese bank Banco Espírito Santo (BES) as a “canary in the coalmine” for equities.

The bank’s shares sold off dramatically after a rights issue in June and other Portuguese banks, sovereign bond prices, and even the VIX index were affected—something that UBS said “tells us a story about market positioning and market pricing”.

Want the latest institutional investment industry news and insights? Sign up for CIO newsletters. 

“The market is already pricing most of the potential good news and is prone to react to bad news,” the strategists argued.

“Valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries.”—US Federal Reserve.Turning to fixed income, UBS said spreads between European government bonds and US treasuries were too low, with some peripheral European countries’ bonds trading at yields consistent with a much higher credit rating.

“While European spreads were extremely cheap during the crisis, they now look too expensive,” the strategists said. “This tells us that it could be difficult for the market to absorb negative news—as we saw with BES.”

UBS’s concerns chime with the US Federal Reserve’s most recent Monetary Policy Report. It said equity valuations were “generally at levels not far above their historical averages” despite the S&P 500 and Dow Jones indices hitting all-time highs.

But the Fed added: “Nevertheless, valuation metrics in some sectors do appear substantially stretched—particularly those for smaller firms in the social media and biotechnology industries, despite a notable downturn in equity prices for such firms early in the year.”

The central bank’s report also flagged the ultra-low reading from the VIX index, which indicates market volatility.

But not all market commentators are so negative.

A report from risk specialists Axioma covering the second quarter of this year found that some equity risk measures declined to levels not seen in more than 30 years.

Melissa Brown, senior director of applied research at Axioma, asserted that “risk is on holiday”, and claimed that an increase in risk levels was unlikely, “at least not in the near term”.

“Axioma’s statistical forecasts do not suggest there is something ‘bubbling under the surface’ that other risk models are not picking up,” Brown added.