Managing Pension Yield Curve Risk
"A Different Strategy on Pensions" by New York Times reporter Mary Williams Walsh (September 9, 2006) showcases International Paper Company for its use of swaps as a way to hedge interest rate risk. She writes that "International Paper's $7 billion pension fund, which covers 175,000 people, is three years into a broad revamping, one that the company believes will protect it from the forces that wreaked havoc in the last few years."
Several points are worth mentioning.
First, the Pension Protection Act of 2006 makes a practice known as smoothing more difficult. The implication? It will be harder for companies to disguise funding problems going forward. Changes due out any day from the Financial Accounting Standards Board are likewise expected to put the kibosh on this type of illusory reporting mechanism. CFO.com reporter Helen Shaw writes that FASB Chairman Bob Herz opposes smoothing and favors a more accurate representation of funding status. (Click here to read her 2005 article.)
Second, defined benefit plans are affected by changes in interest rates (and related yield curve shifts). As rates drop, pension liabilities increase. (The extent to which they rise depends on a host of factors.) Moreover, a drop in rates (depending on the cause) could depress the return (assumed and realized) on some (not all) investments, thereby widening the pension gap and making things worse.
Third, the effectiveness of any interest rate hedging technique is influenced by current levels of interest rates, capital market conditions, the shape of the yield curve, the steepness of the yield curve, choice of instrument and so on. That's why Fed watching is such a popular activity.
Fourth, the pension situation is not hopeless. While some companies and municipalities are in dire straights (perhaps well on their way to financial distress or outright failure), other organizations can and should consider what works, what doesn't work and why.
Pension governance best practices are worth the time. Millions of people count on decision-makers to evaluate plausible solutions as a way to keep their word.
Incisive...as usual. Steve Cypen