Stagflation's Impact on Pension Costs


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Stagflation's Impact on Pension Costs

  1. 1. HRS Insight Human Resource Services HRS Insight 11/18 August 31, 2011 Staring down stagflation: A pension tale gives pause - and possibilityStagflation returns. Buta lot has changed sincethe days of disco. Savvy Authored by: Sheldon Gamzonplan sponsors can hedge and the business balance sheet. Readagainst sky-high costs. As stagflation simmers, on for insights into the economic nows the time to find factors behind todays challenges and the retirement plan changes that can ways to ease retirement give plan sponsors a better way forward plan pain for the organization and its human capital. Many economists think we may be entering a time of rising inflation. If A look back at a bleak this turns out to be the case, the combination of rising inflation, high time for the economy, unemployment, and slow economic businesses, and growth harkens back to a bleak period for the US economy — the stagflation of retirement plans the 1970s. In fact, recent empirical data suggests that the current mixture of Until the 1970s, traditional economic economic indicators reflects the very theory on the interplay between definition of the term. Stagflation is inflation and unemployment was based back, along with platform shoes. And on the Phillips Curve, which held that its not very pretty. inflation and unemployment have a stable, inverse relationship. It was Still, savvy employers can apply lessons thought that inflation, and therefore learned from the days of disco to lower unemployment, came along with protect employee retirement savings
  2. 2. economic growth. An economic returns were locked in at lower levels — slowdown, on the other hand, was employees became disappointed with viewed as a harbinger of high their underperforming portfolios. unemployment and low inflation. Unfortunately, Guaranteed Investment Contracts didnt permit a direct transfer But in the 70s, the statistics zigged to competing fixed-income when they should have zagged, and the investments, and balances lost their Phillips Curve was thrown a curve, purchasing power. resulting in simultaneously high levels of unemployment and inflation. Changing times, The inflation that haunted the 70s was changing plans finally and substantially deflated when the Federal Reserve Board raised With this history in mind, how can interest rates to record highs; alas, this employers and employees prepare for a also spurred a severe recession and potential repeat of stagflation in the high levels of unemployment. Further coming years? Fortunately, although we headaches plagued employers already find our economy once again primed mired in slow growth: they were also for stagflation, the intervening yearsThe pension feeling the pain of increased costs in have seen significant changes to themathematics behindmanna their retirement plans. plans employers sponsor and the rules Rising inflation is usually manna from governing them.The spread between heaven for pension plans. But theinvestment return and Saturday Night Fever era also saw In the 70s, the final-pay defined benefitsalary increases should feverish spikes in salaries, and plan (calculated using the final averagerange from 1.5% to 2.5%. collectively bargained pension benefit earnings formula) reigned as theFor example, if inflation liabilities. Neither the equity nor the prevalent retirement program. So whencaused salary increases to fixed income markets met the actuarialspike from 4% to 6%, it inflation hikes stoked salary increases, return expectations necessary to offset they also drove up the final average pay,would be problematic onlyif investment returns the growing liabilities. The result: increasing pension benefits for past anddidnt rise by 2% as well. significant increases in cash future service. But in todays benefitIn fact, if investment contributions and pension expense. plan schemes, salary increases are notreturns rose by exactly the Given the already sluggish economy, expected to affect plan liabilities — or atsame percentage as the additional financial pressure of least not as dramatically as they did insalaries grew, and retirees rising pension costs could not have the 1970s.were not granted cost of come at a worse time for US increases, costswould decline. Thats because most defined benefit Employees werent too happy, either. plans today have been curtailed by at When interest rates first rose, many least one of these factors: employers with defined contribution plans had opted for insurers Many defined benefit plans Guaranteed Investment Contracts, have been frozen and replaced which promised a fixed rate of return by defined contribution plans, for a period of time. But when money meaning that no defined market and bank CD returns continued benefits are being earned by to increase with inflation — and any employees. Guaranteed Investment Contract PwC HRS Insight 2
  3. 3. The plan is closed to new contributions and expenses employees, with only a finite significantly higher, even without an group earning additional increase in liabilities. The knee-jerk benefits. reaction to an expected increase in The plan continues to accrue interest rates is often a transfer of benefits for all employees, but assets into short-term fixed-income in the form of a cash balance assets, where rising rates are expected plan, in which salary increases to have a more limited effect. That dont affect past service would be sensible — if one could be benefits. certain that the effect of inflation would be similar for both long and short-term liabilities.Changing rules The risk? A mismatch between assetsThe 1970s retirement plan experience and liabilities. With their longerpredated current accounting and durations, liabilities are more sensitivefunding rules. At the time, under APB 8 to interest rate movements than shorterand ERISA, actuaries based plan duration assets. Predicting whatinterest rates on the expected long-term happens next is a challenge. If interestreturn for current and future plan rates rise across the entire yield curve,assets. An increase in market interest liabilities are likely to fall by more thanrates didnt necessarily change the the plan assets — and contributions andinterest rate used for actuarial expense are likely to decrease. But ifvaluation; rising salaries were the short-term interest rates increase moreprimary reason for the volatility in than long-term rates, liabilities willliabilities. When those salary increases decline only a small amount; assets willoccurred in the 1970s along with falling drop sharply — and youll see increasedasset values, the result for businesses cash and expense and a negativewas a costly cocktail of rising balance sheet imprint.contributions and expense.Under todays funding and accounting A smart plan to outflankrules, because liabilities are marked tomarket, the discount rates used for stagflationaccounting and funding valuations are A more prudent approach: Maintainadjusted upward as inflation and fixed-income assets at a duration thatsinterest rates rise. With plan design similar to that of the liabilities. Thekeeping rising salaries from precise percentage of assets to besignificantly affecting plan liabilities invested in fixed-income securities, asand rising interest rates cutting the opposed to equities, as well as the typepresent value of pension benefits, one of equities (large versus smallwould expect a favorable, or at worst, capitalization, international versusmarginally unfavorable impact on domestic) depends on the employersliabilities. risk tolerance and the funded ratio of the plan. This can be assessed in anYet, as we saw in 2008, a precipitous asset/liability modeling analysis, usingdecline in asset values can drivePwC HRS Insight 3
  4. 4. forecasting techniques, in reduced prices. Employers shouldwhich the optimum asset mix can be communicate with employees toselected. reinforce this important information and build understanding of dollar costBut how should you invest cash balance averaging.assets amid soupy stagflation? Its animportant challenge. While futurechanges in the discount and cash No time to stagnatebalance crediting rates can be expectedto offset one another, the likely increase The stagflation of the 1970s was ain the crediting rate during stagflation difficult period for defined benefit andwill also increase existing account defined contribution plans. Withbalances — not unlike the way salary economic indicators again pointingincreases push up accrued benefits in toward stagflation, plan sponsors mightfinal-pay plans. understandably be bracing themselves for another round of bloatedSince cash balance crediting rates are contributions and expenses. But theyrealways positive — while bond values not condemned to repeat history.move positively and negativelydepending on interest rates — Much has changed in the 30 years sincetraditional hedging techniques using the last bout of stagflation ended: newbonds of similar duration to liabilities approaches to plan design, investmentcant match the effect that changing vehicles, funding and accounting rulescrediting rates have on cash balance for retirement plans, and improvedplan liabilities. Its likely that stable asset/liability modeling. Thesevalue funds will need to be introduced developments should provideto hedge the effect of cash balance employers with the tools they need tocrediting rates. Once again, an manage through a period of stagflationasset/liability analysis using stochastic far more effectively than they did threeforecasting capabilities is critical to decades ago.formulating an effective strategy. To have a deeperDefined contribution plan sponsorsshould focus on the implications for conversation about howemployees who are nearing their this subject may affectdistribution phase. Short- to medium-term stable value and money market your business, pleasefunds should be offered to enable thosenearing retirement to lock in balances contact:with a guarantee that stagflation wont Sheldon Gamzoncause irreparable damage to their Principalplans. In contrast, employees who are (646) 471-7857in the accumulation phase can benefit declining asset values as netpurchasers of securities buying atPwC HRS Insight 4
  5. 5. For more information, please do not hesitate to contact your local PwC professional: Charlie Yovino (678) 419-1330 Atlanta, GA (704) 344-7739 Charlotte, NC Ed Donovan (617) 530-4722 Boston, MA (646) 471-8855 New York Metro Matthew Cowell (617) 530-5694 Boston, MA Pat Meyer (312) 298-6229 Chicago, IL Jack Abraham (312) 298-2164 Chicago, IL Paul Perry (312) 298-3157 Chicago, IL Terry Richardson (312) 298-3717 Chicago, IL Kansas City, MO St. Louis, MO Cindy Fraterrigo (312) 298-4320 Chicago, IL Brandon Yerre (214) 999-1406 Dallas, TX Theresa Gee (312) 298-4700 Detroit, MI Todd Hoffman (713) 356-8440 Houston, TX Carrie Duarte (213) 356-6396 Los Angeles, CA John Caplan (646) 471-3646 New York Metro Scott Olsen (646) 471-0651 New York Metro Bruce Clouser (267) 330-3194 Philadelphia, PA Bill Dunn (267) 330-6105 Philadelphia, PA Amy Lynn Flood (267) 330-6247 Philadelphia, PA Sandra Hunt (415) 498-5365 San Francisco, CA Julie Rumberger (408) 817-4460 San Francisco, CA San Jose, CA Scott Pollak (408) 817-7446 San Jose, CA Jeff Davis (202) 414-1857 Washington, DC Nik Shah (202) 918-1208 Washington, DCThis document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.SOLICITATION© 2011 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP, a Delawarelimited liability partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is aseparate legal entity.PwC HRS Insight 5