Bond managers could see a surge of new business over the next few years as a result of upcoming funding reform proposed by the Bush administration that would match the time profile of future cash flows with discount rates of similar duration. This would encourage pension funds to increase their bond allocations to match liabilities, said Mike Johnston, practice leader at Hewitt Associates. Corporate plans, on average, allocate 26.97% to bonds and 63.92% to equity, according to Wilshire Associates survey. Some believe these exposures could reverse.
A Morgan Stanley report titled the Financial Market Implications of Pension Reform says, "The amounts involved would be significant, given that private [defined benefit] plans hold $1.5 trillion in assets, and much more if state and local plans, which hold another $2.5 trillion, were to join them. Shifts by the two groups could perhaps move $650 billion or more out of equities into fixed-income assets, and could also entail a major move to increase fixed-income duration." Increased demand for bonds could drive up the market, Johnston added, but this may be offset by the government issuing more debt to address its deficit.
Johnston said new funding calculations could push some companies to close their DB schemes to new entrants in an attempt to limit costs—a move that could lead to even higher bond allocations. Closing a fund shortens its liability profile, which can encourage plans to boost their bond stakes to match liabilities as they run down.
The Bush administration's Single Employer Defined Benefit Pension Reform Proposal suggests that funds calculate their liabilities using interest rates drawn from a yield curve for high-quality zero-coupon corporate bonds. The Secretary of the Treasury would issue this monthly and would base it on the interest rates, averaged over 90 business days, for AA-rated corporate bonds with varying maturities. Using a yield curve would make the liabilities of corporate plans with more immediate cash flows look larger, said Richard Berner, managing director and chief U.S. economist at Morgan Stanley. In general the plans with the largest deficits are fairly mature, so their liabilities would appear even larger, he added.
Using this yield curve would make liabilities, and thus also contributions, more volatile year-on-year because, unlike with current pension accounting, there is no smoothing mechanism, said Jim Klein, president of the America Benefits Council. Pension funds currently calculate liabilities using the weighted average over the past four years of a composite of three long bond indices. Before legislation last year, funds used a floating four-year average of 30-year Treasury rates. Matching liabilities with bonds would dampen the volatility of contributions.
Current accounting rules allow corporations to make rosy return forecasts for stocks and most other assets, provided they are based on historical returns and are ratified by an external auditor. Bond returns, however, must be forecast based on current yields to maturity. As yields have fallen over the past couple of years, pension funds have lowered their bond exposures. "Last year must have been the lowest allocation to bonds in modern history," said Ron Ryan, chief financial architect of Ryan ALM. "This whole game is based on trying to look good and avoid embarrassment and avoid cost," he said, "but will cost more in the long term" because liabilities aren't matched.
