Fed Action May Affect Benefit Costs

Additional defined benefit plan funding may be warranted if corporate bond yields drop.

February 1, 2011

By Scott D. Knapp and Kenneth W. Newhouse

The Federal Reserve’s plan to buy more Treasury bonds, announced Nov. 3, 2010, could increase pressure on credit unions’ defined benefits plans in the form of lower funding ratios, larger pension expenses, and, depending on the funded status of the plan, the possibility of higher funding requirements.

In an attempt to invigorate the economy, the Fed will purchase $600 billion of long-term U.S. Treasury securities in $75 billion monthly increments until June 2011.

Analysts had been expecting the announcement after several weeks of telegraphing signals from the Fed. Only the size of the effort was in question, and it landed slightly lower than expectations.

The Fed’s goal is to drive market interest rates lower, thereby stimulating credit creation and aggregate demand in the economy while fending off a deflationary spiral.

The strategy is controversial and loaded with risk, but the Fed clearly believes the risks of doing nothing are greater. The Fed also indicated it reserves the right to change course if the program produces unintended results.

One potential byproduct of more quantitative easing is increased pressure on defined benefit plans. Pension liabilities are calculated as the discounted value of the future benefits owed to employees. The rates used to discount those obligations are based on a corporate bond yield curve.

If corporate bond yields drop in response to quantitative easing—which is by no means a certainty in spite of the Fed’s actions—pension liabilities will increase.

A 50 basis point drop in discount rates will generally cause pension liabilities to increase 8% to 10%.

Next: CUs have funding cushion

CUs have funding cushion

Most credit unions have funded their defined benefit plans well beyond 100% of the plan's liabilities. They have a funding cushion that can absorb the increase in liabilities due to discount rate changes and investment fluctuations.

Although not required for well-funded plans, credit unions may consider additional funding in 2011 to offset some of the increased pension expense if interest rates drop.

Falling interest rates could also lead to increased interest in liability-sensitive investment strategies among plan sponsors. Such strategies are designed to immunize a plan’s funded status to some degree from interest rate changes in either direction.

But implementing and executing liability-sensitive strategies can be challenging, especially when interest rates are at extremely low levels and continue to be artificially suppressed by the Fed.

This is the Fed’s second attempt at quantitative easing since the beginning of the financial crisis and subsequent recession.

The first attempt was substantially larger and included purchases of U.S. Treasury securities, direct obligations of government-sponsored enterprises (Fannie Mae, Freddie Mac, and the Federal Home Loan Banks), and mortgage securities backed by the same agencies.

The Fed will reinvest an additional $35 billion of monthly proceeds from maturing mortgage-backed securities into more U.S. Treasury securities during this second round.

According to the Fed’s statement, information received since the Federal Open Market Committee met in September confirmed that the pace of the economic recovery continues to be slow.

Household spending is increasing gradually. But it remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit.

Kenneth W. Newhouse (ASA, EA, MAAA) and Scott D. Knapp (CFA) are directors of retirement plan services at CUNA Mutual Group.