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Stagflation's Impact on Pension Costs
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HRS Insight
Human Resource Services
HRS Insight 11/18
August 31, 2011
Staring down stagflation: A
pension tale gives pause - and
possibility
Stagflation returns. But
a lot has changed since
the days of disco. Savvy Authored by: Sheldon Gamzon
plan sponsors can hedge
and the business' balance sheet. Read
against sky-high costs. As stagflation simmers, on for insights into the economic
now's the time to find factors behind today's 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
it's 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
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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 didn't 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 years
The pension
feeling the pain of increased costs in have seen significant changes to the
mathematics behind
manna 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 the
investment return and Saturday Night Fever era also saw In the '70s, the final-pay defined benefit
salary increases should feverish spikes in salaries, and plan (calculated using the final average
range from 1.5% to 2.5%. collectively bargained pension benefit earnings formula) reigned as the
For example, if inflation liabilities. Neither the equity nor the prevalent retirement program. So when
caused salary increases to fixed income markets met the actuarial
spike 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 only
if investment returns the growing liabilities. The result: increasing pension benefits for past and
didn't rise by 2% as well. significant increases in cash future service. But in today's benefit
In fact, if investment contributions and pension expense. plan schemes, salary increases are not
returns rose by exactly the Given the already sluggish economy, expected to affect plan liabilities — or at
same percentage as the additional financial pressure of least not as dramatically as they did in
salaries grew, and retirees rising pension costs could not have the 1970s.
were not granted cost of come at a worse time for US businesses.
living increases, costs
would decline.
That's because most defined benefit
Employees weren't 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
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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
don't 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 assets
The 1970s retirement plan experience and liabilities. With their longer
predated current accounting and durations, liabilities are more sensitive
funding rules. At the time, under APB 8 to interest rate movements than shorter
and ERISA, actuaries based plan duration assets. Predicting what
interest rates on the expected long-term happens next is a challenge. If interest
return 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 than
rates didn't necessarily change the the plan assets — and contributions and
interest rate used for actuarial expense are likely to decrease. But if
valuation; rising salaries were the short-term interest rates increase more
primary reason for the volatility in than long-term rates, liabilities will
liabilities. When those salary increases decline only a small amount; assets will
occurred in the 1970s along with falling drop sharply — and you'll see increased
asset values, the result for businesses cash and expense and a negative
was a costly cocktail of rising balance sheet imprint.
contributions and expense.
Under today's funding and accounting A smart plan to outflank
rules, because liabilities are marked to
market, the discount rates used for
stagflation
accounting and funding valuations are
A more prudent approach: Maintain
adjusted upward as inflation and
fixed-income assets at a duration that's
interest rates rise. With plan design
similar to that of the liabilities. The
keeping rising salaries from
precise percentage of assets to be
significantly affecting plan liabilities
invested in fixed-income securities, as
and rising interest rates cutting the
opposed to equities, as well as the type
present value of pension benefits, one
of equities (large versus small
would expect a favorable, or at worst,
capitalization, international versus
marginally unfavorable impact on
domestic) depends on the employer's
liabilities.
risk tolerance and the funded ratio of
the plan. This can be assessed in an
Yet, as we saw in 2008, a precipitous
asset/liability modeling analysis, using
decline in asset values can drive
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stochastic forecasting techniques, in reduced prices. Employers should
which the optimum asset mix can be communicate with employees to
selected. reinforce this important information
and build understanding of dollar cost
But how should you invest cash balance averaging.
assets amid soupy stagflation? It's an
important challenge. While future
changes in the discount and cash
No time to stagnate
balance crediting rates can be expected
to offset one another, the likely increase The stagflation of the 1970s was a
in the crediting rate during stagflation difficult period for defined benefit and
will also increase existing account defined contribution plans. With
balances — not unlike the way salary economic indicators again pointing
increases push up accrued benefits in toward stagflation, plan sponsors might
final-pay plans. understandably be bracing themselves
for another round of bloated
Since cash balance crediting rates are contributions and expenses. But they're
always positive — while bond values not condemned to repeat history.
move positively and negatively
depending on interest rates — Much has changed in the 30 years since
traditional hedging techniques using the last bout of stagflation ended: new
bonds of similar duration to liabilities approaches to plan design, investment
can't match the effect that changing vehicles, funding and accounting rules
crediting rates have on cash balance for retirement plans, and improved
plan liabilities. It's likely that stable asset/liability modeling. These
value funds will need to be introduced developments should provide
to hedge the effect of cash balance employers with the tools they need to
crediting rates. Once again, an manage through a period of stagflation
asset/liability analysis using stochastic far more effectively than they did three
forecasting capabilities is critical to decades ago.
formulating an effective strategy.
To have a deeper
Defined contribution plan sponsors
should focus on the implications for conversation about how
employees who are nearing their this subject may affect
distribution phase. Short- to medium-
term stable value and money market your business, please
funds should be offered to enable those
nearing retirement to 'lock in' balances
contact:
with a guarantee that stagflation won't
Sheldon Gamzon
cause irreparable damage to their
Principal
plans. In contrast, employees who are
(646) 471-7857
in the accumulation phase can benefit
sheldon.a.gamzon@us.pwc.com
from declining asset values as net
purchasers of securities buying at
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