According to economists, the current low-interest-rate environment is primarily intended to bolster business activity by making it easier for companies to invest in growth-producing projects. That's been hard on savers, but increasingly, one factor has made major corporations want interest rates to rise as well: the growing problem of pension liability.
What low rates have done to pensions
For years, companies have been doing everything they can to minimize or eliminate their pension liabilities. Just last year, for instance, General Motors (NYSE:GM) and Verizon (NYSE:VZ) took major steps toward outsourcing their liabilities to an insurance company, Prudential, in order to get rid of the risk of long-lived pensioners beating the actuarial odds and draining corporate coffers to a greater extent than expected. Dozens of major companies have shuttered pension plans, forcing new employees to make do with 401(k) defined-contribution plans and the profit-sharing and matching contributions that employers have in many cases made on their behalf.
Yet low interest rates have caused problems for legacy pension plans and their funding status. As an article in The Wall Street Journal Monday noted, many companies with big pension plans will have to make substantial contributions this year in order to boost their funding levels. Ford (NYSE:F) will divert $5 billion in profits to go toward its pension funds, sapping its ability to make capital expenditures to grow its business. Similarly, Dow Chemical (NYSE:DOW) said that lower rates added $2.2 billion to its pension liabilities, forcing it to add an extra $250 million to $300 million in pension expenses this year to start on making up the difference.
Why do rates matter so much?
It may seem surprising that low interest rates have such a huge effect on pensions. But the simple explanation is that, as with ordinary people investing for a long-term financial goal, assumptions on what interest rates and rates of return will prevail over the decades can make huge differences to how much money you have to save in order to achieve the best results.
For pension funds, rate assumptions have to stretch far into the future -- half a century or more for those companies that still let new employees participate. For brand-new workers, the time horizon is the longest, but the benefits are also the smallest. As workers stay longer in their careers and earn more benefits, what an employer needs to set aside gets a lot bigger -- and it becomes much more sensitive to rate risk.
Falling rates have boosted the amount that employers have to set aside now in order to cover those expenses far in the future. But conversely, if interest rates were to rise, then the discounted value of future pension obligations could fall substantially. That would leave companies looking far healthier in terms of pension funding without spending a single penny toward extra benefits.
Lost in the shuffle?
As massive as pension-related charges can be, they often go unnoticed by investors. That's because typically, you'll see pension expenses lumped into the "one-time charge" category that doesn't get included in most analysts' expectations.
Even as such charges become more common, companies are doing their best to draw attention away from them. Boeing (NYSE:BA), for instance, reports a core earnings figure that doesn't include provisions related to pension expenses, which helps investors focus less on pension volatility and more on core operations.
Ready for higher rates
For the most part, corporations have done a fine job of taking advantage of low interest rates. They've refinanced much of their higher-rate debt and built up cash reserves they can use for future lean times. Having learned the lessons of the liquidity crisis during the 2008 financial meltdown, companies treasure cash, and they're willing to borrow at attractive rates to get it.
With the capital they need already at hand, many companies have already gotten all the financing benefits available from low rates. As a result, they'll applaud higher rates when they come -- if it can help them avoid massive pension payments that will hurt their short-term earnings. For the millions of workers and retirees who rely on those pensions, that could be the answer that ensures the stability of pension funds throughout their lifetimes.
Fool contributor Dan Caplinger has no position in any stocks mentioned. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Ford and General Motors. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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