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Pricing Economic Risk into Pension Funding

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While Treasury 30-year bond yields (red circles) were lower by September 30 than at the beginning of the year, corporate bond yields as represented by Moody’s Aaa (blue diamonds) were higher. A spread of about 1.00% at the beginning of the year had widened to 1.70% by the end of the year’s third quarter.

I don’t expect that wide spread to persist far into 2009, if even through the close of 2008. But although some of the contraction of the spread will come via easing of corporate bond yields, long-term government bond yields will likely rise somewhat as the economic crisis shakes itself out.

Several pension prognosticators seem to be expecting contraction of the yield spread, based on comments that have been made about estimated pension funded status levels as of September 30. Since measurement of pension obligations under generally accepted accounting principles is based on corporate bond yields rather than on government bond yields, is is quite correctly observed that declines during 2008 in the values of pension asset equity investments have been partially offset by decreases in the value of pension obligation, due to the higher corporate bond rates.

But at that point, those prognosticators and I part company, since they then proceed to imply or to directly compute how very deeply pension funded status would be further eroded if the yield spread were to return to the beginning-of-year levels entirely via a drop in corporate bond yields, without any corresponding change in the value of pension assets.

First, it is extraordinarily unlikely that we might have an economy where government bond yields would remain locked in so low while corporate bond yields take up all the slack by dropping so far. Without going into extensive detail at this stage, since that is not my biggest beef with those prognostications anyway, suffice it to say that with the low government bond yields having largely come on the heels of government intervention in the current credit crisis, and since the high corporate bond yields conversely reflect the private sector’s riskier side of that same credit crisis, it is extraordinarily unrealistic to expect the private sector’s fears to be completely eliminated while anticipating that the government bond market would persist in pricing government intervention into the equation. More likely, as I’ve indicated earlier in this post, is that we might have a contraction in the spread from both sides, so that pension liabilities might increase more moderately than would be realized if the entire spread contraction came via falling corporate bond rates.

But that’s just looking at the liability side of pension funding. What’s with this idiocy of playing so heavily with that side while keeping asset values depressed?? I argue most vehemently against a scenario that drops corporate bond yields by 70 basis points or more while holding equity values underwater at their current low values. Consider the following chart, which uses the same Moody’s Aaa bond yields in a discounting equation (red circles) compared against the actual S&P 500 stock index for the first 9 months of the year. I’ve included in my discounting equation a variation of the discounting period to reflect temporary economic risk assessments, but I could strip that out and leave the discounted line variable solely on the basis of the corporate bond yields and still gain a very close fit of the two series.

Not a bad match, eh? So what does that suggest? Simply this: for the first 9 months of 2008, the same economic risk premium that bond investors slapped onto corporate bonds is the primary – indeed, virtually the only – economic factor that has been priced into the valuation of corporate equities. Which would then suggest that if one were to eliminate that economic risk premium from corporate bond yields and consistently eliminate the same economic risk premium from the valuation of equities, we’d be looking at an S&P 500 index of about 1300, a rather nice bull market above today’s close below 900!

Now it is true, there are many other factors that go into pricing of both bonds and equities, just as there are numerous other factors affecting pension funding itself (such as employer contribution levels). And as emerging concerns of global recession grow, among many other things affecting corporate profits, the near-term expected values for the S&P 500 could be dampened somewhat from that 1300 target level, perhaps even as low as 1100, even if the yield spread were to contract all the way back to beginning-of-year levels. That still doesn’t excuse prognostications of pension funding that hypothesize illogical scenarios that would make a Lewis Carroll vision seem normal by contrast.

Since elimination of the economic risk premium from one side of the market while pretending that it would remain completely intact in the other side of the market is ludicrous, the punchline: don’t expect contraction of the yield spread to generate any significant erosion in pension funded status levels, at least nowhere near what those prognosticators have been suggesting.

(Remember, as I’ve previously disclaimed, posts such as this represent efforts of my favorite pastime. My formal work does not involve any of this, and none of it represents any position or comment that should in any way be attributed to my employer. Likewise, as always, it represents general personal impressions and should not be treated or used as formal professional advice.)

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Written by macheide

22 October 2008 at 7:23 pm

Posted in άctuary


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