Business Management Blog

Retirees may soon have to worry about returns, not underfunding — thanks to the Pension Protection Act (PPA). The new law, coupled with FAS 87s restrictions on smoothing pension earnings over time, encourages fund managers to be more risk averse and to match the duration of a portfolio’s assets with its liabilities. And this so-called liability-driven strategy may sharply curtail gains in favorable markets.

The PPA requires that fund managers calculate pension liabilities based on current bond rates rather than the expected rate of return from a portfolio. Thus, liabilities will be more sensitive to interest rates, and high expected gains from stocks can no longer help diminish them, since they are no longer part of the calculation.

According to CFO, even before the ink had dried on the law, companies had started eyeing safer returns. Towers Perrin found that about 25 percent of companies would consider weighting portfolios more toward bonds or making more use of derivatives to compensate for the new prominence given to interest rates. As of 2005, only 3 to 6 percent of U.S. corporate pension plans took such steps as matching asset and liability durations through derivatives to buffer their portfolios from rate fluctuations.

It remains to be seen how many companies will make similar moves. Those that do are likely to go slowly. Very few people will go toward a totally liability-driven portfolio, since there’s no upside potential. If you were to take it to its logical conclusion, you’d end up with more-expensive pension plans.

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