New legislation set to shake up US pensions

Following lengthy arguments over how best to shape legislation to cure corporate America's ailing pension system, President George Bush signed the Pension Protection Act into law on August 17. The Act, which was passed by Congress prior to the start of its summer recess earlier in the month, has the potential to significantly change many aspects of corporate America's pension plans - from funding requirements to the role of hedge funds, and even the continued existence of some defined benefit plans. A two-year transition period for adoption of the new rules will begin for most companies in 2008.

Speaking ahead of the signing in of the act into law, Republican senator for Wyoming Mike Enzi said in a statement that the Act, which is also referred to as HR 4, is "the most sweeping reform of pension law for more than 30 years". Enzi is chairman of the Senate Committee for Health, Education, Labor and Pensions.

During his signing-in ceremony address, President Bush focused on the Act's provisions relating to the functioning of the Pension Benefit Guaranty Corporation (PBGC), a federal body that protects the pensions of defined benefit pension plan members. The Act changes how the variable rate premium paid by companies to the PBGC is calculated, in effect stopping companies exploiting a previous loophole that allowed some to avoid paying as much premium as was intended under the rules.

Bush said the Act will "shore up our pension insurance system in several key ways", and highlighted the Act's requirement that pension obligations be measured more accurately. The practice of smoothing - where actuarial values, rather than fair market values, are used in financial reporting - has long generated criticism from analysts who claim that it can allow companies to paint a distorted picture of their pension obligations.

The Act represents something of a compromise between those who argue that fair market values should be used, and those who claim existing rules should continue to help prevent swings in pension plan performance, causing excessive volatility in the sponsor company's shares. Under the Act, companies are encouraged to use a segmented yield curve approach (Risk March 2006, page 32). This means the present value of obligations are calculated using a discount rate based on a US Treasury department-constructed yield curve, created from the two-year average of monthly yields on high-grade corporate bonds split into three segments: zero to five years; five to 20 years; and beyond 20 years.

The segment used in the calculation depends on the nature of the liabilities in question - so a company with few retirees and lots of young workers would use the rate from the final segment of the curve.

Credit Suisse predicts the Act could significantly affect companies' cashflows. Some companies in the S&P 500 would have to contribute $47 billion to their pension plans if the rules were fully phased in for 2006 - 57% more than the $30 billion they are expecting to pay this year, according to their 2005 annual reports. A total of 102 companies could see their contributions more than double. Credit Suisse expects firms may respond by freezing pension plans or borrowing more to fund their schemes. Controversially, the cash-strapped US airline industry has been granted special treatment under certain provisions within HR 4. For example, those airlines that decide to freeze their pension plans are allowed to amortise their underfunding over 17 years.

One of the not-so-widely discussed implications of the Act arises in the provisions related to modernisation of the Employee Retirement Income Security Act (Erisa). Under previous rules, any manager of a collective investment fund - including hedge funds - with more than 25% of its assets coming from pension funds would be subject to Erisa. The new Act removes any public and foreign pension assets from the calculation to assess whether a manager has exceeded the 25% limit. In other words, individual hedge fund managers will be able to manage more US corporate pension assets without exceeding the 25% limit and becoming subject to Erisa's onerous administrative and transaction rules.

"Good first step"

In his testimony before a US Department of Labor-organised meeting on August 11, Jack Gaine, president of the Washington, DC-based Managed Funds Association (MFA), a hedge fund industry trade group, said HR 4 represented a "good first step" for encouraging sensible investment of Erisa plans in hedge funds. Gaine went on to state that the MFA believes the 25% threshold - even in its amended form under HR 4 - is arbitrary, especially given the fact that venture capital funds and real estate funds aren't subject to this floor.

"When a hedge fund chooses to accept Erisa investors, all fund investors are negatively impacted by the added administrative costs imposed by Erisa, including both actual compliance costs and opportunity costs experienced by a fund," said Gaine. As a minimum, the MFA is calling for the US Department of Labor to raise the limit from 25% to at least 50%.

- Ryan Davidson and Navroz Patel.