Fitch sees corporate pension timebomb by Colin Barr @FortuneMagazine August 23, 2010, 6:54 PM EST E-mail Tweet Facebook Google Plus Linkedin Share icons Low interest rates could leave U.S. companies scrambling to cover huge pension shortfalls, Fitch warned Monday. The rating agency noted that the manic bond rally has benefited big issuers such as IBM and Johnson & Johnson , both of which were able to sell debt this month at record low yields. But the flip side of tumbling rates, Fitch analyst Mark Oline warns, is a fall in likely investment returns. Cut the rates, bleed the pensions A drop in forecast returns could force companies that are already behind on their pension obligations to boost contributions to underfunded plans. That shift could penalize profits and hit shareholders, who are betting on strong earnings growth. “Simply put, lower yields will likely require higher contributions at a time when certain underfunded programs are already experiencing a schedule of sharply higher required contributions,” he writes. “Public sector pension funds face the same challenges of a low yield environment, but the very large funding gaps and lack of funding requirements could present an even more severe scenario” for big companies. Fitch isn’t alone in considering the ramifications of a dip in expected returns. Calpers, the giant California pension fund, is studying whether it should revise its discount rate, the number that tracks the investment return expectations. At 7.75%, Calpers is already more conservative than most states or big companies. New York, which has been using an 8% discount rate for a quarter of a century, is considering dropping that forecast as low as 7.5%. Dropping the discount rate by a half a percentage point seems like a footnote, but any decline in projected returns stands to increase the present value of liabilities the funds will have to make good on – which means more taxes or cutbacks for municipalities, and a drain on earnings for big companies. Oline worries that the response in corporate America will be not to adopt more conservative expectations and pony up cash now, but to join the reach for yield that is characterizing the debt markets now. This could lead to bigger problems later at risk-taking pension funds, should the oft-discussed bond market blowup come to pass. “Companies will be challenged to achieve the assumed return targets incorporated into their accounting statements given 2010 year-to-date equity returns and current fixed income yields,” the Fitch analyst writes. “This situation could encourage yield chasing and a shift in asset allocation to higher risk asset classes, including leveraged loans, real estate, private equity funds, and equities.” Just this sort of thing happened when the bond market last went parabolic at mid-decade, and we all know how that turned out. Further complicating matters, the recent bond mania says some equities aren’t necessarily riskier than bonds for pension managers confronting Ben Bernanke’s (right) zero interest rate world. Consider, for instance, the yield differential for those looking at high-quality stocks and bonds. If a pension manager with an 8.5% assumed return is looking at the purchase of recent new issues (e.g. the three-year IBM bond with a 1% coupon or the 10-year Johnson & Johnson bond at a 2.95% coupon), the risk of capital losses that meet or exceed the coupon over a near-term time horizon is a valid concern. Throwing dividend yields into the equation (2.0% for IBM, 3.7% for JNJ) further complicates the assessment of what the most conservative or appropriate allocation would be. In any case, pension funding is another risk factor to consider in investing – and it’s not one that’s going away. “Simply hoping for a rescue from high equity returns or the impact of higher interest rates on the measurement of benefit obligations is not a prudent strategy,” Oline writes.