Pension pain off the charts

October 29, 2010, 8:56 PM UTC

Big company pension funds are in their worst shape in at least 15 years, thanks in no small part to falling interest rates.

So says Bank of America Merrill Lynch, which issued a report Friday estimating the aggregate pension funding deficit at S&P 500 companies at $380 billion. That’s up 44% from a year ago and represents a funding gap of almost 3% of the index’s market capitalization.

30-year Treasury yields' long tumble

The average defined benefit plan is just 77% funded, BofA Merrill estimates, down from 82% last year.

The biggest problem, writes economist David Bianco, is that falling interest rates have raised the value of the long-lived promises the plans will have to make good to future retirees. The yield on the Moody’s Aa corporate bond index, used as a proxy for pension fund discount rates, has fallen by 1.3 percentage points since 2007, BofA notes.

Looking at the bright side, Bianco writes that a reversal of the falling rates trend could help to close the pension deficit – and he notes that rates appear not to have a lot more room to fall. Thus a long-lived pension funding headwind could in a few years’ time become a tailwind, the report speculates.

Were long-term interest rates to rise by a percentage point and a half, Bianco says, the corresponding decline in the value of pension funds’ liabilities could wipe out the entire funding deficit.

Of course, that projection assumes that asset values would hold up even as rates rise, which is let’s say not a wholly safe assumption. It’s worth noting that Bianco isn’t counting on rate rises any time soon, and expects rising obligations and weaker-than-expected pension asset returns to take a chunk out of next year’s earnings estimates.

He writes that the unhappy pension trends could hit S&P 500 earnings by $1 a share next year – though he contends that the fallout isn’t likely to be too heavy given the index components are currently pumping out profits at a rate in line with his $90 earnings per share target for 2011.