Human Resources

Fed Action May Affect Benefit Costs

Additional defined benefit plan funding may be warranted if corporate bond yields drop.

February 01, 2011
KEYWORDS funding , liabilities
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By Scott D. Knapp and Kenneth W. Newhouse

The Federal Reserve’s plan to buy more Treasury bonds, announced Nov. 3, 2010, could increase pressure on credit unions’ defined benefits plans in the form of lower funding ratios, larger pension expenses, and, depending on the funded status of the plan, the possibility of higher funding requirements.

In an attempt to invigorate the economy, the Fed will purchase $600 billion of long-term U.S. Treasury securities in $75 billion monthly increments until June 2011.

Analysts had been expecting the announcement after several weeks of telegraphing signals from the Fed. Only the size of the effort was in question, and it landed slightly lower than expectations.

The Fed’s goal is to drive market interest rates lower, thereby stimulating credit creation and aggregate demand in the economy while fending off a deflationary spiral.

The strategy is controversial and loaded with risk, but the Fed clearly believes the risks of doing nothing are greater. The Fed also indicated it reserves the right to change course if the program produces unintended results.

One potential byproduct of more quantitative easing is increased pressure on defined benefit plans. Pension liabilities are calculated as the discounted value of the future benefits owed to employees. The rates used to discount those obligations are based on a corporate bond yield curve.

If corporate bond yields drop in response to quantitative easing—which is by no means a certainty in spite of the Fed’s actions—pension liabilities will increase.

A 50 basis point drop in discount rates will generally cause pension liabilities to increase 8% to 10%.

Next: CUs have funding cushion

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