Pension plans are the next big shoe to drop in corporate accounting.

That's the new buzz. With stock prices way down, pensions that were over-funded two years ago are now under-funded. When the annual reports for 2002 come out next spring, many companies may report lower earnings because they'll have to feed new cash into their pension funds.

But that's only half the story.

David Hershey, a senior portfolio manager at Lotsoff Capital Management   in Chicago, wants to change how pension funds are managed. He makes the case that pensions are heading for another crisis (the first big one since the 73-74 market crash) because they're focused on the wrong goal. That focus leads them to invest in volatile stocks. He believes pensions can achieve their financial goal by investing in bonds.

"There's a widespread belief that stocks outperform bonds over the long term," he said in a recent telephone interview.

"I differ. The real reason equities outperform over time is that equities have more risk. If you elevate your risk in bonds you can achieve the same return. For instance, if you leverage up the bond portfolio you'll get the same risk." Corporate bonds and Mortgage-backed securities, for instance, could be leveraged with short-term debt to provide 12 percent net yields.

"Stocks are fine for most investors. But they aren't good for pension plans because pension plans have real liabilities."

Mr. Hershey, whose early background was as a federal bank examiner with experience during the Texas Savings and Loan crisis , pointed out that management, investor, and public attention were all focused on the performance of pension plan assets.

But that was only half the problem, he said.

The other half was pension plan liabilities--- the lifetime pensions that were promised to millions of employees. When interest rates went down, the cost of funding those lifetime pensions went up. When interest rates went up, the cost of funding those lifetime pensions went down. As a result, a pension fund portfolio dominated by bonds would move in the same direction as its liabilities, not the opposite.

I asked for an example.

"Look at 1989 and 1995. Those were two big years for stocks. They were up more than 30 percent. In spite of that, pension liabilities rose faster than pension assets."

I asked how that could happen.

"Interest rates went down so the cost of funding a pension went up," he said.

"Now look at 1994. That was the year the Fed raised rates from 3 percent to 6 percent. They had left rates low for a long time (due to the banking crisis) and then had to go from a low rate to a market neutral rate in a short time. Pension liabilities went down."

An examination of the figures shows just that. In 1994 stocks provided a puny return of 1.54 percent. Bonds had their worst year in history. But rising interest rates meant that it cost less to fund pensions. As a result, pensions zoomed from being under-funded to nearly fully funded.

In 1995 everything reversed. Stocks returned a stunning 37.57 percent as interest rates fell. But lower interest rates also raised the cost of funding pensions. Pensions went back to being under-funded. (The table below shows how assets and liabilities of pension funds changed in 1994 and 1995.)

In Measuring Pension Fund Strength, Liabilities Can Do As Much As Assets
Rising interest rates in 1994 caused pension fund portfolios to have a tiny return. But the same rising interest rates also reduced the cost of funding pensions, so pension funds were stronger. In 1995 the reverse happened. Stocks soared as interest rates fell. But the cost of funding pensions rose 41 percent, so pension funds were weaker. All figures in percent.
Index % Weight 1994 1995
Cash 5%        3.94    7.11
Lehman Brothers Aggregate (bonds) 30%      (2.92) 18.47
S&P 500 60%        1.29 37.57
MS EAFE    5%        8.06 11.56
Pension Assets 100%        0.55 28.67
Ryan Labs Liability Index 100% (12.60) 41.16
Pension Assets minus Liabilities       13.15 (12.49)
Source: Lotsoff Capital Management, Chicago

"What I'd like people to do is look at pensions as an asset/liability matching problem," Mr. Hershey said. He pointed out that stocks had positive, bull market returns for 10 of the last 13 years. In spite of that, pensions had lost ground against their liabilities over the period. In 1989 pension funds were under-funded by 1 percent. At the end of 2001 they were under-funded by 7 percent.  

Tuesday: The IBM Pension--- The Footnotes vs. The Income Statement