A Simulation of the Future Economic Impact of Pension Rate Reductions

Pension rate estimates are important because they provide information to the market, and because they are useful in estimating future cash flows or for other analytical purposes. This is especially true now, because the economic environment has deteriorated to a point that many investors perceive increased uncertainty with respect to pension plans and the effect they have on future income. In fact, several authors in the popular financial press have speculated on the impact of such fundamental changes in pension assets, liabilities, and estimates. Often, however, these articles are sensational, and do not appear to appreciate fully the complexities of pension accounting. In order to model the economic impact of pension rate declines, we develop a two‐period analytical model of pension cost, which allows us to simulate future pension expense and its associated earnings impact using a triangular distribution of rate estimates. In addition, we model the incremental cash contributions required under these estimates in order to maintain the ratio of pension assets to liabilities at 100 percent. Our results indicate that while the pension expense effect is large in both periods across firms with small, mid‐sized and large pension plans, firms with large plans show the greatest increase in pension expense. Interestingly, however, the earnings impact is the smallest for firms with large plans in both periods. In addition, all firms face significantly increased cash funding requirements in order to prevent funding ratios (plan assets scaled by pension liabilities) from deteriorating. These results suggest not only future earnings reductions from pension rate declines, but also a potentially significant cash flow impact as well.