Corporations that had been expecting to receive some pension relief by lowering their plans' costs ended up with a year-end lump of coal last month when a key factor used to calculate their liabilities turned sharply against them.

The discount rate that is used to determine the present value of a company's pension liabilities took a steep fall south in the final weeks of 2008, compounding the problems facing companies that were already dealing with declining asset values in their retirees' plans. The change in the rate was so swift and so large that several Wall Street veterans said they couldn't recall a similar episode during their careers.

"What we observed in the last two months of 2008 was probably the most precipitous drop in the discount rate in such a short time. It exceeded what you might see in a year," said Ethan Kra, chief retirement actuary at consulting firm Mercer. "It's unprecedented in my experience, and I've been in this business 30-plus years."

The Citigroup Pension Liability Index, a widely used discount rate benchmark, dropped 125 basis points in December alone, finishing the year at 5.87%, a slide that followed on the heels of an 89-basis-point drop in November. Because the index made most of its gains in the early fall, it ended the year down only 61 basis points from December 2007. But that decline will still result in an average pension plan liability increase of about 9% to 10%, estimates Kra.

Companies must use whatever the discount rate is at the end of their fiscal year to calculate their current pension liabilities, or costs, and those liabilities climb as the rate falls. Because so many companies end their fiscal year with the calendar year, the year-end rate will affect a large proportion of U.S. corporations' pension expenses.

The discount rate drop comes at a particularly tough time for corporate pension plans, because the assets they own have been beaten down by poor market performance in 2008, leaving many companies with underfunded plans. Now rising liability costs will compound that further.

It's also an unpleasant turnaround because earlier in the fall -- at a time when companies are usually forming financial plans for the coming year -- the discount rate was up for the year. That led some corporations, ranging from mechanical power transmission manufacturer Altra Holdings inc. (AIMC) to Xerox Corp. (XRX), to predict that their liabilities would be eased by the discount rate.

"The interesting question is whether what happened in December will have an impact on 2009 guidance companies gave as recently as a few weeks ago," says Caitlin Long, head of the pensions solutions group at Morgan Stanley.

Altra Vice President of Finance Todd Patriacca says executives know that the discount rate has worsened since it last gave guidance to investors in November, but the company hasn't finished analyzing the impact it will have on its pension obligations. Xerox declined to comment, citing its quiet period until earnings are announced in two weeks.

The discount rate is based on the yields of corporate bonds rated AA or better. The reason it fell so rapidly in December, say analysts, is that rating agencies downgraded some higher-yielding AA corporate bonds from the financial services sector, including those of Citigroup Inc. (C) and Goldman Sachs Inc. (GS).

The effects of rising liabilities and declining assets in any given year are absorbed by U.S. corporations the following year, so the hurricane that ripped through pension plans in 2008 will start showing up in 2009. That's when underfunded pensions begin to weigh on balance sheets and compensation expenses, triggering debt covenant changes, higher borrowing costs and lower earnings.

-By Lynn Cowan, Dow Jones Newswires; 301-270-0323; lynn.cowan@dowjones.com

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