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    The Big Pension Plan Hole and What It Means to Investors

    by Edwin D. Everett

    Three successive years of stock market declines and lower interest rates have taken their toll on pensions and are presenting defined-benefit plan sponsors—including most major U.S. corporations—with tough decisions about how to face significant shortfalls in funding their obligations to retirees.

    The amounts are not trivial—the Pension Benefit Guaranty Corporation (PBGC) estimates pensions are $300 billion in the hole. (This federal agency guarantees benefit payments for some 38,000 U.S. plans.)

    What corporate sponsors do about the shortfalls could have wide-ranging effects on the stock market. The immediate potential impacts for plan sponsors are a hit to corporate earnings, cash flow pressures as firms have to pony up more cash, and potential write-downs of shareholders’ equity.

    But the effects will likely extend as well to money flows into equities and other assets, stock market volatility levels, and cash available for capital spending and other purposes. And because pension accounting conventions smooth results, the underfunding problems will persist beyond this year.

    Defining the Problem

    There are essentially two kinds of pension plans: defined-benefit and defined-contribution plans. With defined-benefit plans, employers assume a specific, salary-based financial obligation to employees in their retirement, thus “defining” the benefits. With defined-contribution plans, such as 401(k)s, employers define only what they will contribute today toward an employee’s retirement nest egg, leaving the onus on the employee/retiree to manage the assets to achieve retirement goals. The current trouble has come in the defined-benefit plans, which face funding shortfalls.

    Figure 1.
    U.S. Pension Funds
    CLICK ON IMAGE TO
    SEE FULL SIZE.

    The hole is big and getting bigger, asFigure 1 shows. After running surpluses of more than 15% from 1996 through 2000, pension plan funding levels dropped to roughly breakeven at year-end 2001, and fell to a near 30% deficit in 2002. Morgan Stanley estimates the gap for the S&P 500 companies alone last fiscal year totaled around $220 billion. Moreover, the firm suggests the deficit this year could rise to almost $250 billion (assuming no additional contributions and a positive 8% return on plan assets).

    Due to the quirks of defined-benefit pension accounting, plan sponsors, until now, have been able to avoid the unpleasant reality of a bear market and interest rates at historical lows. Now the deficits have reached a point where they are affecting earnings and, potentially, balance sheet values.

    Financial Accounting Standards Board (FASB) conventions that govern plan accounting allow for a super-smoothing of results and permit liberal assumptions about future obligations. FASB rules are a political compromise reached by accountants and companies back in the mid-1980s when corporations first had to record pension obligations on their books (and faced even greater funding shortfalls). The smoothing was an attempt to minimize wild swings in balance sheet values and reported income that were triggered as plan asset values or obligation assumptions changed.

    With all the smoothing, companies got an earnings boost from pensions during the 1990s market bubble and even immediately after it popped. Companies are only just now seeing the past three years’ unfavorable investment results start to roll through their accounting for pensions.

    Rates of Return Are Key

    A pension plan’s funding status should be simple to calculate—expected future assets netted against expected future benefit obligations. FASB’s accounting rules, however, are absurdly complex.

    TABLE 1. Recently Announced Pension Plan Contributions
    Company ($ mil)
    General Motors $4,800
    IBM 3,950
    United Technologies 1,500
    3M 1,000
    Honeywell 800
    Ford 500
    Delphi 350
    Boeing 340
    Pitney Bowes 339
    J.C. Penney 300
    Total $13,879

    Plan obligations are calculated two different ways: one realistically assumes salaries will rise over time and the other does not. Plan assets are also measured two different ways, with one assuming a future market return and the other using actual investment results. The “market value” of assets itself is based on a three- to five-year rolling average of actual value. Even with all the smoothing, companies are still only required to put cash into a plan when the obligation is underfunded by 10% or more.

    Two key items in pension accounting are the assumed rate of return of plan assets and the discount rate of future obligations. Both have come down, the net effect of which is to hurt earnings, force additional contributions, and potentially impair balance sheets.

    A pension’s annual “cost” equals the current year’s portion of the plan’s overall obligation less what the assets earn for the year. The plan’s return equals an assumed rate of return (part of the smoothing) multiplied by the multi-year rolling average value of the plan’s assets. Obviously the higher an assumed return, the lower overall pension costs will be. Conversely, as assumed rates come down, costs go up.

    For 2001, Credit Suisse First Boston estimates the median assumed total return for the S&P 500 companies’ defined-benefit plans was 9.2%. But many companies have been using 10%, some as much as 12%. That return is actually a blended number for all assets. (On average, pensions hold roughly a 65%/35% mix of stocks and bonds according to consultant Greenwich Associates.)

    Now the Securities & Exchange Commission, investors, and auditors are pressing firms to trim assumed rates to more realistic levels. The likes of General Electric, Goodyear, Whirlpool, and IBM have cut assumed returns by ¼% to ½% and other firms are following suit. Even these small changes have big costs. IBM cut its return ½% to 9.5% in 2002, costing it $350 million in profits for the year.

    Recently, the SEC suggested it would challenge anything over 9%, pointing to very long-term returns of 10% and 6% for stocks and bonds, respectively, as appropriate guidelines. At a 65%/35% asset mix, that translates into an 8.6% total return. Credit Suisse calculates that an aggregate ½% drop would hike total S&P 500 pension costs by $5 billion.

    TABLE 2. Largest Underfunded Pension Plans: 2002
    General Motors (29,428)
    Ford Motor (14,273)
    IBM (13,265)
    Exxon Mobil (9,397)
    Boeing (6,846)
    United Technologies (4,737)
    Lockheed Martin (4,409)
    Delta Air Lines (4,376)
    Delphi (4,245)
    Raytheon (3,612)

    Another major drag on earnings comes from the gap between hypothetical and real-world investment results. Eventually actual and assumed plan returns are reconciled through a gain or loss that is rolled into the pension cost. When the stocks were earning 20% a year and plans assumed 9% to 10% returns, hefty windfalls resulted. Now the reverse is happening.

    Discount Rates

    On the liability side of the ledger, the discount rate for pension obligations is also coming down, requiring companies to put aside more money today to cover future pension payments. Companies estimate their total future pension obligation and discount that amount back to present dollars. They then compare that amount to assets currently available. The balance is the funded status of the plan. The discount rate used to calculate today’s value is based on the Moody’s 10-year AA-rated corporate bond yield and rates have fallen sharply. As rates drop, the math requires the current obligation total to increase by a corresponding amount.

    The S&P 500’s discount rate has fallen from roughly 7.5% in 2000 to around 6.75% for 2002 and, realistically, should come down another ½% this year. Here again, small changes make a big difference. Morgan Stanley estimates that a decline of just ½% would increase the S&P 500 funding deficit by $48 billion (assuming no additional contributions and an 8% actual total return).

    The net effect of lower assumed returns and discount rates is higher pension expense and additional funding requirements. Pension expenses could clip S&P 500 earnings by $10 billion to $15 billion this year. How much cash companies will have to add to plans to offset deficits is less clear, thanks to the accounting rules. ERISA, the federal legislation governing pensions, requires plans to be at least 90% funded, but lets companies make up the deficits over three to five years.

       TABLE 3. Pension Position By Industry
    (Ranked by dollar amount for 2001)

    Most Underfunded
       Automobiles
       Oil & Gas
       Pharmaceuticals
       Airlines
       Auto Components

    Most Overfunded
       Telecom Services
       Industrial Conglomerates
       Communications Equipment
       Electric Utilities

    Benefits consultant Watson Wyatt Worldwide estimates 30% of corporate defined-benefit plans required additional funding in 2002 and that this year 65% of plans might need bolstering. So far roughly 40 of the 360 S&P 500 companies that have such plans have announced plans to kick in more funds. The 10 largest contributors alone will pony up almost $14 billion, as Table 1 shows. Compare this to the $15 billion to $20 billion added to plans last year by the entire S&P 500. Credit Suisse sees new cash contributions for the overall S&P 500 this year tallying nearly $30 billion.

    The good news is that pension gaps are only a big problem for a relatively small number of industries and companies. Just 10 companies accounted for more than a third of the S&P 500’s defined-benefit funding deficits last year, as shown in Table 2. Table 3 shows industries with the largest funding deficits and surpluses (yes, there are some). The biggest problems are in the more mature, heavy industries with unionized work forces and large numbers of retirees.

    However, large deficits per se are not the problem. More relevant is how big the overall pension obligation and funding deficit are in relation to market capitalization and cash flows. These are better measures of how easily a company can fund the shortfall without a cash flow crisis or need for new external capital. These measures highlight the particularly deep trouble of the airline and auto industries. But conditions vary company by company. The only way to know the funding status is to check pension details buried in financial statement footnotes (click here for what to look for).

    Conclusions

    What is the net effect of funding deficits for investors?

    The most immediate impact is the earnings drag from greater pension costs. However, these accounting expenses, like depreciation, do not affect cash flows or real plan assets and should be excluded from operating earnings. They do affect reported earnings per share, price-earnings ratios, and earnings-based valuations. Pension issues are one area that will continue to be a source of confusion in measuring companies’ true economic progress.

    Required new contributions to plans, meanwhile, do affect cash flows, diverting funds otherwise spent on capital spending, debt reduction, or higher dividends. If the shortfalls and new funding requirements are significant enough, companies could face debt-rating downgrades, which would increase financial pressures. Shareholders could also face dilution as companies issue stock to their plans to fund the pension gap (up to 10% of a plan can be invested in company stock) or are forced to sell new shares to raise funds.

    Significant underfunding can also require equity write-offs. Some 40-plus companies have already announced write-offs, the 10 largest of which total more than $17 billion. The problem again, though, is that the accounting does not fully reflect assets and liabilities, anyway, and the write-off has no real economic meaning. However, a write-off does reduce owner’s equity on the balance sheet. This distorts meaningful metrics such as return on equity, return on assets, and debt-to-equity ratios, and makes analysis more difficult.

    The major upside to funding shortfalls is that as they are made up, real money will flow into new investments, particularly stocks. Pensions need the greater long-term returns that stocks have historically offered over bonds to help them make up lost ground. If only half of Credit Suisse’s roughly $30 billion new funds estimate goes into equities, that would total $15 billion compared with the S&P 500’s current market capitalization of roughly $8 trillion. Public pension funds, which face even larger deficits, will likely be adding money to the stock market as well.

       Spotting Pension Problems
    Neither an employer’s future pension obligation nor the current plan assets are required to be included on a public company’s financial statements. Instead, information related to the defined-benefit pension plan is included in footnotes to the financial statements.

    So how can you tell if a public company has an overfunded or underfunded pension plan or is making overly optimistic assumptions?

    According to Rebecca McEnally, CFA, vice president, advocacy, at the Association for Investment Management & Research (AIMR), here are things to look for:

    1. Read through a company’s Notes to the Financial Statements and find the note that addresses pension or retirement plan issues.

    2. In the accompanying table, check the line item for “benefit obligation at end of year,” then compare that to the line item for “value of plan assets at end of year.” If assets exceed the pension-benefit obligations, that company is sitting pretty. If the reverse is true, the company is suffering from an underfunded pension plan.

    3. Assess the “funded status” line entry to definitively determine if the plan is overfunded or underfunded (parentheses mean the plan is underfunded).

    4. Within the same notes, compare the “expected return on plan assets” rate to the “actual return on plan assets.” If the expected return is high, but the plan lost assets (again, shown by a number within parentheses) then expectations are out of whack.
    from “The Financial Journalist,” January/February 2003, published by the Association for Investment Management & Research.

    Also, regardless of funding condition, pensions should be rebalancing their portfolios, shifting money from bonds into equities to offset the strong recent outperformance of bonds and stay true to their asset allocation guidelines. Of course, more volatile markets have managers rethinking their allocations, prompting some to put more assets into bonds, as they try to more closely match assets to liabilities and reduce risk.

    The pressure to relieve underfunding may be good for equity demand, but it may also lead to greater risk as pensions overreach for returns. Just to avoid bigger deficits or more funding, Morgan Stanley estimates over 75% of S&P 500 plans would need to earn a total return of 15% from current portfolios in 2003 (using a 6.25% discount rate for obligations). As plan sponsors try to grow their way out of deficits, they are getting more aggressive and investing in alternative asset classes such as hedge funds, real estate, high-yield bonds, and emerging market debt, which have all performed well recently. The risk is that, like individual investors, they chase performance in trendy and risky areas and end up getting burned.

    Moreover, by pouring money into hedge funds rather than more traditional long-term equity positions, corporations are helping make markets more volatile. Hedge funds, by design, balance combinations of long and short positions and look to take advantage of mispriced assets, which adds to market volatility. Ironically, pension funds are turning to short-term-oriented performance and assets (with their attendant risk) to pay for very long-term liabilities.

    Besides simply funding shortfalls, companies may also deal with deficits by modifying or eliminating the defined-benefit plans altogether, or simply declaring bankruptcy.

    Bankruptcy is the most drastic step, sticking the PBGC with the pension bill. This is effectively what the steel industry has done, and the airline industry is now teetering close to doing. The PBGC itself faces a deficit, having run through its insurance-premium-funded surplus paying off steel company obligations. As a result, pension insurance premiums, paid by all corporate defined-benefit plan sponsors, could well go up, raising overall pension costs. Hopefully, the situation will not deteriorate to the point where the PBGC requires a savings & loan-type bailout and Congress rushes in with a hasty, political solution.

    Proliferating funding deficits have put the spotlight on the accounting procedures that got us to this point. FASB’s original standards were intended as a first step. Some 18 years later, FASB is now actively reconsidering how it can make pension accounting more reflective of economic reality in financial statements. However, the process will likely again lead to new (but different) transition adjustments and compromises.

    The perfect storm of negative stock returns and low interest rates will eventually abate. A turnaround in equity markets and rates, whether imminent or more gradual, will certainly alleviate some of the pension funding pressure. Congress, regulators, and FASB may take steps to reduce the near-term stress as well.

    However, given the long tail that pension obligations involve and the smoothing used to account for pensions, this problem will be with us for a while.


     


→ Edwin D. Everett