Pension Facts: Why The Hit to Earnings and Cash Flow Is Upon Us

July 29th, 2010 by hackel Leave a reply »

September is normally a month for serious year-end planning, including the year’s pension contribution-and in this arena, some nasty surprises are in store for almost all participants in defined benefit plans, of which there are 1,753 publicly–held firms according to the S&P Compustat database. Lest you think all firms will be waiting for the last minute to pony up, think again. In the past week, Ford (F), Lockheed (LMT), and The New York Times (NYT), all announced large contributions to their plans.

I believe almost all defined benefit plans of publicly held companies are currently underfunded, and the expected contributions into these plans underestimated. This is because the assumptions under which the plans are funded are not in touch with today’s economic reality. The median discount rate, also known as the settlement rate, is used to determine the present value at which the plan’s projected benefit obligation could be effectively settled. As of their latest fiscal year, the median S&P company had a 5.9% discount rate. If firms can in fact find high grade fixed income securities, or annuities of highly rated insurers, with that yield, I would highly suggest they grab it on behalf of their participants. If not, their pension liabilities are probably overstated. Higher interest rates, which I do not foresee, would save some firms.

Yesterday, James Bullard, president of the Federal Reserve Bank of St. Louis Fed said the United States might be in for a protracted period of Japanese-style deflation. If he is correct, long-term interest rates will fall, raising pension liability obligations further.

An exaggerated assumption is also held for the expected return on plan assets of 8%-what financial instruments are yielding 8% these days? Government bonds yield are around 3%; hedge funds, stocks and real estate prices have also not recovered.  Someone should call the good folks at Verizon, which continues to forecast their plans will produce annualized returns of 8.5%.

For their last fiscal year, the S&P 500 group of companies paid a combined $85 billion in pension benefits against $67 billion paid into their plans, or 22% less. If the equity market, which has the largest allocation of most plan assets, had been positive for the past 3, 5 and 10 years (instead of negative), some pension liquidations might make sense. But that hasn’t been the case. And with very slow revenue growth, both here and the rest of the world, the returns on equities, bonds, and hedge funds, will most likely be sub-par.

What is also important to explore is the pension and retirement expense on the income statement versus what is actually contributed. Firms that expense a greater amount than actually contributed are over-stating their cash flows. For their most current fiscal year, the list includes Aetna (AET), which expensed $309MM but contributed just $71.6MM, Berkshire Hathaway (BRK.A), which expensed $775MM, yet contributed just $224 MM, Fortune Brands (FO), $79.7MM versus $26.4MM and Parker-Hannifin (PH), $114.8 MM versus $61.9MM. But there were plenty others.

As of their latest fiscal year, the S&P 500 companies reported a combined $1.2 trillion in pension assets with $262 billion underfunding, a result of the decade-long poor equity market. They thus report a combined $1.4 trillion projected benefit obligation, which is the value of all benefits earned by the employees to that date plus projected benefits attributable to future salary increases. If you think the $200 billion shortfall is minor, recall the assumptions, which need to be changed to mirror the current reality. I believe the shortfall could be closer to $400 billion-and that’s just for the S&P 500 companies.

Which are some of the better known firms that need to make larger than their estimated contributions? In my judgment they include 3M (MMM), IBM (IBM), Abbott Labs (ABT), Alcoa (AA), Perkin Elmer (PKI), UPS (UPS), Verizon (VZ), and Xerox (XRX).  But the list is long and I purposely left out government contractors (like Raytheon (RTN)) as they pass a lot of this cost along to Uncle Sam.

The numbers are already causing a serious dent to earnings and cash flow. For 3M, whose plans during 2009 benefitted from $1.5 billion investment performance gains and $1.3 billion in cash contributions, its pension status remained underfunded by $ 1.7 billion. The year before, when the financial markets were weak, their plan’s funded status deteriorated by $2.6 billion. 3M’s pension contributions have averaged 12.3% of pretax income and 13.7% of cash flow from operations over the past 6 years. Given its current 17.5 free cash flow multiple, it isn’t unreasonable to think if 3Ms contribution and liability were cut in half, the stock would be $15, or 17% higher.

For affected companies, investors can’t expect the picture to get any better anytime soon. The hit to earnings and cash flows is now too large and too important to ignore. Unless interest rates and stock prices see a big move up over the year’s final five months, expect to see large unexpected downward revisions to many of our largest companies, some of which will be accompanied by debt raises.  Even if stock prices were to continue to rise, low interest rates would force the pension liability to grow to the point of stepped-up contributions. And if stock prices somehow retreat, the shock will be that much greater.

If you are interested in learning how to analyze the pension plan, including plan accounting, effect on earnings, cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis.”

Please see our related articles on pensions and free cash flow implications of underfunding:

Disclosure: No positions

Kenneth S. Hackel, CFA
CT Capital LLC

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If you are interested in learning how to analyze the pension plan, including plan accounting, effect on earnings, cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” out this fall from McGraw-Hill.


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