What Investors Don’t Understand About Pension Plans

August 11th, 2010 by hackel Leave a reply »

It now strongly appears as if that luck has run out.  The biggest challenge to defined benefit pension plans has always been the discount rate, the rate at which the liability can be effectively settled with no further risk to the company. Also providing a strong headwind has been the long-term investment assumption, as the S&P 500 now is up less than 1% so far this year.

Consider the following:

  • A 1% change in the discount rate is roughly equal to a 15% decline in stock prices. As of today, the median discount (settlement) rate is 5.9%, while annuities, according to MetLife, hovers around 3.7%. The annuity rate could very well be lower depending on the specific plan. That’s an appreciable differential and one that must be recognized this year, if rates stay low. By far and away, the level of interest rates has the most profound effect on the pension funding status.

 

  • There are other post-retirement benefits not being recognized, such as health care and life insurance, which will be eating up cash flows. And these affect almost all companies—not just defined benefit plans. Countless firms spend many millions of dollars a year on insurance, which premiums must be paid regardless of interest rates, profitability, or cash flows. Regarding health insurance, which is not typically prefunded, costs are expected to far outstrip prospective increases in cash flows. As I pointed out in my article last week, “New Era of Buybacks, Dividends, and Mergers?” investors should not expect that balance sheet cash build to be shared due to a slowdown in prospective cash flows, resulting from the general economic growth rate.
  • The Pension Reform Act requires employer diversification with respect to employer securities. Many of the companies which have been, or would ordinarily consider, the contribution of company stock in lieu of cash, will now need to think twice.

It will be interesting to note next fiscal year, the number of companies which will announce (and I expect many to do so) shortfall contributions, which must take place under the Act. Because firms that are less than 80% funded could be subject to accelerated “at risk” contributions, I would expect most firms to stick to their actuarial “guns.” In reality, however, if interest rates remain low, it is just a matter of time before we start seeing a massive hit to earnings, cash flows, and leverage. Firms’ actuaries and auditors will force the decision.

  • We estimate defined benefit plans for the S&P 500 companies are no better than 75% funded. That means firms like BP (BP) will, in my estimation, be forced to contribute billions more to its plans, despite claiming their funds are fully funded.
  • Increases in life spans (affecting the mortality assumption and ratio of active workforce to retired former employees) are not adequately factored into actuarial assumptions. While it is difficult to quantify this additional liability, it would not be out of hand to think an additional 5 years of life would add several trillion dollars to the collective unfunded liability.
  • So far there has been no migration to a more realistic long-term investment assumption, currently at 8% for the S&P 500. Many large firms have investment assumptions of 8.5% and higher. That group includes AT&T (T), Brown-Forman (BF.B), Campbell Soup (CPB), Eaton (ETN), Johnson and Johnson (JNJ) and Verizon (VZ).

 Given corporate pension plans are already, for the most part, severely underfunded, despite what the pension and other post-retirement footnotes are showing, investors are in for a severe and rude jolt. Undoubtedly, CFOs are well aware of the needed and large stepped-up contributions, but have been praying the financial markets would somehow bail them out, as was the case last year. They will most likely continue to tell analysts such plan payments are “non-operational,” just as they do with taxes and other items they shove under the rug.

It certainly appears, however, this time they won’t be so lucky.

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

Disclosure: No positions

Kenneth S. Hackel, CFA
President
CT Capital LLC

Subscribe to CreditTrends.com by Email

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.

Advertisement

1 comment

  1. John Kapili says:

    Mr. Hackel,

    After reading your article on “What Investors Don’t Understand About Pension Plans” I would like to point out possibly some other information to look at. These Companies such as Verizon Corp and others that have Frozen or Stopped their Defined Pension Plans have Plan Rules that may also require the Pensions to be fully funded if ever stopped. Alltel Wireless which was bought by Verizon Wireless will completely stop in 2010. The Plan states it must be fully funded if ever stopped. This also may apply to Verizon Corp since they Froze Management Pensions. Just some food for thought.
    John Kapili