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Pension Funds-Analysts Need to Immediately Make Adjustments to Cash Flow and Financial Structure

September 5th, 2011


Pension funds, which benefitted last year, when the financial markets underwent a strong second half rally, may not be so fortunate this year.

And while a headline in today’s Financial Times reported the gap in US pension plans was $388 billion, CT Capital LLC reports the gap is considerably higher, perhaps by as much as 50% when using interest rates available today and the fall in hedged fund returns, which many pension sponsors have been viewing  as “high return, low risk.” They have taken the same tact with private equity investments.

In fact, we expect to see a considerable step up in pension contributions later in their year, including selling equity and debt, as well as the contribution of company stock, where allowable.

For the 1400+ public companies we track which have defined benefit plans, the median investment return assumption is currently 7.75% (average 7.36%), a discount rate of  5.4%, and has a 57% exposure to the equity markets, 37% debt markets, and the balance real estate and hedged funds.

The average company reported their plan was $376MM underfunded, but that assumes their assumptions are realistic. The current financial markets tell us otherwise.

For some firms, including Boeing, GM and IBM, the underfunding is in excess of $10 billion each.

This means these firms financial leverage is greater than reported and their cash flows (from operating activities and free) are overstated.

The list of firms in pension trouble is not restricted to U.S. based entities. For example, Allianz SE, BP, Daimler, Deutsche Telecom, Siemens, Toyota, and Volkswagen have huge pension liabilities that must be addressed.

The defense sector is especially prone to large pension liabilities, unfortunate given the slowdown in the defense budget.

And for the many firms like Honeywell, which changed their actuarial methodology from asset smoothing (outside the corridor) to mark-to-market, which recognizes gains and losses in the current period, their timing appears unfortunate.

Although firms may not begin to recognize the financial markets impact on funding until their fourth quarter, analysts should begin to make these important adjustments to cash flows and financial structure immediately.


Kenneth S. Hackel, CFA


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