{"id":1569,"date":"2010-08-11T12:35:32","date_gmt":"2010-08-11T16:35:32","guid":{"rendered":"http:\/\/www.credittrends.com\/blog\/?p=1569"},"modified":"2010-08-13T18:02:31","modified_gmt":"2010-08-13T22:02:31","slug":"what-investors-don%e2%80%99t-understand-about-pension-plans","status":"publish","type":"post","link":"https:\/\/www.credittrends.com\/blog\/2010\/08\/11\/what-investors-don%e2%80%99t-understand-about-pension-plans\/","title":{"rendered":"What Investors Don\u2019t Understand About Pension Plans"},"content":{"rendered":"<p>I\u2019ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009.\u00a0<\/p>\n<p><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/08\/11\/what-investors-don%e2%80%99t-understand-about-pension-plans\/2\/\"><span style=\"color: #ff0000;\">READ FULL ARTICLE<\/span><\/a><\/p>\n<p><!--nextpage--><\/p>\n<p>It now strongly appears as if that luck has run out.\u00a0 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&amp;P 500 now is up less than 1% so far this year.<\/p>\n<p>Consider the following:<\/p>\n<ul>\n<li>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\u2019s 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.<\/li>\n<\/ul>\n<p style=\"text-align: center;\">\u00a0<a href=\"http:\/\/www.credittrends.com\/blog\/wp-content\/uploads\/2010\/08\/Pension-Cataclysm-08-11-2010.jpg\"><img loading=\"lazy\" decoding=\"async\" class=\"size-medium wp-image-1570 aligncenter lazyload\" title=\"Pension Cataclysm - 08-11-2010\" data-src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/uploads\/2010\/08\/Pension-Cataclysm-08-11-2010-300x217.jpg\" alt=\"\" width=\"300\" height=\"217\" src=\"data:image\/gif;base64,R0lGODlhAQABAAAAACH5BAEKAAEALAAAAAABAAEAAAICTAEAOw==\" style=\"--smush-placeholder-width: 300px; --smush-placeholder-aspect-ratio: 300\/217;\" \/><noscript><img loading=\"lazy\" decoding=\"async\" class=\"size-medium wp-image-1570 aligncenter\" title=\"Pension Cataclysm - 08-11-2010\" src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/uploads\/2010\/08\/Pension-Cataclysm-08-11-2010-300x217.jpg\" alt=\"\" width=\"300\" height=\"217\" \/><\/noscript><\/a><\/p>\n<ul>\n<li>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\u2014not 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, \u201c<a href=\"http:\/\/www.credittrends.com\/blog\/2010\/08\/03\/new-era-of-buybacks-dividends-and-mergers\/\">New Era of Buybacks, Dividends, and Mergers<\/a>?\u201d 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.<\/li>\n<li>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.<\/li>\n<\/ul>\n<p>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 \u201cat risk\u201d contributions, I would expect most firms to stick to their actuarial \u201cguns.\u201d 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\u2019 actuaries and auditors will force the decision.<\/p>\n<ul>\n<li>We estimate defined benefit plans for the S&amp;P 500 companies are no better than 75% funded. That means firms like BP (<a href=\"http:\/\/seekingalpha.com\/symbol\/bp?source=search_general&amp;s=bp\">BP<\/a>) will, in my estimation, be forced to contribute billions more to its plans, despite claiming their funds are fully funded.<\/li>\n<li>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.<\/li>\n<li>So far there has been no migration to a more realistic long-term investment assumption, currently at 8% for the S&amp;P 500. Many large firms have investment assumptions of 8.5% and higher. That group includes AT&amp;T (<a href=\"http:\/\/seekingalpha.com\/symbol\/t?source=search_general&amp;s=t\">T<\/a>), Brown-Forman (<a href=\"http:\/\/seekingalpha.com\/symbol\/bf.b?source=search_general&amp;s=bf.b\">BF.B<\/a>), Campbell Soup (<a href=\"http:\/\/seekingalpha.com\/symbol\/cpb?source=search_general&amp;s=cpb\">CPB<\/a>), Eaton (<a href=\"http:\/\/seekingalpha.com\/symbol\/etn?source=search_general&amp;s=etn\">ETN<\/a>), Johnson and Johnson (<a href=\"http:\/\/seekingalpha.com\/symbol\/jnj?source=search_general&amp;s=jnj\">JNJ<\/a>) and Verizon (<a href=\"http:\/\/seekingalpha.com\/symbol\/vz?source=search_general&amp;s=vz\">VZ<\/a>).<\/li>\n<\/ul>\n<p>\u00a0Given 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 \u201cnon-operational,\u201d just as they do with taxes and other items they shove under the rug.<\/p>\n<p>It certainly appears, however, this time they won\u2019t be so lucky.<\/p>\n<p>Please see our related articles on pensions and free cash flow implications of underfunding:<\/p>\n<ul>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/07\/29\/pension-facts-why-the-hit-to-earnings-and-cash-flow-is-upon-us\/2\/\">Pension Facts: Why The Hit to Earnings and Cash Flow Is Upon Us<\/a><\/li>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/07\/15\/pensions-buyer-beware-the-firms-exposed-to-greater-risk\/\">Pensions-Buyer Beware<\/a><\/li>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/07\/08\/cnbc-strategy-session-underfunded-pensions-earnings-bombshell\/\">CNBC Strategy Session \u2013 Underfunded Pensions Earnings Bombshell<\/a><\/li>\n<li><a href=\"http:\/\/www.cnbc.com\/id\/38152067\">CNBC\u2019s Herb Greenberg \u2013 Underfunded Pensions are Red Flag for Investors<\/a><\/li>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/06\/10\/the-next-shoe-to-drop\/\">The Next Shoe to Drop?<\/a><\/li>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/06\/17\/the-other-shoe-part-ii\/\">The Other Shoe \u2013 Part 2<\/a><\/li>\n<li><a href=\"http:\/\/www.credittrends.com\/blog\/2010\/07\/08\/with-35-an-10-year-stock-returns-negative-why-are-pension-funds-assuming-8-returns\/\">With 3-, 5-, and 10-Year Stock Returns Negative: Why Are Pension Funds Assuming 8% Returns<\/a>?<\/li>\n<\/ul>\n<p>Disclosure: No positions<\/p>\n<p><a href=\"http:\/\/www.credittrends.com\/blog\/about\/\">Kenneth S. Hackel<\/a>, CFA<br \/>\nPresident<br \/>\n<a href=\"http:\/\/www.credittrends.com\/blog\/ct-capital-llc\/\">CT Capital LLC<\/a><\/p>\n<p><a href=\"http:\/\/feedburner.google.com\/fb\/a\/mailverify?uri=CreditTrends&amp;loc=en_US\">Subscribe to CreditTrends.com by Email<\/a><\/p>\n<p><a href=\"http:\/\/www.amazon.com\/gp\/product\/0071744355?ie=UTF8&amp;tag=credtren-20&amp;linkCode=shr&amp;camp=213733&amp;adid=0VR08J2ZHP6QA42KSCDA&amp;creative=393185&amp;creativeASIN=0071744355\"><img loading=\"lazy\" decoding=\"async\" title=\"Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making\" data-src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/uploads\/2010\/07\/Kens-Book4.jpg\" alt=\"\" width=\"96\" height=\"136\" src=\"data:image\/gif;base64,R0lGODlhAQABAAAAACH5BAEKAAEALAAAAAABAAEAAAICTAEAOw==\" class=\"lazyload\" style=\"--smush-placeholder-width: 96px; --smush-placeholder-aspect-ratio: 96\/136;\" \/><noscript><img loading=\"lazy\" decoding=\"async\" title=\"Security Valuation and Risk Analysis: Assessing Value in Investment Decision-Making\" src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/uploads\/2010\/07\/Kens-Book4.jpg\" alt=\"\" width=\"96\" height=\"136\" \/><\/noscript> <\/a><\/p>\n<p>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 \u201c<a href=\"http:\/\/www.amazon.com\/gp\/product\/0071744355?ie=UTF8&amp;tag=credtren-20&amp;linkCode=shr&amp;camp=213733&amp;adid=0VR08J2ZHP6QA42KSCDA&amp;creative=393185&amp;creativeASIN=0071744355\">Security Valuation and Risk Analysis<\/a>\u201d out this fall from McGraw-Hill.<\/p>\n<p class=\"facebook\"><a href=\"http:\/\/www.facebook.com\/share.php?u=https:\/\/www.credittrends.com\/blog\/2010\/08\/11\/what-investors-don%e2%80%99t-understand-about-pension-plans\/\" target=\"_blank\" title=\"Share on Facebook\">Share on Facebook<\/a><\/p><div class=\"tweetthis\" style=\"text-align:left;\"><p> <a class=\"tt\" href=\"http:\/\/twitter.com\/home\/?status=What+Investors+Don%E2%80%99t+Understand+About+Pension+Plans+https%3A%2F%2Fwww.credittrends.com%2Fblog%2F%3Fp%3D1569\" title=\"Post to Twitter\"><img decoding=\"async\" class=\"nothumb lazyload\" data-src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/plugins\/tweet-this\/icons\/en\/twitter\/tt-twitter.png\" alt=\"Post to Twitter\" src=\"data:image\/gif;base64,R0lGODlhAQABAAAAACH5BAEKAAEALAAAAAABAAEAAAICTAEAOw==\" \/><noscript><img decoding=\"async\" class=\"nothumb\" src=\"http:\/\/www.credittrends.com\/blog\/wp-content\/plugins\/tweet-this\/icons\/en\/twitter\/tt-twitter.png\" alt=\"Post to Twitter\" \/><\/noscript><\/a> <a class=\"tt\" href=\"http:\/\/twitter.com\/home\/?status=What+Investors+Don%E2%80%99t+Understand+About+Pension+Plans+https%3A%2F%2Fwww.credittrends.com%2Fblog%2F%3Fp%3D1569\" title=\"Post to Twitter\">Tweet This Post<\/a><\/p><\/div><!-- AddThis Advanced Settings generic via filter on the_content --><!-- AddThis Share Buttons generic via filter on the_content -->","protected":false},"excerpt":{"rendered":"<p>I\u2019ve been writing for a couple of years now about an impending cataclysm about to hit company earnings, cash flows and credit. As we know, many firms were bailed out from having to make stepped-up contributions thanks to the large rally in the financial markets in 2009.\u00a0 READ FULL ARTICLE Share on Facebook Tweet This [&hellip;]<!-- AddThis Advanced Settings generic via filter on get_the_excerpt --><!-- AddThis Share Buttons generic via filter on get_the_excerpt --><\/p>\n<p class=\"facebook\"><a href=\"http:\/\/www.facebook.com\/share.php?u=https:\/\/www.credittrends.com\/blog\/2010\/08\/11\/what-investors-don%e2%80%99t-understand-about-pension-plans\/\" target=\"_blank\" title=\"Share on Facebook\">Share on Facebook<\/a><\/p>","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"om_disable_all_campaigns":false,"_monsterinsights_skip_tracking":false,"footnotes":""},"categories":[1],"tags":[331,57,138,202,30,37,203,204,23,279],"class_list":["post-1569","post","type-post","status-publish","format-standard","hentry","category-general","tag-bf-b","tag-bp","tag-cpb","tag-dia","tag-etn","tag-jnj","tag-qqqq","tag-spy","tag-t","tag-vz"],"_links":{"self":[{"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/posts\/1569","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/comments?post=1569"}],"version-history":[{"count":0,"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/posts\/1569\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/media?parent=1569"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/categories?post=1569"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.credittrends.com\/blog\/wp-json\/wp\/v2\/tags?post=1569"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}