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The problem of public pension underfunding is rapidly becoming the next major administrative nightmare as the over $1 trillion underfunding will at some point have to receive appropriate funding treatment. But public workers are not the only ones who should be very concerned as a result of pension fund underperformance, due in major part to the collapse in capital markets and pension funds' large investments in public equities. Hat tip to reader Colin who points out an interesting report from Merrill Lynch dated October 24, 2008 in which author Gordon Latter discusses the adverse impacts to shareholders of public companies with Defined Benefit and Post-Employment Benefit Plan underfunding, as these will likely see substantial ongoing drops in company earnings, as increasing pension underfunding is eventually expensed through the income statement.

The core of the problem is that the top 40 companies which have defined pension liabilities are cumulatively looking at over $100 billion in pension underfunding (based on ML's estimates from the table below, click to enlarge).

The corresponding impact to the income statement for S&P constituents, as predicted by ML in October of last year, would be $34 billion of pension expenses in 2009. However, since then the S&P 500 has dropped another 20% implying a significantly higher amount of expensing will be necessary to catch up, assuming the market is flat from now thru year end. The feedback loop impact from deteriorating capital markets on both the balance sheets and income statements only gets worse: Merrill estimated that the total impact as companies restate pension contributions and are forced to switch strategic asset allocations out of equities into Treasuries (or vice versa) could be as large as $200 billion, leading to more shocks to an increasingly less liquid stock market.

Of course, in tried fashion, nobody is willing to acknowledge the problem, and all involved parties are pushing hard to postpone judgment day. The Pension Protection Act (PPA) which was signed into law in 2006 requires companies to amortize their pension deficits over 7 years. One loophole is for companies that have a Credit Balance that would afford them a contribution holiday in 2009 (and potentially later), but as expected the rules governing Credit Balances are convoluted and outdated. Other accounting chicanery involves the usage of an appropriate FAS87 mandated discount rate, which as seen below (click to enlarge) permits the pick up of up to 125bps in pension liability discount rate accounting reduction from a purely actuarial basis. This results in an average decrease of plan liabilities by 11%, thereby somewhat moderating the whopping reduction in assets.

Lastly, there is an ongoing attempt by the American Benefits Council to obtain funding relief. In a 10 point plan, the council hopes that the sought after relief may be sufficient to help offset the current economic crisis.

None of these measures will likely matter at all in the long-run if the market remains at its current levels (or continues dropping). The median assumed asset return for companies sponsoring US pension plans is 8.0%, and, which is scarier, many companies used expected ROAs in excess of this median in order to keep funding requirements to a minimum (click on chart to enlarge).

These companies which "abused" the system will now be pressured by their retirees and shareholders to reevaluate their pension accounting fairly, dropping the assumption to a level in line with peers and current conditions (indicatively a $1billion fully funded pension plan lowering its assumed rate of return from 9.5% to 8% would have an additional $15 million of associated expense).

The same PPA requires companies to attain fully funded pension status within 7 years, thereby setting a somewhat loose deadline by which all hell could break loose (aerospace/defense companies can opt out until 2012). It is, of course, very likely that the administration will change this law as well as it constantly pushes back on the day when it all comes crashing down.

So what does all this mean practically?

Basically, companies will have to dramatically slash earnings estimates over and above what today's economic realities dictate. The table below (click to enlarge), which was also created in October of 2008, demonstrates that the majority of S&P companies are facing a huge readjustment to EPS based on the continued onslaught of capital markets. While Merrill estimated a roughly 15% decrease to EPS based on adjusted pension expenses alone, the 20% drop in the S&P since then may imply an even more pronounced reevaluation of 2009 earnings, thereby augmenting selling pressure on the stocks, and further hurting pension asset returns (ergo the closed loop).

Furthermore, with regards to practicality, investors who are currently invested in companies such Unisys (UIS), First Horizon (FHN), Con Ed (ED), New York Times (NYT), Fed Ex (FDX), Pactiv (PTV), Goodyear (GT), Dupont (DD) (which recently reported a significant earnings miss the bulk of which was attributed to increased pension expense) and 3M (MMM) should carefully reassess the bull cases here, due to the significant earnings downside potential that could arise out of pension expensing (we neglect to mention General Motors' (GM) and Ford's (F) adverse pension impact as both companies have many other things to worry about currently).

Additionally, while not immediately apparent as a threat to earnings, the following companies have tremendous pension underfunding which will eventually catch up to them: Lockheed Martin (LMT), Raytheon (RTN), Alcoa (AA), Johnson & Johnson (JNJ), Exxon Mobil (XOM), Verizon (VZ) Honeywell (HON) , Caterpillar (CAT) and Exelon (EXC). Shareholders should proceed with extreme caution as this topic becomes more and more noticed by the mainstream media and the chattering heads on cable TV.

Source: Pension Underfunding: The Next Earnings Shock?