Pension Underfunding: The Next Earnings Shock?

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holiday in 2009 (and potentially later), but as expected the rules governing Credit Balances are convoluted and outdated.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.

Comments

[Dave Wrixon:]

Why should this be a shock? Pension funds are invested in stocks. The value of those stocks is part of the adequacy calculation. If the value of the stocks more than halves then it not surprising that fund is coming up short. How old do you need to be to work that one out? 10?

The problem is with Ponzi schemes is that they fall flat on their face when the economic tide goes out. Pension funds are no different.

Mar 07 03:53 PM

[johnny inca:]

Tyler, you could have written a factual piece without all the buzzword blathering and scare tactics.

It would also help if you actually knew what you were talking about.

For instance:

>>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).

Um, no. You are thinking of the FASB's expected return on assets assumption, which is used to determine pension cost under FAS 87. Discount rate setting for federal funding requirements is prescibed by law and is nowhere near 8%.

74.125.47.132/search?q...

This is a very very complicated subject, so please don't presume to speak on technical matters to which you have no training or expertise.

The long story short is that plan sponsors who have suffered investments losses, which is almost all of them, will face increased cash requirements and GAAP / IFRS earings and balance sheet impacts which could be onerous relative to the size of their organization.

Mar 07 04:13 PM

[bigmoney:]

>> Of course, in tried fashion, nobody is willing to acknowledge the problem, and all involved parties are pushing hard to postpone judgment day.

The first rule of Pension Club is that nobody talks about Pension Club ~ Tyler Durden. Haha

I'd like to see some charts of the S&P500 that has frozen their pension. My company, one of the above listed, froze theirs a few years ago.

Another thing I would like to see is Pension total value over time / vesting. I believe the typical curve is exponential

A frozen pension means that many baby-boomers working at these S&P500 corps will have their pension frozen just as they enter the power curve of vesting. Talk about a rude awakening.

Anyway, I think its about time the public sector start taking pension haircuts like everyone else. The only government sector that should get special protection is military, because once those guys sign a contract, they cannot quit. Politicians, administrators, social workers, IRS tax collectors can easily do with less. If they don't like pension haircut, they are free to quit, and get a job in the private sector. I don't think we'd be the less for it.

Mar 07 06:13 PM

[Jolly_Rancher:]

Actually, state guard can quit. And none were forced to join. I'd say that service men who did active duty get full pension, but the rest are considered in the same category as government bureaucrats. How many active troops are in Iraq and Afghanistan, compared to the total forces? And so how is our military stretched thin? That's a joke. Most of the military today are paper pushers. First thing Obama should do is cut the Pentagon budget by half and tell the brass to stuff it. The guys on the front line get no support from them. This from a retired marine.


On Mar 07 06:13 PM bigmoney wrote:

> >> Of course, in tried fashion, nobody is willing to acknowledge
> the problem, and all involved parties are pushing hard to postpone
> judgment day.
>
> The first rule of Pension Club is that nobody talks about Pension
> Club ~ Tyler Durden. Haha
>
> I'd like to see some charts of the S&P500 that has frozen their
> pension. My company, one of the above listed, froze theirs a few
> years ago.
>
> Another thing I would like to see is Pension total value over time
> / vesting. I believe the typical curve is exponential
>
> A frozen pension means that many baby-boomers working at these S&P500
> corps will have their pension frozen just as they enter the power
> curve of vesting. Talk about a rude awakening.
>
> Anyway, I think its about time the public sector start taking pension
> haircuts like everyone else. The only government sector that should
> get special protection is military, because once those guys sign
> a contract, they cannot quit. Politicians, administrators, social
> workers, IRS tax collectors can easily do with less. If they don't
> like pension haircut, they are free to quit, and get a job in the
> private sector. I don't think we'd be the less for it.

Mar 07 10:16 PM

[Hmm?!:]

Here is an interesting twist. The company I used to work for filed for Chapter 11. I applied for a lump sum benefit as soon as the plan allowed (5 months after the end of severance) and should have been processed before even the first bankruptcy meeting of creditors.

Now they cannot pay because of an IRS regulation and I have to reapply for an annuity. The only law I can find is the "Pension Plan Protection Act of 2006". Of course it does not apply, because they froze benefit accumulations in 2007.

If they stall me and others long enough, they can use the PBGC (i.e. government insurance) and save more out of pocket. Got to keep the corporate jet gassed up somehow.

Obama, start reaching for the checkbook again!

Mar 07 11:55 PM

[Rob Viglione:]

There's already some heated debate on this article, but the main premise is:

1) Many pension plans are severely underfunded
2) This will have a big impact on corporate earnings as cash requirements to adjust plan funding come due

Bottom line is to tread carefully in the markets. Reality is that the federal government will likely stick its paws into yet another crisis brewing...

Mar 08 05:15 AM

[billyboy54:]

Despite all the criticism, I found this article informative. Thanks for writing on a very important "below the radar" type topic.

Mar 08 09:30 AM

[2houndz:]

The pension "shock" is definitely going to surface in the near future, along with commercial real estate default "shock" and a treasuries "shock". Deleveraging is a slow and painful process. Are we near the end of this yet? Not hardly.

Mar 08 10:21 AM

[ArtfulDodger:]

Even if you cut in half the numbers TD presents, it's a certainty that many of the US's largest companies have a serious problem, and it's the same one that the rest of the nation has: debt.


Indeed, debt got us into the mess we're currently in, and the government is using debt to get us out.

I would imagine that many of these companies will borrow to start up funding their pension requirements.

Sometime, somehow, this must stop.

Mar 08 10:52 AM

[optionsgirl:]

What about T? I read somewhere that AT & T is also underfunded. Does anyone know their story?

Mar 08 11:18 AM

[johnny inca:]

This story may be "below the headlines" but is hardly news to any analyst. With the adoption fo fas 158, its realitively easy to get GAAP #'s on a plan's status on a quarterly a basis and make projections. Any EPS / REV guidance you get from a company these days will most assuredly include up to date EPS impacts from the pension plans based upon market values of assets.

The only government interference at this point is a delaying of the tightening funding requirements set by PPA in 2006.

Mar 08 11:25 AM

[formerhawk:]

Not currently underfunded


On Mar 08 11:18 AM optionsgirl wrote:

> What about T? I read somewhere that AT & T is also underfunded.
> Does anyone know their story?

Mar 08 12:19 PM

[Dotcom:]

I retired from AT&T and took the lump sum, but remain concerned about any impacts to this and other companies/corporations bottom lines. I have medical, dental and eye benefits which the company provided as part of a retirement incentive program. These benefits can be stopped at any time without reason, adding yet another funding concern for retirees.

Mar 08 02:18 PM

[skwestorange:]

Are we all focusing too much on the negatives and forget that there is an economy with 300 plus million people? They all have to eat, dress, take medicines for illness, have a roof over their heads, move about from here to there and so on. That should sustain a level of economic activity that, albeit with a lot of pain in the near term, overcome our excesses of the past. Perhaps it is time to start thinking of the positives and move on. Hopefully we would all have learned the lessons from this debacle and behave better, i.e., live within our means and not binge on credit. May be the baby boomer generation, ie mine, which is largely responsible for this mess, may not clean up after itself. But it will certainly own up to its irresponsibility and set in motion the wheels of progress needed to help our successive generations do better.

Mar 08 02:27 PM

[hwood007:]

There are several things that are unfunded, corporate pensions, state pensions, federal pensions, federal medicial benefite (MediCare, MedIcaid, and the drug plan. There is also social security, whcih is unfunded.

Social Security, as we know it.

Current opinion of social security by the public and media is in 2016 when social security collections are not enough to make payments, the Social Security Trust Fund will provide the difference until 2041, when some new money will be needed.

My reading of a 100 page pamphlet on social security from the American Institute for Economic Research in Great Barrington, MA, causes me to change my opinion of the solvency of social security.

I think public opinion believes a myth and there is nothing of value in the Old Age and Survivors Insurance Trust Fund (OASI) other than government IOUs. That means beginning in 2017; the USA must tax or borrow money to make some social security payments in 2017, sounds like bad news to me.

viel gluck to all,

Mar 08 08:56 PM

[MiddleOfRoader:]

Is real estate cheap in Nebraska? I believe that is the only state which does not have unfunded liabilities, as they are barred in the state constitution. Then I would only have to worry about unfunded Federal promises.

Mar 08 10:30 PM

[svosavvy:]

thanks for the article author,

I would personally wonder in my most unprofessional lay mind how the credit freeze is impacting pension underfunding by companies. Just looking at alcoa their pension funding levels according to what I am reading are running at or about 2005 numbers while 2007 saw record funding so it appears as if 2008 has fallen off a cliff. I would wonder if underfunding isn't almost a legal way to rob peter to pay paul as a means of getting by during this credit period when even AAA firms get saddled with onerous terms not to mention BBB firms like alcoa. Yes it will need to be brought in at a later date, but, hopefully during a less hostile credit environment. Seems to me it might be a way to shore up balance sheets in the near term. I just mention alcoa because it is my favorite mutt at the pound these days.

Mar 08 11:27 PM

[PDT:]

Appreciated the article. True it may not be a revelation to those of us who do this for a living, but there is value in getting the discussion started. Unfortunately, the data from the Merrill report Tyler referred to might be a little old to act on from a trading standpoint, IMO. Still, good to get a wider audience thinking and talking about it.

Mar 09 01:01 PM