Past comments on various Frontier Communications (FTR) articles have expressed concern the funding gap in the retirement and pension funds would start eating into cash required for capital expenditures, debt reduction and the biggest worry, dividends, especially if the unfunded status grows.
FTR has unfunded liabilities in excess of a billion dollars. It is reflected on the balance sheet under long-term liabilities labeled "Pension and other post-retirement benefits". Much of this is due to the acquisition of the Verizon (VZ) properties in 2010. This article will look at the unfunded status of the Pension Plan and the OPEB or "Post-retirement Benefits Other Than Pensions" followed by a conclusion.
We'll start by taking a look at results over the last three years by quarter ($ in thousands):
At first glance one can see why this issue may raise a few concerns:
- The Plan's assets have declined over the period shown.
- Benefit payments are rising.
- Actual returns with the exception of FY2012 are falling short of the expected long-term return rate.
In 2010, 2011 and 2012, the expected long-term rate of return on plan assets was 8.0%, 8.0% and 7.75%, respectively. The 11.1% return in 2012 includes the Verizon transfer of $87 million. Excluding the VZ transfer actual investment return would be 4.1%.
Expected pension benefit payments from the 2012 10-K is:
The 2013 benefit payments are well above the 2013 estimate (through Q3) so this deserves a closer look. During the nine months ended September 30, 2013, lump sum pension settlement payments to terminated or retired individuals amounted to $149.0 million. Lump sum is the key phrase here. On a personal note a family member of mine was offered a lump sum payment vs. an annuity payment that would be typical. (He did not work for FTR). Although the lump sum was very tempting i.e., a large dollar amount, he chose the annuity since on further analysis the annuity payment over his expected life was much larger than the lump sum offer. The decision depends on a number of factors such as how long you hope to live and how confident you are that some future event will not affect your pension income. Why would FTR offer lump sum pension settlement payments? This would eliminate estimated future liabilities for those that chose the lump sum option. That being the case we should expect the funded status to improve. FTR noted the following in the recent 10-Q:
As a result of the recognition of the settlement charge in the third quarter of 2013, the net pension plan liability was remeasured as of September 30, 2013 to be $447.8 million, as compared to the $697.9 million measured and recorded at December 31, 2012. The remeasured funded status of the pension plan would be 71% as of September 30, 2013 as compared to 64% as of December 31, 2012.
We can compile and calculate the funded status details as follows:
What to expect. When the 2013 10-K is filed next year, there should be a large actuarial gain in part due to those accepting lump sum payments vs. annuity payments. To date the funded status percent is at its high since 2011. The next 10-K should also show some reduction in the expected benefit payments given earlier.
The current balance sheet does not reflect this re-measurement. The company did not record any adjustment to the pension plan liability, beyond the settlement charge, as a result of this re-measurement. The net pension liability will be re-measured and the appropriate adjustments will be recorded in the fourth quarter of 2013 (10-K filing).
This is a completely different animal than the pension and much less a concern. First the unfunded status is $433 million, down from $472 million after the VZ transaction. Looks like a scary number but the fact is it will always be unfunded. Why? The fund is maintained at minimal levels; approximately $5 million. The majority of the benefits paid come from Plan participants' contributions and employer contributions. The yearly benefits paid for the OPEB amount to about $16 million through 2012; a fraction of the pension obligations. Plan participants' contributions amount to about 26% of this number while FTR picks up the rest. The expected benefit payments over the next 10 years are as follows:
The strategy of offering lump sum settlements is a sound strategy, possible reducing the funded status by hundreds of millions of dollars; of course, this is dependent on how many employees choose the lump sum option over the annuity. The short-term downside is additional cash is required although FTR has shown a propensity to contribute real estate assets (with a long-term lease back) along with cash.
One concern at this point is their expected rate of return of 8%. This is a long-term assumption, but in the short term it is a challenging number to meet since the expected long-term rate of return on plan assets is based on an asset allocation assumption of 35% to 55% in fixed income securities, 35% to 55% in equity securities and 5% to 15% in alternative investments.
Based on this analysis, the Pension obligations do not pose a short-term threat to the dividend. Longer term, as with any Plan, depends on the accuracy of the actuarial assumptions not being wildly optimistic. The good news is the funded status has shown a marked improvement since the end of 2012. That said it should be monitored, since while improving, it is still underfunded.
The OPEB does not pose a threat to the dividend either short or long term. The benefit payments pale in comparison to the pension payments and the majority of payments are funded by a different mechanism, i.e., it will always show as unfunded.
The major threat hinges around the revenue issue which we discussed in our last article.
A detailed breakdown of the financial data used in this article can be found here.