The almost 4% recent decline in the S&P 500 from the close of Nov. 5 (recent peak) through today could not come at a worse time for firms with underfunded pension plans. The median assumed long-term investment performance, for most firms, is now below the 8% median for the year, and noticeably below for the past 5 and 10 year periods. While the median discount rate assumption of 5.9% has seen some minor relief, it is still providing pressure, given the fall in yields during 2010. The discount rate assumption compares with a current 2.77% 10-year treasury rate while annuities hover around 3.8%. Firms may also elect to partially close out their plan through annuitizing a segment of its population.
The median fund on this list is, according to CT Capital’s estimates, 21% underfunded, when taking current market values and recent multi-year returns into account. Even firms like Honeywell (HON), whose stock saw relief following its recent announcement of placing $2 billion total into its plans this year and next year, will be affected. Its change to reflect current market values (from smoothing) would not make sense (from a current funding viewpoint) should equity prices continue to fall. Even for Honeywell, a strong credit with access to the cheap commercial paper market, $2 billion is significant.
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As we have seen with so many firms on the list, stepped-up contributions have become the norm, as we forecast this past summer. The impact to cash flows and financial structure are material and affect equity valuation.
We have received many requests to run the list again, given the recent fall in equity prices. Some firms on this list will undoubtedly resort to the type of financial engineering which took place at Heinz (HNZ), which set up a receivable securitization program from which it received $84 million while bringing in an additional $48 million from a total return swap. The company also “worked its balance sheet,” all of which helped provide the cash to fund its additional contribution. It was only because of these measures that Heinz was able to report an improvement in its cash flow from operating activities.
If stocks should decline through the balance of the year, firms which have not yet announced will be forced to, impacting operating and free cash flows. The best scenario would be rising equity and yields so firms could match their liabilities and be able to get on with their operating businesses. Until that time occurs, the pension deserves careful watching, as it impacts operating decisions, including acquisitions, capital spending, research and hiring.
One should expect to hear of additional contributions through the reporting and 10K season. The funds will come from a combination of internally generated cash, borrowing, asset sales or other creative financing. The only question will be if investors buy the company line, “it doesn’t affect our operations.”
Disclosure: No positions.