By Michael McMillan, CFA
David Zion, CFA, managing director and senior analyst at Credit Suisse, was the bearer of yet more bad news about pension plans at the 65th CFA Institute Annual Conference in Chicago. He demonstrated that the aggregate funding status of the S&P 500 defined benefit pension plans has been declining precipitously over the past 15 years and that the funded status of these plans at the end of 2011 was even worse than it was at the end of 2008. In 1991, for example, these plans were 30% overfunded. By the end of last year, however, they were only 79% funded — or underfunded by $355 billion.
Investors therefore shouldn’t waste their time focusing on the pension expense number that companies report on their income statements, because it doesn’t reflect the “true” economic health or financial condition of the company. That’s because pension expense, as shown below, does not reflect the actual amount of cash being contributed into the plan. In addition, the expense includes the amortization of certain items, which reduces the volatility of reported pension expense from period to period. That, in turn, “smooths” reported earnings.
+ Service cost
+ Interest cost
− Expected return on plan assets
+ Actuarial (gain)/loss
+ Prior service cost
+ Transition (asset)/liability
+ Other cost
Net pension expense
Zion suggested that instead of focusing on the reported pension expense number, investors should use the following framework to determine the “true” economic status of a company’s defined benefit pension plan:
1. Determine the impact of the pension plan on the company’s balance sheet.
Zion added the pension plan assets of the S&P 500 companies to their balance sheets and found that their total assets increased by more than 50%. For such companies as IBM (IBM), Northrop Grumman (NOC), Boeing (BA), and Lockheed Martin (LMT), total assets increased by approximately 72%. Therefore, investors need to ask themselves whether they are investing in a company’s underlying business or in its pension plan. Equally disturbing was the dramatic increase in reported debt-to-equity ratios when pension plan liabilities were added to the companies’ balance sheets. Zion found that debt-to-equity ratios increased by more than 100%. The reported debt-to-equity ratios at Northrop Grumman, Rockwell Collins (COL), and Raytheon (RTN), for example, would increase from 36%, 37%, and 37%, respectively, to 222%, 233%, and 263%!
Investors should also determine the funded status of the defined benefit plan because it provides an indication of past decisions (assets greater than liabilities: overfunded; assets less than liabilities: underfunded). If the plan is underfunded, Zion recommends treating this amount as net debt and adding it to the company’s long-term liabilities. Zion estimates that the average after-tax underfunded status of the S&P 500 companies represents 15% of their market capitalization. For such companies as Goodyear Tire (GT) and U.S. Steel (X), however, the underfunded status of their pension plans represents 75% and 39%, respectively, of their market capitalization.
2. Determine the impact of the plan on the company’s income statement.
Zion treats service cost, which is the amount of future benefits that plan participants earn in the current period, as the plan’s ongoing cash cost. He then uses service cost to adjust EBITDA in order to calculate the economic impact of the pension plan on the company’s earnings (i.e., Adjusted EBITDA = Reported EBITDA + Pension costs − Service costs). It should be noted that under new International Financial Reporting Standards (IFRS) pension accounting rules that take effect in 2013, pension costs will include only service costs and interest costs (i.e., the interest on the pension benefit obligation) and smoothing will not be allowed.
3. Examine and compare the pension plan’s underlying assumptions.
Two important assumptions that have a major impact on pension plan calculations are the discount rate and the expected return on plan assets. The discount rate is used to calculate the present value of the pension benefit obligation (PBO). Companies are loath to reduce this rate because it increases their benefit obligation (liability). The expected return on plan assets, rather than the actual return, is used to calculate pension expenses. All else being equal, the higher the expected rate of return that is used, the lower the pension expenses. Zion finds that companies often use unrealistic or overoptimistic assumptions, which can obscure the “true” economic status or cost of the plan. As a result, when comparing two or more companies, it is important to examine whether and how their pension plan assumptions differ.
Zion also suggests examining the plan’s liquidity risk in terms of its funded status to determine whether the company will eventually have to inject (i.e., contribute) large amounts of cash into the plan. He expects that over the next five years, many companies will have to contribute large amounts of cash into their pension plans in order to address severe underfunding.
Zion hopes that investors will use this three-step framework to obtain a clearer understanding of the impact of a defined benefit pension plan on a company’s leverage, margins, earnings volatility, and risk, which, in turn, should help them determine the company’s intrinsic value. As investors well know, a little financial clarity can go a long way.