Saturday, March 7, 2009

Pension Underfunding As 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).

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holiday in 2009 (and potentially later), but as expected the rules governing Credit Balances are convoluted and outdated.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

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, 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, First Horizon, Con Ed, New York Times, Fed Ex, Pactiv, Goodyear, Dupont (which recently reported a significant earnings miss the bulk of which was attributed to increased pension expense) and 3M 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 GM and F's 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: LMT, RTN, AA, JNJ, XOM, VZ HON, CAT and EXC. Shareholders should proceeds with extreme caution as this topic becomes more and more noticed the by the mainstream media and the chattering heads on cable TV. Sphere: Related Content
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Anonymous said...

Fred Hickey's last hi tech strategist newsletter (subscription required) has more on underfunded pensions.

Nooyawka said...

You could have saved yourself an awful lot of typing and thinking had you truncated this entry by writing: MESSAGE TO ANYONE WHO DOES NOT PLAN TO RETIRE IN THE NEXT TWO YEARS: Too bad, sucker, you're scr*wed. Your parents took the money and ran off to the gated community.

David said...

So if we assume a $50B charge to earnings for the S&P 500 companies in 2009, that would be about $5 reduction in the S&P earnings per share.

Currently, S&P is estimating 2009 earnings at $25/share so that would be a 20% reduction.

DK Matai said...

Trust you have seen:

"Is Re/Insurance Next Victim of Global Financial Crisis? Could Buffett be wrong?"

For Financial Times:

If you are not a member:

Anonymous said...


May interest you to know that John Mauldin, who is fairly good on such matters believes that a combination of actual and projected earnings from S&P 500 produces a P/E of around $14.36 per share - makes a $5 reduction even more meaningful !

bb said...

something missing in this article: all pension plans are run as ponzi schemes. their survival is preconditioned on:
- ever increasing contributions;
- ever going appreciation of assets held:
- and approximately correct estimation of future payouts.
none of the above has materialized in the past 20 years. why?
- wages have been stagnant;
- manufacturing (aka capital producing) jobs are being outsourced;
- hitting a ceiling of leverage growth in the financial system;
- ever growing healthcare costs;
- ever longer life expectancy.
so we can only expect pension plans to further liquidate positions as their expenses are increasing faster than contributions. this in turn will suppress assets further and we enter a self feeding negative loop.
what will be the end result?
ultimate nationalization of pension plans and healthcare, european style, while all the loot is gone. but since the system is rotten from within, it will still cost 5-10x more than in europe.

Anonymous said...

this is a huge issue. It would be nice to have a basic spreadsheet tool that would allow for sensitivity adjustment of the rate of return. It would highlight the uncertainty associated with the risk.

Anonymous said...

>this in turn will suppress assets further and we enter a self feeding negative loop.

you mean positive feedback loop, not negative. Falling prices causing further falling prices is POSITIVE feedback. Negative feedback would be a process where a drop in an asset price gets fed back into a rise in the asset price (with a delay).

Also the positive feedback loop is, IMHO, when underfunded pension plans start sinking companies, which then causes other pension plans that hold equities of said sunk companies to get further underfunded.

Less extreme version is where equity prices fall, causing pension plans to require more input cash, causing firms to have less cash, causing equity prices to further fall.

Unknown said...

fair point. negative was meant as an ethical term. and your points are all valid