Investor relations officers at companies with defined benefit plans should pay rapt attention to the current drama unfolding in the US and Europe. More and more companies are showing gaping pension fund deficits, often demanding sudden and giant contributions. How are they explaining this shortfall to their investor audiences in this fierce bear market?
Low interest rates and a falling stock market have sharply reduced the value of assets held by many company pension plans. Greenwich Associates recently showed that US pension funds and endowments lost an alarming trillion dollars over the past three years. Dev Clifford, a Greenwich Associates consultant, calls the period 2000-2002 ‘probably the most destructive in the whole history of the US fund business.’ The study’s sample of 380 corporate pension funds had an average decline of 14.6 percent in 2002, even worse than the 10.2 percent loss sustained the year before.
Over the last several months US companies like General Motors, Ford, IBM and Honeywell have had to pour cash into their pension funds to try and fill the gap. Some market commentators suggest this is still just a trickle compared to the flood that will come as more companies try to assuage investor concerns about future liabilities.
In early February, Standard & Poor’s put twelve European companies on CreditWatch negative because of their underfunded pension liabilities. The list included France’s Michelin, the UK’s Rolls-Royce and Portugal Telecom.
The pension problem is not likely to go away any time soon. As expressed by Chris Legge, managing director of credit ratings at Standard & Poor’s, ‘There are a lot of environmental factors you cannot ignore and that won’t go away. It’s a range of things that the investor community is asking about.’
As complex an issue as pension fund liability is, investor relations officers should try to come to grips with it because investors are definitely asking the questions. One analyst suggests that while IROs are becoming more aware of their corporate pension plan dilemma, it’s still too complex a topic for them. He prefers to pose the nitty-gritty questions to the CFO higher up the chain of command.
Reversal of fortune
Until three years ago most companies were in the luxurious position of having pension fund surpluses. Accounting rules in the US allowed companies to use surplus gains from well-performing pension fund assets to reduce, for example, operating costs, which had domino effect of inflating earnings.
Critics say the current underfunding has been exacerbated by that type of accounting. But John Wood, president of the Playfair Group, an Atlanta-based consultancy, points to the regulation under the Pension Benefit Guaranty Corporation in the US, which prevents companies from socking away funds for a rainy day. ‘This is about managing risk, but the apparatus in the US has almost a counterintuitive dynamic, which is that in good times you do nothing and in bad times you have to do everything.’
Accounting rules let companies project rates of return for pension funds. Despite falling interest rates and a dismal stock market, a lot of corporate pension funds were until recently projecting more than 10 percent annual returns. Now they have begun dropping their projections to the slightly less implausible figure of around 8.6 percent.
At Greenwich Associates they’re still skeptical. ‘While it may not be right to adjust the actuarial assumptions as they cover 20 or more years, the average rate of return expectations of both corporate and public funds are so much lower that, overall, they don’t have a prayer of reaching their actuarial assumptions in the foreseeable future,’ avers Greenwich’s William Wechsler.
The long bull market lulled pension funds into forgetting the long-term risk, according to Wood. Some moved away from actuarial smoothing-to-market-value to take full advantage of inflated market rates. He explains: ‘The irrational exuberance of the 1990s not only projected huge returns, we also expected them to be instant. Not only the regulatory framework but also the fiscal framework of pension funds was a far more long-term game plan.’
Throw long
This long-term outlook should be emphasized by IROs as the issue of pension underfunding gains more prominence in the business news and in investor meetings. Standard & Poor’s also takes a long-term view with all debt obligations, be they operating leases or pension fund liabilities. Legge emphasizes that none of the twelve European companies on CreditWatch negative were facing a particular liquidity crunch: ‘There was no indication of a sudden stress point for companies to fill a hole in a rush.’
Bear in mind, too, that it was only twelve out of 500 European companies that were put on the watch list. By the completion of its analysis of all 500 companies, Standard & Poor’s expected that most would find their ratings confirmed.
However, Legge says that the small number of companies on CreditWatch does not mean Standard & Poor’s is saying that others don’t have pension problems. ‘Some companies are closer to the edge while others have lots of headroom in their existing ratings. Clearly the rest of the companies in the portfolio, to a lesser or greater extent, have the same sort of issues dealing with post-retirement obligations, but the credit ratings of the companies currently assigned as we assessed them can accommodate the degree of risk which their pension obligations present.’
Companies are obliged to make contributions when reserves fall below a 90 percent threshold for three years — cash that could be otherwise used for investments to drive growth. In the UK, pension problems were brought to the fore by accounting standard FRS 17, which requires companies to mark liabilities to market.
So what can companies do to deal with liabilities? Stump up the cash, is the simple answer. Look at IBM, which came up with a strategy to deal with its pension plan through a combination of shares and cash totaling close to $6 bn at the end of December last year. At the time of the announcement, CFO John Joyce said of the scheme, ‘Although we are not required to fund the US pension plan at this time, we want to deal with the pension gap now.’
Measured reactions
Other companies are sitting back and playing wait-and-see. John Wood counsels his clients not to lose their heads while recognizing that there are two parts to solving the pension problem: one is managing risk; the other is remembering you’re in it for the long term. ‘If you play tactically, especially in a volatile market, then you become as volatile as the thing you are trying to evade.’
Moreover, he cautions against overreaction and extreme measures taken by some pension funds like Calpers, which pledged $1 bn to hedge funds last April. Wood thinks resorting to sometimes risky hedge funds or distressed company funds is a short-term fix and potentially shortsighted.
Standard & Poor’s does not offer advice to companies, but Legge does note, ‘There are ways to mitigate the impact, but it’s really down to the company to manage the balance sheet and the liabilities itself.’
Given that pension obligations are viewed like any other debt obligation that has to be repaid in the future, companies facing a pension gap should be plugging it by reducing debt in some way, be it equity issuance or asset sales. Those with substantial free cash flow may be able to use it after meeting requirements for capital expenditures and dividends.
Wood suggests companies try to shore up what they’ve got. And they should resist the temptation to remove the obligation in terms of inflation built into long-term benefit plans. ‘It may save you some money up-front but it makes a bad situation worse with employee participants.’
‘This is not going away in 2003,’ concludes Wood. ‘At a minimum this is going to be a problem until 2006. So don’t go for the tactical play of getting brownie points in one quarter and paying them back in a year and a half. This is something that needs a measured, long-term plan because we are in a long-term environment. It is easier to make a big problem manageable over ten years than over ten months.’
