Toward the end of the bull market of the 1990s many companies found themselves in possession of a pension fund with assets well in excess of accumulated liabilities. Some of these firms chose to take pension holidays and channel cash that would otherwise be destined to top up their pension funds into investments that might produce acceptable returns for the company. The reasoning was sound because, under Employee Retirement Income Security Act (Erisa) rules, contributions to overfunded plans are not tax-deductible if the fair value of the plan assets exceed the current liability, and in some cases can even be taxed.
When the market downturn at the beginning of this decade dealt a round of negative returns to most corporate pension schemes, many companies saw a healthy surplus become a funding shortfall. A 2005 study by actuarial consultants Milliman, for example, finds that IBM saw its corporate pension scheme pass from a surplus of over $1.5 bn at the end of 2001 to a deficit of almost $7.4 bn at the end of 2004. In some industries, particularly steel production, airlines and automobile manufacturing, the situation is now critical.
The implications are negative not only for participants in the pension scheme and workforce morale; investors are also concerned when companies have to divert large amounts of cash to alleviate pension fund shortfalls at the expense of the bottom line and shareholder equity. This could have grave implications for the company’s competitiveness, and may even affect national economic growth. New proposals from the Bush administration, however, seek to reduce the possibility of plans becoming critically underfunded during economic downturns by allowing companies to make additional tax-deductible contributions to their plans during times of prosperity.
Ever increasing circles
The vicious cycle spawned by pension scheme underfunding starts with earnings coming under pressure as corporate profits are diverted to reduce pension fund shortfalls. The reduction in profits or shareholder equity may then lead to a deterioration of corporate credit ratings and higher interest on outstanding debt, which creates further drains on cash and reduces profitability. The picture gets worse in a recession because lower portfolio growth makes pension fund shortfalls larger, placing even higher demands on depleted corporate coffers.
When Standard & Poor’s downgraded its rating on General Motors in 2002, analyst Scott Sprinzen explained the principal reason was that ‘poor pension investment portfolio returns have contributed to a huge increase in GM’s already large unfunded pension liability.’ One year on, GM used a major portion of that year’s bond offerings to reduce its scheme shortfall.
The underfunded position may be worse than it appears. If the Milliman sample is indicative, 61 percent of corporate US pension fund assets are invested in equities, with 29 percent in bonds and 10 percent in other investments, including cash, and the average scheme assumes a total return of around 8.5 percent (down from 9.5 percent in 2001). A 2004 Credit Suisse report found that if all S&P 500 companies lowered expected rates of return from the then average of 9.2 percent to 6.5 percent, the total cost to corporate earnings would be $30 bn.
It is surely problematic that the higher the assumptions of the fund’s growth, the less the company has to pay in order to remain fully funded. These expected growth rates can be found in the SFAS 87 information in the company’s 10K, and in Form 5500. Auditors, the SEC and investors need to know on what criteria companies are basing their expected returns and discount rates, and assumptions vary widely, based on the composition of the funds and the risk tolerance of the trustees. For example, FedEx, which isn’t considered fully funded, assumes a 9.1 percent return on fund assets; Berkshire Hathaway, which is considered fully funded, is using projected returns of just 6.5 percent; and Merrill Lynch, which has a surplus, is projecting returns of only 5.5 percent.
Clarifying the picture
In order to understand a scheme’s true funding position, investors need to ask how realistic current assumptions are. The Pension Funding Act of 2004 changed the benchmark for defining pensions liabilities. ‘The act replaced the 30-year Treasury bond rate with long-term investment-grade corporate bonds as the benchmark rate for determining the amount of contribution a company must make to its pension plan,’ explains Rohit Mathur, accounting specialist at ratings agency Moody’s.
The act provides temporary funding relief for a number of hard-pressed pension funds, but only applies to 2004 and 2005 plan years, unless extended by new legislation. ‘The relief was, however, a boon for plan sponsors with large shortfalls in their defined benefit plans, particularly airlines and steel producers, which would otherwise have needed to make large cash injections into their plans in order to reduce their underfunded position,’ notes Mathur. However, the Pension Benefit Guaranty Corporation (PBGC) has expressed concern that the legislation might provide only temporary relief, and could compromise the long-term solvency of some plans.
New disclosure requirements have also come into play since the end of 2003. ‘The Financial Accounting Standards Board’s (Fasb) revision of FAS 132 brought a lot more transparency to pension accounting,’ muses Greg Clifton, vice president and airlines analyst at Moody’s. At the start of the financial year, firms now state how much they will contribute to their pension fund, and material modifications during the year must be communicated.
With companies required to disclose broad details about asset allocation and investment policy, including goals and risk management practices, investors can better assess how reasonable assumptions are regarding plan returns. Some companies have also expressed enthusiasm for the measures. ‘We believe the recent changes in reporting recommended by the SEC have made pension accounting more transparent for investors,’ comments Cathy Wright, investor relations officer at retail giant Target. ‘We are comfortable with this direction and have provided additional disclosures in our 2004 10K filing.’
Simplifying the metrics
To date, investors have been reluctant to look too closely at corporate pension schemes because of the multiple complexities involved. New Bush administration proposals aim to simplify the rules and foster disclosure. First, they will replace multiple measures of pension liabilities with one measure, adjusted to reflect risk of termination, and there will be one basic method of measuring minimum required and maximum allowable pension fund contributions. They would allow companies to make additional tax-deductible contributions during healthy economic periods. Importantly, they also require plan sponsors to reduce funding shortfalls to specified acceptable levels within a reasonable period.
‘The administration’s proposal is a marked improvement over current law, which provides a Byzantine and ineffectual system of funding requirements that has allowed the nation’s pension plans to become underfunded by an estimated $450 bn,’ notes PBGC spokesperson Jeffrey Speicher. ‘The plan will bring simplicity, accuracy, stability and flexibility to the funding rules. It will also give investors a more accurate picture of whether, when and to what extent corporations will need to deal with their scheme funding issues.’
In all scenarios, funding requirements will put older firms at a disadvantage to younger rivals with a lower proportion of employees at pension age. A Morgan Stanley study estimates GM’s pension costs at some $1,800 per vehicle in 2003, leaving profits of just $144 per vehicle. By contrast, Toyota, with a much younger US operation, spends $200 per vehicle on pension costs, leaving a healthier profit margin. Similarly, without the burden of legacy pension plans, low-cost airlines such as JetBlue can undercut the big boys and still make a profit.
Outside of the steel, automobile and airline industries, investors seem less concerned that pension funding requirements might turn into a real problem. Jay Khetani, vice president and member of the aerospace and defense research team at SG Cowen, notes that ‘for many aerospace companies it’s a profit and loss statement item, but not fundamentally a cash issue. Furthermore, the funding deficit in the industry impacts the P&L to varying degrees, although these are not substantial issues for commercial suppliers.’ However, cash-strapped airlines may, in time, reduce investment in their fleets, thus impacting commercial suppliers.
An improving outlook
Even so, thanks to a recovering market, and perhaps to optimism over the new legislation and proposals, investors are getting more sanguine about corporate pension shortfalls. ‘The issue did gain more prominence a couple of years ago because the underfunding gap was growing,’ admits Khetani. ‘But that tendency has now reversed and corporate pension funds are no longer a top-five issue for the investors we talk to.’
So what can companies do if they want to stay ahead of the game? ‘Although it is not required, it would be useful if companies could provide a breakdown of their pension plan funding requirements – perhaps discussing them in the MD&A, rather than aggregating the information,’ says Clifton. ‘Different countries have different funding requirements based on local laws or regulations, and this can distort the picture.’
Clifton also notes that in company tax filings on Form 5500 there may be credit carry-forwards, which companies can use to offset current contribution requirements as calculated pursuant to Erisa and IRS guidelines. ‘Companies should disclose and discuss how Erisa calculations compare with US Gaap calculations,’ he suggests. ‘They could also disclose the timing of cash flows associated with the demographic structure of their defined benefit plans, as these vary between companies. This would allow investors to gauge whether the plan’s assets match its liabilities in terms of duration.’
Potential improvements notwithstanding, there is general agreement that recent legislation has brought more transparency and simplicity to pension fund accounting. Firms, employees and investors hope it might also help rein in future shortfalls.
