Pension gaps drag down earnings
Sagging retirement plans need more cash from their companies, and the problem could last for a long time.
By Larry Dignan
April 22, 2003
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When Ford Motor earlier this year recapped its fiscal 2002 for Wall Street, the company rolled out the usual earnings, revenue, market share and operating statistics -- but it was an appendix that stole the show.
A series of financial slides showed the car maker's U.S. pension plan was underfunded by $7.3 billion, while the worldwide version was $15.6 billion in the hole. After a portfolio loss of 9.7 percent for 2002, the company said it added $500 million of cash to the fund with plans to contribute more.
Ford isn’t alone. The market downturn of the past three years decimated pension plans: According to research from human resources consultant Watson Wyatt, the percentage of U.S. employers with fully-funded pensions -- plans whose assets can pay for at least 100 percent of all retirement benefits accrued by workers so far -- tumbled to 37 percent in 2002 from 84 percent in 1998. Of the 348 S&P 500 companies with defined benefit plans, most will have liabilities exceeding assets, said Merrill Lynch, in a late 2002 report. As a group, the pension liability is roughly $184 billion to $342 billion, a big drop from a surplus of $2 billion for 2001.
Some analysts say the pension fund problems will be a drain on U.S. companies' cash and earnings for at least two to four years, and others are even more pessimistic. The big question is: What can these companies do to reduce their pension liabilities?
“With pension plans falling short, we expect to see many companies struggling in a very bad economy to make massive cash contributions to improve their funding levels,” said Kevin Wagner, a retirement practice director at Watson Wyatt, a human resources consulting company. “Whether things get better is guesswork -- it depends on the market.”
Faced with the bear market, companies have been taking free cash flow and directing it toward defined benefit pension plans. For now the only way out for companies is to dump cash into the plans. Some recent examples:
- United Technologies said it contributed $753 million -- about a third of net income -- to its domestic pension plan in 2002 and lowered its expected rate of return to 8.5 percent.
- IBM said in December it would fully fund its pension fund with a combination of cash and stock. At the time of the company’s announcement, there was a $3 billion funding gap.
- General Motors said in Securities and Exchange Commission filings it contributed $4.9 billion to its U.S. pension plans.
"It’s an enormous issue," said Bryan Place, principal of Place Financial Advisors. "The issue isn’t necessarily for the employee even though you have to watch it. The issue is for investors" who may fret that cash normally earmarked for research, expansion, acquisition or shareholder dividends will instead pay for benefits of people who don't work for the company anymore.
Analysts note that the federal government's Pension Benefit Guaranty Corp. gives employees some relief that their benefits will be delivered, but the safety net is being stretched. The agency, which has a current deficit of $3.6 billion, recently took over US Airways pension plan for pilots and the plans for WHX, Bethlehem Steel, Polaroid and a unit of Global Crossing. The PBGC’s databook for 2002 notes that almost half of its $16.3 billion in total claims is from the plans of the six steel companies on its top 10 list. More than $2 billion is from the plans of three defunct airline companies.
So aside from bankruptcy, what’s the best way for companies to get out of the pension hole?
Companies, if they haven't done so already, are phasing out defined benefit plans and shifting to defined contribution plans such as 401(k)s. Companies that are strapped for cash and can barely afford fund their pension plans will have to cut costs through layoffs or plant closures, said analysts. Airlines are negotiating with unions to gain deep concessions to preserve jobs. General Motors' pension problems will dominate its labor talks when the current union contract expires in September.
But don’t expect unions to yield unless a company is on the brink of collapse. "Most of the companies with pensions also have unions that aren’t going to let go of them," said Louis Stanasolovich, CEO of Legend Financial Advisors.
Companies can also cut the benefit payout, but Watson Wyatt urges companies to avoid that "knee jerk" reaction, noting that defined benefit plans are a key component to keeping employees.
Stanasolovich notes that pension fund managers, which mainly invest in large capitalization stocks, may need to alter asset allocation plans. Pension funds could increasingly look toward hedging and shorting strategies and real estate investments to diversify.
Wagner said there’s also a "schizophrenic" set of federal rules that govern pension funding and magnify the problem. The current rush to fund pension plans is an effort to stay in good stead with the PBGC; if a plan's funding falls below 90 percent two out of three years, a company faces financial penalties. But when the stock market is thriving and companies can boost their pension fund cushions, they face excise taxes. Under current rules a company can build a 10 to 15 percent cushion, Wagner said.
"When companies do well, they can’t put money into pensions," Wagner said. "But when it’s they are at the bottom of the cycle they have to put out the money."
There is anecdotal evidence that the rules influence behavior. Even though Ford's pension fund is in the red, the company will only accelerate plans to add another $500 million to the first half of 2003 if that contribution would be tax deductible.
Most analysts agree that the pension conundrum isn’t going away for a while. "It’s just another piece of the puzzle that’ll cause earnings to be cut short," said Jeffrey Saut, investment strategist at Raymond James. "It may not be a time bomb, but it is a problem in an optimistically-valued market."
Saut’s biggest gripe is the return expectations that companies provide for their pension. On average, companies are still predicting a return in the 8 percent to 9 percent range. IBM recently was projecting an annual return of 8 percent and GM estimates a 9 percent gain for its fund.
Well-known investor Warren Buffett believes 6.5 percent is a more realistic estimate. In Berkshire Hathaway’s annual report, Buffett notes that company leaders "not only don’t know today what our businesses will earn next year -- we don’t even know what they will earn next quarter."
Given the still lofty expectations for long-term pension returns, analysts say a continuance of the market downturn will keep the pension fund issue alive for a while. "This could be an ugly situation because price-to-earnings ratios are historically high and the pension fund problems take away the 'E,' " Stanasolovich said. "This could take at least a decade to work off."
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