Sears Holdings Corp. Is Sitting on a Ticking Time Bomb

Although Sears Holdings CEO Eddie Lampert has mostly dismantled the once-vast retailing empire, retirees could see their pensions cut if the retailer ends up voiding its plan. Image source: Memphis CVB.

It's pretty much a given that Sears Holdings (SHLDQ) is in dire straits. Sales are falling, losses are widening, and even the one analyst left covering the retailer thinks the likelihood it goes bankrupt is pretty high. But it doesn't appear many are aware of the ticking time bomb Sears is sitting on that's just waiting to explode and hasten the end.

A not-so-comfortable retirement
Sears has a massively underfunded pension plan that will either drive the retailer to the brink or result in retirees receiving dramatically reduced payouts. It may have just signed a five-year agreement with the federal Pension Benefit Guaranty Corp to "protect" those pensions, but having accumulated $8.3 billion in net losses since 2011, it suggests the potential for a complete implosion is very real.

Sears says the fair value of its pension plan assets total almost $3.2 billion, but it acknowledges its pension obligations amount to nearly $5.3 billion, leaving it with a huge, $2.1 billion deficit. As bad as that sounds, the situation's actually worse, because Sears is using imaginary numbers to make the situation appear better than what it is. Even though the accounting is perfectly legal, and many companies also deploy the same tactics, the bill is coming due, and it won't be pretty.

The problem arises from Sears' use of unrealistic assumptions, which lets them set aside less for pension obligations while lowering the hit it takes to earnings.

Pension accounting involves two numbers: the rate of return a company earns on its investments, and the discount rate, which it uses to discount future obligations back to a present value. Changing one or the other (or both) allows management to massage the results more to its liking.

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As it has for at least the past three years, Sears thinks its pension managers can earn a 7% return on their investments. With historical stock market returns being about 10%, Sears estimates seem conservative except that around three quarters of the historical averages come from dividends and inflation, with earnings growth being the smallest contributor. Historical bond returns are much lower than that.

Sears' pension plan portfolio is dominated by fixed-income investments that make up 63% of the total assets, with equities largely comprising the remaining 37%, a wholly appropriate balance for a pension plan. This year, it intends to have fixed-income investments account for 65% of the total.  

What's unreasonable is to think Sears can make a 7% return. While it did exceed that amount in 2013, generating returns of about 10.5%, its non-equity investments were below 60% at the time, and the stock market had a huge year that year, surging 30%. Last year the market was down 2%, and Sears' pension lost more than 7% on its investments.

Don't discount the danger
The second part of the equation is the discount rate, and Sears uses a 3.7% rate to discount its future obligations. That's better than the 4.6% rate it used in 2013, and certainly more appropriate than the near-5% rate from 2011, but even though the retailer has lowered its expectations, it too, is still too high. In a world where 10- and 30-Year Treasuries go for 1.9% and 2.7%, respectively, Sears' near-4% rate still seems ambitious.

But there's a good reason for it having an abundance of confidence in the abilities of its pension manager: A one percentage point decrease in the discount rate would cause its pension obligations to balloon by $600 million. With it having all of $141 million in cash and equivalents at the end of January, and nearly $2.2 billion worth of pension obligations to pay in the coming years, a 27% increase in obligations could be devastating.

Stepping on a landmine
Of course, Sears isn't the only one wearing rose-colored glasses when it comes to pension accounting. It's a massive problem all across all of corporate America, and it's getting worse. Global consulting company Mercer says there's a massive $487 billion funding deficit in the pension plans sponsored by S&P 1500 companies, and an $83 billion drop since just the end of last year. It estimates the aggregate value of all pension plan assets of those companies was $1.74 trillion, compared with estimated aggregate liabilities of $2.22 trillion.

While Mercer notes the Federal Reserve's zero-interest rate policies have applied downward pressure on the discount rate, IBM (IBM 0.06%) recently bucked the trend and admitted it raised its discount rate to 4% precisely because it lowered by $100 million its pension costs and expenses.

Data source: Company SEC 10-K filings.

Sears' pension plan has some 200,000 people in it from before 2006, when it was frozen, who are at risk of seeing their benefits reduced if Sears cancels the plan and the PBGC takes over.

Over the years, chairman and CEO Eddie Lampert has stripped the company bare of some of its most valuable assets. Absent real-world numbers, its pension and those of many other corporations amount to little more than cookie-jar accounting systems executives can dip into to obtain the results they want. 

Companies can allow these deficits to grow only so far before they have to expense them on the income statement, and even if Sears doesn't have the biggest corporate pension deficit, it's arguably one of the most distressed businesses already teetering on the edge.

While Sears has used some of the proceeds from Lampert's various financial maneuvers to reduce its pension obligation burden, it's only because of overly optimistic assumptions that the situation -- and its balance sheet -- doesn't look worse than it is.

With a failing business and a reliance upon recurring one-time cash infusions through asset sales and refinancings, this is a ticking time bomb that can go off at any moment.