As we enter the 21st century, U.S. companies are staring down a number of threats to their existence, including global competition, higher raw material prices, and rising energy costs. A number of U.S. companies, however, face an even bigger threat: pension liabilities. Many old-line U.S. companies face the prospect of depressed earnings for years to come as they work off obligations to previous employees.
Since the proliferation of pensions began in the 1940s, millions of workers in the United States have forgone higher current wages for the promise of comfortably funded retirements, paid for by their employers. Pensions inspired loyalty in employees, many of whom spent entire careers with one company in order to build up higher pension benefits. Corporate management liked pensions because a good deal of the cost could be deferred to some point in the future, which brings us to the present-day situation.
I suggest you read Robert Brokamp's commentary on pensions before finishing this article. Go ahead, I'll wait.
Ready? Good.
The funding gap
Some 350 of the S&P 500 companies sponsor defined-benefit pension plans, which offer guaranteed payments in retirement. Pension risk is concentrated in these plans, and it's estimated that last year, 91% of all defined benefit plans were underfunded by a total of $450 billion. Most of this underfunding is concentrated in older industries, particularly manufacturing companies that are exposed to significant risk from global competition.
How do companies get away with underfunding their pension plans, you ask? You see, corporations use expected future returns on pension plan assets to determine the necessary level of current funding; the upshot being that higher expected returns require less current funding. The incentive, therefore, is to inflate future return estimates, which may have been acceptable during the raging bull market of the nineties, but in a stagnant market (like the current one) the difference between estimated and actual returns can be enormous.
On average, U.S. companies expect to earn between 7% and 9% annually on their pension plan assets, which the Pension Benefit Guaranty Corporation, the government agency that guarantees pension benefits, allows. Most pension funds are heavily invested in equities, which -- and this is just a back of the envelope calculation -- haven't returned anywhere near 7% annually over the last few years.
But at least the PBGC is there to fall back on, right? Well, yes and no. By law, the PBGC has to pay pension benefits if the insured company goes bankrupt and can't pay, but the PBGC payments are almost always lower than the original plan. (Just ask Bethlehem Steel pensioners.) Nor is the PBGC in solid financial health. The agency insures approximately 32,000 plans (down from nearly 175,000 20 years ago) with an aggregate value of $1.5 trillion. The agency's funding level went from a $9.7 billion surplus in 2000 to a current $11.2 billion deficit. With fewer companies participating in defined-benefit plans, and more old-line companies turning to the PBGC, this deficit will only widen. To give you a sense of the magnitude of this emerging problem, the PBGC reported that 12 years of insurance premiums (at current levels) are required to cover claims from 2002 alone, and claims were $1 billion higher in 2003.
Here comes the piper
Pensions were a win-win situation when introduced in force after World War II. Benefits were exempt from wage control laws instituted during the war, so employees were happy to accept higher future guarantees for lower current pay. Plus, pension income isn't taxable until collected sometime in the far distant future. Management liked pensions because the plans didn't require 100% funding, so more profits dropped to the bottom line. Besides, when the day of reckoning finally came, this generation would be long retired and resting eternally. Just like Social Security, defined-benefit pension plans were a pyramid scheme from the start, enriching the current generation at the expense of future ones.
Things have finally caught up to U.S. companies. Airlines have been hit hardest, though for reasons other than just pension obligations. UAL's United Airlines and US Airways are both in bankruptcy, and Delta (NYSE:DAL) is teetering on the edge. Part of these companies' survival strategy has been to stop, or threaten to stop, funding their pension plans. Automakers likewise face huge liabilities. Last year, General Motors (NYSE:GM) issued $17.6 billion in bonds, using $13 billion of the proceeds to fund its pension plan. GM's interest expense on those bonds is 7.54%, and the auto manufacturer expects to earn 9% on the funds, possibly by following a rainbow to the pot of gold.
When the assets in a company's pension plan don't generate enough cash to cover annual payouts, the shortfall comes right off the bottom line. To understand just how damaging this can be, let's turn again to the automobile industry. A Prudential Financial study estimates that pension and other retiree benefits contribute $1,360 to the cost of every General Motors vehicle, $734 of every Ford (NYSE:F), and $631 of every Chrysler (NYSE:DCX). Compare this to Honda's (NYSE:HMC) $107 and Toyota's (NYSE:TM) $180, and you see why Japanese companies can sustain higher profit margins.
The interest rate effect
In the arcane world of high finance there's always a catch, which in the case of pensions I call the interest rate effect. Because funding requirements for pension plans are generally the present value of future obligations, a drop in the discount rate -- until recently the 30-year Treasury yield -- dramatically increases funding requirements. The 30-year Treasury rate went from 6.6% in January 2000 to just 4.9% today, driving up funding requirements at the worst time -- when asset values were crashing.
A short-term solution, then, would be to raise the discount rate used to determine funding requirements. Always on the cutting edge of high finance, Congress did just that. HR 3108, signed into law earlier this year, allows companies to switch discount rates from the 30-year Treasury yield to a blend of higher corporate bond rates, reducing the present value. Additionally, if interest rates are in a long-term uptrend, as analysts suspect, the discount rate will continue to rise, further alleviating the accounting problems. At the same time, higher bond yields will help managers achieve higher returns on pension assets.
Conclusion
I expect that pension liabilities are going to be a serious drag on corporate earnings over the next several years as companies come to grips with two ugly facts: pension funding gaps must be filled, and expected returns on plan assets are too optimistic. More than a stock bull market, pension funds need a period of higher interest rates to alleviate some of these problems. As an investor, I'm staying away from companies with significant defined-benefit pension liabilities, because, while nominally owned by shareholders, these firms will be turning most of their profits over to former employees.
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Fool contributor Chris Mallon owns shares of Honda Motors through his private investment partnership.
