Like every other investor these days, pension plans are having a tough time earning a decent return from high-quality investments. The prolonged low-interest-rate environment continues to pose a big challenge, and CFOs are crying out the consequences this earnings season. What are the implications, and, better yet, what lessons can investors take away and apply to their financial planning?
Delusional discount rate
Calculating a pension plan's obligation (roughly, what it owes its workforce in retirement) involves using a "discount rate," which is the rate of return that the plan can reliably earn on its investments from now until the times it must pay benefits to its retirees. Last summer, Congress revised the rules for calculating obligations by allowing plans to use a higher discount rate (about 1% higher). The higher the discount rate, the lower the plan's estimated obligations.
Although a 1% increase may seem like small potatoes, it can have a significant effect. The change led to lower required contributions from companies with substantially underfunded pension plans. For example, according to The Brookings Institution, this 1% increase would cause United Parcel Service's (NYSE:UPS) required pension plan contribution to drop to $47 million from $1.6 billion.
Fast-forward to this earnings season
When UPS released its most recent earnings, the package-delivery behemoth reported a $3 billion non-cash charge as a result of its pension plan. Meanwhile, $53-billion-market-cap aircraft manufacturer Boeing (NYSE:BA) reported a net pension deficit of nearly $20 billion at the end of 2012. Ford (NYSE:F) and Goodyear Tire and Rubber (NASDAQ:GT) have also disclosed gaping pension shortfalls during this earnings season. Just last year, Ford's pension deficit widened by 21%.
During the past few years, robust stock market performance has buoyed investment returns. But persistently low interest rates, amplified stock market volatility, and increased life expectancy are working against pension plans, regardless of last summer's Congressional ruling that eased up on them.
Some companies are effectively throwing in the towel. During the past year, both General Motors and Verizon scuttled a combined $32.5 billion in pension liabilities to Prudential Financial (NYSE:PRU). As a result, the insurer took on the risk of paying out the pension plan obligations to retirees. In the process, Prudential is compensated by big cash injections in the form of premiums (that it's hopefully priced correctly).
So, what do corporate pension plans have to do with those of us planning for our own retirement? I think there are three key takeaways.
1. Save more of what you earn.
This is the single biggest factor of your retirement planning that you can control. In my years as a financial advisor, I never heard anyone approaching retirement say, "I wish I were retiring with less money." But I heard plenty of individuals utter, "I wish I started saving sooner and invested more."
2. Diversify your investments.
By doing this, you'll reduce your risk and minimize volatility. I know, it sounds boring. And, frankly, it is. But real wealth is built slowly, over time, with calculated risk-taking. As marketing strategist and advisor Becky Saeger says, "Risk averse doesn't mean you're afraid -- it means you're thinking."
3. Revise poor assumptions and unrealistic expectations.
Sometimes we make bad assumptions ("Sure, I think my portfolio can return 20% annually over the next three decades") and have unrealistic expectations ("I'm 40 years old, have nothing saved for retirement, and want to retire by age 50"). But not revising unrealistic assumptions and expectations -- when the writing is clearly on the wall that we must -- is detrimental to reaching our long-term financial goals.
Planning means giving thought to what could go wrong and then magnifying that. Many corporate pension plans must dig themselves out of huge deficits because of poor assumptions that were made and not enough money pumped into the plan. But it's so much easier to start out ahead than it is to play catch-up later.
Fool contributor Nicole Seghetti owns shares of United Parcel Service. Follow her on Twitter @NicoleSeghetti. The Motley Fool recommends Ford, General Motors, and United Parcel Service. The Motley Fool owns shares of Ford. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.