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The New Pinch from Pensions


Amid the wreckage of the worst bear market in at least three decades, hemorrhaging corporate pension plans are rapidly becoming Wall Street's biggest new worry. They have lost hundreds of billions of dollars, and now companies face the end of their long-running holiday from writing checks to the plans. Over the next 18 months or so, companies ranging from General Motors to United Technologies face having to pump billions into their plans to comply with federal laws to protect pensioners.

Even if plan investments somehow manage to eke out 5% returns this year, companies in Standard & Poor's 500-stock index will be $40 billion short of their projected pension obligations, according to Morgan Stanley estimates. If plans lose 5%, they'll be $150 billion in the hole. Either way, it is a world away from 1999 when the plans had a $292 billion surplus and a 30% cushion over their commitments. "The squeeze on U.S. pension funds has the potential to be the defining U.S. financial crisis of the 2000s, like the savings and loan squeeze of the 1980s," says Bob Prince, director of research and trading at money manager Bridgewater Associates.

The economic consequences of the squeeze could extend far and wide. Cash that companies earmarked for buying new equipment, expanding markets, hiring employees, buying back stock, or repaying debt will have to be used to shore up pension plans. The shift will be another downer for stock prices, cutting out spending that used to boost growth in earnings per share. And the impact will soon be felt.

Under government rules, some companies must start making up for 2001 shortfalls by the end of this year. For others, the bites will start in 2003 or 2004. "Some companies are going to be contributing for the first time in 10 years," says John Ehrhardt, a principal and consulting actuary at Milliman USA Inc. "In thinking about capital expenditures, there is a new party at the table, the pension plan."

Old-line companies or those with large unionized workforces will be particularly hard hit because they have large defined-benefit plans--ones offering guaranteed payouts to pensioners. The biggest obligations are among auto, telephone, airline, steel, chemical, and pharmaceutical companies. For example, if plans lose 5%, United Technologies (UTX) could have to cough up $1.4 billion in 2003, Delphi (DPH) $1 billion, and AMR (AMR) $415 million, according to the Morgan Stanley estimates. The companies say they're stepping up infusions sharply, but doubt they'll need to put in as much as quickly as some estimates. United Technologies Corp. says it recently contributed $247 million worth of its own stock to its plans. Delphi Corp. says it is putting in at least $200 million a year for the next five years, but concedes that won't be enough if its investments don't appreciate 10% a year. AMR Corp., parent of American Airlines, says it intends to make larger contributions than in the past, but won't say how much. General Motors Corp. (GM), which has the biggest pension plan of all, with $80 billion in obligations, disclosed July 16 that it expects to put $9 billion into its plans by 2007.

How did companies paint themselves into such a corner? It was more than bad luck. They made a bold bet during the 1990s that stock prices and interest rates would move in opposite directions, as they have nearly every year since the Great Depression. The relationship is crucial to pension funds because when interest rates go down, government rules require the plans to have bigger pools of investments to meet future obligations. That can only happen if stocks rise or companies put more money into the funds.

For years, the tactic worked like a charm as fund assets went up while their liabilities increased. Companies became confident about putting more of their pension assets into stocks than before. The resulting investment gains during the bull market more than covered most of the payouts they made to current retirees, averaging about 7% of the funds' total values. Better yet, accounting rules allowed companies, quite legally, to boost their reported earnings by billions with higher projected investment gains because they were holding more stocks. Some, again quite legally, were able to actually tap the surpluses to help pay retiree medical expenses and even merger consolidation costs.

Lately, however, the bet has turned sour. Stocks--in which a record 60% of fund assets were invested in early 2000--have gone down in the bear market, as have interest rates. The result: Funds' assets have plunged at the same time that their liabilities have soared. The pincer movement has wiped out surpluses racked up during the long-running bull market, and then some.

The reversal has been fast and furious. As recently as 1999, nearly 78% of the plans at S&P 500 companies had surpluses. But by the end of this year, less than 26% will have one. And workplace demographics are making matters worse. With average lifespans lengthening, more plan beneficiaries are retiring than dying. So cash to pay benefits is draining out of the weakened funds as never before. Besides, the funds are dwindling as new workers are put into defined-contribution plans such as 401(k)s, in which employees, not the company, take all the investment risks.

With impending cash calls, the stock market is getting a double whammy from corporate pension plans. The first battering came late last year when investors realized companies had inflated their reported earnings by exploiting loopholes in accounting rules. By making overly optimistic assumptions about future investment returns, companies were able to puff up earnings by some 10% even though the maneuver generated no new cash. Now, investors are being side-swiped again. This time, reported earnings aren't affected even though real cash exits to the pension plans.

The fear is that nobody but the companies knows exactly how big the cash calls will be. Companies hardly ever disclose anything in their Securities & Exchange Commission filings about the impact of the government pension rules on them. "The specific calculations are impossible to get right with publicly available data," says Trevor S. Harris, accounting analyst at Morgan Stanley. That is important because it means investors can't accurately predict corporate cash flows. Milliman's Ehrhardt, who helps companies navigate funding rules, says many companies know more about the coming cash calls than they have been telling. For investors' sake, "opening up the book on funding strategy is where companies should be going," he says.

Some companies may have reasons for not showing their cards. Ehrhardt says many that have cash on hand are putting more money into their plans even when the government rules don't require it. One big appeal: Executives get to figure the additional assets into their estimated investment returns in their reported earnings. If they are estimating 10% investment returns, a $100 million contribution will boost operating income by $10 million, which is more than many believe they can earn elsewhere right now. Also, they can often get tax deductions for the payments. And thanks to a recent change in tax law, they can sometimes contribute to overfunded plans without suffering penalties.

Meantime, by making estimates based on the numbers companies do report, Harris and other analysts are scoping out the ailment and the most seriously diseased companies. For example, Harris figures that if the Delphi plan's investments end this year with even a 5% loss, its remaining assets will be enough to fund just 65% of its $8.4 billion in obligations. Besides the $600 million Delphi should put in this year, government rules suggest it would need to put in an additional $1 billion next year.

John G. Blahnik, treasurer at Delphi, says the company is being "open and frank" in earnings conference calls about the cash needs of its pension plans. But like most companies, Delphi is presenting its assessments on its own terms, without regularly reporting all the assumptions that go into its estimates. Blahnik says Delphi recently doubled its contributions to the plans, to $400 million this year, to try to get it back on track. Assuming the plan's assets earn 10% a year, he intends to put in at least $200 million, taking advantage of some extra time Delphi earned under government rules for contributions made in the past.

Worries about pension plans sucking cash out of companies are increasingly catching Wall Street's attention. They were a factor in the downgrade of GM's credit rating last fall by Standard & Poor's, and they are in part to blame for its stock falling 34% since mid-May. GM's forecasted $9 billion in makeup payments through 2007 compare with $3.6 billion in cash flow the company is expected to generate this year after dividends, interest, and capital expenditures. To help fund a $2.2 billion payment this year, the company sold convertible debt in April. GM may have to repeat that operation in the future. "We're going to have to put in more cash than we planned," says Vice-Chairman and Chief Financial Officer John M. Devine.

"All companies are going to have to look at their pension plans," warns Patrick D. Campbell, CFO of 3M. His company hasn't decided yet how much cash to pony up, but he doesn't quarrel with Harris' estimates that $378 million will be needed in 2003 if investments lose 5% this year. The company's U.S. and foreign plan assets were 11% short of projected obligations at the end of 2001, according to the company's annual report. And since then, U.S. stocks have fallen another 27%. "Obviously, we're going to have to think this through," says Campbell.

At Raytheon Co. (RTN), CFO Franklyn A. Caine says he is preparing contingency plans for its funds. He had expected pension assets to earn 9.5% this year. Now, he figures that even if the fund suffers no losses, Raytheon will have to pump in an extra $85 million in 2004. If the fund loses 9.5%, he will have to find an extra $189 million in 2004.

Last year, Maytag Corp. (MYG) made its first payment in years to its plans, some $65 million, says CFO Steven H. Wood. This year and again next, it will put in $115 million as it tries to make up for the poor markets and for an increase in benefits won by its labor unions. "We think it is prudent to contribute to the plan," says Wood. But he concedes the money would be well spent paying down debt, Maytag's other priority. During the bull market, available money went toward stock buybacks even though the plans were slightly underfunded.

Investors will probably wish for a long time that Maytag and other companies still had the luxury of not tending to their pension plans. The complexity of funding rules, filled with various triggers, allowances, and accelerated payment requirements, will add uncertainty to corporate cash flows for years to come. More complexity and greater uncertainty are the last things that battered investors want. By David Henry in New York, with David Welch in Detroit, Michael Arndt in Chicago, and Amy Barrett in Philadelphia


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