Tripping Over Pension Shortfalls


By David Henry For the past three years, the damage from corporate pension-plan losses has been piling up like a slow-motion train wreck. As stock prices stayed low and interest rates declined, on average, plan assets have lost 15% of their value, while their liabilities have soared 59%, according to money manager and researcher Ryan Labs. The squeeze has vaporized surplus assets in nearly all funds. Pension plans of companies in the Standard & Poor's 100 index were showing a 16% deficit to liabilities at yearend, down sharply from a 30% surplus two years before.

Thanks to what had been a seemingly endless bull market and the magic of pension accounting, plans once boosted companies' reported earnings, typically by about 5%. But now the plans are sucking up tens of billions of dollars that companies might otherwise want to spend on capital investments and share buybacks that boost shareholder returns.

INFLATED EARNINGS. So great is the pension debacle that Washington politicians are holding hearings on it now, some 18 months after Wall Street first began factoring it into earnings estimates and stock prices. Pols worry whether the plans will have enough money to pay what will be due to retirees.

And they're fretting over how much corporations might have to pay in fees and premiums to support the Pension Benefit Guarantee Corp., the federal government-sponsored insurer for most pensions. The PBGC's own accounts have swung from a surplus of $7.7 billion last year to a deficit of $5.4 billion in the past 18 months as it has had to assume plan obligations for bankrupt corporations such as US Airways (UAWGQ).

Usually by the time politicians hold hearings on a topic, the markets have already found out all they need to know and moved on. That's only partially true with the shortfalls in defined-benefit pension plans, which, unlike popular 401(k) plans, promise to pay specific benefits to retirees for life. It seems the markets have already learned to look through the illusion of pension plans, seeing how complex accounting for fund assets and liabilities inflated companies' earnings during the bull market and propped them up another couple of years afterward. The plans essentially made the market look less expensive than it was.

The problems are concentrated among a couple of dozen stocks, primarily those companies in the auto, airline, and paper industries. But it may well take a few years before it's really parsed out how crippled those corporations could be and how much of a pall their troubles could cast on the whole market. Public hand-wringing by politicians and actions by regulators to reform pension accounting will add to the sense of crisis. At the same time, some plan managers may start to pull some of their investments out of stock to buy bonds as a better way to align plan assets with liabilities, further depressing those stocks.

AUTOS, AIRLINES, & PAPER. The threat would ease if stock prices rose dramatically and lifted the value of plan assets. Also, a sharp rise in 10-year interest rates would do even more to cure shortfalls. But even those turns in the markets wouldn't solve the chronic problems of the most beleaguered companies. Concentrated in heavy manufacturing, such as auto and paper, and air transport, those outfits will still carry the burden of pension promises made years ago, when their businesses were stronger.

"An investor in an auto company, in an airline, or in any company that suffers from economic cycles while carrying heavy labor obligations is going to continue to have to look at these funding issues," says Adrien LaBombarde, an actuary with pension consultants Milliman USA. "For some of these industries, pension obligations will continue to be a recurring nightmare for years to come."

Nearly three-fourths of companies in the S&P 500 have defined-benefit pension plans. But most of those plans are relatively small, and their funding deficits are small enough to be managed. Only about 30% of the companies with plans have deficits that exceed 5% of their stock-market values, a ratio that implies they have the financial wherewithal to raise money for their plans, according to a survey by Morgan Stanley accounting analysts. In fact, the firm estimates that just 10 companies will account for more than one-third of funding shortfalls by yearend -- $91 billion of $249 billion in deficits.

CURTAILING CASH FLOW. The mother of underfunded pensions is General Motors (GM). Its plan obligations of $92.2 billion exceeded the value of plan assets by $25.4 billion at yearend, which is the only time virtually all companies report their pension obligations. GM's market value was only $20.5 billion as of May 12. Ford Motor's (F) plans were also only about 73%-funded, coming up $15.6 billion short of liabilities. Plan assets of auto-parts maker Delphi were $4.1 billion short of liabilities, covering 58% of liabilities, according to a study of major plans by Milliman.

In the airline industry, pension obligations have already contributed to the bankruptcy filings of US Airways and UAL and added to the pressure on AMR Corp. (AMR

. Delta Air Lines' (DAL) plans were only 58% funded at yearend, coming up $4.9 billion short. Its recent market value was only $1.7 billion. The numbers may be smaller in the paper industry, but the problems are still formidable. At yearend, International Paper's (IP) plans were $1.5 billion short, and Kimberly-Clark's (KMB) and Georgia-Pacific's (GP) were each short $1 billion. Boise Cascade (BCC) was $610 million short and only 62%-funded.

Since the liabilities won't all come due for 10 to 20 years, the companies theoretically have time to work out solutions. But the need to catch up severely limits what they can do with their cash flow. The deficits also jeopardize their credit ratings. Last year, GM put nearly $5 billion into its plans after raising a similar amount by selling bonds. What's more, government rules penalize companies that fall below 90% of required funding.

LONG-TERM PROBLEM. For investors, it's hard to know how quickly the companies will have to beef up plan assets. While they report funding levels annually according to generally accepted accounting principles, the government's funding requirements follow a different set of rules. The Securities & Exchange Commission is starting to press companies to disclose more about what they'll have to pay and when, but the rules are so complex that it's not clear how much more companies can accurately say. What's more, those with plans overseas fall under funding rules of other governments.

All of this puts a cloud over the market that's being noticed around the globe. London-based strategist Patrik Schowitz of HSBC Group recently looked at the pension problems of the S&P 100 companies. Though he noted their concentration among "a relatively small number of companies," he still concluded that they'll be a long-term drag on earnings and cash flow. He said they reinforce his negative view of U.S. markets. For some time to come, these long-term promises made to workers years ago are turning into long-term headaches for today's investors. Henry writes for BusinessWeek in New York


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