Wednesday, October 29, 2008

Sunny Days Ahead But Pension Storm Looming


The Federal Reserve cut its benchmark interest rate by half a percentage point to 1 percent, matching a half-century low, in an effort to avert the worst U.S. economic downturn in the postwar era:

``Downside risks to growth remain,'' the Federal Open Market Committee said today in a statement in Washington. ``Recent policy actions, including today's rate reduction, coordinated interest-rate cuts by central banks, extraordinary liquidity measures, and official steps to strengthen financial systems, should help over time to improve credit conditions and promote a return to moderate economic growth.''

Central bankers worldwide are trying to revive credit and stop a self-reinforcing downturn in consumer spending and bank lending from triggering a global recession. Today's decision follows the half-point reduction the Fed coordinated with the European Central Bank and four other central banks on Oct. 8. Borrowing costs were pared today in Norway and China.

The cut in the target lending rate sent the U.S. dollar lower against all the major currencies:

The ICE's Dollar Index, which tracks the greenback against the euro, the yen, the pound, the Canadian dollar, the Swiss franc and the Swedish krona, fell 0.5 percent, extending the biggest decline since October 1998. It touched the highest level since April 2006 on Oct. 28.

...

The Canadian dollar gained the most in at least 37 years as its U.S. counterpart weakened and commodities including oil, natural gas, copper and gold increased. The loonie appreciated as much as 5 percent to C$1.2126 per U.S. dollar.
Indeed, the falling U.S. dollar bolstered Canadian stocks as commodities surged, sending the main index to its best two-day gain in 32 years:

``It's pretty much about the Fed today,'' said Martin Roberge, portfolio strategist at Dundee Securities in Montreal. ``A huge decline in the U.S. dollar is a prerequisite for a commodity rally. We probably saw the market lows two days ago.''
The Financial Ninja also agrees that there are signs of improvement following the second major day of accumulation yesterday.

I will add my two cents here: powerful vested interests want this market to rally as much as possible going into year-end. Mutual funds, hedge funds and pension funds are all hemorrhaging so bad that they will be buying this sucker on every dip going into the final two months of 2008.

The ferocity of the last selloff was indiscriminate, hitting many solid companies that are now trading at attractive valuations. This explains why Warren Buffett is buying and why Stephen Schwarzman, chairman of Blackstone Group LP, said private-equity firms that buy companies during the credit crisis may see "phenomenal'' profits once global economic growth resumes:

``In periods like this, people get scared out of their minds,'' Schwarzman said in a speech at the North American Venture Capital Summit in Quebec City today.

``This kind of environment is tailor-made for making absolute fortunes in the private-equity business.''

Falling asset prices are bound to help investors, said Schwarzman, whose New York-based firm oversaw $119.4 billion on June 30, including the world's largest buyout fund. Companies being acquired by private-equity firms at just three to four times earnings before taxes, depreciation and amortization will boost future returns, he said.

``I'm not Robert De Niro, but I'm close to a raging bull on private equity,'' Schwarzman said. ``This is a wonderful time to be an investor. In almost every asset class because of this dislocation, you can make phenomenal returns with very little risk.''

...

Schwarzman warned commercial real-estate investors not to expect an immediate rebound in prices.

``Real estate now is suffering because there is no liquidity on a global basis for companies,'' he said. ``That liquidity will come back but it will come back relatively slowly.''

Nowhere was the "dislocation" more irrational and brutal than the solar sector which got pummeled along with oil and commodities during the last selloff.

But solar is hot right now after solar panel maker First Solar Inc. announced its third-quarter profit more than doubled to beat Wall Street expectations by a wide margin.

I will say it again, do not equate solar stocks to the past "internet hype". Alternative energy will be the focus of the soon-to-be President Obama and his administration, so pick these stocks up because they have a lot more room to run-up from these levels.

Importantly, many solar companies are already profitable and they are growing earnings at a feverish pace, showing no signs of a slowdown during this credit crisis.

(Here are some solar symbols to track: CSIQ, ESLR, FSLR, JASO, SPWR, STP, SOL, SOLF, TSL, WFR, and YGE in the U.S. and TIM.TO and VNP.TO in Canada)

That is the sunny near term forecast. Now, let me give you some worrisome trends I see on the horizon.

There is a huge pension storm looming. It looks like a category 2 hurricane right now, but it can quickly escalate into a category 5 hurricane in 2009.

Today the Globe and Mail reported that Canadian companies are lobbying the federal government for relief from their pension funding obligations as market turmoil drives down the value of their pension-fund assets:

Some companies say they are facing possible financial devastation if they are required to immediately make enormous contributions to their pension plans to fund shortfalls.

"There are companies that would absolutely fold if they had to make contributions based on the provisions of the legislation as they stand now," said pension consultant Jeff Kissack of Watson Wyatt in Toronto.

One company executive, who spoke on condition of anonymity, said his firm cannot afford to fund the huge gulf in its pension plan, which was already a problem even before stock markets tumbled this fall. Since the beginning of 2008, Canada's benchmark S&P/TSX composite index has fallen about 37 per cent and yesterday's surge will do little to offer much relief.

The executive said it cannot be the government's policy intent to act in defense of employee pension plans if it means fatally weakening companies that would otherwise have no other financial problems.

"If you actually force some of those companies out of business, it would be a disaster for the poor pensioners who only get 70 cents on the dollar or 80 cents or whatever it was at that point," the executive said.

"It's not asking for a tax break or a bailout or a handout. ... You're really saying let us use the money earned within the company and being spent to do the best things for people's jobs and for the company in the long run."

...

One solution proposed by companies would be a temporary extension of the time limit for funding pension shortfalls, increasing it to 10 or 15 years. Companies currently have five years to make up shortfalls.

Another proposal being weighed by Ottawa would give companies a reprieve from doing a pension solvency valuation at year-end, which would help them avoid recording and "locking in" their lower asset valuations for required funding purposes.

Pension funds normally have to do a valuation of their obligations and assets every three years, then plan sponsors have five years to fund shortfalls. However, once federally regulated funds are in a shortfall position, OSFI requires valuations to be done annually.

Ms. Cameron said about half the pension plans OSFI oversees were in a shortfall position prior to this year, so are doing valuations annually. That means a majority of Canada's federally regulated pension funds will be required to do a valuation report at Dec. 31 this year, giving companies no leeway to wait to see whether asset values recover over the next year or two.

Another pension industry expert said the funding situation is especially exaggerated because pension funds are required to measure their obligations and assets on a "solvency" basis, which assumes a company is going to shut its doors immediately and must fund its pension now.

He said the calculation is artificial for most companies that are in good health, but they must nonetheless make large contributions to allow for this worst-case scenario.

"Before the market turmoil, this was a big issue, but now it's much worse," he said.


The situation for corporate plans in the United States is equally dire to the point where a trade group whose members include Lockheed Martin Corp., Dow Chemical Co. and General Motors Corp. is pressing Congress to help close a record $200 billion deficit in U.S. pensions created by this month's global stock-market collapse:

The Committee on Investment of Employee Benefit Assets is kicking off a lobbying effort today to delay provisions of the Pension Protection Act that it says will force companies to drain cash flow to comply with funding rules set to take effect next year.

``This will be real money that companies will have to come up with,'' said Judy Schub, managing director of the Bethesda, Maryland-based group, which represents 110 of the nation's largest retirement plans holding almost half of U.S. assets. ``The law will be forcing people to be taking money out of operations at the worst possible time.''

Aetna Inc., the third-largest U.S. health insurer, said today that pension expenses caused by stock market declines will lop 30 cents to 40 cents a share off next year's operating earnings.

Ryder System Inc.'s pension contributions will ``significantly increase in 2009'' and force ``cost management'' to protect profit, Chief Executive Officer Gregory Swienton told a conference call Oct. 22. The Miami-based, truck-leasing company's plan had $1.5 billion in assets in 2007 and was underfunded by $1 million, according to Standard & Poor's Corp.

Pension obligations at Lockheed, the world's biggest defense contractor, would also deplete cash and hurt earnings, Chief Financial Officer Bruce Tanner said last week. Lockheed, Bethesda, Maryland-based maker of F-22 Raptor stealth fighter jets, said on Oct. 21 that 2009 profit will be shaved by about 30 cents a share as it records a $60 million expense next year, compared with the projected $125 million gain on its pension this year.

Better Uses for Cash

Even companies that aren't necessarily anticipating an impact on earnings are suggesting better uses for the cash.

``While we support the Pension Protection Act and improved funding for corporate pension plans, we are very concerned about the immediate impact to the overall economy if massive cash contributions are required due to the recent stock market declines,'' FedEx Corp. CFO Alan B. Graf Jr. said yesterday. ``In the current liquidity crisis, that money would be better used to support immediate working capital needs, make capital investments and protect American jobs.''

The value of so-called defined benefit plans fell to $1.1 trillion by Oct. 24 from $1.3 trillion at the end of September, according to Mercer, a pension consulting unit of Marsh & McLennan Cos., as the Standard & Poor's 500 index declined 36 percent this year. The $200 billion gap between U.S. retirement plan assets and liabilities indicates that pensions are about 85 percent funded, said Adrian Hartshorn, who advises corporate programs at New York-based Mercer.

94 Percent Funded

The Pension Protection Act of 2006 compels companies to cover 94 percent of retirement-plan liabilities to be considered fully funded in 2009. The legislation was passed after funding dropped following the technology sector collapse in 2001. Plans covered 104 percent of obligations and posted a $60 billion surplus at the end of 2007, Mercer said.

Companies must cut benefits if assets fall below 80 percent of liabilities and eliminate lump-sum payments below 60 percent, according to the law. At that level, companies must also freeze their plans and prevent participation by new hires.

The law ``was unnecessarily conservative in its funding requirements and unnecessarily punitive in cases where companies make an unwise decision relative to plan funding,'' said North Dakota Representative Earl Pomeroy, a member of the House Ways and Means Committee, which will hold hearings on pensions and economic-recovery plans today.

`Squeeze on Cash'

``Any stimulus package needs to address the pension issue,'' said Pomeroy, a Democrat and sponsor of legislation that would delay the pension act's ``draconian'' funding provisions. ``The squeeze on cash may not happen tomorrow, but I can assure Congress that if it fails to act, this will be upon us before we know it.''

The first deadline most companies will need to meet is Dec. 31, when they will have to calculate their funding ratio and develop budgets for contributions beginning in the second half of 2009.

``Companies will be facing quite significant cash calls in 2009 and 2010 and more than a few will find it difficult to meet these,'' Hartshorn said.

The impact of rising pension expense is making companies cut spending in areas including dividends, said Howard Silverblatt, an S&P analyst in New York. Dividends will fall 10 percent this quarter the worst year-over-year decline since 1958, he said.

``The cash-flow hit is killer,'' Silverblatt said. ``You look in your pocket and there is a hole all the way through to your socks.''

2008 Returns

Next year's pension costs will be determined by 2008 returns on plan assets and interest rate assumptions that won't be made until year-end, according to federal rules.

``Like every other defined-benefit plan, we'll have suffered losses in line with what the markets have done, and we'll have to see what happens,'' Burlington Northern Santa Fe Corp. CFO Thomas Hund said in an Oct. 23 call.

``We were fairly well funded, although not fully funded, prior to the disruption this year,'' said the second-biggest U.S. railroad's CFO. ``And so, there will be funding required if the assets don't return back to previous levels.''

The Dec. 31 deadline to set next year's plan contributions gives Congress, which returns from recess Nov. 17, less than six weeks to resolve the issue.

Push Off Rules

Congress should push off the 94 percent funding requirement and compel the Treasury Department to redefine how companies deal with market volatility as they calculate assets and liabilities, according to the Committee on Investment of Employee Benefit Assets. The American Benefits Council, another pension-plan trade group, asked for similar action last month.

Canadian companies are lobbying that country's federal Finance Department for temporary relief from their pension-fund obligations, including an extension of the time allowed to make up shortfalls, the Globe and Mail reported today.

About 59 percent of the 100 largest U.S. pension plans will fall short of the required 2009 funding level, even if stocks pared their decline to 13 percent, Pomeroy said.

Midland, Michigan-based Dow's pension funds were overfunded as of Sept. 30, CFO Geoffery Merszei said on the company's Oct. 23 earnings conference call. He didn't say how they'd been affected by the market decline since then.

It's ``too early'' to comment on 2009 pension expenses, he said. Dow is the largest U.S. chemical maker.

``Of course, we all know that the equity markets have suffered since the end of September,'' Merszei said. ``I don't know where we are right now, and I don't have the crystal ball to tell you what's going to happen by the end of this year.''

Raytheon Overfunding

Raytheon Co., the world's largest missile maker and fifth- largest U.S. defense contractor, predicts it will meet the new pension-funding levels.

Raytheon, based in Waltham, Massachusetts, contributed funds to its pension plan ``well in excess'' of requirements, spokesman Jon Kasle said in an e-mailed statement. In 2007, the company added $1.3 billion, of which $900 million was discretionary. This year, the company will add about $550 million, he said.

``Raytheon is focused on managing its pension plan to the guidelines of the Pension Protection Act with an objective to be fully funded well within its required timeframe for our company,'' Kasle said.


Corporations should do exactly what Raytheon is doing with its pension plan, contributing funds well in excess of requirements during good periods to weather the storm during bad periods.

The the truth is that too many corporate pension plan surpluses were being plundered in the good old days to "pad" earnings and now that pensions laws are forcing companies to fund obligations during a liquidity crisis, many are crying foul.

Clearly the funding rules need to be revised. In my pension liabilities section, I posted a link to a paper by Christian Weller of the Center for American Progress, Sensible Funding Rules to Stabilize Pension Benefits.

In this study, Mr. Weller states that a closer look at pension funding and proposed rule changes shows the following:

  • Current funding rules are counter-cyclical. Employers are required to contribute more to pension plans during bad economic times than during good times.
  • The administration proposal would exacerbate the counter-cyclicality of pension funding and thus increase the uncertainty associated with pension plans.
  • Alternative funding rules could that provide for greater leeway in averaging fluctuations in pension funding over the course of a business cycle improve the outlook for pensions. This process is called “smoothing.”
  • As a result of smoothing, the burden on the PBGC would be reduced through better-funded pension plans. Employers would benefit as pension funding would become less counter-cyclical, lowering the burden during bad economic times and increasing it during good economic times, when employers are best able to contribute to their pension plans.
Policymakers should revise the funding rules to take into account the counter-cyclical nature of pension funding.

If they don't they will be forcing companies to cut costs to meet their pension obligations, which means many people will lose their jobs at the worst possible time.

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