Monday, April 8, 2013

Corporate America's Pension Time Bomb?

David Randall of Reuters reports, Pension underfunding grows despite U.S. market rally:
The gap between what major corporations will owe retired workers and how much they have put aside grew last year despite a strong stock market rally, according to a study set to be released on Monday by Wilshire Associates.

The cumulative liability among defined benefit pension plans sponsored by companies in the benchmark Standard and Poor's 500 index increased to $1.56 trillion in 2012 from $1.38 trillion the year before, outpacing the growth in assets.

As a result, the overall funding ratio - a measure of a plan's assets divided by its commitments - for all plans fell from 79.7 percent to 78.1 percent, the study found.

Low interest rates - which are used to calculate future benefits - were a significant factor behind the increase in pension liabilities, said Russell Walker, a vice president at Wilshire and one of the authors of the report. Mergers and acquisitions also increased pension funding liabilities.

United Technologies Corp (UTX) saw its liability increase by $5.2 billion after its acquisition of Goodrich Corp, for instance, while the pension obligation at Kraft Foods Group Inc (KRFT) increased $7.2 billion as a result of its spinoff of Mondelez International Inc (MDLZ).

Walker said plans will either have to invest in riskier, long-duration credit, hope that interest rates rise and/or increase their contributions.

The issue of pension funding will grow in importance to both corporations and investors alike as the oldest members of the baby boom generation retire and draw down assets.

"The huge cohort of upcoming plan beneficiaries are going to put a strain on defined benefit plans," Walker said. "There's no question that we are going to see a need to stabilize funding sooner rather than later."

Approximately 10,000 baby boomers will turn 65 each day until 2029, according to estimates from the Pew Research Center. The generation is the last to be widely covered by defined benefit pension plans that guarantee workers a set monthly benefit regardless of market conditions. Most of these plans are closed to new employees, who instead save for retirement in so-called defined contribution plans such as 401(k)s.

The pending deficits of some companies amount to billions of dollars. At $19.7 billion, Boeing Co. (BA) had the largest shortfall among the 308 companies studied. General Electric (GE), Lockheed Martin Corp (LMT), and AT&T (T) also had shortfalls of more than $10 billion in fiscal 2012. Pension funding could be a risk that affects the future net earnings of these and other companies, Walker said.

Overall, the plans included in the study had a median rate of return of 11.8 percent in 2012, the fourth consecutive year of gains. Plans invested a median of 49.6 percent of assets in equities, 36.4 percent of assets in fixed income, and the rest in a mix of cash, real estate, and private equity or hedge funds.

Benefit payments rose to $76.5 billion from $72.5 billion the year before.
The WSJ also covered this topic in late February, explaining why the corporate pension gap is soaring:
Across America's business landscape, the gap between the amount that companies expect to owe retirees and what they have on hand to pay them was an estimated $347 billion at the end of 2012. That is better than the $386 billion gap recorded at the end of 2011, but the two years represent the worst deficits ever, according to J.P. Morgan Asset Management.

The firm estimates that companies now hold only $81 of every $100 promised to pensioners.
In general, everything happening on the liability side of the pension equation is working against companies. A big source of the problem: persistently low interest rates, set largely by the Federal Reserve.
The article goes on to state:
Boeing's discount rate, for example, fell to 3.8% last year from 6.2% in 2007. The aircraft manufacturer said in a securities filing that a 0.25-percentage-point decrease in its discount rate would add $3.1 billion to its projected pension obligations.

Boeing reported a net pension deficit of $19.7 billion at the end of 2012.

The discount rate is based on the yields of highly rated corporate bonds—double-A or higher—with maturities equal to the expected schedule of pension-benefit payouts.

Moody's decision last summer to lower the credit rating of big banks hurt UPS and other companies by booting those banks out of the calculation. And because bonds issued by some of those banks carried higher yields than other bonds used in the calculation, UPS's discount rate fell 1.20 percentage points.

Another contributor to the pension gap is the fact that people are living longer. Goodyear cited increased life expectancy for its plan's beneficiaries as one reason its global pension gap widened to $3.5 billion last year from $3.1 billion in 2011.

In September 2012, the Society of Actuaries issued a preliminary update to its widely used mortality tables. Andy Peterson, a staff fellow in the trade organization's retirement systems group, said the estimated increase in overall mortality could raise pension liabilities by 3% to 5%, assuming a discount rate of 4%.

The combination of low rates and longer life spans has made it tough for pension plans to keep pace. Between 2009 and 2012, companies in the Russell 3000-stock index have added $1 trillion in assets to their pension plans through investment returns and contributions, but their overall deficit still increased to an estimated $441 billion from $392 billion over that period, according to data from J.P. Morgan Asset Management.

But just as falling interest rates have created a massive hole in pension funding, pension plans could quickly recover if interest rates started to climb.

A report by actuarial consulting firm Milliman found that a 0.27-percentage-point increase in the discount rate and strong equity returns in January helped the deficit of the 100 largest corporate pension plans shrink by $106 billion last month.

That marked the second-largest monthly improvement ever in Milliman's pension funding index, and completely reversed the $74 billion deficit increase recorded for all of 2012.

Still, companies aren't betting that rising interest rates will fix their liability problem in the near term, especially since the Fed said in October that it expects to keep interest rates very low through mid-2015.

As a result, apparel maker VF Corp. (VFC) is pursuing a "liability driven investment" strategy, in which it will move out of equity investments and into fixed-income investments like bonds, said Bob Shearer, the company's chief financial officer.

The switch will allow VF to better match the duration of its returns to those of its obligations. That should, at least in theory, limit the earnings volatility caused by its pension deficit. Falling interest rates, which would increase pension liabilities would also increase the value of fixed-income pension assets.

One insurance-company actuary said other companies could follow suit, seeking relief from their pension burden. "You could see a rush for the exits," said Peggy McDonald, senior actuary in Prudential's pension unit.
You read these articles and wonder how long before these large U.S. corporations follow Verizon and transfer pension risk to Prudential or some other insurer. Before they do, think they should follow Bell Canada's lead and just top up their pensions, recognizing the backdrop of a persistently low interest rate environment.

Interestingly, while the market rally did little to help U.S. corporations, here in Canada, the Canadian Press reports, Market rallies boost Canadian pensions as plans gain 4.1% in first quarter:
Canada's underfunded pension plans received a much-needed boost in the first three months of this year, thanks to a better performing stock market, a new report states.

The Mercer consulting firm says a typical balanced Canadian plan returned 4.1 per cent in the first quarter, sharply improving solvency positions.

That is reflected in the increase in the Mercer Pension Health Index to 87 per cent as of March 31 from 82 per cent at the start of the year.

Stronger equity markets are the main reason for the improvement in pension plan positions, but Mercer also cited a modest rise in long-term interest rates and the fact that plan sponsors are stepping up to fund deficits.

"All the key drivers of pension plan health moved in the right direction in the first quarter of 2013," explained Manuel Monteiro, a partner at Mercer Financial Strategy Group.

As well, "most plan sponsors are continuing to take significant risk in their pension plans," he added. "They take this risk in the hopes that the markets will help to fund some of the existing deficits."

Aon Hewitt Canada also reported similar findings Tuesday, noting that the median solvency funded ratio of a large sample of defined benefit pension plans has risen from 69 per cent at the end of 2012 to 74 per cent as of March 31.

The firm points out, however, that about 97 per cent of pension plans in the sample still had a solvency deficiency at the end of March.

"There are three main ways that plan sponsors will see themselves out of this solvency conundrum," said Ian Struthers of Aon Hewitt Canada. "Through an increase in interest rates, favorable equity and alternative markets returns and/or through higher employer contributions. We saw all three last quarter."

Pension plans were deeply impacted by the economic crisis of 2008-09 and since have been hobbled by historically low interest rates.

The report notes the while the Mercer Index has rebounded from 71 per cent in 2009 to the current 87 per cent, it still remains below pre-crisis levels. It was last at 100 per cent in 2007.

The biggest improvement in the quarter came on the equity side, Mercer says, with developed global equities returning 10 per cent and Canadian equities 3.3 per cent.

In Canada, the best performers were health-care (up 22.8 per cent), information technology (up 17.5 per cent) and industrials (up 14.2 per cent.)

The weakest performers were materials, down 10.4 per cent; utilities, up just 0.5 per cent, and financials and energy, both up 4.2 per cent.
Canadian pensions shouldn't rejoice. Canada's corporate pension hole is huge, forcing companies like Air Canada to strike a deal with the federal government to keep making their pension contributions. Air Canada's bonuses are now tied to pension payments.

As bad as the situation is, some experts think we shouldn't be quick to sound the alarm. Bernard Dussault, Canada's former Chief Actuary, shared this with me:
Due to the unrealistic low yield used in computing pension liabilities, the funding ratios are grossly understated. International accounting standards applying to the valuation of pension liabilities do not provide realistic, reliable or sensible values and thereby make a bad situation look unduly worse and too alarmist.
This is especially true for U.S. corporate plans which use a smaller discount rate than public plans. If U.S. public plans used a rate based on corporate bond rates, they'd be insolvent.

The most important thing to remember when reading these articles is that interest rates are the main driver of pension liabilities. This is because the duration of liabilities is longer than the duration of assets, which in plain English means any decline in interest rates will widen pension deficits because liabilities will grow much faster than assets.

In fact, this is what Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), was referring to when he went over HOOPP's stellar 2012 results and warned:
...the "risks of not owning bonds is huge" because there is an asymmetric tradeoff depending on whether interest rates rise of fall. In particular, the duration of most pension plan assets is shorter than the duration of their liabilities (for HOOPP, it is 12 vs 15), so if long bond yields fall by one percentage point, it will be destructive. "If we enter a Japan scenario, you will get killed not owning bonds." Conversely, if rates rise, your liabilities will go down more than your assets, so you will not be hurt as much.
Indeed, a Japan scenario would mean rates are not too low. One hedge fund manager shared these great insights with me:
...the assumption that discount rate is too low largely depends on another assumption: that central bankers can prevent deflation. Regardless of what academic economic theories say about the effectiveness of monetary policy to stop deflation, there is a REAL risk that they can only do this in the short run and that a Japan-like lost decade(s) scenario is now upon us in the developed world (as demographics would suggest).

If rates remain low and stay there, or even fall further, a Japan-like situation means equities enter a long term bear market. Against this type of shock, funding ratios are underestimated. This risk goes hand-in-hand with deteriorating state and local budgets making it more likely that these governments skip pension contributions to balance budgets. So demographics, equity risk, interest rate risk, and inflation risk are not independent, and must be treated holistically to really understand whether or not current funding ratios are 'too alarmist'.

With so much riding on macroeconomic "theory" about the long term effectiveness of the radical and untested policy measures of the last 4 years, adding equity-like risk to the asset side of the balance sheet in an effort to close the gap is not prudent long term risk management for a pension fund. If monetary policy falls short of expectation, the short run volatility of these assets can easily overwhelm the advantage of being a long term investor who is able to step into risk assets when everyone else is selling.

It is only a pension fund who limits exposure to this shock now who will be in a position to "grab yield" buying heavily discounted bonds and clipping premium selling insurance after the storm (see HOOPP), thereby dealing with funding risk tactically instead of reacting to it. That means going against the herd right now, shunning short duration, illiquid assets in the hope of closing a gap with the latest "historically back-tested" trend in asset class allocation. Yes you may under-perform your benchmarks in any one year or even over a couple of years, but ultimately its no consolation that you outperformed your peers by 2% for 3 years when you're down 40% in year 4. Sadly, five years after 2008, we are right back to the same short term thinking that created some of the worst problems of that period.

What should be very alarming is that after four years of an all-in monetary and fiscal policy, Bernanke and Draghi are both still warning about deflation risk. Setting aside the hyperinflationary conspiracy theory that seem to dominate intelligent macroeconomic policy debates these days, it's clear that these guys are in a position to know what is going on systemically, and have tried and continue to try everything in their power to prevent this outcome. Yet the 10-year US Treasury bond yield is still below 2%. Furthermore, we are in front of a major reversal of one of the two pillars of the recovery to-date from fiscal stimulus to austerity. In the EU, we already have a sense of what this reversal means for long term growth prospects.
Keep this in mind as the Canadian economy posts bleak job figures. The situation in the United States isn't better as the drop in labor force participation is a distress signal, falling to the lowest rate since 1979 (63.3%), forcing millions to collect disability. And in Europe, it's a full depression as eurozone unemployment stands at a record 12 percent with little signs of improvement.

And yet the market that gets no respect shrugs all this bad news off and keeps making record highs. No wonder great investors like Bill Gross are looking in the mirror wondering whether they were just lucky, the product of a 'favorable epoch'.

As I marvel the ingenuity that went behind making Boeing's Dreamliner (pic above), also realize that one small mistake can lead to a catastrophe. Sometimes I think this is the point we have reached with pensions as many funds hope for a rise in interest rates and are taking risks in alternatives that may or may not pay off (but will make Wall Street richer). When it comes to pensions and airplanes, it's nice to dream but much better to plan for the unforeseen.

Below, Betty Liu reports on the $347 billion pension gap in corporate America. She speaks on Bloomberg Television's "In The Loop." Liu is referring to the WSJ article, Why the corporate pension gap is soaring.