Thursday, August 1, 2013

U.S. Company Pensions in Peril?

Benefits Canada reports, S&P 500 company pensions see record shortfalls:
Last year, S&P 500 companies posted record shortfalls in their pensions and other post-employment benefits (OPEB), threatening to leave America’s future retirees empty-handed.

Despite double-digit gains in the markets in fiscal year 2012, the underfunding of S&P 500 pensions climbed to $451.7 billion—up from $354.7 billion in 2011 and $245 billion in 2010, according to a report by S&P Dow Jones Indexes.

OPEB shortfalls also ballooned to $234.9 billion in 2012, compared with $223.4 billion in 2011 and $210.1 billion in 2010.

As a result of the growing gap, the funding status of company pensions fell to 77%. The OPEB funding status was significantly lower—22%.

“The double-digit equity gains of 2012 were no match for the artificially low interest rates, which vaulted pension liabilities into record underfunding territory,” says Howard Silverblatt, author of the report and senior index analyst with S&P Dow Jones Indexes.

While this trend, for the most part, spares current retirees in the United States, it jeopardizes the retirement prospects of those who are still working.

“The American dream of a golden retirement for baby boomers has dissipated for most,” Silverblatt explains. “For baby boomers, it may already be too late to safely build up assets, outside of working longer or living more frugally in retirement.”

He says younger workers need to start saving early, so they can have time to compound their returns. “Corporations have shifted the responsibility to them, and if they don’t step up now, they won’t have anything for retirement,” he warns.

The S&P Dow Jones Indexes report also shows that estimated pension return rates have been falling for 12 consecutive years. They tanked to an estimated 7.31% in 2012, 7.60% in 2011 and 7.73% in 2010.

Discount rates have been on the decline, too. They fell to 3.93% in 2012—down from 4.71% in 2011 and 5.31% in 2010, significantly increasing projected obligations.
Jeff Cox of CNBC also reports, Company pensions in peril as shortfalls hit record:
Young workers may want to start counting on something other than company pensions to fund their retirements.

It turns out that the plans of S&P 500 companies are underfunded to the tune of $451.7 billion, a number that has grown some 27 percent in just the last year alone, according to data released Wednesday by S&P Dow Jones Indices.

While firms have plenty of cash to cover older workers currently on the payroll or in pension plans, that may not be the same once the younger generation gets ready to stop working.

"The good news for current retirees is that most S&P 500 big-cap issues have enough cash and resources available to cover the expense," Howard Silverblatt, senior index analyst at S&P Dow Jones Indices said in a report. "The bad news is for our future retirees, whose benefits have been reduced or cut and will need to find a way to supplement, or postpone, their retirement."

Pension underfunding has been a persistent problem for corporate America for years.

Though many workers have switched to 401(k) plans over the years, pensions still have far more workers—91 million to 51 million.

The combination of poor investment choices along with low interest rates have pushed "pension liabilities into record underfunding territory," Silverblatt said.

This year actually was supposed to be better for pensions under an accounting trick Congress approved in 2012.

The move would allow corporations to use a 15-year average of bond yields, rather than the current level, to calculate their obligations.

However, even that didn't work.

Pension return rates fell for a 12th straight year in 2012. slipping to 7.31 percent from 7.6 percent in 2011 and 7.73 percent the year before. That performance has been triggered by falling discount rates, which dropped to 3.93 percent in 2012 from 5.31 percent just two years before.

A number of companies have tried to reach settlements with employees to reduce their obligations, a process known as de-risking.

General Motors, Ford and Verizon Communications all took significant measures, including offering lump-sum payments and annuity purchases for former vested participants and retirees, according to consultant firm Milliman, which measures the obligations of 100 companies.

The firms included in the Milliman 100 reduced their burdens by $45 billion, but were still left overall with a record shortfall.

GM, for instance, reduced its obligation by $30 billion but still had a $111 billion deficit.

While Fed policies of near-zero interest rates and $85 billion in money creation each month have helped boost the S&P 500 stock index, pension-burdened companies have been hammered.

"Because the Federal Reserve has announced that it plans to keep interest rates low through 2014 (and perhaps longer, until the overall unemployment rate reaches 6.5 percent), there is little expectation that rising discount rates will contribute to improvements in the funded status of the Milliman 100 pension plans," Milliman said in a report.

S&P's Silverblatt said young workers should be paying attention.

"For baby boomers it may already be too late to safely build up assets, outside of working longer or living more frugally in retirement," he said. "For younger workers, they need to start to save early, permitting time to compound their returns for their retirement. Corporations have shifted the responsibility to them, and if they don't step up now, they won't have anything for retirement."
The report, "S&P 500 2012 Pensions and Other Post Employment Benefits (OPEB): The Final Frontier," can be accessed in full by clicking here.

The report confirms that company pensions are not in good shape and if the trend continues, it will indeed be the final frontier for pensions and other post employment benefits, especially for younger workers.

In my last comment, I discussed how Ford and GM are climbing out of their pension abyss, derisking their plans by closing off their plans to new participants, offering lump-sum buyouts and shifting to more conservative investments. They are not out of the woods yet but have taken significant steps to address their pension liabilities.

Other U.S. companies struggling with their pension obligations are also looking at ways to derisk their plans. As mentioned in an excellent article which appeared in CFO magazine back in April, The Great Pension Derisking, companies are getting serious about derisking their plans as they recognize the need for a more permanent solution that does not put their business at risk to another market downturn or drop in interest rates.

But as grim as the situation is, it's important to understand that pensions are long-term commitments and the funded status will gradually improve if the economy improves and rates continue to rise.

This last point was underscored by the Washington Post's Jill Aitoro in her article, A slow return to the days of the pension surplus? Defense contractors are cautiously optimistic:
As interest rates go up, defense contractors offer this positive spin: Pension liabilities could go down, easing employees’ anxiety about the future of their retirement benefits and freeing up some of the billions of dollars these companies contribute each year to keep up with plan obligations.

Executives from both Northrop Grumman Corp. and Lockheed Martin Corp. addressed during calls with investors this week the potential impact on pension obligations of the rising interest rates. In June, interest rates stood about 75 basis points above the estimated 4.5 percent rate assumed at the end of 2012.

“Higher interest rates could improve our funded status to around 90 percent or so, from the 83 percent level that we had at the end of last year,” said Northrop chief financial officer James Palmer during an investors’ call Wednesday.

Because pension payouts run so far into the future — 60 to 70 years to cover the lifespan of all participants — a company’s plan must predict how much it needs in the short term to cover future payments. That’s done by using an assumed discount rate based on the interest rate of fixed-income securities. The lower the discount rate, the higher the assumed pension obligation. In recent years, low interest rates have caused obligations to skyrocket, which has been a major drag on earnings for defense contractors.

To put the increase in perspective, for every 25 basis point change in the discount rate, Northrop’s pension expense goes down $65 million, and Lockheed’s $145 million. According to Mercer LLC, a New York City-based financial services consulting firm, the funded status of S&P 1500 companies' pension plans reached 88 percent at the end of June, compared to 74 percent at the start of the 2013. It’s the highest level since October 2008.

"The defense industry is subject to the same challenges as the S&P 1500, and recent market moves will have helped funded status in that sector,” said Nick Davies, a Mercer principal, who noted that companies should take into account long-term strategic corporate finance goals, as well as shorter term market conditions.

Indeed, companies do take a hit from higher interest rates as well. As Palmer noted, they also reduce returns on the fixed income and international portions of the investment portfolio.

“Pension assumptions are set at the end of the year. And if we look back into the past, a lot can change between now and then,” Palmer added.

Northrop has paid $543 million toward its pension in the first half of fiscal 2013, while Lockheed has paid $1.5 billion in pension contributions to date, meeting its annual requirement set by the federal government.

Unfunded pension liability for defense companies remains high. According to their most recent earnings released this week, Northrop Grumman Corp. carries $5.43 billion on the books, for example, and Lockheed Martin Corp. $14.78 billion. Those totals are always subject to change as well, noted Lockheed chief financial officer Bruce Tanner on a Tuesday conference call with investors.

“Overall, if we were to set the market today, we would expect to have a positive adjustment” if interest rates held, Tanner said.

Tanner noted, however, “I would remind you that between now and the end of the year, we typically do sort of accrual settings that look at the current population of employees to see what has changed."

One of the bigger changes we're watching [for] is a new sort of standard mortality rate. From a good news perspective, all of us are going to live longer… from the bad news perspective, it says liabilities are likely going to be increasing per pension. So that will have a bit of a mitigating effect.”

A year ago, Moody's Investors Service claimed in a report that because certain defense contractors have large pension obligations relative to their market capitalization, they're good candidates for selling their pension plans to annuity firms.
Finally, while this comment focuses on U.S. companies, DBRS notes many Canadian companies have pension deficits that have fallen in the 'danger zone'. Here too, the situation isn't as dire as the media makes it out to be but the reality is low rates and longer life spans are driving pension liabilities higher, placing pressure on companies to respond.

Below, Verne Sedlacek, Commonfund president & CEO, discusses the problem of underfunded pensions, and why it will continue to be an issue for the next decade.