Corporate Canada’s Pension Hole?
The rock-bottom interest rates and volatile equity returns of recent years have wreaked havoc on many investors’ portfolios — and that includes the managers of corporate pension plans.I went to Veritas Investment Research's site but this report is not available to the public yet. The findings hardly shock me. Bombardier's pension hole is troublesome and unlike other companies (BCE, CP), they have not made significant cash contributions to cover their pension deficit.
Disappointing returns have set up a vicious cycle in which pension plans become underfunded, and the companies that sponsor them have to pump in more money. That cash comes right out of operations, making the companies’ shares less attractive than before.
Investors should take into account the possible effect of the pension gaps that are developing. A good place to start is with a sobering report from the folks at Veritas Investment Research, which examines Canada’s corporate pension plans, focusing on the 45 companies in the S&P/TSX 60 that offer defined-benefit plans.
(A defined-benefit plan specifies what benefits it will pay, leaving the onus on the plan’s sponsors and managers to come up with the cash. Defined-contribution plans only define what goes in, meaning that if there’s not much there for you when you retire, well, tough.)
The report spotlights the large deficits at several of Canada’s largest companies, ranging from BCE Inc. to Bombardier Inc. But its findings range across a broad swathe of the corporate sector.
Veritas found that, despite an increase in cash contributions since the 2008-2009 financial crisis, pension deficits keep rising because of falling interest rates and the “sluggish” returns on plan assets in 2011. Going into last year, the 45 companies combined for a cumulative $10.4-billion pension deficit. By the close of 2011, the shortfall had ballooned to $18.8-billion, an 81-per-cent increase, according to the report’s authors, Dimitry Khmelnitsky and Diana Akmal.
To some extent, you can see the problem in companies’ bottom lines, as they deduct what’s referred to as “pension expense” before arriving at net income each quarter. But the true cost of an underfunded pension is actually worse because, in a quirk of accounting, the cash contributions can and do exceed the expense recorded on the income statement.
Pension expense “materially understates” the cash amount, the Veritas analysts say, as the total cash contributions of the companies they examined – $6.4-billion – were more than double the recorded expense of just over $3-billion.
Now, to be fair, a big part of this problem is record-low interest rates. When pension plans put a value on what they owe their retirees — their total liabilities — they have to count up all the expected future payments and put a present-day value on that stream of cash. To calculate that number, the plans need to use a discount rate. And the way the math works, the lower the interest rate, the bigger the current-day number. (The opposite is true: The higher the interest rate, the smaller the current-day liabilities number looks.)
If interest rates moved upward, a lot of these pension problems would be sorted out. Veritas figures that many of the companies could wipe out their pension deficits if interest rates rose 0.5 to 1 percentage points. Others, with larger deficits, probably need interest rates to rise 1.5 to 2 percentage points.
The problem is that interest rates show no sign of co-operating. They have remained parked near the bottom, year after year.
“Over all, we do not expect a meaningful reduction in deficits by the end of 2012,” the Veritas analysts say. “The prospect of elevated deficits implies that future cash contributions and pension expenses are likely to keep rising for many members of the S&P/TSX 60.”
Who, specifically?
Bombardier, with a $2.3-billion pension deficit, equal to more than one-third of its market capitalization, “is most likely to experience a material hike in cash contributions,” Veritas says.
Bombardier spokeswoman Isabelle Rondeau says the company’s pension numbers represent plans throughout its worldwide operations, and other countries may have less-stringent funding requirements than Canada. Ms. Rondeau adds the deleterious effects of low interest rates on the company’s plan, and said Bombardier has been consistent in putting hundreds of millions of dollars in its plan each year, recently.
Veritas says other companies that “may also face higher than average contribution requirements” are BCE, Canadian Pacific Railway Ltd, Imperial Oil Ltd. and George Weston Ltd. Their pension deficits, as a percentage of their market value, range from about 11 per cent down to about 4 per cent.
BCE and CP both made major cash contributions to their plans in 2011, which means they “should enjoy greater contribution stability” than the others in coming years, Veritas says. “The other companies may face the unattractive prospect of an additional rise in cash contributions over the next few years, assuming no change in discount rates and asset returns.”
Unattractive, indeed, given how long pension managers have been waiting for good, consistent news on discount rates and asset returns.
There are other issues at corporate pension plans. There is a significant dispersion of talent among corporate pension fund managers in Canada and even some of the best are struggling in this environment. For example, CN Investment Division, widely regarded as the best corporate plan in Canada, has had a tough time adapting to the post-2008 environment. Still, their defined-benefit pension plan remains in great shape because they took it seriously over the years, properly managing it and topping it up.
Air Canada's pension division changed their staff a few years ago and are doing a much better job now of managing assets and liabilities. Problem is the pension staff inherited a mess and the company neglected to top up the pension plan for years, which means their deficit has grown significantly as interest rates fell.
In fact, Reuters recently reported that most major Canadian pension plans are underfunded:
All but 7 percent of Canada's federally regulated, private defined-benefit pension plans were underfunded at the end of 2011, the government's Office of the Superintendent of Financial Institutions reported on Friday.I'm certain the situation has improved in 2012 but not by much. Assets have risen but interest rates remain near historic lows and unless we get a major backup in bond yields, which will cripple the overleveraged Canadian consumer, I don't see any material improvement in corporate Canada's pension hole.
An underfunded plan is one in which liabilities would exceed assets and employees or retirees would not get all that was promised if the company were terminated.
OSFI's annual report for fiscal 2011-12 showed that the proportion of those plans that were underfunded had risen to 93 percent on December 31, 2011, from 76 percent at the end of 2010.
Employers have struggled with yawning pension gaps on their defined-benefit plans - under which employers commit to regular pension payments regardless of what stock markets may do - due to historically low yields on investments. This has caused some like Air Canada to seek adjustments and concessions.
Air Canada, the country's largest airline, had separately revealed that its pension deficit had doubled to C$4.4 billion ($4.5 billion) during 2011, and it is trying to get a cap on its payments extended from 2014 to 2024.
Private pension plans under federal regulation registered a 4 percent return on their investments in 2011, down from 11 percent in 2010 and 13 percent in 2009, OSFI said.
OSFI supervises 1,354 private pension plans covering 646,000 employees in federally regulated areas including banking, inter-provincial transportation and telecommunications. Of these, 358 are defined benefit plans, covering the vast majority of assets in the federally regulated plans.
"Although the impact of lower solvency ratios on pension plans' funding requirements will be moderated by recently implemented changes to federal funding rules, OSFI expects many defined benefit pension plans to face materially higher required contributions in 2012," it said.
The number of plans on OSFI's watch list - the ones for which it has serious concerns - more than doubled to 115 at the end of March 2012 from 49 a year earlier. Of these 115 troubled plans, 104 are defined-benefit plans.
The average estimated solvency ratio - the ratio of assets over liabilities if a plan were terminated - of the defined-benefit plans it supervises declined to 0.81 on December 31, 2011, from 0.93 a year earlier.
The situation in the US and UK isn't any better. TIME magazine recently covered America's pension funding problem, noting the following:
Finally, corporate pension plans are in the red as well. More than two-thirds of the companies that make up the S&P 500 have defined-benefit plans, and as of last quarter only 18 of them were fully funded. Seven had shortfalls of more than $10 billion apiece, according to the New York Times. All told, the unfunded liabilities add up to around $355 billion, or about 22% of the funds’ promised benefits. Moreover, recent legislation has allowed companies to use higher (and more optimistic) return assumptions. In the very short run such changes take financial pressure off troubled companies and also boost corporate income tax revenue for the government by reducing deductions. But in the long run the deficit is increased and eventually has to be paid.
All together, those unfunded pension liabilities add more than $2.5 trillion to America’s $16 trillion Federal debt and $2.8 trillion state and local debt. Just as it is vital to reduce government deficits, it will eventually be necessary to bring down this pension funding deficit. One way would be to slash retirement benefits by 20%. Another would be to force employees to pay an additional 5% of their salaries toward such benefits. Or taxpayers could cough up the money, bailing out pension funds as they get into trouble. Switching everyone over to defined-contribution plans, such as 401(k)s, would eventually solve the problem as far as young workers are concerned, but would still leave a huge unfunded liability for those approaching retirement.And the Telegraph reports, Deepening pension deficit is leaving many UK companies staring at the abyss:
JLT Pension Capital Strategies has released figures which show the total deficit of FTSE 100 defined benefit pension schemes has increased by two thirds in the past year.Yes, face up to the fact that the corporate elite have managed to kill defined-benefit plans through years of neglect and outright theft, and now they're shifting the retirement onus entirely onto workers, effectively condemning them to pension poverty.
The consultancy said the total deficit stood at £55bn on June 30 compared to £33bn a year earlier.
Eleven FTSE 100 companies have pension liabilities that are greater than their equity market value; BAE Systems, BT and RBS are committed to paying out pensions that are worth more than double their market value.
The deepening deficit hole has been caused by factors including poor returns on equities and the Bank of England’s quantitative easing programme, which pushes up the price of government gilts, creating lower returns for pension funds.
The deficit figure is down from £73bn in March, largely thanks to a slight rally in the corporate bond markets through which pension liabilities are measured, but the FTSE 100 have been in a “big deficit zone for quite a long time,” said Charles Cowling, managing director of JLT Pension Capital Strategies.
“We have reached the stage where scheme deficits are widening substantially on an annual basis,” he said.
Blue-chip companies are trying to plug the gap with capital injections while looking for alternative sources, such as property investment, to fund their pension schemes.
If the FTSE 100 companies are staring into an abyss, smaller companies are going bust on a regular basis because they can no longer finance their pension schemes.
“Mortality rates are improving at a rate of five hours a day,” said Mr Cowling said. “That’s great news to us as a nation, but if you’re the person that’s got to pay out the pension, that represents a lot more you’ll have to pay.”
Companies have generally shifted towards defined contribution pension schemes, where a company makes contributions or matching contributions to a pension but doesn’t guarantee future payments to the employee, as they can’t afford defined benefit schemes where the employee has a fixed amount guaranteed on retirement.
“We have to face up to the fact that DB’s gone and DC’s coming,” said Mr Cowling.
Let's get one thing straight, shifting workers to defined-contribution plans is not a solution to the retirement crisis, it will make things much worse. If you don't believe me, have a look at America's 401(k) nightmare.
Below, Reuters Columnist James Saft says one of the overlooked victims of the fall of interest rates are corporate pension plans which are facing a ballooning liability even as returns stay tepid. (Transcript).