It is not uncommon to read about very large companies taking non-cash charges associated with their defined benefit plans – UPS $3 billion, Boeing $3.1 billion, Ford $5 billion…
A defined benefit pension program is a retirement plan funded by the employer, which promises a monthly benefit to the employee upon retirement. Contribution amounts are based on a benefit formula which takes into account employee income, age and years of service. Simply stated, employers set aside an amount today that is expected to grow over years, to be able to satisfy a future commitment. If you have ever discounted cash flows, you know that low interest rates will slow the projected growth of the dollars set aside.
It is these low rates that are a primary cause of a trend in under-funded pension liabilities. “Defined benefit pension assets for S&P 500 Index companies increased by $113 billion, from $1.11 trillion to $1.22 trillion, while liabilities increased $174 billion, from $1.39 trillion to $1.56 trillion. The median corporate funded ratio is 76.9%, which represents a modest decline from 77.7% last year.” (94% of Pension Plans Underfunded: Wilshire, by John Sullivan, AdvisorOne 04.11.2013)
While the goal should be to have a funded ratio of 100%, rating agencies use this statistic as a factor in judging the soundness of programs. The scale is as follows – Strong Funded Ratio >= 90%; Above Average > 80% but < 90%; Below Average > 60% but < 80%; and Weak <= 60%.
Based on this rating scale, on average, defined benefit pension assets for S&P 500 Index companies are below average.
In response, companies are setting aside large sums of money to fund programs, rather than invest or issue dividends to shareholders. “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.” (WSJ, Why the Corporate Pension Gap Is Soaring, 02.26.2013)
However, “Pension sponsors can’t sustain having to make large contributions year after year to finance their pension plans; they have to depend also on favorable investment markets and reasonable interest rates to contribute toward funding.” (Pension & Investments, The cost of low rates, 02.20.2012)
A protracted low rate environment will continue to make this pension plan structure a drag on corporate balance sheets for some time. The likely impact will be a further decline in the usage of this pension plan structure. According to the U.S. Department of Labor, the number of defined benefit plans fell 55% from 103,346 plans in 1975 to 46,543 plans in 2010.
Results are similar within the public sector –
According to Morningstar (The State of State Pension Plans A Deep Dive Into Shortfalls and Surpluses) using the rating scale revealed that in 2011, 70% of state pension funds were below average or weak: 7 programs were strong with Wisconsin the strongest. 8 programs above average, 23 programs below average; and 12 programs weak with Illinois the weakest.
The only way to counteract this trend is to enter an environment with sustained, higher rates.
What are your thoughts?© Copyright 2013 Regis Quirin, All rights Reserved. Written For: CFO Tips - What you need to know, to be a CFO TODAY!