Time to Notice Corporate Pension Plans?

Corporate pension plans have been able to hide in plain sight in this past decade of unprecedented asset
returns. While pension plans have generally been well funded throughout 2004 – 2008, record low
interest rates and dismal asset returns in the past 2 years have finally forced companies and the media to
pay much more attention to their pension obligations, and for good reason.

Bloomberg recently reported that “the gap between the assets of the 100 largest company pensions and
their projected liabilities widened by $108 billion in August from the previous month to a $459.8 billion
deficit” (1), and that “less than half the 50 state retirement systems had assets to pay for 80 percent of
promised benefits in their 2009 fiscal years” (4), shocking readers at how poorly funded our pension plans
actually are despite the rebound in the equity markets last year.

When times are good, a fully funded pension plan neither increases a company’s earnings, nor provides a
financial boost to its sponsor, making its financial impact negligible to most companies. However, when
things go south like the 2008 financial crisis, companies are required to not only book extra pension costs
on their financials, but also make extra cash contributions into their pensions when they can least afford
to. It is the financial equivalent of a company selling a put option on the stock market with no definite
maturity date and constant additional collateral requirements, that nobody really pays attention to until it is
too late.

There are 2 sides to pensions, assets and liabilities. Pension assets suffered severe losses in the 2008
market downturn, but have been able to recover most of their losses with the 2009 market rally and an
increase in company contributions. The liability side, however, has not performed as well as most people
would suspect. Corporate pension plans are mandated to value the liabilities based on investment grade
corporate yields, and record low corporate yields have created a spike in pension liabilities that pension
asset returns aren’t able to catch up to.

Composite Indexed Values from

Corporate Funded Status
of 78%
8.50 120.0

8.00 110.0

7.50
100.0

7.00
90.0

6.50
80.0
6.00

70.0
5.50

60.0
5.00
Aggregate Corporate
Yield of 5.16% 50.0
4.50

4.00 40.0
Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10

Pension Liabilities Pension Assets Average Corporate Yields

(Proxy of 40-Year Annuity) (80% Equities 20% Bonds) (Lehman, Merrill and Citigroup
High Grade Bond Index)
As a simple illustration, let’s assume a pension fund was 100% fully funded with asset and liability values
indexed at 100 as of 1/1/2008. According to Towers Watson’s Global Pension 2010 Asset Study (2), the
average pension had an asset allocation of 61% in equities, 19% in bonds and 20 % in other investments
such as real estate, hedge funds and private equity. So an asset portfolio of 80% equities and 20% bonds
would be a good proxy for the average pension asset portfolio, while the average pension liability duration
is somewhere around 15 years, and a 40-year annuity that pays $1 every year (which has a duration
close to 15 years at 6% yields) would be a good proxy for the average pension liability as well.

If we run this asset and liability portfolio through the S&P Index, the Dow Jones Corporate Bond Index,
and the average of Citigroup, Lehman and Merrill Lynch composite corporate yields from 1/1/08 to 9/1/10,
you will notice how asset values diverged from liabilities in 2008 and have since been unable to catch up
to liabilities. This is caused by the long duration nature of pension liabilities, making them very sensitive to
interest rate fluctuations. With an average duration of 15 years, a 100 basis point drop in corporate yields
would increase pension liabilities by around 15% (not including convexity) and would require assets to
return at least 15% to break even.

These data points do not reflect the effects of monthly benefit disbursements, company contributions or
asset allocation changes, and only seeks to explain the high level divergence between pension asset
and liability values given current market conditions.

So how does an under-funded pension plan affect a company?

Companies book their annual pension costs for keeping their staff another year on their income
statement, and are required to make a cash contribution every year as well. If they have a shortfall, they
are required to book additional pension costs and make extra cash contributions to eventually fill the
funding gap, lowering earnings and decreasing free cash flow, while the actual funding shortfall shows up
as a liability on its balance sheet reducing shareholder equity. Below a certain funding threshold,
pensions are also considered “at-risk” and are required to use more conservative assumptions to value
their liabilities, resulting in higher financial costs, with increasingly harsher penalties every year it remains
below that threshold. Hence given a big enough pension obligations relative, a severe pension funding
gap could bankrupt a company. Case in point: General Motors and the airline industry.

Although rarely mentioned, severely underfunded pension plans also exert a human capital costs on the
company as well. Below a 80% funded ratio, retirees aren’t allowed to take out their full retirement benefit
as lump sums, and below 60%, plan participants have to stop accruing additional benefits and aren’t
allowed to take any lump sums at all. Telling your employees that their pension fund is facing benefit
restrictions not only dampens overall morale, but also makes employees question the financial stability of
their company. This is especially important as most new employees are part of a defined-contribution
401(k) plan instead of defined benefit plans. Defined benefit plan participants are usually management
level employees who have served in the company for a long period of time and are highly vested in their
pension benefits. Having managers worried for their future livelihood and retirement income would be an
undeniable distraction at a time when they need to focus the most.

So where were we, where are we, and where will we be?

Pension plans have the discretion to use smoothing methods to value their assets and, to a certain
extent, pick and choose the assumptions they use to value pension benefits which include discount rates,
expected return on assets (which reduces their pension costs), retirement rates and so on, in order to
reduce the volatility in their funded status.

During the market crash of 2008, companies were able to average their asset values over 3 years,
smoothing out their asset losses against their gains from the prior 2 years, and take advantage of
abnormally high corporate yield rates caused by the freeze in the capital markets in valuing their liabilities.
They were able to maintain high funded ratios in their 2009 financial statements and avoid the financial
penalties a pension funding shortfall would have cost them, only through a series of unusual
circumstances. Notice the spike in corporate yields in October 2008 and the drop in pension liabilities that
followed.
In 2009, corporate yields came crashing down as the Federal Reserve set near zero interest rates which
substantially increased pension liabilities. The 30 - 40% asset returns in 2009 cushioned the increase in
pension liabilities but weren’t enough to fully offset the increase in liability. Companies had to record
funding shortfalls on their 1/1/2010 financial statements, forcing them to recognize higher pension costs
on their books and make extra cash contributions into their pension funds. However, the financial impact
was fairly muted as companies were able to amortize their funding shortfalls over 7 years.

Now with 3 months left in 2010, corporate yields have trended even lower from last year while the equity
markets have been hovering between negative and positive territory. The 30-year treasury yield has
dropped from 4.63% to 3.52% while the S&P index has returned only about 1%. Companies with huge
pension obligations are looking at even higher pension costs and cash contributions next year as they
have to recognize their prior year funding shortfall and the additional losses they incurred this year.

The Towers Watson Pension Index clocking in its lowest funded ratio since 1990 at 60.0 as of 8/31/2010
(3)
.

Congress is cognizant of this fact and recently passed the Pension Relief Act which lessens the financial
impact on companies facing substantial pension funding shortfalls by extending the period companies can
amortize their additional shortfalls. Unfortunately, this relief only applies to additional shortfalls incurred in
2009, 2010 or 2011 and only benefits corporate pensions that were fairly well-funded to begin with. It is of
marginal use to pensions who were already severely underfunded to begin with. Furthermore, it comes
attached with conditions such as not being able to pay out excess compensation above $1 million or
issue extraordinary dividends/redemptions to its shareholders, which could cause operational and capital
issues of its own. More information can be found at
http://www.plansponsor.com/Senate_Passes_Pension_Funding_Relief.aspx

The interesting question would be, what would happen to pension funds if the economy double-dips?

In a double-dip scenario, the housing and equity markets would collapse while treasury rates and high
grade corporate yields would depress further caused by a flight to safer assets, translating into lower
pension asset returns and higher pension liabilities. Companies will then have to pony up even more cash
to make up for their funding shortfall in an environment when they need their cash flow the most. Plan
participants who are worried of the plan’s financial health would make a “run on their pension” and take
out lump sum benefits instead of annuities, further depleting pension assets. If the plan sponsor is unable
to make its extra contributions, the pension plan would fall into benefit restrictions (below 60% funded),
which might violate corporate debt covenants that mandate a certain pension funding status or a balance
sheet leverage ratio, giving bond-holders the right to redeem their bonds immediately and potentially
causing a host of liquidity or capital structure problems in a tough market environment. Pension
obligations bankrupting companies would become much more common, unless Congress intervenes and
passes additional pension funding relief laws.

Nevertheless, the pension risk a company holds is only proportional to the size of its pension liability
relative to its balance sheet. A $1 million pension plan company will never bankrupt a $500 million
company regardless of how poorly funded it is. There are several metrics one could use to estimate the
pension risk of a company, such as the ratio of total Pension Obligation to assets or the ratio of cash
contributions to cash flow. The idea is to approximate the potential effect an unexpected change in
pension liability could have on a company’s cash or financial position. A company with pension
obligations making up 50% of its total liability, with 30% of its free cash flow going into pension
contribution should raise red major flags since any negative shock to the pension plan could put the
company in a precarious financial position. It should also be noted that companies in a financial bind often
cut their pension costs first since it’s one of the easiest costs to reduce, which could serve as a first
indicators of a company in financial distress.

While many pension plans have drastically reduced their equity exposure, increased their fixed-income
allocation (which probably played a part in lowering bond yields), and moved into a liability driven
investing framework, it might be too little too late. If a pension plan could bankrupt a company like
General Motors, perhaps it is time to pay more attention to corporate pension plans.

Sources:

1) http://www.businessweek.com/news/2010-09-14/-silent-heart-attack-for-pensions-driven-by-yields.html

2) http://www.towerswatson.com/united-states/research/2750

3) http://www.towerswatson.com/research/972

4) http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=aBmLC0yRt3QY