The Great Pension Debacle - The Next Shoe To Drop
As of June 2003, investors have been made well aware of the pension woes of many large North American companies.
Many defined benefit pension plans have begun to accumulate large deficits because of stock market losses in 2000 through 2002.
Many pension plans operate on the assumption that they will earn 7.5% to 9.0% on their combined stock and bond portfolios, after expenses. The reality has now generally begun to set in that the return assumptions of many companies are too optimistic and that the stock market will not rise fast enough to eliminate the pension deficits.
Companies will have to increase their pension contributions and pension expenses to eliminate the existing pension deficits even if do in fact earn the 7.5% to 9.0% going forward. And if they lower those return assumptions then they will automatically face even larger pension expenses.
The result will be higher pension contributions for employees and companies and lower profits for companies. In the worst cases the pension plans will suck every dollar of profit out of some companies and even that may not be enough. Some companies will go bankrupt over this issue and the pension plans will be turned over to trustees who will be forced to reduce pension benefits to retirees. A vicious circle may result where newer companies with no pension deficits will out-compete the old-line companies and hasten their demise. Another result is that many companies will stop offering defined benefit pension plans to new employees. They are just too risky for the companies.
As if all of the above was not bad enough, another huge shoe is about to drop. Actually it is more like a heavy boot and it will probably crush many a pension plan when it lands.
This other shoe is the impact of today's dramatically lower interest rates. While the stock market losses have lowered the pension assets, lower interest rates are dramatically increasing the value of the pension liabilities. The result is a double whammy that will see pension deficits absolutely soar. In fact this has already been happening but has not been generally recognized.
Long term interest rates were recently dropping like a stone. The 30 year government bond rate in the United States was 4.2% and in Canada was 4.75%. High quality corporate bond yields were at about 5% for 10 year issues, and this probably represents a reasonable weighted average across the spectrum from short to very long bonds. (Yield figures were as at June 14, 2003). As of July, 2003, rates have recovered somewhat but are still extremely low.
Lower long term interest rates will lead to dramatically higher pension plan deficits. A pension deficit exists if the value of plan liabilities (pensions) discounted at the appropriate rate is lower than the value of plan assets. In Canada, the Canadian Institute of Chartered Accountants handbook at section 3461 requires that the discount rate be based on high quality corporate bond yields with maturities matched to the pension obligations. And guess what? today's dramatically lower high grade corporate bond yields used to discount the future pension liabilities automatically leads to a dramatically higher value of those liabilities. When those higher liabilities are subtracted from the same level of plan assets, voila, you get a huge increase in the deficit. Or you move from surplus to deficit. To demonstrate, imagine that the weighted average liability amounts to $100 million to be paid in 15 years. Discounted at 7% this represents a present value of $36.2 million. But discounted at a lower interest rate of 5.0%, the liability rises to a present value of $48.1 million. This represents a huge 33% increase in the value of the liabilities.
Now, it appears that many Canadian companies have not yet adequately reduced their discount rates for pension liabilities. For example CN has used 6.5% for each of the last three years, with no recent recognition of the dramatic decline in long-term interest rates. Canadian Utilities lowered its discount rate to 6.9% in 2001 from 7.1% in 2000. Manulife lowered its discount rate to 6.7% from 6.8%. It appears to me that these companies and their advisors are refusing to fully face the market realities of dramatically lower long-term interest rates. I expect that under the handbook, they have some leeway to use expected corporate bond yields rather than the spot rates at their year-end.
In fairness, using corporate bond yields as the discount rate is conservative. Normally, one might use the (higher) expected return on plan assets as the discount rate. But the Canadian law states that high quality corporate bond yields must be used. So it appears that if interest rates remain at recent very low levels or decline further, companies will be forced to lower their discount rates thereby increasing their pension liabilities.
From the example above, you can see why companies would be reluctant to lower the discount rate. Since the end of 2002, interest rates have dropped a further significant amount. By the end of 2003 many companies may be forced to cut their pension discount rates substantially. If these companies are indeed forced to lower the pension liability discount rates, we will hear this other shoe drop.
So forgetting about the stock market, pension deficits will probably soar with the 2003 annual reports because of the dramatic drop in interest rates and (more specifically) in high grade corporate bond yields.
And there is more bad news. The declining interest rates have actually led to large capital gains in the bond investments held by pension plans. These capital gains have been adding to the pension assets and have hidden the true extent of the unfolding disaster. At some point interest rates must bottom out. At that point the capital gains must abruptly stop. At that point the pension liability amounts will be maximized by the low discount interest rate (high-grade corporate bond yield) used in the calculation. And at that point yields on high grade corporate bonds will be at or below their recent historic lows of about 5% for 10 year bonds.
Now a typical pension plan may have 40% of its funds in bonds. At that point with stocks returning perhaps 7 to 8% and high-grade corporate bonds returning perhaps 5% on average, pensions will have a tough time forecasting more than a 6% - 7% overall average return. This will automatically lead to higher pension expenses and reduced profits.
Most defined benefit pension plans are probably headed for an absolute disaster. When the extent of the damage that will be caused by extraordinarily low long-term interest rates becomes known, the stocks of some of these companies could be hit hard. As an investor I will combat this by generally avoiding investing in large companies that have large defined benefit plans. I will particularly avoid those companies with a high ratio of retired workers compared to active workers. I wish that this shoe was not about to drop - but I really think it will, and I plan to get out of the way!
Shawn Allen, P.Eng., MBA, CMA
June 15, 2003 (Last revised July 1, 2003)
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