The Great Pension Debacle – Relief May Finally Be In Sight

As of mid 2013, investors and the public are well aware of the pension woes faced by most large North American companies, as well as by governments.

Many defined benefit pension plans began to accumulate large deficits because of stock market losses in the “tech wreck” of 2000 through 2002. And (as I predicted in my original 2003 article) despite the relatively strong Canadian stock market of 2003 through 2007 many pension deficits remained very large as of 2008. At that point pensions were walloped by the stock market losses of the financial crisis. If that was not bad enough pension liabilities have soared throughout the 2000’s as interest rates dropped.

Corporations have also had to deal with accounting rule changes that have required pension deficits to be recognized on their balance sheets.

As a result of all of these pension woes many companies have closed or eliminated their defined benefit pension plans. Those that remain have generally increased contributions dramatically.

Pension deficits result when pension assets are less than the pension liability. Pension assets are of course the value of cash and stocks and bonds that the pension fund has accumulated. A pension liability is the amount needed to fund the future pensions assuming the amount is invested at some expected rate of return. In order to be conservative the pension liability calculations for corporations (government plans have different rules) assume that all of the money is invested to earn interest in relatively safe high-grade corporate bonds.

The resulting pension “liability” (and therefore the pension deficit) is arguably significantly over-stated since in reality the corporation fully expects to earn the higher returns associated with a mix of bonds and equities and therefore a smaller amount of assets would turn out to be sufficient to fund the pensions.

Stock market crashes have led to pensions assets that have grown far less than expected. Lower interest rates have been at least equally problematic because lower interest rates lead to an increase in the pension liability as they lower the assumed return on pension assets.

However, ss of 2013 many of the defined benefit pension plans that remain have started to turn the corner. Pension deficits are beginning to decline due to higher contributions, strong market returns since 2009 and more recently due to the end and partial reversal of the long period of declining interest rates.

The following is some data on the pension plans of some well known companies as of their 2012 annual reports. This data is from a Dominion Bond Rating Service (DBRS) report.

Example Defined Benefit Pension Fund Data 2012 $millions

Company Funded Status Assumed Return Discount Rate Employer Contribution Pension cost recognized
Canadian National Railway Company 97% 7.25% 4.15% $833 $( 9) (benefit)
CIBC 95% 6.3% 4.6% none 125
Canadian Oil Sands Trust 62% 6.5% 4.0% 100 75
Caterpillar Inc. 69% 8.0% 3.7% 580 512
Coca-Cola Company 78% 8.25% 4.0% 1056 241
Dupont 67% 8.6% 3.89% 203 832
General Mills 87% 9.5% 4.85% 222 29
H.J. Heinz 107% 8.2% 4.8% 23 25
Intel Corporation 39% 5.0% 3.9% none 210
IBM 94% 8.0% 3.6% none 507
J.C. Penny 100% 7.5% 4.2% 22 353
Loblaw Companies 85% 5.75% 4.0% 154 60
Moody’s 47% 7.85% 3.8% 21 29

Most pension plans remain under-funded. DBRS found that almost 50% of pension plans are at least 20% under-funded. Only 5% were in surplus.

Many pension plans operate on the assumption that they will earn 7.5% to 8.5% (or more) on their combined stock and bond portfolios, after expenses. These assumptions seem too optimistic. This is particularly the case if 40% or so of the assets are in bonds where average yields to maturity would be under 4%.

Some companies have been reporting unrealistically low pension expenses. For example, in my opinion, it defies common sense to see that CN has reported a pension benefit (as opposed to expense) of $9 million in 2012 while actually contributing $833 million. The reported pension expenses for CN seem sure to rise materially. In the meantime CN shows its “excess” pension contributions as a pre-paid asset. A number of the examples above similarly are reporting much smaller pension expenses than the actual cash they are required to contribute. In part, this may be due to overly conservative pension rules that require large cash contributions to attempt to make up short-falls within a few years even while accounting rules allow the deficit to be accounted for much more slowly.

Over the past few years, companies have raised their pension contributions substantially and this has lowered their profits to some degree. That may continue for some years yet.

What is next for pension plan deficits?

Plan assets should grow with good returns in 2013 due to the strong U.S. equity markets. To some extent this will be offset by weak returns in fixed income investments. (And, in Canada by weak equity returns).

Plan liabilities may decline or not grow as much due to interest rates that have increased materially in 2013.

Fixed income investments are at risk for losses if interest rates continue to increase but overall the impact on funded status would likely be positive.

Updated mortality tables may soon come into place that will add to liabilities and worsen the liabilities and funded status.

Towers Watson provides a model pension that is 60% equities and 40% fixed income. The funded status of this model pension fell from 100% in year 2000 to just 56.1% at Q3 2012. My understanding is that the model pension would not have reflected the higher contribution rates of most actual pension plans. The good news is that the funded status of the model pension has increased in each of the last three quarters and now stands at 62.2%.

Overall it appears that the worst is finally over for pension shortfall levels and that the funded status will likely continue to improve

A possible solution to pension deficits?

Some observers blame pension deficits on the inherent uncertainty of predicting stock market returns. (These people may not have noticed that in reality today’s incredibly low interest rates are the prime contributor to pension deficits). One solution proposed is for pensions to invest strictly in bonds and avoid stock investments. Incredibly then this solution proposes to solve the deficit problem which was caused to a large degree by low interest rates on bonds by restricting investments to only bonds!

Better Solutions

In the long-term corporations are wise to get out of the business of guaranteeing pensions and other post-retirement benefits of workers. Such guarantees amount signing a blank cheque. These defined benefit plans should (if possible) be essentially contracted out to large insurance companies who are in the business of managing such risks. Otherwise, if corporations cannot contract out their defined benefit pension plans then I believe that they would be wise to convert to defined contribution type pension plans.

That would be unfortunate because the pooling of longevity risk that is inherent in defined benefit plans is a major benefit. DC plans need to plan for maximum life-spans whereas DB plans can plan for average life-spans.

If there is any hope of funding pensions at a reasonable cost, then pensions will have to continue to invest a significant portion of their assets in stocks. After all, stocks are expected to return more than bonds.

For existing pension plans the expected returns on plan assets as well as the discount rate assumptions need to be realistic. The accounting rules may need to be changed. It seems overly conservative to calculate pension deficits on the assumption that all plan assets would be invested in bonds, this accounting requirement may need to be challenged.

END

Shawn Allen, P.Eng., MBA, CMA, CFA

InvestorsFriend Inc.

September 28, 2003 (revising earlier and prescient versions of June 15, 2003 and December 10, 2005)