Hidden Liabilities: Pension Plans

The recent market decline along with population demographics posts huge liabilities to corporate America. The defined benefit pension plans will face severe underfunding due to the decline in financial assets coupled with the fast approaching retirement of baby boomers. These hidden liabilities will pose serious issues to valuations and must be accounted for when valuing a potential investment.

Consider this, as the baby boomers start to retire en masse, beginning in 2010, you could see combined pension and health-care costs representing a huge percentage of total gross domestic product. In 2008, companies and their employees have seen their pension assets plummet by some 40-50%. The pension deficits in the S&P 1500 companies have reached $409 Billion by the end of 2008, down from some $100 Billion in mid 2007. And most plans are underfunded by 25% (Source: Washington post).

In a bull markets the problem of pension plans are forgotten due to high rate of return will ensure that companies do not have to contribute to their plans. However, in a declining markets such as this one and in the prospect of deflation in financial assets, corporations who will underfund these plans significantly introducing large debt onto their balance sheets.

Corporate America used aggressive assumptions in its pension plan calculation (aggressive assumptions like high rate of return and high discount rates tend to reduce liabilities and cash contribution by corporations). I dislike seeing assumed rate of returns around 9-10% but many corporations used these figures in good times and was supported by their actuaries, Now these assumptions will be tough to pass the mustard sort of speak.

Moreover corporations used favourable market conditions to be aggressive in their assets allocations. Many have increased equity exposure to more than 50% of the plan assets. No doubt to lessen their expenses and boost earnings. Now these with larger exposure to equities will have pay dearly.

The problem gets worse for corporate America. The increasing life expectancy of people will compound its liabilities. In the old economy, the average employee would work for the same
company for 35 years. In their pension calculations, actuaries of pension plans would make the assumptions that male and female workers would retire at 65, and the majority would die by 68 and 72. Now actuaries of these same plans need to factor in that today a minimum of 10% of all
male pensioners will live beyond 91, and female pensioners beyond 94.

I always looked at reasonable assumptions from the companies I own. What are reasonable assumptions? The most important one is the assumed long-term annual rate of return to be around 5.5-6.5%. That is the big one. Then you go down the line to the discount rate used to calculate net present value of the benefits, in this case the lower the better. Other assumptions to pay attention to is the salary and benefit increases is an important one.

The implication is to look for companies with conservative assumptions about their plans. Look also for their asset allocations. Plans that have larges percentage of its assets in debt are much better than those with more tilt towards equities. Conservative assumptions about their pension plans will translate into lower cost of debt and more capital structure flexibility.
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PS. for good overview of the subject see this primer.