Delta was far from the first corporation to be hamstrung by a turnaround in pension funding status, but the price exacted by investors was a portent of things to come. The shakiness of the Atlanta-based airline’s core business made it keenly sensitive to a deterioration in its balance sheet, yet the fundamental forces Delta confronted in September—a perfect storm that combined a 40-year low discount rate that ratcheted up pension liabilities and a precipitously declining equity market that savaged pension asset values—are threatening all but the most overfunded of America’s defined benefit plans. The result is that, as the year-end nears, a plethora of American corporations will announce reduced earnings, looming significant pension contributions to preclude drastic funding shortfalls, adjustments to shareholder equity, and breaches in loan covenants. The question that remains is to what extent this rush to funding and the concomitant hits to earnings will color the future of defined benefit plans—not only how they invest, but also whether they will continue to exist at all.
“Plan sponsors, like it or not, now find themselves at the capital allocation table, alongside the corporation’s business units, and that’s a place they haven’t been for a decade and don’t want to be now,? says Derek Young, senior vice president of strategic services at Fidelity Management Trust Company. “Defined benefit plans have shifted from a profit center to a cost center—this will increase the firm’s overall cost of capital, and that is negative both for the market and for the future of defined benefit plans.?
Health Factor
The fact that the health of American pension funds is now a factor in stock market performance is far from novel. As recently as 2000, many corporations were able to bolster their earnings significantly from overfunded plans, and the market, obsessed by earnings growth, seemed oblivious to the origins of these earnings. General Electric and IBM in particular proved able, in some years, to generate more than 10% of pretax earnings from their pension plans, according to FitchRating analysts Chris Struve and Mark Oline; a Morgan Stanley analysis in July 2002 reckoned that the operating income of Standard & Poor’s 500 companies was overstated by 5.3% in 2000 and 7.2% in 2001 “as a result of assumed returns on net assets of defined benefit pension plans.? However, the combination of soaring liabilities and an abysmal equity market have ended the free lunch—with a vengeance.
Arguably, current accounting rules overstate corporations? current pension shortfalls: The present value of future pension benefit payments has skyrocketed largely because corporations are required to mark their pension obligation to market using what are 40-year-low interest rates. To complicate matters further, these numbers are not set in stone. “Unlike a straightforward debt obligation, there are all kinds of estimates that have to go into the measurement of the value of the liability,? says David Blitzer, managing director of Standard & Poor’s. “It is always a guesstimate.? However, the accelerating effect of the discount rate—however artificial—cannot be dodged: According to a recent Merrill Lynch study, the average pension of an S&P 500 company could be underfunded by end-2002 to the tune of $323 million, a stark turnaround from an overfunded position of about $500 million at end-2001.
This storm did not
emerge without warning, but the confluence of forces now
in evidence is unique in the history of Employee
Retirement Income Security Act funds. The sustained
downturn in the equity markets, shaving double-digit
declines out of pension funds that are heavily
equity-oriented, has not been seen in a generation. The
basement-level discount rate is likewise an aberration.
These twin evils will ensure that 2002 will be the
“worst year on record? in terms of the growth rate
differential between pension assets and liabilities,
says Ron Ryan, president of New York City-based Ryan
Labs. In the year to date, says Ryan, liabilities have
outpaced assets by 36.5%. “This is the largest financial
problem that
Few corporations with defined benefit plans—and that means about two-thirds of the Fortune 500—are immune to this pressure. The poster child is General Motors, which has been famously described as a company that exists primarily to fund its pension obligations, but GM’s dilemma is far from singular. Many corporations have substantial pre-paid pension assets on their books and, under Statements of Financial Accounting 87, when the market value of those assets on a particular measurement date (and year-end is such a date) is less than the accumulated benefit obligation of the pension fund, that pre-paid asset needs to be reversed and an additional liability booked. For some companies, a portion of the additional liability is recorded as a reduction in shareholders? equity—these companies will face challenges with both their lenders, who tie loans to debt-to-equity ratios, and with their bondholders. In short, companies now may face much larger pension contributions than would be required by either the minimums laid down by ERISA or the variable-rate premiums set by the Pension Benefit Guaranty Corporation. “Perhaps the only positive thing about this situation is that so many corporations will be making these cash infusions to their pensions that I don’t see individual corporations being punished by the stock market,? says Ken Steiner, the resource actuary for Watson Wyatt Worldwide in Washington.
Being Optimistic
Steiner’s view might
prove sanguine. Yet, what is not in
dispute is how broad the problem is. Accounting rules
and a seemingly irrepressible stock market encouraged
the systematic decoupling of pension assets from
liabilities over the last two decades—pension funds rode
the equity boom and surplus assets were used to offset
service cost and pension contributions. “Basically,
corporations have, for decades, been taking two
considerable risks with their pension funds,? says
Michael Peskin, who heads the global asset liability
effort at Morgan Stanley in
It is now clear that risks gone sour no longer can be hidden deep in company annual reports. Just 14% of large corporations with defined benefit plans made contributions in 2000, according to estimates from Watson Wyatt, but, according to a mid-2002 study on pension funding and liabilities—sponsored by Fidelity Investments and PLANSPONSOR—spanning 200 large corporate plans, fully 70% anticipated that they would be making a contribution to their plans this year.
“There are no easy outs now,? says Dan Fuss, vice chairman of Loomis, Sayles & Company, who has spoken for decades to the changing dynamics of defined benefit plans. “Terminating or immunizing a plan is cost-prohibitive right now; changing plan structures risks employee antagonism and even a move to unionize; and the only other route open is a big charge to earnings—that’s unpalatable, but it is the best option.? Fuss, who is sanguine on corporate earnings in the short term, believes that the pension charge will be offset somewhat by positive income from operations, but he does believe that the volatility associated with defined benefit plans will come home to roost. “The nature of corporations is changing, and the social nature of the employment contract is changing with it,? says Fuss. “No one should be taking defined benefit plans for granted.?
The increasing scrutiny
by corporate CEOs and CFOs of defined benefit plans,
exacerbated by the present volatility of these huge
pools of money, comes at exactly the time that the first
cracks in the great defined contribution experiment are
likewise becoming patent.
Plan redesign, however, is easier said than done, but moves are afoot to do exactly that. “In non-negotiated situations, the present funding problems will accelerate the movement to hybrid plan designs like cash balance,? says Dallas Salisbury, president and chief executive of the Washington-based Employee Benefit Research Institute. “It is also likely to accelerate the movement to lump-sum distribution options, since they are generally included in hybrid designs.?
To
In fact, a rash of
hybrid plans have already been established, and lump-sum
payouts are evident everywhere. Even public funds—most
recently the State of
So, what’s a plan sponsor to do? To a great extent, as EBRI’s Salisbury observes, the rapidity of the turnaround—in 18 months, in some cases, plans have gone from substantially overfunded to underfunded—has precluded the option of making intelligent changes to plan design or asset allocation while the plan was still well funded. While plan design changes at a 30,000-foot level are beginning to occur, the mismatch between defined benefit assets and liabilities remains very much in place. For decades, corporate plans have sought return in the equity markets and, even now—with the cost of an underfunded plan so prohibitive in terms of corporate earnings—few chief investment officers are showing any appetite to switch into bonds. “Right now, there’s a real reluctance to give up on the long-term promise of equities,? says Maarten Nederlof, managing director of the pension strategies group at Deutsche Bank Securities.
Consequently, asset allocation strategies have stayed remarkably constant despite the funding turmoil. While investment banks say they are fielding increased interest from institutional clients in hedging solutions of various types, the Fidelity/PLANSPONSOR Pension Funding and Liabilities Study shows that only 12% of the funds surveyed are using immunization or hedging techniques to remove variance between assets and liabilities; likewise, as many as 80% of the plans surveyed would not change their strategic asset mix in the event of a funding shortfall.
However, pension strategists say that the present pension turmoil will leave its mark. “To the extent that the pension fund was not part of general corporate risk management, those days are over,? says Nederlof. “The fact is that most pension assets don’t hedge pension liabilities that well, and the risk inherent in that mismatching is catching CFOs? attention.?
Peskin goes one step further. “It might well be that chief investment officers at plans would like to keep their world exactly as it is, and focus largely on assets,? says Peskin, “but CEOs/CFOs are going to look at this differently, and their tolerance for risk is going to be considerably reduced. There will be much more focus on risk and risk control.?
That inevitably will lead over time to more investment in bonds and, where the risks can be measured, into alternatives. Few funds, however, are likely to follow the outliers like Tacoma, Washington-based Weyerhaeuser, with its massive exposure to hedge funds, or British drugstore Boots, which in midyear divested itself of its entire equity portfolio for a 100% fixed-income allocation. “Conviction to long-term strategic allocations is always tested in these types of market environments,? says Fidelity’s Young. “Long-term views may clash with short-term cash environments.?
Beyond even asset allocation is the larger question of where defined benefit plans fit into a world where a multiplicity of forces are aligning themselves against a guaranteed retirement income approach. “This is a death knell for many defined benefit plans,? says Tom Healey, senior fellow at Harvard’s Kennedy School of Government and an advisory director at Goldman Sachs. “CFOs are going to more aggressively seek to reduce their exposure to this type of liability and hand it off to employees.?
Ultimately, this becomes
a societal dilemma—underfunded public plans will seek
refuge in tax increases, and corporations will shift to
less expensive and hence less secure retirement
solutions. A CIGNA Retirement & Investment Services
forum last month in