Analysis: Pension shortfalls a stark corporate challenge
NEW YORK (Reuters) - With worries about the debt crisis in Europe and high unemployment in the United States drawing the public's attention, the sliding value of corporate pension funds has largely gone unnoticed.
The problem came into stark relief on Wednesday, when Boeing Co joined a raft of U.S. companies that have announced hefty cash injections into underfunded pension plans, including General Electric Co, DuPont, Alcoa Inc, Honeywell International Inc and Raytheon Co.
Boeing said it would add $1.5 billion in cash to its pension plan in 2012, nearly triple the amount it injected in 2011. The huge jump caused the aircraft maker's full-year earnings forecast to miss Wall Street estimates.
Analysts say pension top-ups will take a big bite out of corporate earnings this year, due to more rigorous funding requirements and an erosion of investment returns caused by weak stock markets and low interest rates.
Of the 341 companies in the S&P 500 index with defined benefit pension plans, 97 percent are underfunded, according to a Credit Suisse analysis. Despite generous contributions last year, Credit Suisse estimated the plans' liabilities at $458 billion at the end of 2011, an 86 percent increase from a year earlier.
"This level of underfunding is something, at least in the time that we've been following the issue, that we haven't seen," said Credit Suisse analyst David Zion, noting that the 2011 estimate is nearly three times larger than underfunding in 2002, after another U.S. recession.
Large pension contributions are an immediate hit on cash flow, diverting money from shareholder dividends, stock buybacks and capital investments. (Click here to see a graphic that compares a selection of pension obligations against cash positions: r.reuters.com/zyd36s)
The brunt of the pain will be felt by manufacturers and other large industrial companies, which have legacy pension obligations and older workforces, analysts say. Many companies have done away with pension funds in recent years, moving to 401(k) retirement plans, which are funded by employee contributions and in many cases a company match.
Credit Suisse singled out seven companies whose estimated 2012 pension contributions likely will exceed 10 percent of trailing cash flow from operations. They include A.K. Steel Holding Corp, Goodyear Tire & Rubber Co, Weyerhaeuser Co, Boeing, Northrop Grumman Corp, Lockheed Martin Corp and U.S. Steel Corp.
Like Boeing, AK Steel has disclosed a pension contribution for 2012. Lockheed said it is fully compliant with government funding standards. Northrop Grumman declined to comment. The other companies were not immediately available to comment.
IMPACT ON EMPLOYEES
The U.S. Pension Protection Act requires a company to notify its employees when their pension fund's asset value dips below 80 percent of obligations. When that happens, companies can only make lump sum distributions equal to half the benefit owed to workers. The other half has to be in the form of an annuity.
Plans that are less than 60 percent-funded are frozen and prevented from making any lump sum payouts. They can only provide annuities, and workers no longer continue to accrue benefits until the funding status climbs higher.
While the Pension Protection Act was passed in 2006, corporate America persuaded lawmakers to delay implementing major aspects of the law during the recession. These kick in this year.
Many companies try to decrease the volatility of their pension plans by changing asset allocation or culling headcount through offering a lump sum payment.
More than half of plans are likely to offer lump sum distributions over the next two years, according to a recent survey of senior-level financial executives by Mercer and CFO Research Services.
"We're likely to continue to see corporations attempting in one form or another to essentially buy out some employees from these defined benefit plans," said Robert Strong, a business professor at the University of Maine.
The U.S. stock market ended last year virtually unchanged, after a volatile 12 months that produced monthly performances ranging from gains of nearly 11 percent and declines of more than 7 percent in the S&P 500 index.
Interest rates were pressured by the U.S. Federal Reserve's stimulus program last summer, known as "Operation Twist." The yield on U.S. 30-year Treasuries dropped 34 percent in 2011 to 4.39 percent, while the 10-year note fell 44 percent to 1.89 percent.
Fed Chairman Ben Bernanke said on Wednesday the U.S. central bank would likely keep interest rates near zero until at least late 2014.
Rock bottom interest rates force a company to have more cash on hand to meet payments since its money cannot earn as much in future interest.
"For years now, we haven't had to make a contribution," said Nick Fanadakis, DuPont's chief financial officer, after the chemical giant announced a $500 million cash injection into its U.S. pension fund. "The return on assets was able to fund the pension plan."
The interest rate DuPont uses to calculate returns, known as the discount rate, fell to 4.5 percent in 2011 from 5.5 percent in 2010, Fanadakis said.
Besides meeting regulations that require companies to shore up underfunded pension plans, companies have other incentives to do so. For example, UBS analysts point to a peculiarity in accounting rules that let companies forecast pension performance using long-term rates of return, which are currently higher than actual market results. Any shortfall in the return can then be amortized over five years. (here)
Nor is it necessarily true that a cash infusion into a pension fund is a bad thing. Pension funds invest in stocks, bonds and other assets that can help the economy, said Jeremy Bulow, a professor at Stanford Business School.
"This money is going into the pension fund, which is being used to invest in corporate America, as opposed to going into whatever else the company might use it for," he said. "It's not really clear to me that takes away from investment in the economy."
Regardless, large payouts will be the rule, not the exception, for many companies this year.
Mark Oline, an analyst with Fitch Ratings, said companies that have dangerously underfunded pensions could be at risk of a ratings downgrade.
"For us, a strategy of hoping for higher interest rates or higher asset returns is not a strategy," said Oline. "Higher contributions are required."
(Reporting By Ernest Scheyder and Jilian Mincer; Editing by Tiffany Wu and Steve Orlofsky)
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