Rising equities markets and a higher long-term interest rate environment mean corporate defined-benefit (DB) pensions are at their strongest since 2001.
In 2009, a typical DB plan was about 70% funded, according to Mercer, a global financial services company. That same pension today is fully funded. “2013 was an amazing year for pension plans,” says Manuel Monteiro, a partner in Mercer’s financial strategy group in Toronto.
So amazing, that of the 607 plans for which Mercer is the actuary, the percentage of fully funded plans rose from 6% to 40% between 2013 and 2014.
But despite this rosy development, DB pensions challenge firms that provide them by making company financials more volatile, because promises to employees must be kept regardless of economic conditions.
And since several S&P 500 and S&P/TSX 60 companies have made these promises, investors shouldn’t ignore pensions’ potential impact.
Why you care
Under DB plans, a company typically collects contributions from employee salaries, and also makes contributions for employees. In exchange, it legally commits to paying a certain sum, sometimes inflation-indexed, to retired employees—regardless of whether there’s sufficient capital to do so.
Yet few analysts monitor this obligation, says Howard Silverblatt, senior index analyst for S&P Dow Jones Indices in New York. That’s a mistake. “You always have to pay attention to anything that has a big liability, even if it’s not due today,” he says.
And while Mark Rosen, co-founder of Accountability Research in Toronto, says it would be rare for a poorly funded pension to sink a stock—“you’d see [a failed pension] in concert with significant other
problems”—underfunding “can depress valuations.”
Unhealthy pensions can also hurt corporate bond ratings. “We look at under-fundedness as additional debt on the firm, and mandatory contributions as similar to debt maturities,” says Rick Tauber, director of corporate bond research at Morningstar in Chicago.
He adds that, with all factors considered, he’d be more comfortable investing in a company without a DB pension than with. “It takes that risk off the table. A pension that’s fully funded today could be a problem down the road.”
Those problems start when a company has a shortfall. “It becomes an issue if [companies are] forced to fund pensions in lieu of investing in their networks,” or delay capital expenditures, maintenance and expansion, says Lee Klaskow, a senior analyst at Bloomberg Industries in New York.
A plan that’s 90% funded or better is a good benchmark. And from an employee perspective, “as long as you have faith the employer is going to be around, even if the plan is 80% funded, you don’t need to worry,” says Monteiro. “But if you don’t think it will be around, you may need to worry, even if the pension is 100% funded today.”
Sectors to watch
Unionized and large-workforce companies tend to have bigger pension liabilities. “The more workers, the more you want to look at it,” says Silverblatt. And companies such as Boeing, Caterpillar, AT&T and Verizon are highly represented by the United Auto Workers union.
Tauber notes Ford and GM have underfunded pensions that are “double, triple their debts outstanding. In that case, pension debt would be 20% to 25% of our rating assessment because we’re looking at a major liability.”
He adds DB pensions primarily impact older industrial companies, such as airlines, defence contractors (including Lockheed Martin and General Dynamics), heavy industrials, metals and mining.
Silverblatt would also watch utilities, trucking and telecom. On the other hand, tech companies have younger, more mobile employees, and tend not to have DB plans. He adds, “The retail sector has [these plans], but they’re not as [large] because a lot of the employees are part-timers.” For public companies, you can determine pension health using financial statements (see “How to examine pensions,” this page).
Goodbye DB plans?
Right now, record levels of corporate cash will help keep pensions healthy. “With interest rates up and companies having significant cash reserves, pensions are a manageable controlled expense,” says Silverblatt. But “pensions for most of the S&P 500 are a dying breed,” he adds.
When the economy bounces back, though, Monteiro counters they’ll likely be used as recruitment tools. “HR concerns will become more prominent as the labour force shrinks, and there’s a war for talent,” he says. “Having a DB plan is a huge attraction.” Nevertheless, a March 2014 PwC survey of Fortune 500 companies finds 83% of them are closing their DB plans to new employees.
Such firms are “capping the growth of the liability and risks,” says Tom Lappalainen, director of strategic advice at Russell Investments in Toronto. “They’re sending a message to investors that it’s a recognized risk to the balance sheet and income statement.”
PwC also found 90% of companies are adopting defined-contribution (DC) plans. These schemes delegate asset management responsibility—and risk—to employees. While the companies may contribute to the pot, they don’t guarantee what employees ultimately get upon retirement.
With DC, “the volatility [inherent in DB plans] doesn’t disappear; you’ve just passed it onto plan members,” says Monteiro. “They bear their own longevity risks.”
Many pension experts wonder if employees should take on that responsibility. “We’ve underestimated the skillset and attention required for people to manage their own retirement programs effectively,” says Lappalainen. “When I think about my son learning to drive, I don’t say, ‘Here’s a book, here’s the theory; now here are the keys.’ That’s a quick way to get my car destroyed. But that’s what we’ve done with DC plans.”
Monteiro adds DC suitability may vary by sector: bank and insurer employees may be more financially inclined, whereas with manufacturing and mining, “plan members may not be particularly savvy, or the company doesn’t think they are.”
De-risking: a better solution
Instead of mass-closing DB plans, companies should first revisit their risk exposures.
“For some [foundering] plans,” says Lappalainen, “sometimes it’s as simple as lowering their overall portfolio risk from an asset-liability relationship, such that they can afford to improve that strategy and keep the plan open.” And with many plans healthy, Monteiro doesn’t want to repeat the last five years. “This is the opportune time to revisit risk, because some plans are taking too much,” he says. “Many are heavily invested in equities, whereas they have a liability that behaves more like a bond, so you have this mismatch.
“Things look good now, but they could slip back if companies don’t revisit risk.” Plans should measure how much they’re taking, and consider increasing fixed income and alternative investment allocations.
Other de-risking solutions fall along the DB-DC continuum. Companies can ask DB members to share administration costs, rather than bearing all of them. They can also purchase annuities to meet pension obligations.
Under what’s known as an annuity buy-in, the plan sponsor pays a single premium and retains both assets and liabilities—but they will remain equal on the balance sheet. The annuity reimburses the sponsor for payments to retirees.
Then there’s an annuity buy-out. The company pays an insurance company to take over the plan and make member payments directly; then all pension assets and liabilities move off the sponsor’s balance sheet.
A catch: “if you’re underfunded, you need to make the plan whole before you do [a buy-in or buy-out],” says Lappalainen, so it depends on the company having enough cash flow to do so.
Finally, target benefit plans are an emerging alternative. They pool longevity and investment risk across all members, because employee contributions are centrally managed, but benefits can vary based on market performance.
“If there’s a good experience, you increase the pension; if there’s a bad experience, you cut it back,” says Monteiro. “You fix your costs, or let them vary within a small range. Instead of promising a benefit, you target the benefit so you’re levered in terms of how to deal with [bad] experiences.” But such schemes aren’t widely used because only New Brunswick’s regulator fully recognizes these plans.
While DB pensions may no longer be the gold standard for retirement benefits, they’re still a large part of many companies’ liabilities. Investors and employees alike should pay attention.
How to examine pensions
Publicly traded companies must report the health of their DB pensions, and do so in their financial statement notes. The dedicated section is usually called something like “Pensions and other benefits.” Here are important data points for five S&P/TSX 60 companies.
| Company | Year | Benefit obligation at end of year (millions) |
Fair value of plan assets at end of year (millions) | Plan surplus (deficit) |
Funded status (%) |
Discount rate
of pension obligation |
Free cash flow | EBITDA (loss BITDA) | Pension deficit (surplus) as a % of free cash flow | Pension deficit (surplus) as a % of EBITDA/LBITDA |
|---|---|---|---|---|---|---|---|---|---|---|
| CP Rail | 2011 | $10,099 | $9,215 | $(884) | 91% | 4.55% | $(532) | $967 | 166% | 91% |
| 2012 | $10,647 | $9,763 | $(884) | 92% | 4.28% | $317 | $949 | 279% | 93% | |
| 2013 | $9,921 | $10,722 | $801 | 100% | 4.90% | $353 | $1,420 | 227% | 56% | |
| Barrick Gold | 2011 | $361 | $227 | $(134) | 63% | 2.80–5.21% | $(7,512) | $7,010 | 2% | 2% |
| 2012 | $328 | $207 | $(121) | 63% | 1.75–4.55% | $(1,082) | $(303) | 11% | 40% | |
| 2013 | $288 | $216 | $(72) | 75% | 2.15–4.90% | $(998) | $(8,819) | 7% | 1% | |
| Enbridge | 2011 | $1,686 | $1,355 | $(331) | 80% | 4.50% | $(1,708) | $2,591 | 19% | 13% |
| 2012 | $1,879 | $1,500 | $(379) | 80% | 4.20% | $(3,330) | $1,594 | 11% | 24% | |
| 2013 | $1,903 | $1,799 | $(104) | 95% | 5.00% | $(6,090) | $1,365 | 2% | 8% | |
| RBC | 2011 | $8,337 | $8,092 | $(245) | 97% | 5.30% | $(723) | $8,980 | 34% | 3% |
| 2012 | $9,857 | $9,348 | $(509) | 95% | 4.40% | $(5,839) | $9,690 | 9% | 5% | |
| 2013 | $10,413 | $10,266 | $(147) | 99% | 4.60% | $6,878 | $10,617 | 2% | 1% | |
| TELUS | 2011 | $7,748 | $6,746 | $(1,002) | 87% | 4.50% | $582 | $1,968 | 172% | 51% |
| 2012 | $8,511 | $7,142 | $(1,369) | 84% | 3.90% | $1,161 | $1,994 | 118% | 69% | |
| 2013 | $7,910 | $7,915 | $5 | 100% | 4.75% | $857 | $2,215 | 1% | 0% |
- Benefit obligation at end of year Total amount the company must pay to pension members.
- Fair value of plan assets at end of yearMarket worth of the plan’s assets.
- Plan surplus (deficit) Fair value less obligation.
- Funded status (%) Fair value / benefit obligation. Companies do not usually include this percentage in the financial statements, but it’s an easy calculation. Compare the number to the 90% minimum experts recommend. “A 10% gap can be closed within a year,” says Mark Rosen of Accountability Research.If there’s overfunding, Rosen says you don’t need to get concerned until a plan’s at 120%. After that, says Tom Lappalainen of Russell Investments, the company has “just sunk capital into a place where I can’t get it back.”
- Discount rate of pension obligation An actuarial estimate of returns based on the plan’s asset mix. Even a small change can bring a plan from underfunded to funded status, so getting the number right is important. Lappalainen says the rate is “driven by how aggressive the plan sponsor wants to be. If you drop the rate, the liability increases. That’s why you might see unreasonably high discount rates. But that’s a shortsighted game. When that discount rate can’t actually be achieved, you’ll have to load money into the plan.”To determine reasonableness, compare the rate with that of sector peers, as well as previous years. “Historically, looking across a number of TSX companies, the spread tends to be 0.6% between first quartile and third quartile,” says Lappalainen. Adds Rosen, “A 50-basis-point difference may be cause for concern in a large plan, like a telco’s, but could be irrelevant to a smaller plan.”
- Free cash flow Net cash provided by operating activities minus net cash used by investing activities (found in cash-flow statements). Excess pension contributions may have to come from this source, so understanding its size—compared to the deficit—is important (the bigger the ratio, the better).
- EBITDA/loss BITDAAlso called operating income and found in the income statement, it’s another way to judge the size of the deficit relative to company size. In the case of Barrick, the plan was 75% funded in 2013, but the deficit was only 1% of its LBITDA.
All companies report in CAD except Barrick Gold, which reports in USD. Source: Company financial statements, via SEDAR. Analysis conducted with assistance from Mark Rosen of Accountability Research.