KWR International Advisor #16 December 2002/January 2003

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The Pension Fund Issue

By Scott B. MacDonald

The issue of pension fund shortfalls was given considerable media time in October when General Motors (GM) declared that its pension plan may be under funded by as much as $23 billion by year-end 2002. This prompted Standard & Poor's to downgrade GM’s BBB+ ratings to BBB. GM is hardly alone. Over the past couple of months, a number of major companies have indicated that pension shortfalls are a growing concern – Ford, Maytag and Whirlpool to name but a few. Pension funding shortfalls are the next issue which have the potential to disrupt the stock market, due in large part to the complex nature of funding and accounting rules, the large size of numbers involved and rating agency reactions. We would add that although this may cause spread widening, equity price volatility and negative ratings actions, not all companies have this problem. Some of the companies with pension plan shortfalls, like IBM and Boeing, are in much better shape to make up any differences compared to AMR and Delta, which will be hard-pressed with a multitude of other problems. The bottom line is that companies that are already on the margin with their ratings (for other reasons) are very likely to be negatively impacted by this issue. Our recommendation is that with any company that you are examining, take the unfunded portion of pension plans and treat that as debt. If the impact on leverage is significant, you should be concerned.

The roots of the pension shortfall are to be found in the excesses of the 1990s. Many companies used gains from pension investments to inflate profits. They were allowed to do this by accounting rules that permitted corporations to mingle pension income with operating earnings. While this worked well in an upwardly mobile stock market, it has hurt when the same market has had two consecutive years of steep declines and 2002 looks like it could be year number three. This is painfully evident by Standard & Poor's 500 Index of companies with defined benefit plans, which indicates that there will be a $243 billion shortfall in 2002, the first since 1993.

The critical issue for many companies is that if the stock market does not recover, a number of companies will be forced to divert earnings and cash to make up the difference. This takes capital away from capital spending at a time when capital spending is already tight. It also reduces the availability of funds to help the process of reducing debt. Moreover, the pension funding issue is a bigger concern to the industrial sector of the economy than it is to financial services.

We see three major trends emerging from the pension funding issue:

Investors will avoid companies with large gaps in pension funds unless those companies can clarify that they have the means to deal with the situation. We have already seen this in the case of the autos;
Rating agencies are looking more closely at the issue and are likely to downgrade those companies that are unable to satisfactorily demonstrate that they can handle the situation without resorting to a further buildup of debt. S&P already downgraded GM and placed Ford and auto-parts maker Delphi on watch for possible downgrades. (Delphi’s unfunded pension obligations increased in 2002 to $3.5 billion);
Pension shortfalls can become a political issue if there is enough pain from the workers and if taxpayers’ dollars must make up the difference. This could result in accounting changes as well as greater regulatory oversight. Pension shortfalls in the United States do not mean that retirees stop receiving benefits. Ultimately, benefits are backed by the Pension Benefit Guaranty Corp (PBGC), a federal agency, which guarantees benefits for around 44 million U.S. workers in 35,000 pension funds. The PBGC is paying benefits for 624,000 workers of 2,975 under-funded plans that have been terminated since the agency was created in 1974.

We are seeing companies respond to the pension fund issue. IBM has stated that it will add as much as $1.5 billion a year to its pension fund in 2003 and 2004 because it expects declines in the value of the plan’s assets. United Technologies also announced that it would put another $500 million in cash into its pension plan, taking total contributions in 2002 to $1 billion. Boeing announced that it expects no pension income in 2003 after getting $500 million in 2002. However, the lack of pension income in 2003 contributed to a cut in the aerospace company’s 2003 profit forecast.

The U.S. corporate sector has been through a succession of tough challenges in 2002. Corporate scandals, an anemic economic recovery, and concerns over a host of geopolitical issues have created a difficult business environment. Now as Q3 earnings have a better tone, we have pension fund shortfalls. In reality this is not a new problem, but something that has been quietly building up as the stock market has deflated. However, as the economy remains weak and companies still lack traction for stronger growth and earnings, the financing of shortfalls in pension programs will be a major issue. And, like all the fear and loathing over scandals and the state of the economy, the scare over pension fund shortfalls has the potential to be overblown.