Want to know what the next hit to corporate earnings in the U.S. could be? Take a look at the health of the nation’s defined-benefit plans. Once a nice little plus on the balance sheet of practically every company that had one, most corporations today are seeing the value of the assets in their pension plans erode–if not plummet–as the stock market nears the end of its third straight year of losses. And that means companies will have to fork over cash to make up the difference.
How bad is it? Analysts have come up with some hair-raising estimates of the extent of the pension under-funding. Standard & Poor’s Corp.’s survey of 624 big companies found a shortfall of $65.4 billion. UBS Warburg analysts calculate the shift to under-funded status from over-funded will have an adverse effect of 95 cents on the S&P 500′s earnings per share this year and another 40 cents in 2003.
Giving at the Office
And since federal law requires companies to make at least minimum contributions to defined benefit plans when their plan assets drop below 100% of current plan liabilities, this year’s drop in asset values is likely to force many more companies to deplete limited cash reserves to comply with standards set under Erisa. Watson Wyatt Worldwide estimates that 30% of all plan sponsors will have to contribute this year and as many as 65% may have to next year if the equity market remains weak. This compares with only 14% needing to make contributions in 2000 and 25% in 2001.
If a company’s assets drop below 90% of its plan liabilities, Erisa requires that it make additional, more onerous contributions. Companies with serious shortfalls can also be required to pay the Pension Benefit Guaranty Corp. (PBGC) $9 for every $1,000 of unfunded vested benefits. That’s in addition to the $19 per participant per year that the PBGC collects from all sponsors of defined-benefit plans.
The magnitude of the shift to under-funded from over-funded is so large that it in itself has become a further drag, albeit relatively small at present, on the overall market, says David Bianco, director of U.S. valuation and accounting at UBS Warburg. Bianco adds, however, the small negative could be a more significant problem for certain sectors. Specifically, he cites “old-line” industries, particularly auto makers, auto component suppliers and airlines.
Meanwhile, there’s growing criticism of companies’ assumptions about the return they’re likely to get on their investments going forward. The UBS Warburg report describes current assumptions as “optimistic,” noting that 60% of S&P 500 companies assume returns of 9% to 10% and 20% assume returns of more than 10%.
Of course, many companies have already moved away from defined-benefit plans. According to the PBGC, 22% of private sector workers were covered by defined-benefit plans in 1998, down from 38% in 1980. The shrinkage in pension assets looks like a factor that could scare more companies away from defined-benefit plans.
“At some point, the volatility of this system is going to drive some companies to say, ‘We can’t stand to have our finances impacted by something that we just can’t predict where it’s going to be a year from now,’” says Mike Johnston, North American practice leader for retirement and financial management at Hewitt Associates.
On the other hand, defined-benefit plans are an “extremely efficient way for companies to pay for retirement benefits,” he says. Moreover, demographics make this a bad time to eliminate defined-benefit plans. “With 401(k) plans down as much as they are, companies need the pension plans they have to help people get out the door,” Johnston says. “Now would be a funny time to cut the pension plan since you would find this big Baby Boom blob that’s moving through having a hard time leaving.”
Paying Over Time
Johnston argues that pension under-funding isn’t really a crisis. From the pensioners’ viewpoint, companies are still making payments, and from the company’s standpoint, “there is no theoretical reason why a pension plan needs to be fully funded at all times,” he says. The rules dictate “that over a period of time, we need to be sure the money is there to deliver the benefits, but not at every point in time,” he adds.
Still, he notes that the change affects not only companies’ bottom lines but their relative competitiveness: “When plans were over-funded and throwing off corporate income, you could argue that the big old-line companies that sponsored defined benefit plans actually had a competitive advantage. They could have strong retirement programs at very little cost,” Johnston says. “Now, the pendulum has swung, and these old-line companies are facing this future expense. Because of the stock market, we have changed a significant piece of cost for many of these companies, and somehow that’s changed their competitive position.”