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Tuesday, May 5, 2009

* Underfunded Pension Plans: The Next Shoe To Drop?

As the government tries to thaw the credit freeze, the next potential catastrophe is starting to heat up. I am beginning to see more and more written on the pending problem of underfunded pension plans. Unfortunately, this problem could have many faces and take a significant amount of time to sort out.

First, a short primer for those fortunate enough not to be involved in pension accounting. There are two basic types of company sponsored retirement plans - defined contributions (DC) and defined benefits (DB) plans. As the names imply, a DC plan defines what the company will contribute to the plan on behalf of the employee. An example of a DC plan is a 401(k) where the company will match the first 5% contributed by the employee. There is no guarantee of what the employee will get out of the plan. The DB plan in contrast defines the benefit the employee will receive upon retirement, such as a salary of 80% of his or her highest earnings year, weighted by years of service. In the DC plan the employee assumes the risk of under-performance, while in the DB plan the employer assumes the risk.

For DB plans, actuaries will look at the number of employees, their ages, their income and other factors to determine what the company's future liability will be. The actuaries will then look at the invested assets, estimate a future return and determine if the assets will be sufficient to cover the future liability. When the market is spiraling up, assets are usually greater than the liabilities and the company does not have to put any money in the plan, thus it does not have recognize an expense. But when the market is down, as it has been lately, the liability is greater than the assets on hand. This is referred to as underfunded, and over time the company has to come up with cash and recognize an expense.

One of the biggest pension plans in the world is General Motors (GM). A recent New York Times article looked at GM, which hasn't been doing so well lately, and the effect of its underfunded pension plan. As of last November the estimated shortfall in GM pension plan was $20 billion. So what happens if it fails?

If GM's pension plan collapses, the Pension Benefit Guaranty Corporation (PBGC) will pick up part of the tab. However, most of that shortfall would be made up by workers in the form of smaller benefits — not by GM or the PBGC. Unfortunately, this will likely set other pension funds into play. Since GM's plan is so large, its failure will result in the PBGC losing a big source of the premium revenue. But more importantly, other automakers such as Ford, Toyota and Honda will be looking to rid themselves of their DB plans to cut costs and stay stay competitive.

The Pension Protection Act (PPA) and IRS regulations impose restrictions on accelerated payments (e.g. lump sum distributions) when the funding level falls below 80%. This is not just a problem with companies in struggling industries. Tyler Durden in a March 7, 2009 article cites data from a Merrill Lynch Pension Database showing several well-known companies with a projected (data as of 10/22/08) funded status below 80%. Here is a sampling of some traditional dividend companies:
  • Johnson & Johnson (JNJ) Deficit: $3.5 billion Funding Status: 70%
  • Exxon (XOM) Deficit: $3.4 billion Funding Status: 69%
  • Chevron (CVX) Deficit: $2.6 billion Funding Status: 69%
  • General Dynamics (GD) Deficit: $2.3 billion Funding Status: 68%
  • PepsiCo (PEP) Deficit: $1.8 billion Funding Status: 72%
  • Kimberly-Clark (KMB) Deficit: $1.4 billion Funding Status: 72%
  • Kraft Foods (KFT) Deficit: $1.1 billion Funding Status: 83%
Generations before us relied on defined benefit pension plans to ensure their lifestyle in retirement. Our generation may not have the same luxury. There is one thing this economic and financial downturn has taught us - there are no sure things in life. We must take responsibility for our financial future and mange it.

Full Disclosure: Long JNJ, CVX, PEP, KMB (my income holdings)

Tags: [CVX] [GD] [GM] [JNJ] [KFT] [KMB] [PEP] [XOM]

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