Because of investment losses, most companies that offer defined-benefit pensions no longer have enough money set aside to meet their future obligations. Meanwhile, instead of adding to corporate profits, as they did through the 1990s, pension plans will begin to detract from them this year.
Neither development greatly imperils the retirement income you have already earned, which is guaranteed by the Pension Benefit Guaranty Corp. But a severely underfunded pension signals a financially strapped organization, one that may scale back future benefits outside the pension plan. Dozens of companies, including Ford and Sears, have reduced retiree health-insurance benefits this year.
These pension issues are a serious concern to investors. Short of mass firings, there are two ways for a company to reduce its pension shortfall: set more money aside or earn higher returns on its investments. Forget the second fix; companies already assume rates of return that are plain out of touch. According to a UBS Warburg study, 4 out of 5 companies project average annual returns of 9% or more — returns that are highly unlikely, with pension managers now investing about 40% of assets in bonds. Companies are more likely to lower their expectations, as Citigroup has — to 8% a year from 9.5%.
The difference between the projected and actual rates of return is critical. Pension managers assume that they achieved the projected rate, regardless of their actual results. The idea is to smooth volatile returns over long periods. But this practice produces some gross distortions. Of 355 companies in the S&P 500 that offer a defined-benefit plan, 52 report profits from their pension fund when the fund is actually costing the company, according to UBS Warburg. The study concludes that S&P 500 companies are now $126 billion short of what they need to pay pension benefits in the future. Merrill Lynch expects the S&P shortfall to reach $323 billion by year's end.
To close this gap, companies will have to divert more money to their pension plans. UBS Warburg analyst David Bianco estimates that pension costs will make S&P 500 earnings 95 lower per share than they would otherwise be this year. Companies with the greatest pension shortfalls are candidates to announce a special charge, which often creams a stock. "It's perilous to assume these issues are already reflected in stock prices," Bianco warns. Pension accounting is so complex, he says, that the underfunding issue isn't fully appreciated.
The worst-situated industries include airlines, autos, construction and heavy equipment. At the end of August, UBS Warburg reports, General Motors had a whopping pension-fund shortfall of $22.2 billion, equal to 83% of the company's market value. Excluding tax benefits, $4 of the first $5 that GM earns per share each year stands to get eaten up by pension obligations. Delta Airlines' shortfall is $3.5 billion, equal to one and a half times its market value. The company is essentially in business to pay retirement benefits — yet it still doesn't make enough.
Sorting through such issues is beyond most investors. A handy rule is to avoid shares of companies with pension shortfalls equal to 10% or more of their market value — and consider buying shares of those whose pension plans are generously funded.