Pension Funding Is an Increasingly Important Issue

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Retirement in the United States has been changing. It used to be that a benevolent employer would provide retirees a generous pension, with savings and Social Security filling out the void left by the lack of a paycheck. Companies realized very quickly that generous pension plans are great for employees, but not so good for the bottom line. While many have shifted to defined contribution plans (401k plans, for example), still lingering pension obligations are a big issue to watch. AT&T (NYSE: T) is just the tip of the iceberg.

AT&T's problem
Like many companies that have been around for a long time, AT&T existed before there was such a thing as a defined contribution retirement plan. So, it has material defined benefit plan (pension) obligations. To make matters worse, the company also has unions, which steadfastly defend their pensions, as they should.

To pay for future obligations, AT&T puts money aside today and invests it. The goal is to make enough from the investments to pay the obligations when they come due. There are fairly complex rules and regulations surrounding the funding of pension obligations, but suffice it to say that companies don't have to have all of the money today to pay their obligations of tomorrow.

Part of the determination of a defined benefit plan's funding is the company's determination of the expected returns it will earn on its investments. This return, while required to be reasonable, is largely up to the company to determine. And that's the issue, the higher your expected returns, the less you have to fund the plan. The less you fund the plan, the better your earnings look.

Prudential trims its market call
Prudential's (NYSE: PRU) expected portfolio returns are a key aspect of its business. As an insurance company, it takes money from customers today and invests it to pay for claims later—if it makes more than it pays out, it gets to keep the difference. Late in 2012, Prudential lopped more than a full percentage point off of its long-term market expectations. That's a huge change.

Although the evidence of the last decade or so is to the contrary, many investors look at the market and expect annualized returns in the 10% area. This is much better than the 20% figure that was frequently thrown around in the late 1990s, just before the big technology driven crash. Prudential's new market call is several percentage points lower than the historic 10% figure. Worse, other smart individuals, including John Bogle of Vanguard fame and John Hussman of the Hussman Funds, have even more dire expectations, going as low as the 5% range.

A bad market and underfunding
AT&T also trimmed its performance expectations, noting the poor performance of the market. That's a good call, but this event exposes a notable Achilles heel. And it's a weakness shared by many other companies. For example, fellow Dow-30 telecom Verizon also has material pension obligations. The automakers, do, too. In fact, while it was impressive that Ford (NYSE: F) was able to avoid going bankrupt, the debt it took on to avoid that fate just compounds the company's pension woes. Both Ford and Verizon have notable union membership in the employee ranks, which means it will be hard for them to make changes to their plans.

This wouldn't be an issue if the stock market had just grown to the sky, but neither markets nor trees do such things. Heck, if the market could be expected to just provide historic returns this wouldn't be an issue. That hasn't been the case, however. While the market's return from the 2009 lows is impressive, it is only just getting back to the highs it saw in 2007. Pension fund portfolios, then, have gone nowhere for a long time while obligations just continued to increase.

How do you know?
The list of companies with old-style pensions is long and is a who's who of giant U.S. corporations, including names like General Electric (NYSE: GE), Caterpillar (CAT), and Deere (DE), among many, many others. Pension information is disclosed in a company's annual report. Of course it isn't easy to find, since it generally gets buried in the notes section and in other written commentary. However, if a company has a pension that information is there.

Using GE as an example
For example, in GE's 2011 annual report investors will find this information: “Approximately 15,800 GE manufacturing and service employees in the United States are represented for collective bargaining purposes by a total of approximately 108 different union local bargaining units....”  Clearly, the company has lots of unionized employees for which it has existing obligations. Note that this number doesn't include already retired individuals, so this is a big issue.

In that same paragraph: “These agreements modestly increase ongoing costs over the term of the contracts on an aggregate basis. However, the agreements also implement new features that focus on cost containment for health and pension plans.” For example, new employees will only be eligible for defined contribution retirement plans. Clearly GE knows it has a problem and is working on the issue. But that doesn't remove the obligations it already has. In fact, it notes the pension issue as a business risk.

How big a problem is this for GE?
The risk factor states, “At the end of 2011, the GE Pension Plan was underfunded, on a U.S. GAAP basis, by $13.2 billion, and the GE Supplementary Pension Plan, an unfunded plan, had a projected benefit obligation of $5.2 billion.” Those are big numbers!

But it gets worse.  The company's plan, “...had average annual earnings of 4.7%, 6.7% and 8.7% per year in the 10-, 15- and 25-year periods ended December 31, 2011, respectively.” The company continues to expect 8% long-term returns even though the trend is clearly heading south over shorter time periods. This would be OK, if the baby boomers, which make up much of the pension eligible group, weren't set to retire shortly.

What to do?
Few companies are going to bring the pension topic up until it's a problem. Therefore, there is only one thing for an investor to do with regard to pension obligations and that's research. Companies have to disclose the data in their annual reports. While it is unlikely that a financially sound company will go bankrupt because of pension obligations, weaker companies may have no choice but to use the courts to get out from under these debts. Take a quick look at the airline industry if you want proof of that.

Yours,

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ReubenGBrewer has no position in any stocks mentioned. The Motley Fool recommends Ford. The Motley Fool owns shares of Ford and General Electric Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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