Despite better-performing stock markets and proposed accounting changes, defined-benefit pension plans still remain underfunded and risky, these coauthors state. However, despite the fact that some companies are closing down their defined-benefit plans these plans won’t be disappearing any time soon. The conclusion magnifies the need for companies and boards to manage risk even more effectively.
Canadian defined benefit (DB) pension plans have finally gotten a break. After three long years of declines, equity markets improved in both 2003 and 2004. Yet despite this improvement, DB pension plans remain surprisingly underfunded. What has happened? We conducted a study of Canadian DB pension plans to find out.
- Aggregate funded status of Canadian DB pension plans did not improve in 2004. In contrast with expectations, the aggregate funded status of the 100 largest Canadian DB pension plans deteriorated slightly in 2003 and 2004: The deficit grew from $18.5 billion in 2003 to $19.3 billion in 2004, and the number of underfunded companies increased from 77 in 2003 to 81 in 2004. This was driven, in part, by a slight decrease in the discount rate and lower contributions to pensions by plan sponsors. Further, 89 of the 100 companies in our sample offer other post-retirement benefit (OPEB) plans, all of which are underfunded because of a “pay-as-you-go” funding policy. These plans add an aggregate $22 billion to the overall funding deficit.
- Pension plan exposure for shareholders and cash flow. While DB pension plans do not pose a risk for all companies in our sample, they do create areas of exposure for some. Eleven companies have combined DB pension and OPEB underfunding that exceeds 25 per cent of their market capitalization. Further, 10 companies made pension contributions in 2004 exceeding 25 per cent of cash flow from operations. Six companies had significant exposure for both shareholders and cash flow. They are Abitibi Consolidated Inc., Bombardier Inc., Bowater Canada Inc., Inco Ltd., NorskeCanada and Stelco Inc.
- New asset allocation disclosures. For the first time, Canadian companies were required to disclose the allocation of their pension plan assets. The average Canadian portfolio was allocated as follows: 57 per cent equities, 38 per cent debt securities, 1 per cent real estate, and 4 per cent other, including cash. This sample portfolio is somewhat more conservative than the average portfolio of S&P 500 firms with DB pensions. In this latter case, the allocation is 62 per cent equity, 29 per cent debt securities, 3 per cent real estate, and 6 per cent other. Disclosures of target allocations for Canadian firms for 2005 indicate that they are planning a slight reduction in the allocation to equity, on average.
- Pension Accounting. Changes in accounting rules are being considered in the U.S. and Canada. The elimination of the smoothing permitted under current accounting rules could bring an additional aggregate $26.2 billion of off-balance-sheet debt back ontothe balance sheet.
The staying power of deficits
In July 2005, Standard & Poor’s reported that the status of pension funds in the S&P 500 failed to improve in 2004, with the aggregate underfunding remaining basically unchanged, at $164 billion. This compared with the $165 billion reported a year earlier. In a study based on the 2003 and 2004 financial statements of the 100 largest Canadian DB pension plans, we found that the status actually deteriorated slightly, with the aggregate deficit increasing from $18.5 billion to $19.3 billion. In fact, the number of companies that were underfunded increased from 77 in 2003 to 81 in 2004.
These findings are surprising given the healthier equity markets; however, there are additional factors that affect the funded status of a pension plan. In 2004, the pension liability (or benefit obligation) grew 11.5 per cent-from $156.8 billion to $174.9 billion, while the pension assets grew 12.6 per centfrom $138.2 billion to $155.6 billion. (See Exhibit 1 for summary statistics on our sample for 2004. All exhibits at end of article) The pension liabilities increased, in part, because of a slight decrease in the discount rate used to value them, from 6.2 per cent in 2003, on average, to 6.1 per cent in 2004.
Pension plan assets did benefit from improved equity markets. On average, pension plan assets returned an average of 9.6 per cent; only one company lost money on its pension assets, and one company earned a return of 22 per cent. In aggregate, returns added $14.3 billion to pension assets. However, other factors worked against the growth of pension assets. While cash contributions to pension plans were relatively high in 2003, at an aggregate $5.95 billion, they decreased slightly to $5.70 billion in 2004. At the same time, benefit payments to retirees increased from $8.1 billion to $8.9 billion. Many argue that the Ontario Court of Appeal’s ruling against Monsanto Canada Inc., which allowed employees to share in the pension surplus resulting from layoffs, and the reinforcement of surplus-sharing in many Canadian jurisdictions, are strong deterrents to the overfunding of a pension plan.
Looking ahead to 2005 results, two favourable trends are predicted, namely modest increases in interest rates and average market returns. While the aggregate funded status for Canadian companies should improve in 2005, we do not expect improvements to be substantial enough overall to wipe out existing deficits. (N.B The authors completed their report earlier this year, before most of the “modest increases in interest rates” had occurred and before market returns for the year began to shape up as “average.”)
In addition to DB plans, most companies in our sample offer other post-retirement benefit (OPEB) plans, such as life insurance and health care. Because most of these plans are “pay as you go” and their costs are increasing, the deficits for these plans are growing. Of the 89 companies in our sample with OPEB plans, all were underfunded. In 2004, the aggregate OPEB liability was $23.4 billion, with only $1.4 billion in assets set aside to meet this obligation. Including the resulting $22-billion deficit with the DB plans’ deficit represents an aggregate net underfunded position of $41.3 billion.
Pension plan exposure
Given that the funded status of Canadian pension plans worsened in 2004, a number of companies continue to be exposed to risk. We examine two aspects of this risk: shareholders’ exposure and cash flow exposure. To examine shareholders’ exposure, we compute the DB pension plan funded status as a percentage of market capitalization on Dec. 31, 2004. Significant underfunding could result in large cash contributions to the plan in future years. For example, in 2003 General Motors made a whopping $18.6-billion (U.S.) contribution to its U.S. pension plans to address its funding problem. We also compute the combined funded status of the DB and OPEB plans as a percentage of market capitalization. Eleven companies in our sample had combined plans with deficits that exceeded 25 per cent of their market capitalization. These companies are reported in Exhibit 2.
To examine cash flow exposure, we compute 2004 cash contributions to the plan as a percentage of Cash Flow from Operations, averaged over 2003 and 2004. (In instances where a company restated 2003 operations in the 2004 annual report, the restated 2003 figures were used for consistency with the 2004 presentation.) While the median percentage is only 3.2 per cent for 2004 (and a mean of 11.3 per cent), 10 companies made contributions to their pension plans in excess of 25 per cent of Cash Flow from Operations. These companies are reported in Exhibit 3. Six companies have significant shareholder and cash flow exposure and appear in both exhibits. The six are Abitibi Consolidated Inc., Bombardier Inc., Bowater Canada Inc., Inco Ltd., NorskeCanada and Stelco Inc.
Asset allocation: New disclosure requirements
In 2004, and for the first time, financial statements include a new and useful disclosure to help investors assess the risks and expected long-term rates of return of defined benefit pension plans-that is, information on asset allocations. The investment categories that firms must disclose include, but are not limited to, equity securities, debt securities and real estate. Standard-setters hope that these disclosures will help financial statement readers understand the exposure of corporate pension plans to risks such as the 2001/2002 equity market collapse.
The decision of pension fund managers to weight pension asset portfolios more or less heavily in risky assets remains controversial. Some investment professionals believe that the proportion of equity and other risky investments should be reduced to lessen the volatility of the pension asset portfolio. (See, for example, Joel Chernoff, “Pension Funds Turn to Asset, Liability Matching-Again,” Pension & Investments, Nov. 1, 2004, and Eric Tuer and Elizabeth Woodman, “Recent Trends in Canadian Defined-Benefit Pension Sector Investment and Risk Management, Bank of Canada Review, Summer 2005.) Others believe that to maximize long-run returns, equity exposures should increase. For example, in May, 2005, the Canada Pension Plan Investment Board announced that its private equity commitments grew to $8.3 billion. In its media release it stated that it is investing in equities, real estate and infrastructure to increase the long-term value of the funds invested.
We provide descriptive data on the disclosed asset allocations in Exhibit 4. This information is largely available for 2003 as well as 2004, since most firms provide retroactive disclosure of the prior year’s allocations in their 2004 annual reports. Ninety-nine of our 100 firms disclosed asset allocations in 2004. Both the mean and median percentage of pension assets invested in equities in 2004 was 57 per cent. The mean (median) percentage invested was 38 per cent (40 per cent) in debt securities, 0.8 per cent (0.0) in real estate, and 3.9 per cent (2.0 per cent) in all other categories, including cash. These averages are very similar to those reported in 2003, although results are not strictly comparable, since 11 of the sample firms failed to provide retroactive disclosure for 2003.
The allocations of Canadian firms are slightly more conservative than their U.S. counterparts. A study by Credit Suisse First Boston (“The Magic of Pension Accounting, Part III,” Feb. 7, 2005) indicates that the pension assets of S&P 500 firms at the end of 2003 were comprised of 62 per cent equity, 29 per cent fixed income, 3 per cent real estate and 6 per cent other asset classes. The significantly higher allocation to fixed income among Canadian plans may, in part, explain the lower mean return on assets (ROA) assumptions. In Canada, the mean (median) ROA assumption for our sample was 7.3 per cent (7.3 per cent) compared to a mean ROA of 8.5 per cent for S&P 500 plans, according to a study by Mercer Human Resource Consulting released in June 2005.
There is, however, considerable variation in the investing strategies that firms employ. Sixteen firms in 2004 (13 firms in 2003) adopted the conservative strategy of investing less than 50 per cent of their pension portfolio in equities, while six firms in 2004 (eight firms in 2003) adopted the more aggressive strategy of investing 70 per cent or more in equities. In 2004, the maximum percentage invested in equities was CP Ships Ltd., with 82 per cent, while the minimum was 25 per cent, Timberwest Forest. Timberwest also had the maximum allocation of debt securities, 65 per cent. The maximum allocation to real estate was Toromont Industries Ltd., 11.8 per cent (down from 14.7 per cent in 2003); the maximum allocation to “other” was Weyerhaeuser Co. Ltd., 62.1 per cent. Almost 40 per cent of Weyerhaeuser’s “other” category consists of hedge funds; the company states in its 2004 annual report that its pension investment approach is to invest in “a diversified mix of nontraditional strategies.” The company has an expected ROA of 9.5 per cent, the highest of our sample firms.
As we see from the above, more firms deviate from the normal 60/40 equity/debt portfolio by investing less heavily in equities than do firms who adopt an equity-intensive investment approach. Further, the 32 companies that chose to disclose target allocations for 2005 indicated an expected reduction in average allocations to equity, from 59.8 per cent to 57.8 per cent. This indicates that Canadian firms do not appear to be adopting a more aggressive investment strategy to make up funding deficits. While a more conservative strategy does serve to reduce the risk of the pension portfolio, the downside is that plan contributions will need to go up if the current low interest rate environment persists.
Changes in accounting rules
A risk for companies with large DB pension plans is that accounting rules may change in the not-toodistant future. In June 2005, the Securities and Exchange Commission released a report criticizing off-balance-sheet arrangements, including those applying to pensions, urging improvements in “both the transparency and usefulness of the balance sheet.” And standard-setters at both the Canadian Institute of Chartered Accountants and the Financial Accounting Standards Board have indicated they are considering a full re-evaluation of pension rules in the near future. As such, changes to pension accounting are gaining global momentum. A controversial new pension accounting standard, Financial Reported Standard (FRS) 17 “Retirement Benefits,” became mandatory in the U.K. on Jan. 1, 2005; in December 2004, the International Accounting Standards Board issued an amendment to its pension accounting standard (International Accounting Standard 19), allowing the use of FRS 17.
The most significant change under proposed rules involves eliminating the extensive smoothing permitted under current rules. In the future, pension deficits and surpluses (to the extent recoverable) will likely be fully reflected on the balance sheet, and components of pension expense will be reported in different sections of the income statement, including the recognition of pension gains and losses in comprehensive income. For our sample, this would result in the recognition of an aggregate $26.2 billion of negative off-balance-sheet amounts on the balance sheet.
Exhibit 5 demonstrates the potential impact of balance-sheet changes. Here we analyze 100 companies with the largest pension plans that also have full pension asset and liability data available for the five years from 2000 through 2004. (Note, this sample is similar but not identical in firm composition to our primary sample.) Two facts are clear from this chart. The first is that the funded status took a sharp downward turn in 2001/2002 from 2000 and has not yet recovered. The second is that current accounting rules allow extensive smoothing of gains and losses, which do not make their way onto the balance sheet very quickly. Changes in accounting rules would bring these unrecognized amounts back onto the balance sheet. Even if the accounting rules do not change in the next two years, a number of companies will see earnings negatively impacted as they are required to recognize a portion of their off-balance-sheet losses in income.
Projected company-specific balance sheet and income statement effects are further analyzed in the C. Wiedman and H. Wier article “Pension Accounting: The End of Smoothing?” Ivey Business Journal Online, March/April 2005. The authors report that, had the new rules been in place for 2003, 21 of 100 firms would see additional liabilities of greater than 5 per cent of total assets on their balance sheets.
Are DB plans becoming extinct?
Cash flow exposure, volatile equity markets, asymmetric surplus entitlement legislation and new accounting rules all threaten existing DB plans. Although a full-scale withdrawal from DB plans has not occurred, and in most cases is not possible, a number of companies are closing their DB plans and offering new employees defined contribution (DC) or combination DB/DC plans. So, might DB plans become extinct? There are two factors that may work in favour of DB plans’ survival. The first is a growing realization that DC plans carry risks too. Watson Wyatt Canada (“Good Governance: Managing DC Plan Risk,” September 2004, company Web site) points out that in the area of communications, risks can be higher with DC plans than with DB plans. In Canada in particular, the lack of investment knowledge of employees with DC plans poses the real risk of a class-action suit against a sponsoring firm, because corporate sponsors are not protected by the same safe-harbour legislation as U.S. sponsors.
DB plans can also be used as an important retention tool, especially for older, experienced and skilled employees (G. Brandon, “Old-Style Pension Showing Some Life,” KiplingerForecasts.com, Aug. 26, 2004). Although this may not be critical today, it could be a significant factor if predicted labour shortages materialize in the years ahead.
Collectively, these trends suggest that DB pension plans are not going to vanish in the near future, despite their risks. Therefore, companies and boards will need to continue to develop sound policies to manage the significant risks associated with their pension plans.
Our sample is based on the 100 companies with the largest pension assets in fiscal 2003, according to Canadian Compustat data. (Canadian Compustat includes over 900 major Canadian industrial companies, all of which have consistently available financial statements and are traded on at least one of the Toronto Stock Exchange (TSX) or the TSX Venture Exchange.) Companies that became insolvent in 2004, or companies that went private, are excluded from our analysis. However, companies that merged with other Canadian companies or changed names are retained, where possible. Note that Nortel Networks was excluded from our primary analysis because of lack of coverage on Canadian Compustat during the sample selection period. For the time-series data reported in Exhibit 4, we select a second sample of the 100 companies with the largest DB plans with full funded status and balance sheet data for the five-year period 2000-2004. The data for this last analysis are taken from Compustat. Also, market capitalization data are from Compustat as of Dec. 31, 2004. All other data reported in Exhibits 1 through 4 are hand-collected from publicly available financial statements for fiscal 2003 and 2004. All values are reported in Canadian dollars (except where noted), and converted using the exchange rate in effect at the fiscal year end, where required.
We are grateful to Lindsey Harold for her data collection work and to the Deloitte & Touche/Canadian Academic Accounting Association grant program for its financial support.