The balance sheets don’t show it but the pension plans of many companies in Canada and the United States are under-funded, a situation that could only worsen in the short term. Worse still, finding out just how cash poor the plans are requires wading through the small print of the notes to the financial statements.
Declining equity markets and low interest rates, combined with a rule that allows companies to report and explain debt off of their balance sheets, are raising investors’ and creditors’ concerns over the status of defined benefit pension plans (DB). In the United States, a recent study by investment bank Credit Suisse First Boston (CSFB) found that at the end of 2001, there were more companies in the S&P 500 with under-funded DB pension plans than at any time during the previous 10 years. Moreover, they estimated that by the end of 2002, 30 companies will have plans, which will be underfunded by at least 25 percent, based on their current market capitalization. Similarly, a study by Merrill Lynch predicted that the aggregate of the S&P 500 companies’ DB plans, including other post-retirement benefits, will be under-funded by more than $450 billion (U.S.).
We conducted a surveyed of Canadian firms at the end of 2001 that revealed similar results: In aggregate, the 100 largest DB plans were under-funded by $1.8 billion CDN ($17.8 billion if we include other postretirement benefits) — even though they report an aggregate pension asset on their balance sheet of over $6.7 billion. We predict that the aggregate status will deteriorate and become a shortfall of over $20 billion by the end of 2002, before considering other benefits. Notably, while detailed pension information is disclosed in the financial statement notes, current accounting rules allow much of this debt to be excluded from the balance sheet. Unless markets rebound quickly, the deterioration is likely to increase borrowing costs, and reduce cash flow and earnings.
Increasing off-balance-sheet debt
With declining equity markets and low interest rates, it is no surprise that defined benefit pension plans have taken a beating in the last two years. In 2001, the top 100 defined benefit pension plans of Canadian companies (ranked by the value of their pension plan assets according to Canadian Compustat) lost, in aggregate, $6.1 billion on their plan assets. They had expected to earn $12.1 billion. This marks a sharp reversal over previous years. For example, in 2000, these plans earned $14.2 billion in aggregate and only expected to earn $10.9 billion. Results for 2002 are likely to be similar to 2001, given that by the end of November, the Dow Jones Industrial Average was down 12 percent and the S&P/TSX Composite Index was down 14 percent from the beginning of the year. Because of smoothing mechanisms permitted under generally accepted accounting principles (GAAP), the difference between expected and actual returns (referred to as experience or actuarial gains and losses) are accumulated off-balance-sheet until they reach a critical threshold, at which point companies are required to recognize a portion of the difference in the financial statements. Consequently, as companies move from having accumulated gains to accumulated losses, the amount of off-balance-sheet debt rises.
Exhibit 1 shows the funded status of the DB pension plans in our study. By the end of 2000, in aggregate, the top 100 plans were over-funded, (that is, their assets exceeded their liabilities) by $20.6 billion. Furthermore, 77 percent of the plans were over-funded. Because of experience gains and assets that emerged when the companies first implemented the new pension rules, they reported net assets on the balance sheet of only $5.7 billion. During the bull market, the smoothing mechanisms had resulted in an overstatement of the liability. The bear market produced much different results: By the end of 2001, the top 100 plans were under-funded by $1.8 billion (only 42 percent of plans were over-funded) with $8.6 billion of net liability off-balance sheet. Yet companies were still reporting an aggregated $6.7 billion asset on the balance sheet, significantly understating the liability.
If negative market trends continue, the outlook only worsens. To illustrate, we make predictions for the funded status of 2002 pension plans over a range of assumptions about the future rate of return on pension fund assets. Our forecasting technique is described in Exhibit 2. We report the funded status under three scenarios: an average estimated plan asset return of –4 percent, –6 percent and –8 percent, to provide an optimistic through pessimistic range. Under these scenarios, the aggregate funded status will decrease to a range of -$17.8 to -$23.5 billion for 2002, with only 17 to 22 percent of plans being over-funded. This analysis shows how quickly a prolonged market downturn can impact the plans. Unfortunately for readers of financial statements, most of the negative effect of the market decline in pension funds will remain off-balance sheet in 2002. The off-balance-sheet debt of -$8.6 billion in 2001 was driven largely by the negative $18.2 billion difference between what companies expected to earn on their pension assets and what they actually earned. The 2002 shortfall will only add to the problem, as companies appear reluctant to lower their rate-of-return assumptions.
To assess the economic significance of pension liabilities further, we computed the funded status of the pension plans as a percentage of the market value of a firm’s equity (MVE). (We used November 29, 2002 prices and common shares outstanding as of October 25, 2002 to compute equity.) In 2000, only 3 percent of the firms in our sample were under-funded by more than 25 percent of equity. However, we predict that this percentage will to increase to 9 percent for 2002. And as we previously noted, the CSFB report estimates that 30 of the S&P 500 companies it surveyed will have under-funded DB pension plans by the end of 2002.
In Exhibit 3, we list the five Canadian companies that are the most over-funded (Saskatchewan Wheat Pool, Hudson’s Bay Company, Doman Industries, Atco Limited and Maple Leaf Foods Inc.), and the most under-funded (Algoma Steel Inc., Ivaco Inc., Slater Steel Inc., Air Canada and Quebecor Inc.) relative to the market value of their common equity. The under-funded status for all five firms exceeds 30 per cent of their MVE, a portion of which is off-balance-sheet. In the absence of significant increased funding, we expect that their funded status will worsen for 2002. Significantly, their under-funded status increases by more than 30 percent (it more than doubles for Slater Steel and Air Canada) when we include their li abilities for other post-retirements benefits. We explain these benefits below.
Other post-retirement benefits
In addition to DB pension plans, many companies also provide other post-retirement benefits, such as life insurance and healthcare. Unlike pension plans, companies often adopt a “pay as you go” system for these plans, funding only the amount of current-period benefit payments. In 2001, 84 firms in our sample disclosed liabilities relating to other post-retirement benefits, but only 25 percent of these firms had any assets set aside for these obligations. When we add the funded status of these other post-retirement benefits plans to the DB plans, the aggregate under-funded status increases from -$1.8 billion to -$17.8 billion. The total amount of off-balance-sheet debt increases from $8.5 billion to $10.8 billion for 2001.
The declining health of pension plans is likely to increase borrowing costs for companies with large deficits. In 2001, the average company’s debt soared as a percentage of market capitalization, even before the inclusion of off-balance sheet liabilities. This was due simply to the fall in the value of its own stock. When we consider the cost of this fall to company pension plans, the effect is even more dramatic. Using 2000 prices as our measure of market capitalization, the average debt/equity ratio for our sample firms in 2000 is 4.82 excluding, and 4.83 including, the net off-balance sheet DB liability. This is a negligible difference. The same ratios for 2001, calculated using 2001 prices as our measure of market capitalization, are 9.44 and 10.23. To calculate these ratios, we removed the GAAP-based balance sheet accruals from either total assets (in the case of an accrued pension asset) or total liabilities (in the case of an accrued pension liability), and replaced these amounts with the net over-funded or under-funded position.
Credit rating agencies such as Standard & Poors adjust company leverage ratios to include off-balance sheet liabilities as an input to their rating process, which in turn is a key determinant of borrowing costs. In the U.S., Standard & Poors downgraded General Motors’ and Ford’s debt ratings in October, citing pension deficits as the main reason. The problem is exacerbated where companies are required to reduce shareholder equity if their pension liability reaches a critical level. The CSFB report predicts that 26 companies, including International Business Machines Corp. and Ford Motor Co., will see their shareholder equity reduced by at least 25 percent because of charges to equity for this minimum liability. Delta Airlines announced in September that it expected to take a similar charge that would contribute to putting it in violation of debt covenants on two of its letters of credit. Because Canadian companies cross-listed on U.S. exchanges must provide a schedule reconciling both income and equity with U.S. GAAP, cross-listed companies will need to make comparable adjustments.
Future cash contributions
In 2000 and 2001, employer funding was relatively low, likely reflecting the healthy funded status of plans in the late 1990’s. While the aggregate funded status of the top 100 plans decreased by $22.4 billion, aggregate contributions to pension plans by employers increased only $0.3 billion, from $1.5 to $1.8 billion. Also, a number of firms made no contributions to the plan at all: 12 percent made no employer contributions in 2000, while 10 percent made none in 2001.
Although it is difficult to predict funding levels over the next few years, they will likely increase to reflect the deterioration in the funded status. There are two reasons for this. One is that companies with an ageing workforce will run into an immediate cash crunch in their pension funds as they attempt to satisfy the claims of retirees. For example, GM currently has 2.5 retirees for every worker on its payroll, and a 2001 pension fund shortfall of $9 billion. (GM’s Slow Leak, Fortune, October 28, 2002). The second is that, in both Canada and the U.S., regulators monitor the funded status of pension plans, requiring additional funding when pension shortfalls become critical. Funding for Canadian pension plans depends on the filing jurisdiction and is regulated by either the federal regulator, the Office of the Superintendent of Financial Institutions (OSFI), or its provincial counterpart, for example, the Financial Services Commission, in Ontario (FSCO). The regulators typically review a plan every three years; therefore revisions to cash flow requirements lag changes in the economic status of the plan. In the U.S., pensions are regulated under the Employee Retirement Income Security Act (ERISA), providing more stringent guidance than regulations in Canada. Despite the differences, the intent is the same: to protect the claims of employees by ensuring that pension funds contain sufficient assets to fund their retirement. For example, GM was required to inject an unanticipated $2.2 billion into its pension fund in 2002 in order to satisfy ERISA regulations.
Pension expense and operating income
A final element in the pension puzzle is pension expense. As a component of operating income, pension expense is itself made up of three main components: service cost, interest cost, and expected return on assets (ROA), plus adjustments for amortization of various items. Despite losses on pension fund assets, the average expected ROA of our sample firms, as reported in 2001 annual reports, is 7.9 cent, unchanged from the 2000 rate. (Interestingly, 18 firms actually increased their rate from 2000, 23 decreased, and the remaining 59 did not change.) These estimates, optimistic relative to actual performance, but still lower than the 9.2 percent average in the U.S., made the aggregate pension expense to be only $0.15 billion in 2000, and $0.30 billion in 2001. In fact, in both years, 36 percent of the firms in our sample reported pension income rather than pension expense. However, if we replace expected ROA with actual when computing pension expense, the expense jumps up to an aggregate pension income of $3.2 billion in 2000, and drops down to an aggregate pension expense of $18.5 billion in 2001.
While unrecognized experience losses must eventually be recognized in pension expense, they are typically spread out over 15 years. Therefore, operating income will only be dramatically impacted if firms reduce their estimates for ROA. Depending on market performance, there could be increased pressure on firms to lower expected rates of return. In fact, on November 7, 2002, the Canadian Accounting Standards Board released an article urging companies to ensure the reasonableness of their pension assumptions.
Re-examining the accounting rules
The discrepancy between the under-funded state of many pension plans and what they actually (do not) report on the balance sheets suggests that pension accounting may be due for an overhaul. In fact, a new U.K. standard proposes significant changes, although implementation was recently delayed to allow for them to be aligned with International Accounting Standards Board rules. The proposed Financial Reporting Standard (FRS) 17, “Accounting for Retirement Benefits”, requires firms to report the full extent of pension underfunding on their balance sheets. Firms will also have to disclose a pension surplus, to the extent that it can be recovered. On the income statement, of the three components of pension expense currently included under GAAP, only the service component of pension expense will be reported under operating income. The interest cost and expected ROA will be reported as other financing costs, removing the impact of potentially optimistic ROA assumptions from core earnings. Any additional gains and losses (such as differences between actual and expected rates of return) will also be shown on the income statement, after the calculation of net income, as an element of comprehensive income. While the implementation of this standard has been delayed, the International Accounting Standards Board is also re-evaluating its pension accounting rules.
The funded status of pension plans deteriorated markedly in 2001, and we estimate that the situation will only worsen in 2002. In the long run, this negative trend will be reversed if markets recover. However, in the shorter term, companies need to come up with the cash both to fund upcoming retirements, and to satisfy regulatory requirements for pension funding. This obligation will certainly reduce the amount of cash available for investment and dividend payments to shareholders. And until pension accounting rules require companies to record liabilities on their balance sheets, those who read financial statements will still have to wade through the detailed disclosure in the notes to ascertain the real status of company pension plans.