Corporate Pension Plan Shortfall – The Next Crisis?

US Corporations are walking a thin line with Pension Plan Shortfalls that may well translate into the next global crisis.  Now that the mortgage crisis is behind us (that is, until the next wave of defaults hit due to more interest rate resets and the reconfigured mortgages that fail anyway – and commercial mortgages to boot), US corporations have racked up pension liabilities that in many cases, well exceed any reasonable chance of being met under the current circumstances and assumptions.  To cap it off, there is legislation mandating that corporations hit 100% funding of their pension liabilities by 2011, up from 90% as of last year.  While 10% may not sound like much, for US large cap firms, it’s the equivalent of Billions of dollars they need to come up with, possibly in a lump sum while plans falling below 80 percent funding may face added limits on actions that would further drain assets, such as some lump-sum payments.

Corporations have behaved much like the US Federal government and local municipalities.  When times were good, put aside the bare minimum and make rosy assumptions that the good times will last forever (i.e. pension fund returns will continue to appreciate 10% or more per year into infinity).  Then, when the Black Swan event occurred (but was it?), ask for a bailout.  Not only do companies now face decreasing revenues and massive severance payouts, but the assumptions they used in their pension modeling has turned out to be, well, a bit overly optimistic.  While stocks have rebounded 50% from their low, they are still well off their highs, when corporate pension funds were already underfunded to begin with!  Now the problem has been compounded.  While corporations are not explicitly asking for a bailout at this time, what they are asking for is a delay to the implementation of this “draconian” pension requirement – the one that’s been on the books for years.

On July 29, ERISA, a trade group that represents big businesses on benefit issues under the Employee Retirement Income Security Act, petitioned Congress to approve “relief” on these Pension requirements.  While I shudder at the notion of US corporations having to make a decision as to whether to chop another 15% of their workforce to meet a pension funding requirement, it also irks me that something that is supposed to be so long term, so strategic, so conservative – a pension plan – that so many corporations got it wrong.

How did we get here?  Pension estimates impact earnings.  Earnings influence near term share prices.  Executives are compensated with performance based bonuses, of which share price appreciation is often a major factor – and with stock options (see How Stock Options Work), which are leveraged to share price appreciation from the grant date.  There is a significant incentive to exercise short-term thinking and little incentive to exercise long-term planning in corporate America; kind of like what got us into this mortgage mess.  You mean some of the best and brightest quants on Wall Street, the MIT math whizzes, really thought that US home prices would continue to appreciate at 8% per year ad infinitum?  Of course they didn’t.  Everyone else was pumping mortgage backed securities, so if they didn’t too, they’d be left in the dust.  Well, this pension issue is not much different.  Given the opportunity to shift payments that could have or should have gone into a pension system years ago and to inflate anticipated returns on pension plans – well, that’s good for the next quarter’s earnings number.

What does this mean for the average investor?  Well, near term, it’s tough to say it will have any impact.  The trend is your friend and right now the trend is up (see my take on the “Sucker’s Rally” back when we were 35% off the highs, 15% ago).  Shares are rocketing up from the realization that we have not and will not, enter the next Great Depression. Bond spreads have tightened, currencies are less volatile and shares are recovering.  However, will the Dow hit 15,000 in the midst of a great pension reset which will impact the bottom line of so many large US corporations?  If the legislation sticks, out in the 2010/2011 timeframe when this topic becomes more prominent, it may not look so good.

For further reading on Pension plans and to check whether your company is following pension rules, the US Department of Labor put together a quick reference guide entitled Protect Your Pension.

Tagged as: Corporate Pension Crisis, Pension Shortfall