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Low yields are a big problem for corporate pension plans [ClearOnMoney]
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Low yields are a big problem for corporate pension plans

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Commentary

Low yields are a big problem for corporate pension plans

14 Sep 2010 by Jim Fickett.

Corporate pension plan underfunding is a chronic problem, but is showing a worse status than usual. The issue is partly investment losses in the last 3 years, and partly that low bond yields make the net present value of future obligations look worse. Companies will likely have to make higher contributions, which will hit income and dividends. If you buy stocks, check that the companies chosen do not have major problems in this area.

Bloomberg has a useful article today surveying this issue, entitled `Silent Heart Attack' for Pensions Driven by Yields. The accounting issue is that the AA corporate bond yield, which is used to discount future obligations to a net present value, has gone very low, raising the present estimate of future obligations. The real issue is that the pension funds have always been underfunded, with the justification being that very high returns would make up the difference, and now it is clear that that was wishful thinking. Bloomberg writes:

The gap between the assets of the 100 largest company pensions and their projected liabilities widened by $108 billion in August from the previous month to a $459.8 billion deficit, actuarial and consulting firm Milliman Inc. said today in a statement.

The shortfall is “like a silent heart attack,” said Kenneth Hackel, president of research and consulting firm CT Capital LLC. “People aren’t recognizing the symptoms until the patient falls on the ground.”

Corporate pension plans are a casualty of Federal Reserve efforts to keep interest rates low to prevent the economy from slipping back into recession. As AA rated company bond yields, a benchmark in determining future liabilities, last month reached the lowest ever, obligations increased $91 billion to $1.54 trillion, Seattle-based Milliman said, without disclosing company names. …

Contributions to the 100 biggest corporate pension plans increased to $54.5 billion in 2009 from $29.5 billion the previous year and compares with an average of $38.7 billion for the prior five years, Milliman said in an April report. Companies may have to spend even more cash to fund their pensions, Hackel said. …

“Liability losses could dwarf even good investment gains,” said John Ehrhardt, a principal and consulting actuary in New York with Milliman. “It’s a cash flow issue, it’s a drag on earnings when you look at the accounting numbers, and it’s a hit to your balance sheet, which can cause all kinds of problems about loan covenants and everything else.”

The assets of corporate pensions relative to their deficits, known as the funded ratio, fell to 70.1 percent in August, also the lowest in at least 10 years, from 75.6 percent the month before, according to the Milliman 100 Pension Funding Index. Pension plan assets declined $17 billion last month to $1.076 trillion, a loss of 1.12 percent. The median expected monthly return for plans in the index is 0.65 percent for 2010, a yearly return of 8.1 percent.

This is an issue that every equity investor needs to take quite seriously. Take dividend stocks, about which I and many others have been writing lately. A concern every investor must have with a dividend stock is whether the dividend is sustainable. This depends on many things. Most often one is advised to look at the business model and the dependability of revenue. A margin of safety is also often advised – dividends should not be too large compared to net income. But pension contributions are also a big issue.

At the moment I'm researching Exelon, a large utility company with both retail and merchant power subsidiaries, and a favorite among those recommending dividend stocks. In 2005 Exelon made a $2.2 billion voluntary contribution to its pension plans, and it was looking as if they would get the underfunding under control. But in 2008 they were heavily invested in risky assets and lost a great deal of money. Now, having made up those losses only partially, and with the lower discount rate greatly increasing the estimate of future obligations, they are underfunded by about $5.8 billion. Compare that to annual net income of $2.7 billion. In the end I think this will probably not be a show-stopper for me, but it is clear that this sort of thing needs a very careful look.

So be careful. When the average Motley Fool, Seeking Alpha, or newspaper article throws out a dividend stock recommendation, it will very likely gloss over difficulties like this. Some hard work is required to make sure you are not getting into a losing situation.