In times like this, who isn't worried about the financial stability of their place of work? Long before their clients hit the panic button, financial advisors need to be analyzing whether their clients' employers are likely to file for bankruptcy, and if so, what the next steps might be. If a company has a traditional pension plan — and if the plan doesn't have enough assets to cover its promises — the pension and bankruptcy laws make it fairly easy to terminate the plan, which can sharply reduce the employees' retirement payouts. But there are also strong reasons a company might retain its plan. Here are some clues an advisor can look for to help predict a pension plan's fate.
(Excerpted from “Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street,” by Fran Hawthorne, Bloomberg Press. Winner of the 2009 Excellence in Financial Journalism Award for books of the New York State Society of Certified Public Accountants.)
The Relative Deficit
The size of a company's pension deficit alone is pretty meaningless when you're trying to determine whether it will go belly up. Companies have terminated plans with underfundings as small as $23.5 million (Levitz Home Furnishing Inc. of Long Island, New York), and as gigantic as United Airlines' $7.1 billion.
But the size of the deficit in relation to other corporate yardsticks can tell quite a story. Experts look at key ratios such as: pension assets to corporate assets or to market capitalization, pension contributions to cash flow or to revenue, pension liability to market capitalization or to corporate assets, pension underfunding to size of the plan, and size of the work force to net profit. Then, those relative numbers must be placed in still other contexts, compared to broader market averages or the type of industry.
“When the plan isn't all that large relative to the company, usually there are financial management techniques the company can apply,” explained Steven J. Kerstein, a managing director at the Towers Perrin consulting firm. “But when the plan gets large relative to the size of the company, then the usual financial-management approach is too risky.”
One particularly important number is pension deficit (or surplus) as a percent of market capitalization. For the big Fortune 100 American companies in 2005, the median deficit came to 1.1 percent of market cap, whereas for a broader set of 300 companies, in a data base maintained by Towers Perrin, it was 2.6 percent. Kerstein also places heavy emphasis on pension contributions as a percentage of operating cash flow, where the medians in 2005 were 3.8 percent and 6.8 percent, respectively.
Taking another approach, Gordon Latter, a senior pensions and endowments strategist at Merrill Lynch, starts by looking at the size of the underfunding in relation to net corporate assets. If the underfunding comes to less than 10 percent of assets, fine. If it's between 10 and 50 percent, iffy. If it's more than 50 percent, “it could be trouble,” he says.
Whether a ratio is risky or not may also depend on the type of industry. The more volatile the underlying business, the harder it can be to cope when a sudden market drop pulls the rug out from under a plan's funding.
One solid sign of trouble might be found by comparing a target company's ratios with those of a company that just filed for bankruptcy or is on the verge of doing so. Delta Air Lines provides a convenient example because the 2006 ranking of the funded status of the nation's largest defined benefit plans, compiled annually by Pensions & Investments magazine and the Watson Wyatt benefits consulting firm, was published less than two months before Delta dumped its pilots' plan. Not surprisingly, Delta led the chart in both dollar size of underfunding (nearly $6.4 billion) and worst funding ratio (just 50.6 percent funded). And its pension assets were a whopping 145.56 percent of corporate assets — at which point, as a common quip in the benefits world goes, Delta becomes a pension plan with a few airplanes.
Demography Is Destiny
Throughout the industrialized world, demographers are fretting over the aging of the population. Whereas in 2000 there were more than five American workers supporting each retiree, by 2025 there will be less than four, according to United Nations projections.
This demographic decline can be a problem for companies, too. Active workers are the assets; the company is putting money into the pension plan for them, and that money stays in the plan earning interest and compounding until they retiree. Retirees are the debits; they're taking money out. In fact, demography is a double problem, because those debits are also living longer. Bethlehem Steel circa 2001, with nearly eight times as many retirees as workers, has become the dreaded prototype.
But the pension fund deficit can't really get too big if there aren't many employees to begin with, regardless of how old they are. Depending on the industry, payroll can constitute anywhere from 25 percent of total expenses in a highly automated field like oil services, to 70 percent in a more labor-intensive business. Another warning sign: if the average age of the work force is rising.
Pension plans enjoy a certain amount of legal leeway in projecting how much their assets and liabilities will grow over the next few decades. The higher the projected earnings and the lower the projected liabilities, the less a company will have to contribute today. It doesn't take an actuary to realize how tempting it can be to make those projections more and more bullish. Nor does it take an actuary to calculate that the more bullish the projections and the skimpier the funding, the more likely a company is to be hit with an unpleasant shock later when the economy or the markets don't meet those projections.
Financial advisors can gauge where a company's numbers stand in relation to the average and to those of companies with some of the worst-funded plans. For instance, the average projected long-range rate of return on plan assets was 8.5 percent in the 2006 P&I/Wyatt chart and 8.4 percent the following year. Delta, the worst-funded in both lists, aggressively pushed up its assumption to 9 percent in 2006. Northwest Airlines, the second-worst both times and also in bankruptcy, was way up at 9.5 percent. The obvious explanation is that the two carriers relied on overly optimistic projections for a while, didn't contribute much to their plans, didn't achieve their projections, and therefore faced severe cash shortages.
In the early days, most pension trust money was safely, cautiously invested in bonds. As plan managers began to feel more confident of their investment smarts, they moved into more and more daring investments. The 60-40 golden rule of pension-fund management dominated in the 1970s: Invest roughly 60 percent of the assets in stocks and 40 percent in bonds. That was modified by the concepts of diversification and the “prudent man” test, as pension managers edged into real estate and alternative investments.
Now, theory has come full circle back to caution. A small but influential minority of financial and pension experts advocate a concept called liability-driven investing, under which pension funds try to match their assets to their liabilities, usually by investing heavily — or even entirely — in fixed income with maturity schedules that track their pension payment schedules. Although the funds lose the chance to gain on big market upswings, they also avoid the risk of big losses. Financial advisors who agree with this theory could study the asset allocation of troubled pension funds.
Income is only one side of the pension funding story, of course. The other side is the outgo — the amounts the plan pays out in benefits.
A final-average system is the most popular, used in 59 percent of plans, according to Watson Wyatt. As the term final-average implies, the pension payout is based on the average of the retiree's last few years' pay (typically the last three or five years). A career-average plan is found in 27 percent of plans, according to Wyatt, and works much like the final-average, except that the pension is based on the person's pay throughout his or her entire tenure at the company. Finally, a flat-dollar system pays the same for everyone, regardless of salary: Everyone gets X dollars multiplied by years of service. About 14 percent of companies use this system, including most unionized and big industrial companies, said Sylvester Schieber, a veteran consultant who retired from Wyatt in 2006.
Since most people's salaries are highest in their last years, the final-average system would seem to provide the richest payout. In the real world, however, neither the career-average nor flat-dollar system stays static. Because the flat-dollar system is common in unionized industries, the dollar multiplier is usually increased with every contract negotiation. Similarly, the career-average formulas “get updated to take into account what's going on in an inflationary environment,” Schieber said. Net result: All three tend to end up with roughly similar benefits, according to Schieber.
The catch is that only the final-average-pay type is actually funded appropriately in advance. That's because it's the only one whose formula acknowledges from the start the fact that the benefit will inevitably increase.
Whether a company keeps its pension plan intact is not just a question of money. Morale is always a concern when something is taken away from workers, be it salaries, benefits, jobs or perks — or, in the case of pension promises, trust. Would employees be so demoralized that they wouldn't be able to work properly? Would they sabotage the company? Would so many key employees flee that the company would be crippled? In light of those possibilities, would the company decide that terminating the plan is just not worth the cost and instead find the cash somehow to keep the pension plan going?
Those are the questions Michael A. Kramer, a partner in the investment boutique Perella Weinberg, asks when he analyzes the potential for restructuring a troubled company. He looks at the company's labor relations history, the employee benefits that would remain after a plan termination, what types of retirement benefits competitors offer, and how many retirees would be fully covered by federal pension insurance through the Pension Benefit Guaranty Corporation (PBGC). Is there another factory in town that people can go to? Do [the workers] all run out the door if you terminate their pension plan?
What The Feds Look For
The PBGC doesn't like to be surprised. Through its early warning program, it monitors companies' pension insurance programs, looking for “any transaction that may pose an increased risk of long-term loss'' to the program, according to its own description. Among the transactions that might worry the PBGC are a spin-off, leveraged buyout, major divestiture, payment of extraordinary dividends, or an exchange offer that involves trading a “significant amount” of unsecured for secured debt. According to agency rules, the warnings focus on companies whose bond rating is below investment grade and whose plan is underfunded by at least $25 million, or companies with a bond rating of any quality and an underfunding of at least $5 million.
Bankruptcy carries its own costs, of course, and they're not insignificant. Shareholders are wiped out. Customers may flee. So might key employees. Creditors will set tougher terms for any future loans or purchase of raw material, and they might even demand that management be replaced. So companies do not take this step lightly.
But bankruptcy has simply gotten a lot cheaper, easier, and more socially acceptable than it used to be. Former U.S. Comptroller General David Walker views the rush to bankruptcy and pension-dumping as part of a larger decline in society's moral values. “Before, there was a taint to going into bankruptcy. When you see that employers have been able to terminate their [pension] plans and have to pay only cents on the dollar, and with the realization that the taint associated with declaring bankruptcy is gone — well,” he concluded sadly, “it's not surprising that more people would be considering this as a viable restructuring option.”