Rising equities markets and a higher long-term interest rate environment mean corporate defined-benefit (DB) pensions are at their strongest since 2001.

In 2009, a typical DB plan was about 70% funded, according to Mercer, a global financial services company. That same pension today is fully funded. “2013 was an amazing year for pension plans,” says Manuel Monteiro, a partner in Mercer’s financial strategy group in Toronto.

So amazing, that of the 607 plans for which Mercer is the actuary, the percentage of fully funded plans rose from 6% to 40% between 2013 and 2014.

But despite this rosy development, DB pensions challenge firms that provide them by making company financials more volatile, because promises to employees must be kept regardless of economic conditions.

And since several S&P 500 and S&P/TSX 60 companies have made these promises, investors shouldn’t ignore pensions’ potential impact.

Why you care

Under DB plans, a company typically collects contributions from employee salaries, and also makes contributions for employees. In exchange, it legally commits to paying a certain sum, sometimes inflation-indexed, to retired employees—regardless of whether there’s sufficient capital to do so.

Yet few analysts monitor this obligation, says Howard Silverblatt, senior index analyst for S&P Dow Jones Indices in New York. That’s a mistake. “You always have to pay attention to anything that has a big liability, even if it’s not due today,” he says.

And while Mark Rosen, co-founder of Accountability Research in Toronto, says it would be rare for a poorly funded pension to sink a stock—“you’d see [a failed pension] in concert with significant other
problems”—underfunding “can depress valuations.”

Unhealthy pensions can also hurt corporate bond ratings. “We look at under-fundedness as additional debt on the firm, and mandatory contributions as similar to debt maturities,” says Rick Tauber, director of corporate bond research at Morningstar in Chicago.

He adds that, with all factors considered, he’d be more comfortable investing in a company without a DB pension than with. “It takes that risk off the table. A pension that’s fully funded today could be a problem down the road.”

Those problems start when a company has a shortfall. “It becomes an issue if [companies are] forced to fund pensions in lieu of investing in their networks,” or delay capital expenditures, maintenance and expansion, says Lee Klaskow, a senior analyst at Bloomberg Industries in New York.

A plan that’s 90% funded or better is a good benchmark. And from an employee perspective, “as long as you have faith the employer is going to be around, even if the plan is 80% funded, you don’t need to worry,” says Monteiro. “But if you don’t think it will be around, you may need to worry, even if the pension is 100% funded today.”

Sectors to watch

Unionized and large-workforce companies tend to have bigger pension liabilities. “The more workers, the more you want to look at it,” says Silverblatt. And companies such as Boeing, Caterpillar, AT&T and Verizon are highly represented by the United Auto Workers union.

Tauber notes Ford and GM have underfunded pensions that are “double, triple their debts outstanding. In that case, pension debt would be 20% to 25% of our rating assessment because we’re looking at a major liability.”

He adds DB pensions primarily impact older industrial companies, such as airlines, defence contractors (including Lockheed Martin and General Dynamics), heavy industrials, metals and mining.

Silverblatt would also watch utilities, trucking and telecom. On the other hand, tech companies have younger, more mobile employees, and tend not to have DB plans. He adds, “The retail sector has [these plans], but they’re not as [large] because a lot of the employees are part-timers.” For public companies, you can determine pension health using financial statements (see “How to examine pensions,” this page).

Goodbye DB plans?

Right now, record levels of corporate cash will help keep pensions healthy. “With interest rates up and companies having significant cash reserves, pensions are a manageable controlled expense,” says Silverblatt. But “pensions for most of the S&P 500 are a dying breed,” he adds.

When the economy bounces back, though, Monteiro counters they’ll likely be used as recruitment tools. “HR concerns will become more prominent as the labour force shrinks, and there’s a war for talent,” he says. “Having a DB plan is a huge attraction.” Nevertheless, a March 2014 PwC survey of Fortune 500 companies finds 83% of them are closing their DB plans to new employees.

Such firms are “capping the growth of the liability and risks,” says Tom Lappalainen, director of strategic advice at Russell Investments in Toronto. “They’re sending a message to investors that it’s a recognized risk to the balance sheet and income statement.”

PwC also found 90% of companies are adopting defined-contribution (DC) plans. These schemes delegate asset management responsibility—and risk—to employees. While the companies may contribute to the pot, they don’t guarantee what employees ultimately get upon retirement.

With DC, “the volatility [inherent in DB plans] doesn’t disappear; you’ve just passed it onto plan members,” says Monteiro. “They bear their own longevity risks.”

Many pension experts wonder if employees should take on that responsibility. “We’ve underestimated the skillset and attention required for people to manage their own retirement programs effectively,” says Lappalainen. “When I think about my son learning to drive, I don’t say, ‘Here’s a book, here’s the theory; now here are the keys.’ That’s a quick way to get my car destroyed. But that’s what we’ve done with DC plans.”

Monteiro adds DC suitability may vary by sector: bank and insurer employees may be more financially inclined, whereas with manufacturing and mining, “plan members may not be particularly savvy, or the company doesn’t think they are.”

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