The bear facts about pensions
Jan 15th 2003
From The Economist Global Agenda
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www.economist.com]
The three-year bear market has left many companies with big pension shortfalls, which may weigh heavily on share prices for years to come
IN THE bull market of the 1990s, many firms boosted their profits by taking “holidays” from contributing to their staff pension funds. Since the funds were stuffed with shares, which were soaring, they seemed more than amply funded to meet future payouts to retiring workers, so there seemed no need to keep putting money into them. In America, the peculiarities of the accounting rules even allowed some firms to treat part of their pension funds’ surpluses as though they were income earned by the company itself.
But now, after three years of falling stockmarkets, at a time when interest rates (and thus the returns on bonds) are also low, many pension funds have swung dramatically from surplus to shortfall. This week, Watson Wyatt, a consultancy, estimated that pension funds worldwide have lost a staggering $2.8 trillion—21% of their value—since 1999. The persistence of the downturn, and the closer attention to accounting practices following recent corporate scandals, is forcing firms to make hefty top-ups to their pension funds that will cut their earnings and thus depress stockmarkets further.
The latest big company to face up to the problem is NCR, a computer-maker, which said this week it would set aside $850m from its retained earnings to cover increased pension liabilities resulting from the stockmarket decline. Oddities in the accounting rules on pensions last year allowed NCR to boost its stated profits with $74m of pension “income”, even though shares plunged. But the persistence of the stockmarket decline means that this year the company will be forced to deduct $95m of pension expenses from its stated earnings.
The pensions crisis is worst at older, heavily unionised firms with lots of retired staff and generous benefits. Last week, General Motors said it would triple, to $3 billion, its annual contribution to its pension fund, to start reducing its $19.3 billion shortfall. Ford, another carmaker, whose pension-fund deficit is $7.3 billion, will suffer a $270m pension charge this year after pensions “income” of $190m last year. A report this week from Fitch, a credit-rating agency, said America’s big airlines now have combined pension deficits of $18 billion. The worst affected are Delta and United (the latter currently in Chapter 11 bankruptcy), each with deficits of more than $4 billion. These longer-established airlines, like the majority of large companies in America and Britain, have “final-salary” pension plans (also known as “defined-benefit” schemes), in which the company guarantees that retired workers will get a certain percentage of their final salary. Under such schemes, the company risks having to top up its pension fund at times of poor investment returns, such as now.
However, companies are increasingly moving across to “defined-contribution” schemes in which the company promises only to contribute a certain percentage of each worker’s salary each month to the pension fund. The value of pensions is not guaranteed—it depends on how the fund’s investments perform—and so there is no danger for the companies of having to make big top-ups.
The rising burden of defined-benefit schemes is forcing some firms to restrict them to existing staff and to put new recruits into new, defined-contribution schemes, thereby transferring to the employee the risk of low investment returns in the future. Britain’s National Association of Pension Funds, which represents 1,400 retirement funds, says 84 of its members closed their final-salary schemes to new members last year, up from 46 in 2001.
Optimists hope that the big top-ups that many firms are having to make to their pension funds will be invested in the stockmarket, thereby helping the market to recover. But pension funds are already over-invested in shares by historic standards, so this may not happen. Meanwhile, the cost of pension top-ups will eat into companies’ earnings and thus depress share prices further. Steve Russell, a stockmarket strategist at HSBC, says that the 350 top publicly quoted companies in Britain now have a combined pension deficit of £36 billion ($58 billion). Unless this is wiped out by a dramatic rebound in the stockmarket, he reckons, paying it off will cost firms about 3% of their profits for the next five years. American firms face a similar hit to their profits as a result of their pension shortfalls.
With or without profits?
The bear market is hitting other types of investment besides pensions. In Britain, small investors who put their money into so-called “with profits” life-assurance policies and endowment mortgages also face disappointment, as falling stockmarkets force insurers to cut the annual bonuses they pay out. This week, Aviva, Britain’s largest insurer, became the latest to do so, cutting its bonus by 0.5%, to 3.25% of the fund balance. This follows Britannic’s revelation last week that it may not pay any bonus. It seems likely that the falling returns on what had hitherto been seen as safe investments might drive many potential customers away—thereby driving the insurers’ share prices down further, as well as reducing the flow of money into the stockmarket.
The current bear market is unusual in that it has come at a time of falling interest rates and bond returns, making it harder still for pension funds and insurers to earn good returns. The growing shortfalls in many funds, combined with a tightening of accounting standards (such as Britain’s new FRS17 rule, which makes companies face up to pension liabilities sooner) mean that many firms face a drag on their earnings for years to come. Another good reason (as if fears of high oil prices and a crashing property market were not enough) to be gloomy about the stockmarkets’ short-term prospects.