Why You Should Consider Defined Benefit Pension Plans Before Investing

April 13, 2017

Why You Should Consider Defined Benefit Pension Plans Before Investing

  • By adjusting a few percentage points on expected returns and discount rates, unfunded amounts become huge.
  • It’s essential to check the possible future pension obligations of your investments as they can easily cost you your returns. I’ll show a possible impact on General Electric.
  • If you have a defined benefit plan of any kind, don’t take it for granted. The only certain retirement income is the one you provide by yourself.

Introduction

A good way to see what’s going on in the pension fund industry is to analyze the 50 largest defined pension plans of the S&P 500 through Goldman Sachs’s 2016 Pension Review.

The health of pension funds is extremely important for retirees, for investors in those companies, and also for the system as a whole. There’s further evidence that a price earnings ratio of 9 for the S&P 500 in 2025 might not be such a crazy idea, more about that here.

Situation

The pension plan funding rate for the top 50 S&P 500 companies has fallen from 81.6% in 2015 to today’s 81.1% despite a nice 5.6% return on assets achieved.


Figure 1: Corporate pension plan funding is declining. Source: Goldman Sachs.

What I’m most interested in is the allocation of funds, and we can see in the figure below that the percentage in equities has been consistently declining despite the historic bull market we’re in.


Figure 2: Equities have less weight as funds shift to bonds due to the fact that most of the baby boomers will start demanding their funds soon. Source: Goldman Sachs.

Higher interest rates will push bond and stock values down, and have a very negative effect on funding ratios. This could lead to various selling activities among pension funds or individual accounts where many could flee from stocks to treasuries. On top of this, there are other issues that make the pension industry very uncertain.

Are Pension Plan Expectations Realistic?

There are two important factors to look at when analyzing pension funds: the discount rate, and expected future returns.

The discount rate is used to determine the present value of future liabilities. The lower the discount rate, the higher the funds a pension plan needs to have. The discount rate used by S&P 500 companies is 4.1% and has, logically, been decreasing in the last two decades alongside generally lower interest rates.


Figure 3: The average discount rate used to calculate the present value of future pension plan liabilities. Source: Goldman Sachs Asset Management.

However, even if the discount rate has been lowered, the expected returns on assets are still relatively high at 7%.


Figure 4: Expected return on assets from S&P 500 pension funds are still much higher than the discount rate. Source: Goldman Sachs Asset Management.

I wonder how pension funds will manage to achieve 7% with a 35% allocation to equities which will yield around 4% in the long term, and a 44% allocation to bonds which will yield around 2.3% (10-year Treasury). The higher expected return means that there is a lot of speculation involved in estimating future obligations which is never a good thing when related to pensions.

Market Decline – A Scary Scenario

As always, I’m not that focused on what’s happening, but mostly on what can happen in order to better assess my investing risks and not lose money.

Last week we discussed how baby boomers retiring will have a negative impact on the markets. Perhaps it won’t be as negative as what I presented in my article, but let’s see what happens with pension funds if the S&P 500’s price earnings ratio drops to its historical average of 15.


Figure 5: S&P 500 price earnings ratio is 76% above its average. Source: Multpl.

If increased selling of equities for retirement needs—or just plain switching from equities to bonds, as most funds have been doing in the last 10 years—pushes down stock prices, many pension fund managers are in for a hard landing. An S&P 500 decline of 40% would lower funding rates by 15 percentage points and something similar could happen if bond yields further increase. Low funding rates mean that companies would have to put up more of their own cash to cover pension liabilities. This can have severe consequences on earnings and dividends, further lowering stock prices.

A Look At Individual Companies

It’s good to take a look at pension obligations by company in order to implement the above into practical investment strategies.

The largest pension fund obligations lie in the heavy industry environment with companies that have been around for a while.


Figure 6: Check out how much pension obligations could deteriorate the balance sheets of companies like GM or Boeing. Source: Goldman Sachs Asset Management.

I’ll take General Electric (NYSE: GE) as an example. It’s pension fund assets are $45.9 billion while its obligations are $71.5 billion for a total unfunded amount of $25.6 billion. This is already included in GE’s balance sheet but not yet into its income statement as pension obligations go into other comprehensive income. However, if the value of GE’s pension assets drop 30%, which is plausible if a bear market comes along, GE’s unfunded amount suddenly jumps from $25.6 billion to $39.3 billion. The $13 billion provision would erase 17% of shareholders’ equity. This translates into $1.3 per share which doesn’t seem much in comparison to the $30 stock price, but it’s significant and something to keep an eye on. Check your investments to see the risks coming from their defined pension plans.

On The Personal Side

This is just an analysis of S&P 500 pension plans, but the situation with state and local government pension funds is even worse. The last data from Moody’s shows that there are $1.25 trillion of unfunded pension plan liabilities.

The unfunded liabilities depend a lot on the discount rate used. Most still use 7%, while a 4% is better, but you could also use the 2.3% that 10-year Treasuries yield. The differences are huge.


Figure 7: Underwater state pension funds. Source: Forbes.

The main message for today? Take care of your own retirement and don’t rely on some actuary in a cubicle calculating your pension checks by using last century discount rates of above 7%.