With interest rates at near record lows, pension funds are finding it increasingly difficult to meet their return expectations while maintaining their conservative approach to investing. In the past, pension plans have favored fixed-income investments, as bonds provide a reliable income stream that the pension funds can match against future obligations. At today’s interest rates, though, it is no longer possible to achieve return targets while also favoring bonds over equities. Something has to give.
The dire state of public pensions has recently been thrust back into the public spotlight with the California Public Employees’ Retirement System (CalPERS) returning a meager 0.6% in the twelve months ending June 30. CalPERS is the biggest U.S. public pension fund with $300 billion in assets. The 0.6% return is far below CalPERS twenty year investment target of 7.5%. Usually one year of low returns wouldn’t be too much of a concern, but it comes on the back of 2.4% return a year earlier. The sub-par returns of the past two years have decreased CalPERS’s twenty-year return to 7.03% annually. This doesn’t seem like a big shortfall, but over long periods of time a 0.5% decrease in annual returns can make a huge difference. And CalPERS is hardly alone. In May, the Hoover Institution, a think-tank, estimated that US public pensions have a $3.4 trillion funding deficit – a rather large hole to say the least.
If pensions continue to fall short of their return expectations, they will be faced with the following options: 1) reduce commitments to retirees; or 2) increase contributions from workers, the company or in the public arena, the taxpayer.
There a two types of retirement plans. The first is a defined benefit pension plan, where the employer is responsible for providing a predetermined stream of payments to the employee during his or her retirement. Under a defined benefit plan, the employer carries the investment risk. The second type is a defined contribution plan, with the most common being a 401(k) plan. Under a defined contribution plan the company may or may not make contributions but does not promise any specific level of future benefits. The employee is responsible for making the lion’s share of the contributions as well as picking the investment vehicles. Therefore, the employee assumes all the investment risk. By and large, companies have moved away from providing employees with defined benefit plans. However, many publicly listed companies still have defined benefit pension exposure through legacy pension plans.
According to Mercer, private U.S. pensions rely on a 6.9% annualized return to cover the costs of retirees and meet other obligations. As of May, 2016, Mercer estimated that companies within the S&P 1500 had pension plans that were just 79% funded with an aggregate deficit of $498 billion. This is up $94 billion from the end of 2015. The main reason for the $94 billion increase in pension deficit was a decrease in high-quality corporate bond yields  from 4.24% to 3.75%. Lower bond yields mean lower expected returns, and lower expected returns widen the pension deficit (all else equal). And with stock market indices at near record highs and bond yields at record lows, the growing concern is that this deficit will continue to increase as companies find it hard to meet their 6.9% hurdle.
Pension accounting is very complicated. What investors need to be aware of is that pension shortfalls can have serious implications for companies’ profitability if the value of plan assets gets too far below the projected future obligations. In addition, investors should know that capital markets volatility can change the projected future obligations, sometimes quite dramatically. However, the accounting for pensions allows for a smoothing effect so that the impact on any individual year is generally small. This smoothing effect can sometimes lead to investor complacency regarding the implications of ballooning pension obligations and/or funding shortfalls. Ultimately, the company will be responsible for narrowing the gap between plan assets and liabilities through cash contributions. Therefore, deterioration in the equity and/ or bond markets can have a materially adverse effect on the financial stability of a company with defined benefit pension exposure. With such a large aggregate funding deficit following 7+ years of massive equity gains and with interest rates at near-record lows, investors need to be more mindful of their exposure.
At Farr Miller and Washington we endeavor to only invest in companies with strong balance sheets and sustainable cash flow. Defined benefit pension exposure is one of the many factors we take into consideration in evaluating a prospective company’s financial strength. We continue to believe that strong financial foundations are being undervalued by investors, and that eventually those management teams opting for financial strength over incremental near-term earnings growth will be rewarded over the long term.
Based on an estimate of the Mercer Yield Curve Mature Plan Index rate.