Underfunded Pensions are Red Flag for Investors: Greenberg


As we enter earnings season, here’s something you must pay attention to: Underfunded pension funds at public companies.

This is something that for years has been swept under the rug, but as Ken Hackel points out, that is about to change or should change.

Hackel, publisher of the always-smart credittrends.com and author of “Security Valuation and Risk Analysis,” has spent years analyzing companies for mergers and acquisitions, and knows a thing or two about analysis and risk.

His take: With three, five and 10-year stock returns negative, there is no way companies should be assuming 8 percent returns on their pension funds.

Yet that’s assumption of the median S&P 500 firm. And short of suddenly making up losses—and adding another 8 percent gain on top of that—Hackel does not believe companies can avoid the inevitable: Raising the funding expense, which in turns will lead to lower earnings and the need to guide down.

This can be fairly arcane (and, let’s be honest, not headline-making) stuff. As a result Hackel doesn’t believe most overworked Wall Street analysts will pay attention “until it is put in front of their faces” by the companies.

And they have to start now. Among his reasons:

  • The most obvious reason is investment performance, which has taken a hit.
  • The pension protection act of 2006 requires funds to be fully funded starting next year.
  • Misleading actuarial assumptions that assumed, on average, 8 percent returns.
  • The cost of benefits.
  • The aging workforce.
  • And the ratio of retired to active employees.

All of this means they will need to adjust various assumptions to more realistic levels. Each adjustment downward impacts earnings.

Consider, for example, that in its 10-K, Campbell Soup said it would lower the discount rate on its pension plan to 6 percent from 6.87 percent. As a result, Campbell’s cash contribution to its pension plan will rise to $80 million from $70 million or, according to Hackel, 10.9 percent of after tax income.

Hackel believes plenty of companies will be forced to re-adjust assumptions to catch-up on their pension funding.

Among them—and assuming investment returns don’t post substantial returns between here and there:

  • Goodyear Tire & Rubber, which has been dogged by pension fund issues for years. On its most recent earnings call, in April, the company insisted its pension expenses should become less. But Hackel says that according to his analysis, Goodyear’s plan is underfunded by $2.7 billion. The estimated catch-up, he says, would result in a $1.76 per share hit to earnings in each of the next four years. (This year analysts expect Goodyear to earn 22 cents per share; $1.49 next year.
  • IBM, which despite historically strong returns on its pension is underfunded by $8 billion. According to Hackel, that translates into an earnings hit of 45 cents a share in each of the next four years. IBM, this year, is expected to earn $11.27 a share. On its May investors’ update, IBM CFO Mark Loughridge spent quite a bit of time discussing pensions, in an almost strategically proactive manger, trying to distinguish operating from non-operating results.
  • Caterpillar is underfunded by $3.78 billion, and based on Hackel’s analysis will need to add the equivalent of 49 cents a share to earnings; estimates call for earnings of $3.20 a share. On its last call, the company merely noted pension costs were higher.
  • Rockwell Automation, with a $599 million underfunding. Hackel believes the company will need to find 34 cents a share over several years to get its fund whole. The company is expected to earn $2.90 this year. It was not discussed on the last earnings call.
  • International Paper, which is underfunded by $2.7 billion, acknowledged the looming hit. Said CEO John Faraci on last quarter’s call: “That number becomes a moving target based on interest rates and returns, so we don't want to end up with on over flooded pension plan, but we have a couple of billion dollars over a several-year period that we anticipate we’re going to need to put into the pension plan.”

My take: Analysts and the companies may try to do as IBM has done—talk this away as non-operational. Either way, it’s part of doing business, it’s real cash, it’s unpredictable and it’s coming soon to a company near you. Don’t say you weren’t warned.


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