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Pension Plan Poison

October 28, 2002

Wouldn't it be nice if you were able to spend the amount of money you HOPED to make in the stock market, rather than the amount you actually make? Well, almost all of America's largest corporations get to do something very similar. Every year, they include in their "earnings" the investment gains that they HOPE their defined-benefit pension plans will earn.

Sometimes, the pension plans perform about as well as expected, especially over a three- to five-year time-frame. But - and here's where it gets interesting - sometimes they don't even come close to making their anticipated return. Instead, like a first date that features far more bad jokes than romantic glances, reality falls well short of expectations.

For example, during the fiscal year ending October 31, 2001, Deere & Co., the tractor company, expected its pension plan and post-retirement benefit plans to produce investment gains of $657 million. In actuality, however, these plans had losses of $1.419 billion. That's a difference of more than $2 billion! These latest losses bring Deere's underfunded pension liability to more than $3 billion. "At some point," observes Apogee Research, "Deere will have to deposit actual cash into its underfunded pension plan to make up the $3 billion shortfall. And yes, that's real money to Deere…$3 billion represents more than five years' worth of average net income!"

Investors should be aware that Deere is not the exception. "Last week investors were rudely awakened to the troubles that underfunded pension plans could pose for corporate America," writes Jacqueline Doherty of Barron's. "With the stock market down and pension-fund assets shrinking, companies ranging from Continental Airlines to Avon Products to New York Times indicated they had made, or planned to make fresh contributions to bolster the value of their pension plans…General Motors reported that assets in its U.S. pension plan had dropped by 10% this year, which means the company's after-tax pension expense could rise by about $1 billion, or $1.80 a share, in 2003." Standard & Poor's promptly downgraded GM's credit rating. "The primary reason for the downgrade is that poor pension investment portfolio returns have contributed to a huge increase in GM's already-large unfunded pension liability," an S&P analyst explained.

During the great bull market of the 1990s, outsized investment returns created a kind of "cookie jar" full of excess earnings. One way or another, America's creative CFOs made sure that these excess found their way onto the income statement, helping to flatter the reported earnings results. But the devastating bear market of the last few years has brought this practice to a screeching halt. Most of the corporate pension plans that once enjoyed a plump surplus, now find themselves woefully underfunded. Despite this uncomfortable state of affairs, most companies are still in denial. They continue to project robust investment returns for their pension plans.

"Recently," Contrary Investor observes, "plan sponsor/investment industry magazine 'Pension and Investments' studied the assumed rates of forward investment return for the 100 largest corporate defined benefit plans in this country…Although the study only provides data through 2001, here are some of the highlights worth noting: The average expected rate of return among the 100 count sample was 9.3% [and] 88% of the plans had a return assumption of 9% or greater…Yet, 95 of the 100 companies that made up the group experienced negative 2001 plan returns."

Eventually, however, companies will have no choice but to face the music and kick cash into their pension plans. That painful moment of truth has already arrived for a few companies and that moment is close to arriving for a few hundred more.

Barron's Doherty explains: "According to David Zion, an accounting analyst at Credit Suisse First Boston, 360 companies in the Standard & Poor's 500 index have defined pension-benefit plans. Of these, 240 had underfunded plans at the end of 2001, the highest level in ten years. With stocks and interest rates both in retreat -- a poisonous combination that spells lower returns on fund assets and increased pension liabilities -- Zion believes the number of companies with underfunded plans could balloon to 325 in 2003."

For many American corporations, the painful consequences will be twofold: The excess earnings produced by large investment gains in their pension plans will be gone, so CFOs will no longer be able to take a portion of their stock market bounty and book it as reported profit. As pension plan surpluses turn into deficits, many companies will have to contribute cold, hard cash to make up the shortfalls.

Neither of these facts will enhance the investment appeal of a stock like Deere. (It's no accident that Deere is one of Apogee Research's most recent short-sale recommendations.)

"If a pension plan remains underfunded," Doherty explains, "a company over time might need to direct its cash flow to pay its pension obligations before investing in its business, paying down debt, repurchasing shares or making other strategic moves that would benefit investors. The upshot: Companies could end up working for their retirees instead of their shareholders."

"Zion estimates that S&P 500 companies with defined benefit plans will have to make $29 billion in cash contributions to their underfunded plans in 2003, up from $15 billion in 2001."

Longer term, the accumulated pension liabilities are even more daunting. Trevor Harris, head of Morgan Stanley's valuation and accounting research group, tells Doherty. "I think it's a huge issue unless the markets rebound. We have over $300 billion of pension-fund deficits in 2002 for S&P 500 companies. That's $300 billion of cash these companies have to come up with over the next few years, and $300 billion that comes out of corporate cash flow."

Incredibly, through the magic of GAAP accounting, these towering liabilities do not necessarily penalize reported profits…at least not immediately. That's because, as we noted at the outset, companies may, within certain broad limits, include in their EXPECTED pension plan returns on their income statements instead of their actual returns. Last year, the difference between these two numbers was substantial. An actuarial Grand Canyon separated actual returns from expected returns.

"Although pension-fund assets lost $90 billion in 2001, an accounting sleight-of-hand allowed companies to show that income of $104 billion had been generated, Zion says. If the smoothing mechanisms were eliminated, aggregate earnings for the S&P 500 would have dropped by 69% last year," Doherty observes.

Investors would do well to remember that accounting practices can obscure more than they reveal. "Pension plan accounting is hiding a lot of landmines," says Apogee's Tracy.

Watch your step.

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