Investment risks of underfunded pension plans

There is much debate about what investment risk (if any) an underfunded pension will bring. Vague accounting and limited disclosure make it difficult for investors to assess this risk. The following are questions surrounding pension risks and how investors should deal with them.

Key points

  • Only the fixed-income pension plan may face the risk of insufficient funding, because it is the employee, not the employer, who bears the investment risk of the fixed-contribution plan.
  • Insufficient funding means that the pension payment liabilities exceed the assets the company must pay for these payments; the company must increase its contribution to the pension investment portfolio—usually in the form of cash.
  • It is difficult to determine whether insufficient funds have occurred, because pension liabilities are used for future expenditures, and companies may make overly optimistic assumptions about long-term investment returns.

Pension risk definition

From an investor’s point of view, pension risk is the company’s earnings per share (EPS) and the risk of financial conditions arising from insufficient funds in the fixed-income pension plan. Please note that pension risks only appear in fixed income plans.

The fixed-income pension plan promises to pay certain (fixed) benefits to retired employees. In order to fulfill this obligation, the company must invest wisely in order to have sufficient funds to pay the promised benefits. The company bears investment risks because it promises to pay fixed benefits to employees and must make up for any investment losses.

Fixed payment plan

In contrast, in a fixed contribution plan (and sometimes a profit-sharing plan), employees bear investment risks. The company does not directly pay fixed benefits to retired employees, but contributes a certain amount to the employees’ retirement accounts. Therefore, any gains or losses from these retirement investments belong to the employees.

Although the number of fixed-income plans has declined over the past few decades, they still exist, and union companies face the greatest risks.

To assess risk, we must first understand the adequacy of the company’s pension liabilities. “Insufficient funds” means that the debt-the obligation to pay pensions-exceeds the assets (portfolio) accumulated to fund these required payments. These assets are the combination of the contributions of the invested companies and the returns on these investments.

According to current U.S. Internal Revenue Service (IRS) and accounting rules, pension funds can be funded through cash donations and company stocks, but the number of stocks that can be provided is limited to a certain percentage of the total investment portfolio. Companies usually invest as much stock as possible to minimize cash input. However, this is not good portfolio management because it can lead to funds that “overinvest” in the employer. The investment portfolio is overly dependent on the employer’s financial situation in order to obtain future contributions and good returns on the employer’s stock.

If the value of pension assets is less than 95% at the beginning of the plan year—or if assets are less than 80% in any year—the company must increase its contribution to the pension portfolio, which is usually in the form of cash. The need to pay this cash may significantly reduce earnings per share and equity. The reduction in equity may trigger a default under the corporate loan agreement, which usually has serious consequences, from higher interest rates to bankruptcy.

That is the easy part. Now it is starting to become complicated.

Shortage risk

Determining whether a company has an underfunded pension plan seems simple. You only need to compare the fair value of the plan assets (including the present value of the plan assets that the company estimates will have in the future) with the cumulative benefit obligations, that is, including current and future debts. The amount of pensioners.

If the fair value of plan assets is lower than the benefit obligation, there is a pension gap. The company must disclose this information in a footnote to the company’s 10-K annual financial statement.

However, this simple comparison is a deceptive process because the company is actually unlikely to pay the full amount in a relatively short period of time. The company must calculate the present value of benefits that will not be paid until the next few years, and then compare that number with the present value of pension assets.

In other words, it’s like comparing the mortgage on your most recently purchased home with your savings account. The current gap is very large, but you want to pay from future income. By making such a comparison, it is difficult to measure the “real” risk that you will default on your mortgage.

Companies that join unions face the greatest risk of insufficient employee pension funds.

Hypothetical risk

When companies use hypotheses to reduce the need to add cash to their pension funds, hypothetical risks arise. Since we are dealing with long-term obligations and uncertainties, assumptions are needed to estimate the cumulative returns and the amount the company needs to invest to provide these returns. These assumptions can be well-intentioned, or they can be used to minimize any adverse effects on the company’s earnings. There is a very real risk that companies will adjust their assumptions to minimize the gap and the need to provide additional funding to pension funds.

For example, a company can assume a long-term rate of return of 9.5%, which will increase the expected contribution from investment, thereby reducing the need to increase cash. However, if you consider that the long-term return on stocks is about 7% and the return on bonds is lower, then this assumption looks too optimistic. It is also reasonable to assume that the pension fund holds some bonds to meet its short-term payment obligations.

Another way companies can manipulate pension liabilities is to assume a larger discount rate. The cumulative pension obligation is the net present value (NPV) of the expected future benefit payment flow. A higher discount rate will result in lower welfare obligations. Investors need to review the company’s assumptions about current economic trends and expectations to assess their reasonableness.

Bottom line

The risk of insufficient pension funds is real and increasing. Insufficient pension funds and an aging labor force pose very real risks to companies and investors, but gaps and hypothetical risks may be difficult to assess.

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