Editorial: Under Funded Pension Plans

Will equity markets force pension plans to rethink investing ?

Non-surplussed: Large company pension plans now underfunded
Plan sponsors see a $70 billion decrease in funding status in Q1; from overfunded to underfunded in three months

By Mark Bruno
April 7, 2008 3:39 PM ET

For large corporate pension plan sponsors, it appears things have gone from bad to worse in a hurry.

According to a new report from Mercer, large corporations saw their pension plans lose a collective $70 billion off their combined funded status during the volatile first quarter. Adrian Hartshorn, a principal in Mercer’s financial strategy group, pointed out that pension plans sponsored by S&P 1500 companies are now only 98% funded.

That’s down from a funded status of roughly 105% at the end of 2007.

“It was a particularly turbulent period for the equity markets,” said Mr. Hartshorn. “And corporations are quite vulnerable to such volatility.”

Most corporations still have the vast majority of their pension plan assets invested in equities, he said. Not surprisingly, a 10% drop in the S&P 500 during the first three months of the year triggered the plunge into underfunded territory.

Over the past five months the value of the assets of pension plans sponsored by large companies dropped by $140 billion. Combined, these companies’ pension plans were operating at a $120 billion surplus at the end of October 2007. Now, Mercer says the plans are sporting a $20 billion deficit.

“All things considered, however, companies could have been in much worse shape,” Mr. Hartshorn said, pointing out that high-quality corporate bond yields increased during the first quarter, prompting corporations’ calculated liabilities to decrease. “The rise in yields provided some relief—just not enough to offset the blow plan sponsors sustained in the equity markets.”

How Safe Are You ?

Is Your Pension Still Safe?
Probably. But new rules could make it harder for you to get all of your money.
By Mary Beth Franklin, Senior Editor
From Kiplinger’s Personal Finance magazine, March 2009

John Sidorenko has hit a few speed bumps along his route to retirement. In December 2007, Delphi Corp., the financially troubled auto-parts manufacturer, shuttered the Columbus, Ohio, plant where Sidorenko had worked as an engineer for nearly 31 years. That was two years before he had planned to retire. But thanks to a comfortable nest egg — his pension plus his 401(k) plan — and the fact that his wife, Betsy, continues to work as a school administrator, Sidorenko, 55, could afford to take an early retirement while many of his colleagues searched for new jobs.

Then last September, Delphi froze its pension plan — meaning current employees will keep whatever benefits they have earned so far but will not accrue future benefits. Fortunately, Sidorenko’s monthly pension checks haven’t been affected, at least not yet. “We’re assuming his full benefit is safe — for now,” says David Kudla, head of Mainstay Capital Management, in Grand Blanc, Mich., and Sidorenko’s longtime financial adviser. But if there is a future reduction in Sidorenko’s pension benefit, he might have to draw more money out of personal savings.

Meanwhile, Sidorenko is thriving. “It’s been better than I expected — not having the stress of the job and having leisure time for projects,” he says.

Pension Protections

Most private-sector defined-benefit pension plans are insured by the Pension Benefit Guaranty Corp., which is funded by insurance premiums paid by employers. If a company’s pension plan becomes underfunded and the company cannot make up the shortfall, the PBGC takes over and continues to pay retirement benefits up to the limits set by law, which are adjusted each year. For a plan that ends in 2009, the maximum guaranteed pension benefit for a 65-year-old is $54,000 a year; it’s substantially less for those who retire at younger ages (see the box below). Retirees are entitled to no more than the maximum amount for their age in the year the plan ends. Those retiring later can receive up to the maximum amount for their age at retirement based on PBGC limits in effect in the year their plan ended.

In 2007, the PBGC took over more than 100 insolvent pension plans. The agency says that more than 80% of retirees in PBGC-administered plans receive their full benefits. But if Delphi terminates its pension plan and turns it over to the PBGC, Sidorenko could lose a chunk of his pension check that exceeds PBGC limits.

Kudla, whose clients include current and former employees of General Motors, Ford, Chrysler and Delphi, says he has been inundated with questions about the safety of their pension plans. “Some people think if their company goes bankrupt, they lose their pension,” he says. But traditional defined-benefit pension plans are protected by ERISA (Employee Retirement Income Security Act of 1974). In the event of financial distress, Kudla explains, creditors have no claim on the assets in a company’s traditional pension plan or 401(k) plan.

Don’t confuse your company’s finances with those of its pension plan. They are entirely separate. For example, GM’s pension plan appears to be well funded for now. Meanwhile, ExxonMobil, which posted the largest corporate profit in history last year, has the most underfunded pension of all the companies in Standard & Poor’s 500-stock index. However, Exxon-Mobil can easily afford to dip into its hefty cash reserves to bring its plan up to adequate funding levels. Many other plan sponsors cannot — and that is the root of the current pension-funding crisis.

Funding Gap

Individual investors were not the only ones who lost money in the stock-market crash of 2008. Private pension plans suffered massive losses during the fourth quarter of last year. Plans sponsored by the largest 1,500 U.S. com-panies went from a surplus of $60 billion at the end of 2007 to a $409-billion deficit at the end of 2008. Mercer, a benefits-consulting firm, estimates that the ratio of pension-plan assets to liabilities fell from 104% at the end of 2007 to just 75% at the end of 2008.

But the market crash is only part of the pension-funding problem. The Pension Protection Act of 2006 reshaped the funding rules for employers who sponsor defined-benefit plans. These rules, which required employers to increase contributions to meet more-stringent pension-funding targets, took effect in 2008 for single-employer plans — just as companies were facing enormous economic challenges to keep their businesses afloat.

Unless the stock and bond markets improve significantly and quickly, these pension-plan sponsors will have to boost their contributions by an estimated $60 billion this year to make up the shortfall between promised benefits and current assets, according to the Mercer analysis. The money has to come from somewhere, and that increases the possibility that some companies will have to lay off workers, freeze their pensions or go bankrupt. “Money that is needed to save jobs and for capital investment would instead be directed to pension plans as a result of sudden, unprecedented market conditions,” warns James Klein, president of the American Benefits Council, a national trade association that represents private employers.

Just before adjourning last year, Congress approved relief for employers, allowing them an additional few years to meet pension-funding targets. But it did not alter new restrictions that prohibit underfunded pension plans from paying some or all of re-tirees’ benefits as a lump sum. In the plans that permit lump-sum distributions (roughly half of all plans), more than 70% of eligible retirees choose the lump sum instead of a monthly annuity payment, according to the Employee Benefit Research Institute. “The new law is intended to shore up pensions and put an end to underfunded plans,” says Brett Goldstein, a pension administrator and president of The Pension Department consulting firm, in Plainview, N.Y. “However, in a time of financial crisis, the law is actually hurting employees who are relying on their pension as their primary source of income at retirement.”

Payout Restrictions

Under the new law, if a pension plan does not have enough money to pay at least 80% of plan obligations, then payout restrictions apply. In that case, retiring employees would be allowed to take only half of their pension as a lump sum. The other half would be distributed as a monthly annuity check. If the plan is less than 60% funded, retirees cannot take a lump-sum distribution at all and must accept monthly checks (except when lump sums are $5,000 or less). Restrictions may not apply to some collectively bargained multi-employer plans until 2010.

Pension plans that were less than 80% funded in 2008 have until April 1, 2009, to meet their target funding levels or be subject to payout restrictions, says Ethan Kra, chief retirement actuary for Mercer. “A fair number of plans will be subject to payout restrictions come April 1,” Kra predicts.

He suggests that if you are planning to retire this year and you want a lump sum, ask immediately about your plan’s funding status for 2008. If it’s less than 80% funded, get all your paperwork in order and have your employer cut you a check by March 31 — or it may be too late.

New retirees aren’t alone in being hurt by the payout restrictions. Workers who have a cash-balance plan — a hybrid that allows you to take a lump sum with you when you change jobs — could also be affected. Younger workers who switch jobs or get laid off this year could have trouble taking a lump sum with them when they leave.

Goldstein recommends that all pension-plan participants ask their plan administrator in writing about the funding status of the pension and whether there are any restrictions on lump-sum distributions. “You can’t do anything about the restriction, but if you were counting on a lump sum, you need to know now if you may have to look for other sources of income,” says Goldstein. To find out whether your plan is in trouble, go to the Web site of the Pension Rights Center and click on the fact sheet that helps you determine your plan’s status.

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$1 homes abound

A dollar doesn’t buy much these days. But in Detroit, it can buy you a house.

Real estate agent Ian Mason, who specializes in selling foreclosed properties, showed us a two-bedroom, 800-square-foot home that his agency recently sold for a single dollar.

“It wasn’t much of a negotiation,” said Mason, who works for Bearing Group. “The seller was ambitiously looking to get rid of it.”

That’s because the seller, a bank, was losing thousands each month in maintenance costs and taxes just to hold onto the foreclosed home, which is badly in need of new paint, carpeting, and bathroom fixtures — but otherwise appears structurally sound and free of mold.

For the price of a can of soda, Mason says it’s a bargain.

“I think you can make this house clean, safe and functional for $500 to $1,000,” said Mason.

There are more than 40,000 vacant properties in Detroit, which has been hit hard by the foreclosure crisis, and the median home price is a stunningly low $7,000. In many neighborhoods, homes that were fetching $75,000 just three years ago are now selling for ten cents on the dollar or less.

“Some of the homes are very nice. Some of them are falling over,” said Mason.

It’s not just Detroit. This weekend, hundreds of foreclosed houses were being unloaded at fire sale prices at giant auctions in New England and New York. For the banks that are in possession of these properties, time is money.

In Detroit, home prices have plunged more than 20 percent, but sales volume is up 37 percent in the past 12 months.

Many of the buyers are real estate investors like Bret Russell. The Michigan native has purchased and renovated more than 120 Detroit-area properties, converting them into rental homes. He works closely with Mason to find the best houses at the lowest prices.

“I see very little risk in the market currently,” said Russell. “You’re buying a home for $10,000. If it goes down to $8,000, your rents are very strong, so from a cash-flow standpoint, you’re on steady footing.”

Remember this is a bear market rally:

Red flags abound

While Wall Street enjoys its relief rally Tuesday, stocks face looming danger from a familiar foe: tightening of credit.

Several metrics that market analysts use to gauge the availability of credit have been signaling trouble in recent days, throwing up a caution flag that tougher times could lie ahead for the availability of cash.

That’s a formula that always spells trouble for investors.

“Unless we start seeing a reversal of the widening of a lot of these credit spreads, any equity rally is going to be short-lived,” says David Lutz, managing director of institutional trading at Stifel Nicolaus. “Unless the credit markets are cooperating, it’s going to be very hard for equities to rise.”

A lack of confidence in Obama administration policies, combined with unabated declines in the economy, are fueling banks’ renewed reluctance to lend. And that’s being reflected in a number of key data points in the credit markets.

“The euphoria over the new administration is out the window at the moment,” Lutz says. “We’re seeing the fact that since they haven’t been able to roll out a comprehensive housing or financial program, it’s a sign they don’t have the right idea yet.”

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Among the signs that analysts say point to credit problems are Libor, or the rate banks charge each other for overnight lending; The “Ted spread,” which is the difference between 3-month Libor and the 3-month Treasury bill; two-year credit default swap rates; and the Commercial Mortgage-Backed Securities index, or CMBX.

Libor rates have swelled to prices not seen since December, with the trend indicating a June three-month rate of 1.7 percent, Lutz said in a research note. A widening in Libor emanates from lower confidence that institutions have in each other and leads to tighter lending policies. Three-month Libor gained Tuesday to about 1.33 percent.

Similarly, the CMBX and the two-year swap spread both are at four-month highs, while the Ted Spread, which indicates willingness to lend, also is moving lower, falling Tuesday to 1.09 percent.

* Get a Full Rundown of Credit Spreads and Libor Here

None of it bodes well for the credit picture in 2009, and if credit tightens up, the stock market will feel the pinch regardless of what Tuesday’s sharp rally indicates.

Stocks surged at the open on some encouraging words from Treasury Secretary Ben Bernanke regarding aid for banks in valuing distressed assets. The market punched up further following the government’s decision to reinstitute the uptick rule, which requires a move higher in a stock before it can be short-sold.

“With those four things showing more and more strain, there’s a disconnect with equities rallying the way they are,” Lutz says. “If they keep trading this way it’s definitely an indication that there could be another leg down in stocks.”

To be sure, the credit indicators are nowhere near the depths of September 2008 or so when lending all but dried up completely.

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But the inability of aggressive government action around the globe to eradicate credit issues is disturbing.

“After several months of swift declines and an environment where global central banks continue to cut short-term interest rates, any increase in Libor rates is a troubling reminder of the tension in credit markets,” says Greg McBride, senior financial analyst for Bankrate.com. “The equity markets have effectively been behind the curve of what the credit markets have seen and experienced first-hand.”

While analysts are quick to point out that the tightening is not at alarming levels at least in the short term, there’s concern over the pressure the failing economy will put on lending practices.

Following a year of aggressive money-easing, Fed fund futures now are indicating a 30 percent chance that the central bank will tighten monetary policy by June.

“The underlying economy continues to deteriorate. The default rates on some of these underlying loans has been able to go up,” says Mike Larson, an analyst with Weiss Research. “While they’ve been able to buy a period of calm, we have yet to see if it’s a genuine turn and not just driven by Fed largesse.”

Other indicators that have analysts concerned include the difference between investment grade bonds and Treasurys, as well as increasing problems in the commercial real estate business that will be reflected in the CMBS rates and other metrics.

Until the government can turn around the news cycle, credit issues likely will remain a significant concern.

“There’s a lack of confidence and a tremendous amount of uncertainty over the fact that all the heavy artillery that the Fed, the Treasury and other central banks around the globe have been throwing at the problem has shown little impact thus far,” McBride says. “Pessimism rules the day.”

Shorts get squeezed today:

The so-called uptick rule, which limits short-selling in stocks, could be restored soon, Rep. Barney Frank of the House Financial Services Committee said.

“I’ve spoken to Chair (Mary) Schapiro of the SEC. I am hopeful the uptick rule will be restored within a month,” Frank told reporters.

His comments accelerated a rally in stocks, which were already gaining on Citigroup’s comments that it was now profitable.

The uptick rule allows short sales only when the last sale price was higher than the previous price.

The rule was first adopted in 1934, five years after the 1929 stock market crash, to prevent short sellers from adding to the downward pressure on a stock that is already falling sharply.

The rule was repealed in June 2007.

“Mary is moving towards the uptick rule, which some people think is very important, some people think it’s not important, nobody thinks it does any harm,” said Frank who is Chairman of the House Financial Services Committee. “I think that will go back (into effect).”

The SEC has so far declined any official comment on Frank’s statements.

The uptick rule is different from the ban on “naked” short selling that was imposed temporarily last summer to prevent the downward spiral in financial stocks. The ban, which was lifted last fall, required investors to actually borrow shares of a stock they were shorting. This prevented “naked” selling, in which investors could put unlimited selling pressure on a stock.

At her confirmation hearing in January, Schapiro told lawmakers the agency would look at the entire area of short- selling and whether to reinstitute the uptick rule.

Several members of Congress have called for a return of the uptick rule. On January 9th, U.S. Rep. Gary Ackerman (D-NY), a Senior Member of the House Financial Services Committee, reintroduced legislation that would reinstate the rule.

Barry puts a toe in the water: