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Falling Markets Push Up Canadian Pension Fund Liabilities
Scott Blythe
 (January 2003) Canada's 100 largest company pension plans are facing an estimated $20 billion shortfall for the 2002 calendar year, up from $1.8 billion in 2001. With flat capital markets, that shortfall could lower many firms' credit ratings while constraining cash flow as companies move to close their pension deficits, according to a study published online in the Ivey Business Journal.
The study, by Christine Weidman, an associate accounting professor at the Richard Ivey School of Business at London's University of Western Ontario, Ivey visiting professor Heather Weir and Ivey MBA candidate Andrej Zybul, suggests that Canadian companies will not escape the underfunding crisis that now besets U.S. defined benefit plans.
In recent weeks, GM, Honeywell, IBM and Hewlett-Packard, among others, have had to boost their pension contributions to slash pension shortfalls. A survey of U.S. pensions plans by Deloitte & Touche indicates that about 60% of companies expect pension expenses to increase from 25% to more than 50% this year after years of pension holidays. A recent survey by Watson Wyatt suggests 30% of U.S. plans will have to make contributions to make up shortfalls for 2002, and as much as 65% will have to make contributions in 2003. That's up from 15% in 2000.
The Ivey study comes amid more bad news for the Canadian pension industry: Morneau Sobeco today published an estimate that the median Canadian pension fund lost 5.1% in 2002, while Mercer Investment Consulting is estimating a 4.6% decline.
Hidden losses
While asset declines are the most prominent feature of the pension crisis, the sources are actually much deeper. Declining stock markets have turned pension surpluses into losses, raising pressure for corporations to make higher contributions to maintain the funded level of a plan. That pressure can sometimes be masked by a pension fund's expected rate of return on its investments.
At the same time, lower interest rates have boosted the present cost of future pension benefits. Future liabilities are discounted to their present value using the interest rates paid by high-quality bonds. Finally, many other retirement benefits, such as extended healthcare and insurance, have been funded on a "pay-as-you-go" basis.
All of these factors mean that Canadian pension funds are much less healthy than they were two years ago, when rising stock markets made for unexpected pension surpluses. The extent of the turnaround in pension fund health may not be apparent because of complex accounting rules and overoptimistic investment expectations, Wiedman and her colleagues suggest. Canadian pension funds are a little more conservative than their U.S. counterparts in projecting investment returns; in 2002, they expected 7.9%, compared to a U.S. projection of 9.2%. Still, the top pension funds saw their assets drop by 3.8%.
Wiedman and her fellow authors note that despite pension shortfalls in 2001, the 100 largest defined benefits plans were able to report pension assets of $6.7 billion. One reason is that differences between expected and realized returns "are accumulated off-balance sheet until they reach a critical threshold."
In 2000, 77 of the largest 100 plans were overfunded, for a total of $20.6 billion. But they only reported net pension assets of $5.7 billion on their balance sheets, thus overstating their pension liabilities, the study says. The next year, however, despite underfunding of $1.8 billion, they reported $6.7 billion in assets, under-reporting increased liabilies. Instead, the pension plans recorded $8.6 billion in liabilities off the balance sheet — the difference between an expected investment return of $9.6 billion and an actual loss of $8.6 billion.
Given a year with equity markets as weak as they were in 2001, the authors expect off-balance-sheet liabilities to widen in 2002 to somewhere between $17.8 billion and $23.5 billion, depending on whether the average plan's investment loss is 4% or 8%. They also expect that only 17 to 22 of the 100 biggest plans will remain overfunded.
Most of those investments losses will still be recorded off the balance sheet in 2002, because companies have proven loath to convert their expected rate of return to the return they actually got.
Unfunded benefits
What will worsen the pension outlook is that many companies are on the hook for other post-retirement benefits, such as insurance and healthcare. In the authors' 2001 survey of pension funds, they found that 84 companies offered additional post-retirement benefits, but only 25 had set aside money to pay for them. That means that in 2001, the 100 largest defined benefit plans had a benefits and pension shortfall of $17.8 billion, not just the $1.8 billion on the pension side.
As off-balance-sheet debt increases, Wiedman and her colleagues predict credit quality will deteriorate, forcing up borrowing costs. Companies will be hit by a double whammy: Not only will their pension liabilities soar in the wake of market losses, but their own market capitalization will decline, making liabilities an even bigger percentage of the companies' market value than before. The study estimates that nine companies will have pension liabilities in excess of 25% of their market value. It also estimates that once pension liabilities are taken into account, the average debt to equity ratio for the top 100 companies has more than doubled since 2000, from 4.83% to 10.23%.
In addition, once pension funds reach a certain threshold of underfunding, they are required to boost contributions to meet solvency and tax regulations. Still, under accounting rules, they can spread pension losses over 15 years. The authors report that the 100 companies' operating income "will only be dramatically impacted if the firms reduce their estimates for return on assets." That's one reason analyst cite for GM trimming its return expectations from 10% to 9%, which many still consider overoptimistic.
Still, there may be an immediate effect on operating income, from two different directions. The first is that many companies are looking at a tranche of new retirees and thus may face a cash crunch. They will also have to raise their contributions in the near future to ensure plan solvency.
Again, this effect is masked by accounting rules. Pension plans are typically reviewed by regulators every three years to ensure that they are adequately funded. Wiedman and her colleagues suggest pension accounting standards need to be overhauled so that the full extent of pension underfunding or overfunding is recorded on the balance sheet and income statement, and not in separate financial statements.
E-mail: invest@barkermoney.com
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