Recent Stock Drop to Impact Pension Contributions, Cash Flow, Financial Structure and Operating Decisions
The almost 4% recent decline in the S&P 500 from the close of November 5 (recent peak) thru today could not come at a worse time for firms with underfunded pension plans. The median assumed long-term investment performance, for most firms, is now below the 8% median for the year, and noticeably below for the past 5 and 10 year periods. While the median discount rate assumption, of 5.9%, has seen some minor relief, it is still providing pressure, given the fall in yields during 2010. The discount rate assumption compares with a current 2.77% 10 year treasury rate while annuities hover around 3.8%. Firms may also elect to partially close out its plan thru annuitizing a segment of its population.
The median fund on the list below is, according to CT Capital’s estimates, 21% underfunded, when taking current market values and recent multi-year returns into account. Even firms like Honeywell (HON), whose stock saw relief following its recent announcement of them placing $2 billion total into its plans this and next year, will be affected. Its change to reflect current market values (from smoothing) would not make sense (from a current funding viewpoint) should equity prices continue to fall. Even for Honeywell, a strong credit with access to the cheap commercial paper market, $2 billion is significant.
As we have seen with so many firms on the list below, stepped-up contributions have become the norm, as we forecasted this past summer. The impact to cash flows and financial structure are material and affect equity valuation.
We have received many requests to run the list again, given the recent fall in equity prices. Some firms on this list will undoubtedly resort to the type of financial engineering which took place at Heinz (HNZ), which set up a was receivable securitization program from which it received $84MM while bringing in an additional $48MM from a total return swap. They also “worked its balance” sheet,” all of which helped provide the cash to fund its additional contribution. It was only because of these measures that Heinz was able to report an improvement in its cash flow from operating activities.
If stocks should decline through the balance of the year, firms which have not yet announced will be forced to, impacting operating and free cash flows. The best scenario would be rising equity and yields so that firms could match their liabilities and be able to get on with their operating businesses. Until that time occurs, the pension deserves careful watching, as it impacts operating decisions, including acquisitions, capital spending, research and hiring.
One should expect to hear of additional contributions through the reporting and 10K season. The funds will come from a combination of internally generated cash, borrowing, asset sales, or other creative financing. The only question will be if investors buy the company line “it doesn’t affect our operations.”
For additional information, contact Kenneth S. Hackel, CFA.
Related articles:
- Honeywell (HON) Pension Accounting
- Honeywell’s (HON) Pension Announcement a Smokescreen—It Does Impact the Firm and its Valuation
- Pensions—What UPS’s $2 billon Bond Sale Represents
- Death, Taxes, and Health Care Costs
- IBM – Again, Pension Underfunding a Leading Indicator
- With 3-,5-, and 10-Year Stock Returns Negative: Why Are Pension Funds Assuming 8% Returns?
- What Investors Don’t Understand About Pension Plans
- Pension Facts: Why The Hit to Earnings and Cash Flow Is Upon Us
Disclosure: No positions
Kenneth S. Hackel, CFA
President
CT Capital LLC
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If you are interested in learning more about cash flow, financial structure and valuation, order “Security Valuation and Risk Analysis” (McGraw-Hill, 2010).
