For years, we’ve been told that the traditional, defined-benefit pension plan was going extinct.
Indeed, over the past several years, companies have abandoned the defined benefit plan in droves. According to a recent analysis by Towers Watson, “only 118 Fortune 500 companies (24%) offered any type of [defined-benefit] plan to new hires at the end of 2013, down from 299 companies (60%) 15 years ago.” But that means that nearly one quarter of the nation’s biggest companies offer some sort of defined benefit plan, while large companies are still responsible for paying benefits indefinitely to millions of workers who served them during the days when these pension plans were more common.
In other words, the leaders of today’s biggest companies are still going to have to spend time thinking about their pension funds and make sure that they are properly funded and able to take care of retirees.
That’s why a bit of really good news, like the fact that people are living longer, isn’t great news for the stock prices of some of America’s oldest and most venerated companies. Will Becker, an analyst at the independent research firm Behind the Numbers, pointed out in a recent research note that in October, the Society of Actuaries updated its mortality tables, which are used to measure life expectancy, for the first time in 14 years. The new numbers show that the average 65-year-old American man is expected to live to the age of 86.6, two years longer than the previous estimate. Women who reach the age of 65 are expected to live 2.4 more years than the 2000 estimate, to the age of 88.8.
This may come as wonderful news for retirees, but it will put pressure on companies to pay more attention and resources to defined benefits plans. Writes Becker:
It appears major changes in terms of accounting for higher longevity risk are coming for US plans. Under the Pension Protection Act (PPA) of 2006, it was specifically noted that defined benefit pension plans have to base the computation of their liabilities on mortality tables prescribed by the Secretary of the Treasury and that these tables must be updated at least every 10 years … given that the SOA just updated these tables on October 27th, the Treasury adoption could occur as soon as 2015.
But are U.S. companies prepared to deal with the changes? Becker continues, “What is perhaps most concerning with this looming impact from higher longevity risk is the fact that Wall Street appears to have regained a comfort level with current pension funding ratios. After all, it was only a few years ago when pension shortfalls were hitting record levels … however according to Deutsche Bank estimates, this record deficit fell basically in half by [June of last year],” because of gains in the corporate bond and stock values.
But these asset markets cannot continue to rise forever. Becker argues that companies that have much of their funds invested in equity markets should be concerned. The S&P 500 has increased more than 120% in the past seven years, but as the recent volatility in the markets has shown us, investors can’t expect this party to go on forever. To identify the companies who will need to give their pension funds extra attention in coming years, Becker looked at non-financial S&P 500 companies with defined-benefit pension plans that satisfy the following criteria:
- They have a significant number of retirees;
- Their pension plans carry heavy (at least 30%) equity exposure;
- Their plans were already underfunded by more than $100 million over the last fiscal year; and
- They are already diverting much of their free cash flow to dividends, share repurchases, and debt servicing
Using this process Becker identified four companies in particular whose stocks could take a hit as life expectency estimates rise:
1. IBM (IBM)
IBM’s stock has fared well in recent years, but executives have kept stock prices and EPS high by repurchasing shares, causing the company to report large free cash flow deficits over the past five years. Becker calls IBM “the 800-pound gorilla of US-based companies” because it has the largest pension-benefit obligation ($99.7 billion) of all the companies he analyzed. While the firm has consistently added employees over the past two decades—giving it a base of workers to support the pension fund—it has recently begun to cut jobs. He predicts that greater longevity risk could raise the amount by which its pension is underfunded by more than $3 billion, and force the company to cut back on its stock buybacks.
2. Caterpillar (CAT)
Caterpillar stock has had a good year, outperforming the S&P 500 since November of last year—boosted by strong sales to a booming North American energy industry. But Caterpillar has been cutting jobs lately, eroding the base of new employees who will pay into their pension fund. The company also has over 60% of its U.S. pension fund invested in equities, putting the firm’s fund at risk if the stock market falters. Becker argues that forthcoming changes to Treasury longevity estimates could cost the firm close to $200 million per year.
3. Dow Chemical (DOW)
Like IBM, Dow has buoyed its stock price with share repurchases, helping it keep pace—and then some—with a booming S&P 500. But these payments to shareholders haven’t been covered by the company’s free cash flow. And, unlike the other companies on this list, Dow is a smaller company today than it was 20 years ago, making Becker concerned that, “Dow’s plans now cover more non-workers than workers.” This means higher pension contributions could soon be in store for the chemical giant.
4. Air Products and Chemicals (APD)
Air Products and Chemicals’ stock has outstripped the broader market over the past year, with Wall Street gaining confidence in the company after activist investor Bill Ackman revealed a nearly 10% stake in the company and helped shake up its management. APD has increased its dividend every year for the past 25 years, but Becker believes the company will have to be less generous with shareholders in the years to come, as the firm announced a large free cash flow deficit over the past year, even after it ended a share repurchase program.
