There is great debate about what investing risk, if any, is posed by underfunded pensions. Murky accounting and limited disclosure make it difficult for investors to evaluate this risk. Here are the issues surrounding pension risk and how investors should approach them.

Key Takeaways

  • Only defined-benefit pension plans can be at risk of underfunding because an employee, not the employer, bears the investment risk in defined-contribution plans.
  • Underfunding means that pension payout liabilities exceed the assets a company has to cover those payouts; the company must increase its contribution to its pension portfolio—usually in the form of cash.
  • It can be difficult to determine whether underfunding is happening because pension liabilities are for future payouts and companies may make overly optimistic assumptions about long-term rates of return on investments.

Pension Risk Defined

From an investor's point of view, pension risk is the risk to a company's earnings per share (EPS) and a financial condition that arises from an underfunded defined-benefit pension plan. Note that pension risk arises only with defined-benefit plans.

A defined-benefit pension plan promises to pay a specific (defined) benefit to retired employees. To meet this obligation, the company must invest wisely so that it has the funds to pay the promised benefits. The company bears the investment risk because it promises to pay employees a fixed benefit and must make up for any investment losses.

By contrast, in a defined-contribution plan, which can sometimes be a profit-sharing plan, the employees bear the investment risk. The company contributes a specific amount to employees' retirement accounts instead of paying fixed benefits directly to retired employees. Therefore, any gains/losses in these retirement investments belong to the employees.

Though the number of defined-benefit plans has declined, they still exist, and unionized companies have the greatest risk.

Evaluating risk begins with knowing how fully the company's pension liability is funded. "Underfunded" means that the liabilities—the obligations to pay pensions—exceed the assets (the investment portfolio) that have accumulated to fund those required payments. These assets are a combination of invested corporate contributions and the returns on those investments.

Under the current Internal Revenue Service (IRS) and accounting rules, pensions can be funded by cash contributions and company stock, but the amount of stock that can be contributed is limited to a percentage of the total portfolio. Companies generally contribute as much stock as they can to minimize their cash contributions. However, this is not good portfolio management because it results in a fund that is "overinvested" in the employer. The portfolio is overly dependent on the financial health of the employer for both future contributions and good returns on the employer's stock.

If during three consecutive years the value of the pension's assets is less than 90% funded—or if in any year the assets are less than 80% funded—the company must increase its contribution to the pension portfolio, which is usually in the form of cash. The need to make this cash payment could materially reduce EPS and equity. The reduction in equity could trigger defaults under corporate loan agreements, which generally have serious consequences, ranging from higher interest rates to bankruptcy.

That was the simple part. Now it starts to get complicated.

Shortfall Risk

Determining whether a company has an underfunded pension plan appears to be as simple as comparing the fair value of plan assets—which includes the current value of the plan assets that the company estimates it will have in the future—to the accumulated benefit obligation, which includes the current and future amounts owed to pensioners. If the fair value of the plan assets is less than the benefit obligation, there is a pension shortfall. The company is required to disclose this information in a footnote in a company's 10-K annual financial statement.

However, this simple comparison is a deceptive process because it is unlikely that the company will actually have to pay the full amount in a relatively short time frame. A company must place a current value on the benefits that won't be paid until several years into the future and then compare this number to the current value of pension assets. To put it another way, it's like comparing the mortgage on your recently purchased home to your savings account. The gap is currently very large, but you expect to make the payments from future earnings. It would be hard to gauge the "real" risk that you will default on your mortgage by making such a comparison.

Unionized companies have the greatest risk of employee-pension underfunding.

Assumption Risk

Assumption risk occurs when companies use assumptions to reduce the need to add cash to their pension funds. As we are dealing with long-term obligations and uncertainties, assumptions are necessary for estimating both the accumulated benefits and the amount the company needs to invest to provide those benefits. These assumptions can be made in good faith, or they can be used to minimize any adverse impact on corporate earnings. There is a very real risk that companies will adjust their assumptions to minimize the shortfall and the need to contribute additional money to the pension fund.

A company could, for example, assume a long-term rate of return of 9.5%, which would increase the contribution expected to come from investments and thus reduce the need to add cash. This assumption, however, looks overly optimistic if you consider that the long-term return on stocks is about 7% and the return on bonds is even lower. It is also reasonable to assume that the pension fund would have some bond holdings to meet the near-term payment obligations.

Another way that companies can manipulate pension liability is to assume a greater discount rate. The accumulated pension obligation is the net present value (NPV) of the future stream of expected benefit payments. A higher discount rate will result in a lower benefit obligation. Investors need to review a company's assumptions, in relation to current economic trends and expectations, to evaluate how reasonable they are.

To Conclude

The risk of underfunded pensions is real and growing. An underfunded pension and an aging workforce present a very real risk to companies and investors, but the shortfall and assumption risks can be very hard to evaluate.