We’ll assume that readers know the origins of the “defined benefit plan” within Industrial America, and how the dreaded “unfunded pension benefit obligation” (unfunded PBO) came about, to keep this post relevant and to-the-point.
Wesley Smith, Senior Accounting Analyst at Moody’s, wrote a piece on January 9th, 2014 entitled, “US Corporate Pension Funded Ratios Post Massive Increase in 2013”. Since Moody’s is a credit rating agency, and thus concerned with cash-flow impact and ratings impact, our thoughts immediately jumped to the impact the increase in assets and the decline in the unfunded PBO would have on corporate income statements and ultimately SP 500 “earnings per share”.
Basically, after reading Wesley’s report (attached here: FCSP500pensionexp) for someone focused on SP 500 earnings per share, the report begs the question, “To what degree did pension gains contribute to SP 500 earnings per share in 2013 ?” Since q4 ’13 results are just being reported, we wont know definitively until late March, early April, 2014, what actual SP 50 net income was, but here is an educated guess for 2013:
q4 ’13 net income: $264 billion (estimated)
q3 ’13 net income: $255 bilion
q2 ’13 net income: $256 billion
q1 ’13 net income: $249 billion
* Source: ThomsonReuters
For 2014, and assuming q4 ’13 net income doesn’t change that much in the next 10 weeks, we could safely guesstimate that the SP 500 components will generate almost $1 trillion in net income for the calendar year 2013. With the change in the “underfunded status” from a negative $363 billion in 2012 to just a negative $69 billion in 2013 (see spreadsheet above), the $254 positive gain in the underfunding status represents almost 25% of the total net income for the SP 500 in 2013.
Now does that mean that 25% of the SP 500’s profits were attributable to the change in defined benefit underfunding ? No it doesn’t, since from what Wesley Smyth explained in our phone conversation, we don’t know the amortization periods for all the individual companies. Just as companies can amortize pension plan losses when the market moves against them as it did in 2007, and 2008, these same companies now have to amortize the gains over the same periods, which presumably could be anywhere from 3 to 10 years.
What I did learn from our conversation on pension accounting was that the shorter the amortization period, the higher the quality of earnings as a reflection of the true earnings impact of the defined benefit plan.
The reason I wrote this blog post was to get readers to understand that technology companies, financials and retailers don’t typically have defined benefit pension plans.
The point being is that Industrials, Basic Materials, Telecom and probably some Energy components have exposure to the swings in defined benefit funding. If we sum the market-cap weightings of all those sectors as a percentage of the SP 500, it is just 36% of the SP 500.
Again, the improvement in the underfunded status per Moody’s projections, can basically be found in just 36% of the “old” SP 500. Depending on their amortization periods employed, think of what that does to their earnings power and cash-flow.
Another final interesting point is that, according to Smyth, AT&T and Verizon have gone to mark-to-market accounting for their defined benefit plans. That means in strong markets, all the gains in the underfunding status should pass through to the income statement and be nicely accretive to earnings, with the opposite occurring in down stock markets. I think the Wall Street Journal already covered this, but if you are looking for who wins under a 30% SP 500 return in 2013 on a defined benefit pension plan, watch VZ’s and T’s q4 ’13 earnings.
We continue to like Industrials and Basic Materials into 2014 and the sectors could get a nice bump after earnings, partially due to this atricle and given the Top 50 Plan Sponsors are predominantly Industrials, heavily unionized and legacy industries.
To summarize this mess, the $253 improvement in underfunding of pension obligations means that the Top 50 defined benefit plans have to come up with that much less in terms of cash-flow contributions to the plans, (depending on their amortization period and such) and that this $253 “improvement” represents 25% of net income of the entire SP 500, not just those companies with plans.
Industrial America is a hedge-fund in drag…
As Boeing recently proved with their latest negotiation, the defined benefit plan is on its death bed. Boeing froze their pensions, and their retirement benefits, and instituted a defined contribution plan to assist workers with retirement benefits.
For some trivia, which only few can appreciate, my very first reading for Level I of the CFA exam way back in the late 1980’s, was an article written that detailed that (at that time) if Ford and GM’s unfunded pension benefit obligation were to be put on the balance sheet as a true liability, then Ford and GM would be functionally-bankrupt companies. 2008 brought that home to roost, and not in a good way. (With the creation of the VEBA Trusts in early 2009, by Ford and GM, these companies offloaded a lot of their healthcare exposure on the unions directly, which should slow the growth of the defined benefit pension obligation.)
This will improve over time, as more companies shelve these plans and get out of the defined benefit business.
Thanks for reading.
Trinity Asset Management, Inc. by:
Brian Gilmartin, CFA
Portfolio manager