Pension Plan Poison

Some estimates put sales on the S&P 500 at 48 times ‘real’ earnings…imagine what would happen if ‘earnings’ suddenly dropped another 69%. What could cause that to happen? Well, says Apogee Research, accurate accounting procedures for pension funds for starters…Eric Fry reports…

Wouldn’t it be nice if you were able to spend the amount of money you HOPE to make in the stock market, rather than the amount you actually make? Well, almost all of America’s largest corporations get to do something very similar. Every year, they include in their ‘earnings’ the investment gains they HOPE their defined-benefit pension plans will earn.

Sometimes, the pension plans perform about as well as expected, especially over a three- to five-year time- frame. But – and here’s where it gets interesting – sometimes they don’t even come close to making their anticipated return. Instead, like a first date that features far more bad jokes than romantic glances, reality falls well short of expectations.

For example, during the fiscal year ending October 31, 2001, Deere & Co., the tractor company, expected its pension plan and post-retirement benefit plans to produce investment gains of $657 million. In actuality, however, these plans had losses of $1,419 billion. That’s a difference of more than $2 billion! These latest losses bring Deere’s underfunded pension liability to more than $3 billion. "At some point," observes Apogee Research, "Deere will have to deposit actual cash into its underfunded pension plan to make up the $3 billion shortfall. And yes, that’s real money to Deere…$3 billion represents more than five years’ worth of average net income!"

Investors should be aware that Deere is not the exception. "Last week investors were rudely awakened to the troubles that underfunded pension plans could pose for corporate America," writes Jacqueline Doherty of Barron’s. "With the stock market down and pension-fund assets shrinking, companies ranging from Continental Airlines to Avon Products to the New York Times indicated they had made, or planned to make, fresh contributions to bolster the value of their pension plans…General Motors reported that assets in its U.S. pension plan had dropped by 10% this year, which means the company’s after-tax pension expense could rise by about $1 billion, or $1.80 a share, in 2003." Standard & Poor’s promptly downgraded GM’s credit rating. "The primary reason for the downgrade is that poor pension investment portfolio returns have contributed to a huge increase in GM’s already-large unfunded pension liability," an S&P analyst explained.

During the great bull market of the 1990s, outsized investment returns created a kind of "cookie jar" full of excess earnings. One way or another, America’s creative CFOs made sure these excesses found their way onto the income statement, helping to flatter the reported earnings results. But the devastating bear market of the last few years has brought this practice to a screeching halt. Most of the corporate pension plans that once enjoyed a plump surplus now find themselves woefully underfunded. Despite this uncomfortable state of affairs, most companies are still in denial. They continue to project robust investment returns for their pension plans.

"Recently," Contrary Investor observes, "plan sponsor/investment industry magazine ‘Pension and Investments’ studied the assumed rates of forward investment return for the 100 largest corporate-defined benefit plans in this country…Although the study only provides data through 2001, here are some of the highlights worth noting: the average expected rate of return among the 100 count sample was 9.3% [and] 88% of the plans had a return assumption of 9% or greater…Yet, 95 of the 100 companies that made up the group experienced negative 2001 plan returns."

Eventually, however, companies will have no choice but to face the music and kick cash into their pension plans. That painful moment of truth has already arrived for a few companies…and that moment is close to arriving for a few hundred more.

Barron’s Doherty explains: "According to David Zion, an accounting analyst at Credit Suisse First Boston, 360 companies in the Standard & Poor’s 500 index have defined pension-benefit plans. Of these, 240 had underfunded plans at the end of 2001, the highest level in ten years. With stocks and interest rates both in retreat – a poisonous combination that spells lower returns on fund assets and increased pension liabilities – Zion believes the number of companies with underfunded plans could balloon to 325 in 2003."

For many American corporations, the painful consequences will be twofold: the excess earnings produced by large investment gains in their pension plans will be gone, so CFOs will no longer be able to take a portion of their stock market bounty and book it as reported profit. As pension plan surpluses turn into deficits, many companies will have to contribute cold, hard cash to make up the shortfalls.

Neither of these facts will enhance the investment appeal of a stock like Deere. [It’s no accident that Deere is one of Apogee Research’s most recent short-sale recommendations.]

"If a pension plan remains underfunded," Doherty explains, "a company over time might need to direct its cash flow to pay its pension obligations before investing in its business, paying down debt, repurchasing shares or making other strategic moves that would benefit investors. The upshot: companies could end up working for their retirees instead of their shareholders."

"Zion estimates that S&P 500 companies with defined benefit plans will have to make $29 billion in cash contributions to their underfunded plans in 2003, up from $15 billion in 2001."

Longer term, the accumulated pension liabilities are even more daunting. Trevor Harris, head of Morgan Stanley’s valuation and accounting research group, tells Doherty: "I think it’s a huge issue unless the markets rebound. We have over $300 billion of pension-fund deficits in 2002 for S&P 500 companies. That’s $300 billion of cash these companies have to come up with over the next few years, and $300 billion that comes out of corporate cash flow."

Incredibly, through the magic of GAAP accounting, these towering liabilities do not necessarily penalize reported profits…at least not immediately. That’s because, as we noted at the outset, companies may, within certain broad limits, include in their EXPECTED pension plan returns on their income statements instead of their actual returns. Last year, the difference between these two numbers was substantial. An actuarial Grand Canyon separated actual returns from expected returns.

"Although pension-fund assets lost $90 billion in 2001, an accounting sleight-of-hand allowed companies to show that income of $104 billion had been generated, Zion says. If the smoothing mechanisms were eliminated, aggregate earnings for the S&P 500 would have dropped by 69% last year," Doherty observes.

Investors would do well to remember that accounting practices can obscure more than they reveal. "Pension plan accounting is hiding a lot of landmines," says Apogee’s Tracy.

Watch your step.

Eric Fry,
for The Daily Reckoning
October 25, 2002

Eric J. Fry, the Daily Reckoning’s "man-on-the-scene" in New York, is the editor of Apogee Research (formerly Grant’s Investor) – an online investment publication devoted to hedge funds and other professional investors. Mr. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years and authored the first comprehensive guide to American Depositary Receipts, International Investing with ADRs.

See: Apogee Research

Aw shucks…zut alors!

Just when we were beginning to like this binge of stock buying…investors suddenly seem to sober up. As Eric reports below, there were more sellers than buyers yesterday.

Frankly, we missed the majestic hallucinations of the foamy phase and were happy to see them coming back. It is such fun to hear people make fools of themselves – panting after imaginary profits…getting hot and bothered at the thought of missing out on a big new bull market…frothing at the mouth about the indomitable dynamism of the U.S. economy…

Alan Greenspan, for example, once again mentioned the remarkable increase in productivity…which will "almost surely be reported as one of the largest advances, if not the largest, over the past 30 years."

Of course, productivity often increases when you fire people – there are fewer people doing the same work. But Greenspan long ago abandoned any serious reflection on the state of the economy. Instead, he does what he is paid to do – pretend that all is well.

There are times when his work is easy – such as the Great Bull Market years, when investors were bidding up stocks for no reason in particular and it seemed as though the Fed chairman knew what he was doing. And there are times when it is tough – when stocks go down for lots of very good reasons and it becomes clear that the nation’s central banker hasn’t a clue.

"Fed Survey Depicts a Battered Economy," says a headline from yesterday’s news. "Sluggish" is the word the Fed used. "Lacklustre" is the word the BBC chose.

Almost from any angle you chose to look at it, what you don’t see is lustre. Everything is dull, tarnished, faded. Mortgage rates are rising, not falling. Unemployment is increasing. Consumers are having trouble paying their debts. And overseas economies are hurting too – except for China.

And when S&P deconstructed earnings, it found that "U.S. companies have been a whole lot less profitable than they say they are," as CNN/MONEY put it. If you reduce them to ‘core earnings,’ taking out expenses for options and pensions, S&P companies earned only a little over $18 last year, not the $24 they reported. This would put the P/E of these companies at 48.8 – not the level at which real bull markets typically begin. In fact, not a level at which any bull market has ever begun.

And not a level at which this bear market is likely to end either.

Over to you, Eric:


Eric Fry, reporting from Wall Street:

– Stocks slipped yesterday for the second time in three days. Is the rally over? Is the fat lady singing? Perhaps she is merely humming scales to warm up her voice.

– Whatever the fat lady may be doing, the Dow hit a flat note yesterday by falling 177 points to 8,317, while the Nasdaq dropped 1.6% to 1,299. Government bonds responded to the weakness on Wall Street by mounting their first major rally in more than two weeks. The 10-year Treasury gained nearly one point to push its yield down to 4.11% from 4.23%.

– On Wednesday, Lucent Technologies reported its tenth straight unprofitable quarter, which is almost as many quarters as it has been unprofitable to own the stock. The company posted a net loss of $2.81 billion, or 84 cents a share, as revenues plunged 56% to $2.28 billion. Incredibly, Lucent lost more money last quarter than it received in total revenue. For perspective, during the peak of the telecommunications boom in 1999, Lucent once reported quarterly revenue of $9.8 billion. But the boom has gone bust, and so has Lucent’s share price.

– From a peak of $63 in December 1999, the stock has collapsed 98% to a mere 98 cents. Hard to believe that the former blue chip now faces the ignominious prospect of being delisted from the NYSE. That’s because its share price has been trading below one dollar for more than a month…and that’s a no-no on the NYSE.

– As the ever-provocative Christopher Byron explains, "Lucent Technologies…is preparing – like just about any penny stock you can name – to undergo a one-for-20 reverse stock split to avoid being bounced from the New York Stock Exchange like a drunk from a bar, and tossed into the stumble-down gutter of a Nasdaq listing on its way to the Pinks."

– Byron chronicles the demise of Lucent in a must-read New York Post story dated October 21, 2002. Lucent’s collapse, says Byron, "[is] one of the most damning chronicles of failure in the whole sweep of American enterprise." Inept management is to blame, he says.

– "Lucent began its life separate from AT&T via an April 1996 spin-off IPO that gave it, as we might say, every advantage," Byron explains. "On the day it went public, Lucent was already the largest supplier of telephone equipment to the consumer market in America. Not only that, it began life with an incredibly strong balance sheet.

– "FRANKLY, it is hard to think of a circumstance in the entire history of modern business when the management of a public company had its opportunities teed up more perfectly than when Lucent Technologies was launched – equipped with money, prestige, customers, and a listing for its stock on the Big Board – to fend for itself in the midst of the greatest boom in telecommunications technology that man had ever known." However, in five short years the company and its share price have become, in Byron’s words, "a pathetic, sick mess."

– "The self-destruction has been simply stupefying," he says. "Every last dime of the company’s equity will now be wiped out by plans announced by the company last week to take a $4 billion charge to the balance sheet in the fourth quarter. The business itself has all but collapsed."

– Meanwhile, an unbelievable 45,700 workers have been laid off, and more cuts are coming. Lucent plans to end the year with about 35,000 workers, down from 106,000 at the start of 2001.

– "Now, at the end of this five-year-long parade of grotesqueries," Byron winds up, "the company has announced…that it will ask permission from shareholders at its February annual meeting to engineer…a one-for-20 reverse split – which is not much different from the sorts of gimmicks you see regularly pulled by Vancouver penny stock promoters…What a sad end for this once great company."

– What might we learn from this "Parable of the Pathetic Telco?"

– The first thought that comes to mind is the phrase a hedge-fund manager I know likes to use: "When in doubt, blow it out."

– When Lucent kicked off its string of 10 straight losing quarters, the stock was still fetching about $30. Even after reporting its second unprofitable quarter, the shares were trading in double digits. In other words, there was plenty of time to make a decent sale.

– But there’s no such thing as a perennial blue chip. A stock is a stock, and investors need to keep a very close eye on each and every one they own. Stocks – somewhat like small children – cannot be left unattended without getting themselves into trouble.


Back in Paris…

*** Another rainy day. More dripping news.

*** ABB, Europe’s 2nd largest engineering group, is on the brink of collapse, says the Financial Times.

*** And here in Paris, a strike by garbage men continues – with trash piling up in the street. Maybe by Monday, the rain will have stopped…the trash will have been picked up…the bear market will be over…and we will all be 10 years younger.

The Daily Reckoning