As in the global warming debate, the problem of underfunded corporate pensions is matched in scale only by its ability to bore and confuse. Investors know many plans are in the red. The aggregate deficit for S&P 1500 companies in the US, for example, reached a near-record $451bn in June, calculates Mercer – in other words, aggregate pension assets of $1,230bn were 26 per cent short of aggregate liabilities.
The complexity of pensions accounting makes matters worse. In a nutshell, plans are below water if the present value of their assets is less than the present value of future obligations. Assets include the plan’s investments, plus whatever money the company contributes, minus the benefits paid out. Investors must dig into the accounts to make sure the expected rate of return is not too high. The present value of liabilities, meanwhile, is dependent on bond yields. The lower the return the funds can generate from bonds, the more expensive the obligation. Also, check the actuarial assumptions, for example that salaries rise over time.
The next problem is how the results appear on income and balance sheet statements. The annual cost of any deficit (the difference between the return on the plan’s assets and the liability costs) has to hit the profit and loss account under modern accounting rules. But this can be fudged via assumptions about asset returns, and losses can be smoothed over time. For valuation purposes, it is probably best to ignore pension costs in the P&L and just lop the underfunding off the company’s enterprise value. (Sometimes companies don’t show gross pension assets or liabilities on the balance sheet, so be careful when calculating debt ratios.) None of which makes the size of the holes smaller, but at least investors should know where they’re stepping.
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