International Perspective, Pension Funds
by Marshall Auerback
March 11, 2003
Value Is In The Eye Of The Pension Fund Trustee Beholder
Battered by corporate scandals, faltering economic growth prospects, and an imminent war in Iraq, European benchmark indices have fallen three straight years for the first time since World War II. Confidence has continued to slide this year as well. Europe’s Dow Jones Stoxx 600 index declined some 10 per cent further in January and February of this year, the worst start to any year since the index was formed in 1987. European households, never true believers in the cult of the equity, have accordingly begun to act to reduce the equity share in their wealth portfolios in line with the fall in their expected risk adjusted returns from the unrealistic euphoric levels of the late 1990’s.
The resultant falls have led many to suggest that sensible valuations are finally upon us in Europe. Superficially, this appears an attractive argument. In the UK, for example, the aggregate market dividend yield is now around 4 per cent, roughly the same level as cash rates. This is usually a good indicator of fair value, if not cheap valuation. And there is little question that 60 per cent falls from the peak (a fairly typical average for most of the major benchmark indices in Europe) would suggest more bargains than might have been the case during the frenzied days of 1999-2000.
Of course, recent earnings shocks, particularly those stemming from huge gaps in pension fund liabilities, have simultaneously called into question the sustainability of such dividend payouts, as well as the underlying quality of the projected earnings. By failing to set more realistic assumptions in their expected pension fund returns, companies are deferring the decision to increase contributions to their pension schemes, thereby presenting an unrealistic earnings picture to the market and calling into question the essence of the “cheap valuation” argument.
To be sure, the issue of faulty actuarial assumptions and economically questionable pension fund return forecasts are hardly unique to Europe. Warren Buffett has long noted a comparable failing amongst American CFOs. In America, however, the problem has not yet been given comparable dissemination in the media, nor have the fiduciaries, pension fund consultants, endowments, etc., grappled with the implications of lower expected stock market returns in the future. It seems as if the collective inertia of pension and endowment institutions, their institutionalised process of extrapolating past returns and volatilities forever forward, have thus far precluded the kind of reassessment now beginning to occur in Europe, which might be one of the main reasons why European equities have significantly underperformed their US counterparts. The increasing appreciation of the potential for greater earnings shocks to the downside is now more widespread in Europe and pension fund trustees and life assurances actuaries have begun to act accordingly. As have stock market investors themselves. By contrast, according to Ned Davis Research, stocks as a percentage of total assets in private US pension funds has only fallen from 53 per cent from the end of 1999 to 47 per cent by the middle of 2002.
To be sure, European corporations have not completely bitten the bullet, but a series of new accounting regulations in Europe are forcing companies to move closer to economic reality than their US counterparts, at least in regard to recognising the problem of pension funding gaps. Part of this belated acknowledgement being forced upon European managements is due to a change in accounting rules. By 2005, all European companies will have to record their pensions as mandated under the new International Accounting Standards Board IAS19 rule. Under the old standard, rule FRS17, a company recorded the full pension fund surplus/liability in its balance sheet. In the event of a deficit, that amount was held in a holding account on the income statement, but did not go through earnings. Under IAS19, the entire deficit/surplus goes through the income statement. Hence, the plethora of announcements seen in the papers since the beginning of this year.
The result is that each time another one of these pension funding gap problems is highlighted, it triggers a fresh cascade of collapsing share prices across the bourses, each successive decline generating a further vicious feedback loop of larger and larger pension funding gaps, thereby raising further questions of earnings and dividends sustainability, in turn leading to further sell-offs. We ought to expect something of this magnitude to hit the US market later on this year, perhaps when the S&P finally breaches its previous September 2002 low of 775. At that point, the final vestiges of what has hitherto been a remarkable complacency may finally cease and panic may well set in; US institutions will be forced to act. Faced with mounting concern from their shareholders, pension fund holders, etc., the corporate chieftains will likely override the administrators and pension fund consultants, who remain captive to unrealistic Bubble era returns. Once this process gains traction within the boardrooms of America, all these institutions may rush to the exit and the US stock market might finally display the pervasively weak conditions that have been prevalent in Europe for some time.
In Europe, examples of these pension fund gaps and increased actuarial liabilities abound: GlaxoSmithKline recently announced that it had injected £320m into its employee pension fund at the end of last year, in an effort to stem a rapidly increasing shortfall. Even so, continuing falls in stock markets this year have caused the pharmaceuticals group to record a £1.3bn deficit on its fund compared with a £457m shortfall at the end of 2001.
BT Group, which runs one of the UK's largest pension schemes, is preparing to plough up to £1.5bn into the fund on top of existing commitments to plug a widening deficit, according to people close to the company. This is one of the largest company cash injections into a pension fund and is further evidence of the problems facing pensions. The additional payments, to be announced formally in May, will more than double BT's existing commitment.
BT is already paying £1bn into the fund during the five years to March 2007, the equivalent of £200m a year. It is now planning to pay a further £70m-£100m annually for the next 15 years. These payments will add up to £2bn-£2.5bn by 2018-19. Earnings and dividends invariably take the strain in such circumstances. In some cases, the deficit is almost as large as the company itself; at Rolls Royce, for example, a deficit of £1.12 billion compares with a market capitalisation of £1.24 billion. The list goes on. Last month, the Wall Street Journal prominently highlighted a new focus by S&P on pension liabilities in their rating process:
“Standard & Poor’s Corp. said Friday it is making funding levels of pension liabilities a more important criteria in its rating of companies’ creditworthiness. The rating agency also said it might downgrade a dozen European companies—including the U.K.’s Rolls-Royce PLC and France’s Michelin SCA—because of grossly underfunded pensions. The awareness of these pension issues is getting greater and greater. ‘It’s a good thing to bring this matter forward and force the debate into the open, the agency said.’ ”
The Journal could have listed hundreds of other companies that fall into this category. These are long-standing issues that have been eating away at the financial health of corporate Europe for several years now. But they were disguised by the long bull market, during which assets generated returns well in excess of historic norms and thereby enabled several companies to reduce or eliminate contributions for a time.
This pension shortfall is likely to impact private household expenditure as well. Actuaries said many employees were feeling the impact of rising pensions deficits, as a large number of companies were considering forcing employees pay more to ease the financial burden on companies. Closing schemes to new members is another proposal, but this will not alleviate the burden of meeting claims for existing employees. BAE Systems, Centrica and Tesco are among the companies that have already publicly proposed these measures as a means of coping with their pension fund shortfalls. This is coming at a time when rising oil prices, higher unemployment and diminishing consumer confidence are triggering a shift toward great savings and less discretionary expenditure. Consequently, any pension funding gap to be made up by private households will exacerbate the deflationary undertow.
Of course, such announcements might lead one to conclude that the problem is now becoming more widely recognised in the markets and consequently factored into share price valuations. This might be true in a limited sense. However, even this rising tide of acknowledgements does not truly reflect the full scale of the problem, as a report by Karen Olney of Dresdner Kleinwort Wasserstein recently illustrated. Her analysis found that the average pension fund assumes that the assets will rise by 7.5 per cent annually. Ms. Olney gave warning that this assumption of past and future asset growth was excessively high (she suggests that a level of 6 per cent is more realistic), and masked the true cost of three years of falling stock markets. Across Europe, DrKW estimates that pension funds are facing a black hole of £171 billion using more realistic growth targets, as opposed to £62 billion using the actuaries' figures. According to Olney: “Pension funds have been hypothetically assuming that pension assets are growing by 7 or 8 per cent a year, but in reality they have been falling by 10 to 15 per cent. After three years of that, you've got a big gap opening up.”
The report advocated that pension funds should be moving to bonds to reduce the level of risk and more closely match assets with their actuarial liabilities. But even implementing this kind of portfolio adjustment at this stage may perversely expose corporations to even greater risk: Shedding equities to immunise the portfolio with laddered bond holdings, pension trustees and CFOs may expose themselves to the risks inherent in any global serious reflation efforts by the Fed, BOJ, and ECB. Ironically, the equity market collapse implicit in the act of CFO’s selling en masse to lock in pension assets in bonds would surely quicken the move toward a debt confiscating inflation, thereby largely eradicating the real returns of fixed income assets.
Many will argue that CEOs, CFOs, pension fund advisors, etc. will be rational and not sell equities at depressed prices and in turn buy bonds at the lowest yields in 40 years. However, their recent track record does not lend grounds for optimism: after all, most substantially increased their equity weightings well into the mature phase of the bull market, piling into questionably valued “growth stocks” at the height of the TMT mania. Such actions hardly lead support the notion that the next asset allocation decision will be any more rational.
So when might one expect a fully fledged capitulation on both sides of the Atlantic? Although these problems have largely preceded Iraq, it is likely that many decisions are being deferred until the outcome of the impending conflict becomes clearer. To that extent, the outcome of the war is crucial.
A swift victory and relatively casualty-free victory by the Americans might engender huge global stock market rallies from current oversold positions, and thereby enable corporate CFOs to avoid the problem for the time being. Indeed, if share prices were to regain anything like their 1999-2000 levels, the current deficits would likely disappear. This is unlikely, given the extremes of overvaluation that pertained during that period, as well as the fact that corporate pricing power on final products continues to fall. Revenue realisations are coming in below plan. Profit margins are getting squeezed. Each company is trying to get margins back up by cutting costs at the same time as they are being forced to increase pension fund liabilities. In the aggregate, cost cuts are eroding the labour market, which along with the equity market is eroding consumer confidence, which is eroding consumer cyclical spending, and consumer spending growth as a whole. Companies that have been bold enough to try to rebuild inventories or restart capital spending in this environment are finding the profit squeeze means their financing gap is widening. Corporate debt outstanding is still growing, rather than shrinking, as is required to defuse potential debt trap dynamics in the corporate sector.
The imminence of war has made investors forget about these underlying realities, and to that extent it has been a sideshow. But in one regard, Iraq has been a significant contributor to the problem. Because of the imminence of conflict, many pension fund advisors or corporate CFOs are afraid to reduce his equity allocation for fear of missing a “victory rally”. If the rally occurs, he will have behaved differently from everyone else, will conspicuously underperformed everyone else, and apparently missed a glorious opportunity to rectify the underlying pension fund gap. By the same token, even if the war goes badly, but corporations persist with a high equity allocation and stock prices fall, leading to further huge unfunded pension liabilities, they will be in the same boat with everyone else if we are to assume (as DrKW has done) that most companies are still employing unrealistic return assumptions. Disastrous though the consequences of this deferral might be, therefore, such corporate CFOs assume that they will be in good company and thereby preserve their own jobs a little bit longer. Keynes’s dictum about failing conventionally comes into play here.
Three years of huge falls in equity prices have created big problems unlikely to be fully eliminated in the event of a benign outcome in the Gulf. Today’s higher pension contributions and expenses are creating serious financial problems. The recovery from capital expenditures excesses of the 1990s is still in its early stages and with huge ongoing output gaps and concomitant pension fund problems, it is hard to envisage an imminent capital investment led-boom anytime soon. On the consumer side, the rise in oil prices have been the equivalent of a huge tax rise and private sector savings must in any case be rebuilt. All of this is occurring against a backdrop of downgraded credit ratings, downgraded ratings for equities, all of which continue to attract widespread attention in the financial press. Suddenly CEOs, CFOs, Chairmen and their boards, government authorities, and union leaders are faced with a possible grave financial burden because of losses of pension assets that they had hitherto not considered. We doubt that the certainly gleaned from a cessation of hostilities in Gulf War II will alleviate these pressures any time soon even if it leads to the long hoped for “relief rally”. And, of course, if events in the Middle East go badly, a greater more sustained oil price shock could decisively bury the remaining props for equity markets around the globe and make today’s pension fund gaps seem trivial by comparison. As the Financial Times concluded in a recent report on the subject: “There are no easy answers to the pensions shortfall. Funds will have to keep running flat out in a race they appear to be losing.” |
