Via David Bianco, Priya Hariani, Ju Wang of Deutsche Bank on the improving conditions of S&P 500 (.INX) pension funds.
S&P 500 pension situation update: Deficits are fading and may never return
This note includes S&P 500 sponsored DB pension plan funding estimates, impact to 2014 S&P EPS, numerous data tables and stock screens. It discusses corporate pension asset allocation. This is a crucial time for S&P 500 pensions. The long awaited simultaneous upturn in corporate bond yields and stocks of 2013 greatly reduced what were record shattering pension deficits. This will boost S&P book value and support 2014 EPS and margins. If rates and equities stay their current course, it should eliminate most deficits in 2014. Upon full funding, plans are likely to immunize their liabilities to stop funding swings.
Today’s S&P 500 pension deficit: $225bn or about 1.5% of market cap
We estimate today’s S&P 500 pension deficit at $225bn or 88% funded versus $450bn at 2012 end. This sizable improvement is more attributable to higher corporate bond yields, which reduces pension liability present value, then asset gains above discount rates. Another 100bp rise in yields or asset gains 10% over annualized discount rates or a combination would eliminate the deficit.
Significant pension tailwind to S&P EPS in 2014: Might be ~$2 EPS benefit
2013 yearend funding status affects 2014 EPS. Our 2014E S&P EPS of $115 includes as much as $0.75 of lower pension costs, but it could be 2-3x that. Adjustable actuarial assumptions and the option to amortize or fully recognize (i.e. fair value) differences in actual from expected assumptions makes it very difficult to estimate pension charges, especially the amount in pro forma EPS.
Periodic pension charges have several components: service cost, interest cost, expected return on assets and then amortization of unrecognized gains/losses. All of these charges are embedded in COGS or SG&A. However, only service cost is an operating item (EBIT) conceptually. Interest expense and expected return on assets are financing items (EBT), but they do pertain to the current reporting period. Amortization costs are neither operating nor pertaining to the current period, rather they reflect true-ups of inaccurate prior period estimates.
A higher base of pension assets should provide a ~$0.75 S&P EPS benefit; this captures the economics of improved funding. But lower amortization charges or full “fair value” recognition of any accumulated unrecognized actuarial gains could substantially boost EPS. Pro forma EPS usually attempts to capture current period performance. We are not sure what consensus pro forma EPS measures will incorporate, but we evaluate corporate profits ex. amortizations of unrecognized losses (or gains) or ex. lump sum fair value remeasurements.
Pensions complicated comparability of 2012 S&P EPS, 2013/14 will be worse
2012 S&P EPS was $103 ex. large FV pension charges from several firms, EPS was ~$100 including such charges. We don’t include anticipated extraordinary items in our EPS estimates, but those who do should expect big pension gains. Also, the EPS quality problem of excessive pension investment income is back.
S&P 500 plan sponsors will end their war with bonds, too mature now to fight
S&P pension equity allocation has been in decline for 7 years, but is still ~45% of assets. The closing or curtailing of DB plans to new employees has and will further shrink most plans investment time horizons and trigger net cash outflows. Thus, late 2014 likely restarts liability immunization: selling stocks to buy bonds. We expect $250bn of S&P PAA equity outflows in 2015-2016.
We have been writing annual S&P 500 pension updates for 12 years, most of those years S&P 500 pensions were suffering substantial funding deficits. This year is the first time since 2007 that S&P 500 pensions appear to be nearly out of the hole, but as we warned in 2007 that doesn’t mean pension risk is gone.
The past handful of years have brought substantial changes to US pension accounting and required funding rules. These changes kept pension analysts like us very busy and resulted in very thick and heavy S&P 500 pension situation update reports in years past. Fortunately, rules changes have settled down and are mostly understood by investors. In general, the new pension accounting rules have made pension funding volatility more transparent and the funding rules have tightened minimum contribution requirements. This note includes a brief review of pension accounting basics with an emphasis on how to incorporate pension funding and risk into intrinsic valuation methods.
The last decade has been a long and bumpy road for managers of and investors in companies that sponsor large defined benefit pension plans. We think the number one priority of managers and desire of most investors we talk to is to put everything related to DB pensions behind them in the past. We think treating pensions as a legacy issue will be the general strategy of most sponsor company managers. Isolating pension risk and eliminating or at least minimizing the effects to earnings and the balance sheet will take top priority.
Given the strength in corporate profits, free cash flow, balance sheets and generally diminished fears of economic shocks, we think companies will take proactive steps to improve their pension funding late this year and next year. We think companies will voluntarily make deficit reduction contributions and further explore and utilize lump-sum settlements with retiring employees. Voluntary deficit reduction contributions will also allow companies to utilize deferred tax assets from actuarial pension losses and would likely result in EPS accretion from applying the pension ROA assumption to a higher asset base.
Between proactive steps by plan sponsors and our constructive view on equity returns even as long-term interest rates rise toward more historically normal levels, we think S&P 500 sponsored plans achieve full funding by 2014 end. As company plans approach and achieve full funding we expect them to shift more toward investment strategies that immunize pension risk, principally by selling equities to buy long duration bonds over the next several years. We do not see this as a threat to healthy S&P 500 returns or normal valuation.
Unfortunately, the long-standing disconnect between pension funding and its impact to earnings continues and despite improvements in disclosures and balance sheet recognition the affect of pensions to earnings is as confusing as ever, particularly given the mixed use of fair value recognition by some large plan sponsors and the continued use of amortized or smoothed recognition by most. Although reduced deficits will boost 2014 S&P EPS, the earnings quality problem of excessive assumed pension investment income has returned. It’s likely to be roughly $2 of excessive S&P EPS in 2014 net of amortizations.