Pension Deficit Distraction

Implications: There is only one point in this comment:  it is not wise to focus on the so-called pension shortfall, and it certainly isn’t wise for management to strive to close the gap between assets and liability before its time.

Analysis: This short comment is addressed to any who might be concerned about the presence of an underfunded pension liability, especially those who see it as a bad thing in every case.  

Certainly, there are situations in which plans are grossly underfunded and in need of massive infusion of new collateral to provide the security required by common sense and the law.  However, the nature of the situation is such that it always makes sense to have an underfunded pension liability.

To explain, the current balance of the liability is the present value of the expected future cash outflows discounted at an appropriate market BORROWING rate.  The target balance of the fund assets is the desired present value of the future cash outflows discounted at an appropriate market EARNINGS rate.  If the earnings rate is greater than the borrowing rate, then it is a mathematical certainty that the target balance of the fund assets will be less than the current balance of the liability.

To illustrate with a very simple example, suppose that there is a single cash outflow of $1 million that is expected to occur after ten years.  If the borrowing rate appropriate to this liability is 5.7%, then the present value of the cash outflow at that rate is $574 thousand.  The target funding amount is the present value of the cash outflow discounted at an expected earnings rate of 8%, which is $463 thousand, or just over 80% of the liability balance.  As maturity approaches, the two present values will converge, but the target fund balance will always be less than the current value of the liability.  (If the time horizon is extended to 20 years, the two amounts are $330 thousand and $215 thousand, with the target being only 65% of the liability balance.  If the horizon is only 1 year, the comparable numbers are $946 thousand for the liability, $925 thousand for the asset, and a coverage ratio of 98%.)

Page 6 of this article documents the distribution of actuarial assumptions for 9,000 companies.  The median expected rate of return appears to be around 8% and the median discount rate is around 5.7%, just as in the above examples.

This outcome is just another example of the amazing benefit of leverage:  borrowing at one rate so that you can invest to earn at a higher rate.  The pension liability represents an amount borrowed from the employees by agreeing to paying them much later after they exerted their efforts.  The saved compensation cash flows are then invested in the pension fund assets to earn at a higher rate, with the consequence that profits are boosted.  

The amazing thing about all the pension deficits is that so few otherwise astute people seem to have figured out that they are potentially good for the shareholders, depending on how deep they are.  On the other hand, fully funded pension plans are never good for the shareholders unless the pension fund is more profitable than the employer’s underlying rate of return in its own industry and markets.  But, of course, if that’s true, then the employer should get out of that business and start managing pension funds for other companies.

So, when you’re looking at a deficit for your own company, or for a company that your analyzing, don’t forget the power of the exponent.  It is your friend and it will help you understand that an employer’s only pension deficit disorder might be not having one.  Once you realize that, all you need to do is sit back and let the exponent take you for a pleasant ride up the curve.