The pension shortfall among private companies is the elephant in the room. No one likes to talk about it even though it is an important issue that needs to be addressed with the same level of scrutiny that publicly funded pension plans should be. Thus, it was interesting to read last week that CP Rail is raising up to $510 million to help narrow its $1.6 billion pension deficit. The recent economic down-turn has only highlighted what has been an issue for many years.
There are two primary types of pension plans. A defined benefits plan pays out a defined benefit no matter how well or poorly a pension is doing. If a pension performs poorly, the company has to make up the difference between the money required to pay out its retirees and the assets under management (if the plan performs well, the surplus can be used in many different ways). A defined contribution plan only pays out how the plan did and the company has no liability.
Most pensions are now structured as defined contributions plans for the obvious reason that the company does not bear any shortfall liability. However, many older companies still have rather large defined benefits plan members on the books. What these companies have been doing is underfunding any shortfalls on the premise that the company can outperform the funding shortage. Of course, during a downturn, this underlying assumption may not be met which merely expands the problem.
How large is the issue? Before the financial crisis, Dejardins Securities reported that companis in the S&P/TSX benchmark had an average shortfall of 91% of free cash flow (in other words, in a worse case scenario, a company would have to use over 90 cents on the dollar to meet its pension liabilities). The average shortfall for the S&P 500 benchmark was $605 million. This has gotten a lot worse since many of the plans were invested heavily in equities before the crash.
Why should you care if don’t work for these companies? Simply put, a company has to fund its pension shortfall or be ordered to by the regulators. Where the shortfall is large and the class of payees growing, a very realistic possibility given our population pyramid, more and more money may have to be used to fund the shortfall rather than pay a dividend or grow the business.
In CP Rails’ case, it is causing up to a modest 7% diluation to the shareholders to reduce the pension shortfall. Although not a large diluation, you are basically telling a shareholder that it has to be diluated so that the company can meet its legal obligations. Not exactly a great spin to a capital raise. Hence, companies are rather reluctant to speak on this issue honestly.
For the average investor, it is one of those financial line items we all have to pay attention to going forward.
February 4th, 2009 at 9:26 am
No where is this more visible than in the Bernie Madoff case. Some small union in New England had their pension go bankrupt because of Madoff.
My mom will be on a pension when she retires, since it’s a state pension I know my taxpayer dollars will bail her out if there are any shortfalls of money.
February 4th, 2009 at 12:43 pm
“A defined benefits plan pays out a defined contribution no matter how well or poorly a pension is doing.”
This probably isn’t the best phrasing. The difference between the two plans comes down to who accepts both the risk and the reward of the plan’s investments.
In a defined-benefit plan, the plan’s sponsor (the employer) accepts both the risk and the reward. If the plan’s investments do poorly, the employer has to make up the shortfall, but the employer also gets the reward if the plan’s investments do well, because the employer’s share of contributions can be reduced when the plan is over-funded.
A “defined contribution” plan is basically just an investment account where the employer and the employee contribute. The employee doesn’t have any guarantee that they will receive a specific pension – at retirement they will have a pool of cash to draw income from, and the income will vary depending on how big the pool of cash happens to be – in other words, the employee gets both the risk and the reward – if the plan’s investments go south, the plan won’t have as much money to pay out a pension to that retiree. Of course, if the investments do very well, the retiree could get a very high income.
The reason for the switch to defined-contribution plans is that, from the employer’s perspective, the risks are too high and the rewards too low, so they would rather pass off those risks and rewards to the plan’s members (their employees).
February 4th, 2009 at 4:07 pm
Good post – compounding the problem is that the ratio of retirees to workers is increasing. We can hope that the boomers spend a lot and increase the bottom lines of companies, but hope is not a viable strategy.
February 4th, 2009 at 4:26 pm
George- thanks for the far more articulate post on pension plans than mine.
Weakonmist- you make an interesting point, in some jurisdictions the public purse has to bail out private pension plans (although there are limits to the contribution).
Preet- I am not sure the boomers have any more credit to spend. We may be going from over-leveraged based down-turn to demographically induced down-turn. Yikes.
February 5th, 2009 at 1:53 am
“A defined benefits plan pays out a defined contribution…”
Wow. In a paragraph trying to distinguish DB from DC, that couldn’t possibly have been more confusing.
February 5th, 2009 at 10:22 am
Patrick- you are ever the able proof-reader. The passage has been fixed. Thanks.
February 5th, 2009 at 11:07 pm
[...] My Wallet wonders if we are going to have a pension plan crisis in the future, given that there are so many underfunded Defined Benefits pension plans out [...]