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Problems with pension(s)?


DTEJD1997
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Hey all:

 

Recently, I've been buying into a manufacturing company.  I believe this company is SEVERELY mis-priced.  So much so, that it one of the few times that I've seen something like this in 25+ years of investing...

 

I've put quite a large percentage of my portfolio into it and am doing well.  HOWEVER, there are a few things that give me pause/worry.

 

ONE OF THEM IS IT'S PENSIONS.

 

Some time ago, the company did away with pensions for any new hires.  However, they have an obligation for retirees and some people that are still working.

 

The pension obligation is carried on the balance sheet as an obligation and liability.  Let us say that the retiree liabilities is an amount of $120MM.  The pensions have assets and are funded to the tune of $100MM.  So there is a $20MM shortfall.  OK, all well & good.

 

Here is where the real problem starts....

 

The company assumes that they will get 7.5% return on those assets.  This manufacturing company is of a more conservative nature...They have invested the pension assets in something like 20% cash & equivalents and 30% bonds.  The remaining 50% is invested in equities.

 

So there is NO WAY that they will earn that 7.5% assumption UNLESS the stock market does exceedingly well.  Cash basically earns ZERO.  Bonds are only slightly behind that.  I would not be surprised if they are getting 2% on the 30% invested in bonds.  So half of the dang portfolio is earning about 1%!  If that is the case, then stocks have to come in about 14% per year, EVERY YEAR just to maintain a 7.5% return!

 

So going forward, a more realistic assumption is that they earn 5% on the pension assets, maybe even 4%.  Under these more realistic rates of return, their pension liability would NOT be $20MM.  It might be $30MM, perhaps even higher?  This liability, if more like $30MM instead of $20MM could come close to wiping out the book value of the company!

 

This is a very, very small company, so for every couple million $, that equates to real amounts for the equity owners.

 

I imagine that those receiving pensions are fairly old...not sure if there is spouse/survivor benefits under the pension?  At some point, I imagine as the beneficiaries pass away, the pension liability will decrease.

 

Secondly, while it is good that the company is pretty conservative financially, they might be shooting themselves in the foot when it comes to asset allocation in the pension.  Why hold so much cash?  Drop that from 20% to 5%?  Why hold so much in bonds if the return is 2%?  Move 1/2 of the bond allocation to equities or maybe real estate?

 

I've looked at larger manufacturing companies like Ford Motor and just simply can't wrap my head around the pension/healthcare obligations!  There is a real chance that Ford is simply owned by the retirees! 

 

These ZERO interest rate environments are really hurting pensions.

 

I am worried that the real owner of this little gem of a company I own are the retirees and not me....

 

Anybody have any thoughts or experience with this?

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There is a small, family owned manufacturer in my area that has run into similar problems as a result of their pension plans.  This company is a union shop that typically employs between 50 to 100 employees.  They have been in business for over 70 years.  There are probably at least 20 family members - some of whom do not work there - who own at least a small piece of the company.

 

I'm pretty good friends with a few of the minority owners, and I have several friends who are long-term employees of the company.  Furthermore, years ago I worked for the consulting firm that did the actuarial and administrative work for the company's pension and 401(k) plans.  As a result, I have a decent insight into the company's situation.

 

It is my understanding that the company had basically been debt-free for decades.  I do know that things were booming during the late 90's - the pension plans were over-funded, the company had major profits, etc.  Unfortunately, when the recession and market collapse hit during 2000 through 2002, the company's fortunes changed drastically.  Foreign imports led to increased competition, they had major layoffs, the pension assets took a major hit, etc. 

 

Also, I can't remember the specific details, but for whatever reason pensioners became eligible to take their retirement benefits in a lump sum.  Many retirees chose the lump sum option, because they feared the demise of their former employer - I don't think many of the retirees fully understood how the PBGC protects pension benefits of failed companies.

 

In any case, it was certainly "touch-and-go" with company for several years during the early 2000's, but they still remain in business today - and still employ at least 50 employees.

 

Here is the interesting thing.  The company actually defaulted on their pension obligations 2 or 3 different times during the 2000's - the large number of lump sum withdrawals (after the large investment losses during the early 2000's) decimated that funding status of the pension plans.  To this day, the PBGC has liens totaling $7 to $10 million filed against the company.  Some of these liens have been in place for 10+ years now.

 

I spoke with one of the minority owners of the company about this situation a few years back.  He told me that the business was still profitable, had no debt (other than PBGC liens) and refused to file bankruptcy as a result of the PBGC liens.  I asked why the company wouldn't just obtain bank financing to pay off the PBGC liens - I'm relatively confident that the company could obtain such financing since they own their buildings and a decent amount of acreage.  My friend replied that the PBGC is much more flexible, lenient and easy to deal with than a bank would be.  He said that the PBGC would NEVER put them out of business.  He told me that the pension plans had been terminated, and that the PBGC would be paid off whenever it happened.

 

This company also has a non-profit, charitable giving division - they have been very generous to the surrounding communites over the years.  I recently located the company's non-profit (Form 990-T) tax filing online.  The non-profit division owns shares in the manufacturing company.  In the past, the non-profit division was basically funded from dividends paid by the manufacturing company, although the dividends had ceased after the PBGC liens.  On this tax filing, the accountants indicated that the shares of the manufacturing company had negative equity (presumably as a result of the PBGC liens).

 

With all this being said, from what I've witnessed over the past 15+ years with this local company, it certainly seems as if this company still has "going concern" value despite the substantial PBGC liens.  A few years ago, my friend indicated that the company was doing between $15 to $20 million in annual revenue.  As a shareholder, I would have to think there would be substantial equity value if / when the PBGC liens are paid off or at least paid down substantially - given that the company has no other debt.

 

With regard to the company that you describe, I'm assuming that it is a publicly-traded nano cap company (rather than a private company)?  In the case of a pension default, I'm not sure if that would force them into bankruptcy, or if they could pay off the pension shortfall like the private company that I described.  Does the company that you describe have any other debt (ie. bank debt, etc.)?

 

I agree with you that pension assets are often invested too conservatively.

 

 

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IMHO, pension assumptions are terrible.  In the late 90s, at the tail end of a huge stock market bubble, return assumptions were generally increased.  Hey, if the stock market has been returning 20%, why would you assume a 8% return, let's mark that baby up.  Much better than contributing more.

 

Anyway, they are totally backwards looking and take no account of the present market values of stocks or bonds.  That is the case even when you have a lot of supposedly learned professionals running things.  I think mostly everyone on this board and elsewhere in the value investors universe thinks the market return is going to be somewhat challenged over the next 10 years or so.  Equity markets are slightly to significantly overvalued, depending upon your metrics and analysis.  The generational bond bull market simply has nowhere to go.  As you say, 20/30/50 is going to have a heck of a time returning 7.5%.  If 20% is cash, you need almost 10% on the 50/30 stocks/bonds.  I don't think you'll get 10% in the S&P at today's prices and can't see how you'll possibly get that in the types of bonds this pension is likely to own.

 

FWIW, without looking it up, I think 7.5% is probably one of the more conservative projections out there.  I think 8% is probably more common.

 

Not sure how that effects the company.

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Interesting topic DTEDJ,

 

I have a question or perhaps a multi-pronged questions:

 

1) Can a company pension be adjusted to assume lower returns going forward? 

2) Are companies/pension funds locked into rates of return negotiated, or promosed some point in the past. 

 

Obviously, 7.5% rates are not doable and haven't been for 15 years. 

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Interesting topic DTEDJ,

 

I have a question or perhaps a multi-pronged questions:

 

1) Can a company pension be adjusted to assume lower returns going forward? 

2) Are companies/pension funds locked into rates of return negotiated, or promosed some point in the past. 

 

Obviously, 7.5% rates are not doable and haven't been for 15 years.

 

I am reasonably confident that the pension has a MINIMUM level of distributions that have to be made...IE you will get $2,500 per month in income no matter what...If the fund does exceedingly well, you MIGHT get more.  This actually happened to my father in the early 90's.  His pension was doing very, VERY well for a few years and he got a small bonus for a few years.

 

I assume that these rates were promised at some point in the distant past.  For example, you work 30+ years and you will receive X amount every month based on your years worked, and ending pay rate.  I think retirees also get health care? 

 

Any way you care to slice it:

 

A). The pension simply does not have enough assets to be self funded.  The company kicks in additional money every year.  This does not appear to be a huge amount, but it is significant, say 15-20 of net earnings.

 

B). The actuarial assumptions are simply not realistic.  My concern is that the company management and BOD has been sold a bill of goods by some financial planner.  Unless there is something that I am missing, why would they have 20% of the pensions assets in cash?  I am 99% sure that pensioners CANNOT withdraw capital from the plan.

 

If you took cash from 20% to 5% and put that into REIT's and other reasonably conservative investments, you might be able to boost the returns on the corpus of the trust by 1-2% a year.  This is NOT an insignificant amount given the size of the assets and the size of the company involved.

 

This company is indeed publicly traded.  They have been in business for about 100 years and have a long, long history.

 

They are doing well now, earning an incredible amount of money (relative to size of equity).  They have some new contracts and have improved the scope of products & services they offer.  They have borrowed $$$$ from the bank, but have paid off about 25% of that in the past 12 months.

 

They are in a "yucky" industry.  HOWEVER, if you look at their annual reports from the 1990's and early 2000's...you might think they were a "fast money, go-go" tech company.  They regularly earned ROE of mid to high teens!  They did this with little to no debt!  They own 3/4 of their manufacturing plants lock, stock & barrel.  In the past, they have paid up to $2/share in dividends. 

 

While this is a company in a cyclical industry, they didn't have the huge gyrations typical of the industry.  When the cycle turned, they certainly earned LESS money, but still had reasonable returns.

This all changed in 2008-2009.  Sales dropped by 35%-45% and they LOST money.  Heck, I think they even had NEGATIVE gross margins for a year!

 

I am unsure if they can attain the levels that they saw in the past...BUT they don't have to!  I bought in at a P/E of less than 2...

 

They have no bonds, simply the bank debt.

 

So if the following happens:

 

A). The economy doesn't fall off a cliff in November

B). The stock market doesn't collapse

C). They can work/deal with the pension problem

D). Keep everything going at a reasonable level

 

shareholders should get paid off handsomely.  The stock might not go back to it's highs, and the dividend won't be $2/share.  No reason why it can't be 1/2 of it's high, and 1/2 of it's dividend in a couple of years.

 

Any chance they expand business and it is simply upside.

 

We will see, it is now my single largest position by far...

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Reits are not conservative investments at current valuations (record low cap rates). I think it is a terrible time trying to juice pension returns by increasing risk. This should have been done a few years ago, but not know.

 

What is the average employee age of those covered by the pension plan. If a 30 year old workers is covered by a pension plan, when will accumulate new claims against the pension plan, as long as he works for he company. Shutting down the pension plan for new employees won't change that.

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IMHO, pension assumptions are terrible.  In the late 90s, at the tail end of a huge stock market bubble, return assumptions were generally increased.  Hey, if the stock market has been returning 20%, why would you assume a 8% return, let's mark that baby up.  Much better than contributing more.

 

Anyway, they are totally backwards looking and take no account of the present market values of stocks or bonds.  That is the case even when you have a lot of supposedly learned professionals running things.  I think mostly everyone on this board and elsewhere in the value investors universe thinks the market return is going to be somewhat challenged over the next 10 years or so.  Equity markets are slightly to significantly overvalued, depending upon your metrics and analysis.  The generational bond bull market simply has nowhere to go.  As you say, 20/30/50 is going to have a heck of a time returning 7.5%.  If 20% is cash, you need almost 10% on the 50/30 stocks/bonds.  I don't think you'll get 10% in the S&P at today's prices and can't see how you'll possibly get that in the types of bonds this pension is likely to own.

 

FWIW, without looking it up, I think 7.5% is probably one of the more conservative projections out there.  I think 8% is probably more common.

 

Not sure how that effects the company.

 

+1

 

Nastiest situation is if your assets are linked to inflation and you actually get it, given that your liabilities will be marked down - do doubt then the regulators will force return assumptions down despite the fact that future returns will in fact have gone up.

 

I think, mentally, investors should add both the asset and the liability to the balance sheet rather than the net amount.  Gives you a clearer idea of what you own.

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I think you also have to consider the liability side of the funding shortfall.  The return on assets  by itself is not generally the issue, it is the returns assumption relative to the discount rate on the liabilities.  Generally companies assume about a 2.5% spread between the return on plan assets and the discount rate for the liabilities - so as long as they continue to beat the discount rate by more than that differential the gap will close without any add'l contributions (and of course the opposite is true).

 

Where it may come into play more directly for your investment analysis is that once the gap reaches certain levels, the company must pay cash into the plan (on a long term basis, not all upfront).  In 2009, following the financial crisis there were so many ridiculously underfunded pension plans that the accounting standards board and the PBGC changed the funding requirements and assumptions to greatly extend the amount of time companies had to fund the gaps.

 

50% equities doesn't seem that aggressive if the plan has a 20+ year life.  From the company's perspective it's almost a free option - if markets crash the PBGC steps in and duct tapes things together until a plan is in place;  if markets soar my funding gap is gone as well as my need to cash fund the plan.  I'm probably wrong on this but I can't think of any times the PBGC has forced an otherwise profitable company into bankruptcy.  That would be political suicide.

 

What would be more concerning that 50% equity allocation is if most of those equities are the company's stock itself.

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I agree with dwy, the return on assets is usually not the issue. The way GAAP works is that there is a pension liability expense generated each year and that is netted against the expected return on assets to compute the pension expense on the income statement. Then the difference between the expected return and actual return on assets comes out of the Other Comprehensive Income statement. So too high of an expected return inflates the income statement by artificially lowering the pension expense and shifting the difference to OCI.

 

The more important number for the balance sheet is the discount rate on the liability- does that look too high?

 

The pension obligation is carried on the balance sheet as an obligation and liability.  Let us say that the retiree liabilities is an amount of $120MM.  The pensions have assets and are funded to the tune of $100MM.  So there is a $20MM shortfall.  OK, all well & good.

 

This is the leverage here worth thinking about. Perhaps the assets are allocated in such a way as to match the duration of the liability so that both sides of the equation move up and down in tandem with rates.

 

These ZERO interest rate environments are really hurting pensions.

 

Totally. And this is really the case with anyone that is trying to earn a return to pay off fixed rate debt. The amount of cash that's ultimately going out the door to pay pensioners is a given amount (assuming no cost of living adjustment), the only question is whether you can come up with the cash to pay it. Lower discount rates (and higher liabilities) are just reflections of the fact that you need to invest more today to have the necessary cash in the future.

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Instead of deciding if the assumptions are reasonable I suggest you recast the income statement and balance sheet. consider underfunding as debt and using a debt rate you consider appropriate, adjust the income statement wiping out the recorded pension expense (which constitutes a range of assumptions and lagged calculations) and taking into account pro forma interest expense.  Try to account for the fact that pension liabilities tend to be understated due to changing mortality tables.

 

The calculation is simplified because new benefits aren't being earned

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IMHO, pension assumptions are terrible.  In the late 90s, at the tail end of a huge stock market bubble, return assumptions were generally increased.  Hey, if the stock market has been returning 20%, why would you assume a 8% return, let's mark that baby up.  Much better than contributing more.

 

Anyway, they are totally backwards looking and take no account of the present market values of stocks or bonds.  That is the case even when you have a lot of supposedly learned professionals running things.  I think mostly everyone on this board and elsewhere in the value investors universe thinks the market return is going to be somewhat challenged over the next 10 years or so.  Equity markets are slightly to significantly overvalued, depending upon your metrics and analysis.  The generational bond bull market simply has nowhere to go.  As you say, 20/30/50 is going to have a heck of a time returning 7.5%.  If 20% is cash, you need almost 10% on the 50/30 stocks/bonds.  I don't think you'll get 10% in the S&P at today's prices and can't see how you'll possibly get that in the types of bonds this pension is likely to own.

 

FWIW, without looking it up, I think 7.5% is probably one of the more conservative projections out there.  I think 8% is probably more common.

 

Not sure how that effects the company.

 

 

As an aside, back as far as the 1970s Buffett's has been making interesting comments on excess pension return projections.  Some googling should bring up the discussions.

 

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As an aside, back as far as the 1970s Buffett's has been making interesting comments on excess pension return projections.  Some googling should bring up the discussions.

 

The interesting things is that these issues been around since 1970s and mentioned multiple times in 1990s, 2000s, now 2010s. And very few companies (none? does GM count?) have gone under.

 

Not saying to ignore pension issues, but so far and at least for big cos, the issues seem to have been contained or maybe kicked down the road. Apart from situations where the co was going under for other reasons already. FWIW.

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See point #2 from Jack Bogle, lol

https://www.yahoo.com/finance/news/retirement-crisis-actually-three-says-103024629.html

 

First, I'm in agreement with what others have said, this is basically a problem of 1. figuring out what the average per annum after tax cash drain is going to be  2. how long will it be a problem (actuarial longevity of the retirees)  3. adjusting your valuation appropriately.

 

Second, there are so many factors that can influence your assumptions on this,I'm not sure how you get close to any level of certainty with what the outcome will be. I may be reading what you wrote wrong, but it seemed like you said that a 10 million increase in the projected pension liabilities or 10% of the stated pension value,  would wipe out the excess equity value in your model. If that is the case you basically have two choices in my view. Either you can do a very deep dive to figure out you best guess on what is going to happen with the pension issue, or look for something else. For myself I know I wouldn't have the expertise to get comfortable enough, with that small of a margin between success and failure.

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Second, there are so many factors that can influence your assumptions on this,I'm not sure how you get close to any level of certainty with what the outcome will be. I may be reading what you wrote wrong, but it seemed like you said that a 10 million increase in the projected pension liabilities or 10% of the stated pension value,  would wipe out the excess equity value in your model. If that is the case you basically have two choices in my view. Either you can do a very deep dive to figure out you best guess on what is going to happen with the pension issue, or look for something else. For myself I know I wouldn't have the expertise to get comfortable enough, with that small of a margin between success and failure.

 

This company was coming off a catastrophic collapse in sales when a couple of their major customers went bankrupt a few years ago...They now have two years of earnings behind them...this year was a good year.  The valuation is just silly low.  I know of no other stock that is valued as low as this one is on a P/E and cash flow basis.

 

If the economy does not fall apart, they can make a LOT of money.  They have invest in plant & equipment & training, they have started to significantly pay down their bank debt...

 

They are trading for 85% off their pre-crisis highs.  They have the capability to be trading a 1x P/E instead of a 2x P/E.  They were paying a dividend that would be equivalent to a current 30% yield...

 

So the potential is certainly there and I need to get it right.

 

Book value is LOW right now, as they have been coming off the worst years since the great depression.  Another 2 years of decent earnings, and the book value problem probably goes away.

 

So it is most definitely worth the trouble...

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As an aside, back as far as the 1970s Buffett's has been making interesting comments on excess pension return projections.  Some googling should bring up the discussions.

 

The interesting things is that these issues been around since 1970s and mentioned multiple times in 1990s, 2000s, now 2010s. And very few companies (none? does GM count?) have gone under.

 

Not saying to ignore pension issues, but so far and at least for big cos, the issues seem to have been contained or maybe kicked down the road. Apart from situations where the co was going under for other reasons already. FWIW.

 

It sure would be interesting to see how companies dealt with the earlier 'gaming' of expected returns.

 

I'd guess firing older workers, attrition, offshoring, mergers, conversion of pensions, etc. I don't see any great downside for management to over promising on this front.

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The discussion here made me think of this letter from Mr. Buffett to Kay Graham.  Hopefully it's good reading for you guys.

 

"There literally were years when the savings account earned more than was earned out of all operating assets of the steel business (In fairness to U.S. Steel, it should be mentioned that they were one of three pioneers in recognizing the importance of pension assets - and have done a better-than-average job through in-house management.)"

Capture.PNG.de45a495cde55c6c0fd3ebd1103c3ca7.PNG

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