Massively underfunded public and private pensions, and all the risks inherent therein, have been a frequent topic of conversation for us recently. Today, Tobias Levkovich at Citigroup published a report pointing out just how dire the situation is for the S&P 500's largest corporate pension funds. The study found that pensions of just the companies in the S&P 500 alone were over $375BN underfunded at the end of 2015 with the top 25 underfunded plans accounting for over $225BN of the underfunding. Moreover, Citi pointed out that pensions don't seem to be participating in the massive equity rally that has grown ever so "bubbly" since 2009 (and issue we explained in detail here: "Pension Duration Dilemma - Why Pension Funds Are Driving The Biggest Bond Bubble In History").
Pension under-funding continues to be a major issue for S&P 500 constituents as very respectable equity market gains over the last seven years have not substantially alleviated pension pressures. The S&P 500 has appreciated by more than 200% at the end of 2015 since the low in March 2009 but the aggregate underfunded status of $376 billion in December 2015 is now 22% higher than the $308 billion under-funding peak seen in December 2008 (see Figure 1). While the funding status in 2013 recovered by more than $225 billion versus 2012 alongside strengthening equity market performance and a higher discount rate, this trend reversed in 2014 and only improved moderately in 2015. Specifically, the slightly higher discount rate contributed to the progress in 2015’s pension funding status, not higher equity prices.
Per the table below, S&P 500 corporate pensions went from being fully funded in 2007, in aggregate, to $375BN underfunded in just 8 years. The primary problem, of course, is the Fed's low interest rate policies which are crushing both sides of the pension equation. Pension assets have basically stagnated since 2007, up less than 10%, as pensions struggle to "find yield." Meanwhile, lower yields on corporate bonds have driven discount rates through the floor causing the present value of liabilities to skyrocket over 40% over the same period.
After dipping in 2014, the discount rate rose modestly in 2015, causing pension obligations to ease but pensions remain severely underfunded. The present value of corporate pension obligations is heavily influenced by interest rates and thus lower yields typically cause deterioration in funding status. While forecasts for higher yields in the future should lead to decreased concerns over the underfunded status of US pensions, Other Post Employment Benefit (OPEB) accounts remain significantly under-funded as corporations attempt to shift these costs onto individuals, but that may take some time.
Citi points out that all ten S&P 500 sectors remain underfunded, with Energy continuing to be the least funded sector. The pension review found that only 30 companies within the S&P 500 were fully funded at year-end 2015, with nearly half of the overfunded companies coming from the Financials sector.
Finally, Citi points out that pensions have been pulling assets out of equities and moving into fixed income, a phenomenon they attribute to pensions being "unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years." But, as we've suggested before (see "Pension Duration Dilemma - Why Pension Funds Are Driving The Biggest Bond Bubble In History"), the problem is less likely due to fear of historical equity volatility and more related to a desire to match asset and liability duration.
Pension funds appear unwilling to allocate assets towards stocks after two major equity pullbacks in the past 15 years clobbered pension programs leaving allocators and consultants relatively risk averse with LDI (liability driven investing) taking over the mindset. Moreover, current ERISA requirements call for companies to keep enough short-term cash and equivalents available to pay out current pension liabilities. Fortunately, corporate cash flow, free-cash flow, earnings and cash holdings are at or near record highs making required cash contributions to pension funds a much more manageable expense for S&P 500 constituents. Note that the funding status at 81.5% declined from the 87.8% level seen in 2013, which was the best reading in the past eight years, but remained markedly better than 2012’s 77.3%, which was the weakest point since 1991.
S&P 500 constituents’ pension plan allocations to equities edged down to 42.4% in 2015 from 44.5% in 2014, the lowest level we have seen in the past nine years (see Figure 4). Interestingly, bond mutual funds saw a reversal of flows, as released by ICI, which saw more than $25 billion flow out of bond funds last year (vs inflows of roughly $58 billion so far this year), while US pension funds increased their fixed income allocation by almost one percent to 44.8% (see Figure 5).
Equity markets have largely dismissed pension underfunding issues as they reach higher highs everyday. That said, at some point the pension underfunding issue will deteriorate to a level that will be too large to ignore requiring either massive cuts in benefits for 1,000s of employees or taxpayer funded bailouts. We suspect we know which will be the more palatable to our elected officials.