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Insight: U.S. pensions' funding gap closes, driving corporate profits

Trader Peter Tuchman smiles as he works on the floor of the New York Stock Exchange after the market opening in New York, December 23, 2013.
Trader Peter Tuchman smiles as he works on the floor of the New York Stock Exchange after the market opening in New York, December 23, 2013.

By David Randall

NEW YORK (Reuters) - Corporate America is rapidly healing one of the last wounds suffered in the 2008 financial crisis.

Large companies' pension plans are reporting among their best returns on record in 2013, dramatically closing funding gaps that had opened up because of losses in the 2008-2009 stock market collapse, and as government bond yields sank.

All told, companies in the S&P 500 saw an aggregate improvement of more than $300 billion in their pension plans, a gain that brought assets to around 93 percent of expected obligations, according to International Strategy & Investment, a New York research firm. That is a robust recovery from 2008, when they hit an all-time low of only 70.5 percent.

For investors, the performance of corporate pension plans is a small but under-appreciated side effect of the bull market that has now lasted for nearly five years. It will free up corporate cash for dividends, stock buybacks, and new investments, while helping to drive earnings growth, which could give a further nudge up to stock prices, analysts say.

Some companies may also see upgrades to their bond ratings, lowering their future borrowing costs.

David Zion, an analyst at ISI who co-authored the report, estimates that the strong performance of pension plans will save companies in the S&P 500 a total of $26 billion in the current fiscal year, resulting in a 1.6 percent boost for the 2014 earnings per share of the index. Analysts tracked by Thomson Reuters currently expect earnings per share to rise 10.7 percent this year.

The benefits mostly accrue to older industrial companies, or those who were traditionally unionized, as some of their workers and many of their retirees tend to have the more generous defined-benefit plans that are directly funded by the companies. The newer technology and service companies, who tend to rely on 401K plans that are largely the responsibility of workers to fund, are mostly not affected.

Some companies reporting their fourth-quarter earnings in the past few days have already said their results are benefiting from reduced pension costs.

Business jet manufacturer Textron Inc, for instance, saw its shares jump to a five-year high Wednesday after its earnings beat analyst estimates. Along with a rebound in the business jet market, the company is riding the performance of its pension plan. In 2010, it contributed about $417 million to the plan as its funding ratio fell to 77 percent, while in 2014, it expects to contribute just $80 million - a decline of nearly 81 percent. And now its pension plan is funded at an estimated 101 percent level, according to ISI.

The same day, AT&T Inc said it expects to record a pre-tax gain of about $7.6 billion in the fourth quarter from its pensions and post-employment benefit plans. A day earlier, Verizon Communications Inc reported fourth-quarter 2013 earnings of $5.07 billion, $3.7 billion of which was due to increases in the value of its pension and other benefit plans.

"These kind of cost-savings over a three-to-four year span don't happen often," said Eugene Stone, chief investment strategist at PNC Asset Management, referring to the decline in pension costs at companies since the end of 2009. "This is going to provide a tailwind to earnings for 2014 that hasn't been there lately," he said.

The gains have largely come from the stock market. The S&P 500 soared 32.4 percent, including dividends, last year, and has

climbed nearly 170 percent since its low in 2009.

In addition, the so-called discount rate - which serves as a proxy for the interest rate a company could expect on a bond today to fund its future obligations - increased as the yield on the 10-year Treasury note rose off of historic lows in the second half of last year. A higher discount rate means that companies do not have to contribute as much to pension plans.

COST SAVINGS

Gains in defined benefit plans had an impact on many S&P 500 companies in 2013, ISI analyst Zion said. Only 58 companies in the S&P 500 now have pensions that are less than 80 percent funded, compared with 197 a year ago, and some recorded pension gains that totaled more than 10 percent of their market caps.

United States Steel Corp, for instance, saw its pension assets rise more than $1 billion (not including the company's contributions), an improvement that brought its pension plan to a 92 percent funded level. The gain was the equivalent of almost 31 percent of its market value at the end of 2012 of $3.4 billion. The Goodyear Tire and Rubber Co, Northrop Grumman Corp and Owens-Illinois Corp saw gains of 15 percent or more of their end-2012 market caps.

Because most Wall Street analysts typically focus more on a company's ongoing business than its pension obligations, those cost savings could result in earnings surprises, Zion said.

US Steel, for example, should see a benefit of 74 cents in earnings per share directly from the improvement in its pension funding, a level that amounts to 65 percent of consensus estimates of $1.15 per share for 2013, Zion said. Alcoa Inc, meanwhile, should get a pension benefit of 16 cents per share, a level that equates to 40 percent of consensus estimates of 41 cents per share. It is unclear how much of the benefit has already been factored into those earnings estimates by analysts.

HELP ON THE MARGINS

To be sure, few investors say they would invest in a company simply because its pension costs are falling.

For example, Matthew Kaufler, a co-manager of the $1 billion Federated Clover Value Fund, has held a position in Macy's Inc for several years. He was pleased to see the department store chain announced on January 8 that it had decided to forgo a $150 million contribution to its pension plan in the fourth quarter because of better-than-expected returns.

The pension plan savings "was a positive but in the list of positives it was not at the top," Kaufler said. "People fundamentally want Macy's to sell lots of clothes and home goods. That's what drives the business, not the pension plan performance."

But higher funding levels do make these companies seem safer bets over the long run because it means their balance sheets look better, portfolio managers say.

"For so many of these companies, the magnitude of the downturn was so great that they were kicked in the shins," said Scott Lawson, an analyst who works on the $178 million Westwood LargeCap Value Fund. "Now, with the plans back to their prior funding levels, it lowers the risk profile."

TAKING RISK OFF THE TABLE

Several companies are heading into 2014 with pensions plans that are in dramatically better shape than a year ago. Harley Davidson Inc, for example, saw a 36 percentage point gain, to 118 percent of obligations, in its funding levels over the past twelve months, according to ISI estimates.

Yet despite the gains in pension assets, companies may still face some risk in the long-term, analysts say. Any sudden reversal in the stock market is one concern. Workers living longer is another.

A 60-year old worker who retires today is expected to live 26.7 years longer on average, a 1.8-year improvement over previous lifespan estimates released by the Society of Actuaries in 2000. That nearly two year increase will result in a 6 percent increase in pension obligations, said Karin Franceries, an executive director at J.P. Morgan Asset Management.

In the past, companies often cited overfunding as a reason to terminate their pension plans. More recently, companies such as General Motors Co and Ford Motor Co, cut their pension risks by offloading their plans onto insurance companies, which then offer annuities to plan participants.

Now, though, many companies may find it more attractive to keep their own plans, said Zorast Wadia, a principal at actuarial consulting firm Milliman, which produces an annual study of pension funding. Insurance companies typically want plans to have a funding rate of 115 percent or more before they will take on their risks, Wadia said.

"A lot of these companies are going to find it's cheaper to keep (it)," Wadia said, referring to the pension plans.

Equities now typically make up about 40 percent of plan assets, though some companies, such as Warren Buffett's Berkshire Hathaway Inc, had as much as 72 percent of pension plan assets in stocks as recently as 2012.

"These plan sponsors are coming off the best year in their careers, and I expect many of them are going to be happy to take some risk off the table," Wadia said.

It may be the final paradox of a 2013 market rally that few saw coming: stocks have helped pension plans so much that they decide to sell them and buy bonds instead.

(Reporting by David Randall; Editing by Linda Stern, Martin Howell and Grant McCool)

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