How to Profit From the Growing US Pension Fund Crisis

By: Money_Morning

Martin Hutchinson writes: Welcome to the latest offshoot of the subprime-mortgage debacle: A burgeoning U.S. pension-fund crisis. Since the global financial crisis struck last fall, the largest 1,500 U.S. public companies have lost a combined $280 billion from their pension funds. Assuming the stock market doesn't move much from here, a typical U.S. company can expect its pension expense – a direct charge against profits – to increase between 20% and 30% in 2009.

With such a hefty burden ahead, it's not difficult to understand that this pension fund crisis will certainly exert a downward pressure on corporate earnings, and doubtless on stock prices, too.

But there is a silver lining: By choosing your stocks carefully, you can dodge this pension-fund crisis altogether. To make sound choices, it's first necessary to have some knowledge of pension systems, and the funding crisis that's brewing up like a summer squall.

Pension-Fund Proliferation Leads to Pension-Fund Crisis

The pension fund problem emanates from the huge expansion of pension funds after World War II, when companies saw additional pension promises as being cheaper than cash wage increases. And they were cheaper: Big industrial companies like General Motors Corp. ( GM ) were growing rapidly, meaning they had relatively young work forces who could be expected to pay pension contributions for many years before being eligible to receive pensions.

Add a certain amount of old-fashioned sloppiness in the accounting – for instance, the total value of pension liabilities didn't have to be reported at all until 1985, and have only been brought onto the corporate balance sheets under the recent pension-focused accounting rule, SFAS 158 – and you can see why defined-benefit pension plans, in which workers got a benefit based on a percentage of final salary, were popular with all concerned.

The defined-benefit pension system got into serious trouble in the 1980s – thanks to some developments from the decade before. Under the ERISA Act of 1974 , employers were forced to make payments to the Pension Benefit Guaranty Corp ., so employees would be paid if the employer went bust. As the 1970s wore on, high inflation (which led to higher wages, and therefore higher pension obligations) and lousy stock markets (which reduced the pension funds' returns), caused many defined-benefit pension schemes to become seriously under-funded, creating a major risk to employee benefits.

The Generally Lousy Moves of General Motors and General Electric

The aging work force didn't help: By 1980, GM had stopped expanding and was moving towards its current position, in which retirees outnumber active workers.

The industry's new solution was the so-called defined-contribution plans, such as today's ubiquitous 401(K) accounts, in which employers and employees combine to fund employee pensions. These had one modest benefit for the employee: They were much more “portable” than defined-benefit plans.

Under the old pension system, if you had completed 20 years at General Motors, you were basically stuck there until retirement. And employers really liked 401(K) plans, as well, for this new format meant that they were freed from being responsible for employees' welfare in retirement (a huge cost savings in the retirement area, thanks to the massive escalation in health-care costs, as it turned out). Employers also could generally substantially reduce the percentage of employee wages they devoted to pension contributions.

Defined-benefit plans had something of a comeback in the 1990s, when inflation declined and the stock market rocketed ahead so fast that the under-funded pensions of the 1970s disappeared, and were replaced with over-funded pension plans, so that employers no longer needed to make contributions. The result was that many companies took holidays from making pension contributions, boosting their earnings, their stock prices and the value of their top management's stock options by doing so.

General Electric Co. ( GE ) even went further; it figured out a way in which it could make negative pension contributions, essentially withdrawing money from the pension fund, and boosting its earnings still further by doing so. GE Chief Executive Officer John F. “Neutron Jack” Welch (whose tenure at GE was from 1982-2001) never missed a trick - as that company's unfortunate shareholders, employees, and customers are only now discovering.

Possible Pension Profit Plays

Since 2000, stock market returns have been lousy. What's more, bond yields have declined. That's had the effect of raising the nominal value of pension liabilities, which are calculated 30-40 years ahead and then discounted back to the present day by some appropriate bond rate.

When you factor in the recent downturn, it's easy to see why defined-benefit pension contributions will be zooming up.

So, how do you deal with the pension-fund crisis?

Avoid the very well established companies with heavy defined-benefit pension obligations. Listen General Motors, I'm a faithful Buick driver. And I'll probably buy another Buick next time around (or maybe a Caddy if I'm feeling rich), and I'm rooting for you to succeed – even though most analysts feel that Toyota and others have you licked . And while I'll remain loyal to your products, that loyalty doesn't include investing my hard-earned savings in you. [For a related story on General Motors' latest woes, check out this report in today's issue of Money Morning .]

GE is one company whose stock I truly hate: In my opinion, General Electric should never have “diversified” away from dependable “drop-it-on-your-foot” electrical equipment and home appliances to fly-by-night finance - and I think GE stockholders have a rude awakening coming, part of which will come from the mess of their defined-benefit pension scheme.

Deere & Co. ( DE ) is a great company, in exactly the right business to make money right now, but you have to be aware that there's a defined benefit pension problem there, too, although only a medium-sized one.

On the other hand, I knew there had to be an advantage in investing in high-flying tech companies, and now I've finally found one. Most of them were founded after 1980 (even Microsoft Corp. ( MSFT ) was tiny before then), meaning that they don't have this pension problem – they rewarded their employees with stock options and kept pensions down to a skimpy 401(K) plan. Check the footnotes in the annual report to be sure, but I would think you're pretty safe in this sector, or in any company founded after about 1985.

International Business Machines Corp. ( IBM ), Xerox Corp. ( XRX ) and the telephone companies would be obvious exceptions, given that pensions may be a problem with these companies.

Finally, you can always invest abroad, where the problem generally takes an entirely different shape, since the demographic and economic patterns are so different. If you want an auto company, what about India's Tata Motors (ADR: TTM ), which is expanding fast and certainly has no great legacy pension problems. (It's worth noting that there are investor concerns that Tata won't have the capital to finance the expansion. But the market has discounted this at current prices, and the company has the giant Tata Group behind it).

If you want a bank, try Korea's Kookmin Bank (ADR: KB ), which has avoided both U.S. pension problems and the U.S. housing crisis.

In Brazil, the work force is young and most pension plans (the few that there are) are mostly of the defined-contribution variety, so consider a look at mining giant Vale (ADR: RIO ).

News and Related Story Links:

The Accounting Onion: FAS 158: Pension Accounting Crawls its Way Towards Reality.

Money Morning Market Analysis : Is Brazil “Investment Grade” for Investor's Money, Too?

Wikipedia: ERISA Act of 1974 .

Money Morning Market Analysis: Tata Targets Jaguar and Land Rover for Long-Term Returns .

Money Morning Market Analysis: GM Tries to Reverse Course, but Can it Catch Toyota?

Money Morning Market Analysis: GE Home Appliance Unit Sale Underscores Again That Corporations and Investors Alike Must Go Global to Succeed

By Martin Hutchinson
Contributing Editor

Money Morning/The Money Map Report

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