Pay into pension, get boost to earnings

January 19, 2012

Companies are going to have to contribute some serious money to shore up their lilting pension plans this year, but there’s a silver lining: higher earnings.

In a Dec. 7 analysis, UBS analysts spell out how contributing to the company plan could handsomely help the bottom line.

It has a lot to do with the peculiarities of pension accounting.

As UBS accounting expert Janet Pegg wrote in the report,  companies that sponsor pension plans mostly don’t use current market results when determining how much their plans cost them in a certain year.  Instead they use an “expected long-term rate of return”  to calculate how their investments did.

Currently, that expected return is usually between 7.5 percent and 8.5 percent.

So if a company put $100 million into its plan in 2011, and it was expecting a 7.5 percent rate of return on investments, it automatically gets $7.5  million in net income added to the bottom line. That goes even for a year like last year when the S&P 500 returned almost zero, and many global markets far less. On the books, pension plans looked to be doing quite well.

In reality, pension plans have not been doing that well.  According to UBS, pensions’ average annual return over the past decade was only about 5 percent, but they  expect to do better, and thus their earnings rise.

Eventually, the difference between the real results and the expected ones does begin to trickle into net income, but with borrowing rates for companies so low right now, Pegg notes, there’s a short-term pension arbitrage to be had. Today a company might easily borrow that $100 million at 4 percent, put it into the pension, claim the 7.5 percent expected return, and  increase pretax earnings by a net $3.5 million.

There are other financial reasons for companies to pony up a little extra for the pension in 2011.

For one, companies have the money to do so. The industrial firms in the  S&P 500 index alone have almost $1 trillion in cash on hand, according to S&P analyst Howard Silverblatt.

The UBS report highlights  28 companies with cash on their balance sheet and significantly underfunded pensions. Among them: AT&T, Verizon, Honeywell, Xerox and Hewlett-Packard.

DuPont’s already announced it will be adding $875 million to its plans in 2012, on top of $320 million this year.

The hole these companies must fill is getting bigger. In a Jan. 10 report, David Zion, an accounting expert at Credit-Suisse, calculated the pension plans of the S&P500 hit record underfunding in 2011, with just 74 percent of their future promises covered, a $458 billion shortfall.

In multiple ways, the math looks right for significant cash contributions to pensions this year and next.

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