Can a pension drown a company?

Recently, Hostess Brands, the maker of Twinkies and Wonder bread, filed for Chapter 11 bankruptcy protection in the U.S. The company blamed, in part, its current cost structure, calling it “not competitive, primarily due to legacy pension and medical benefit obligations and restrictive work rules.” At first glance, it might be hard to see how an ancillary benefit like a pension can drive a company into bankruptcy; however, it can be a major risk in today’s business environment.

Naturally, the size of the pension obligation is the determining factor. With Hostess, the company’s funding shortfall to the Bakery & Confectionary Union & Industry International Pension Fund was US$944 million. This overwhelmed the company, which had US$982 million in assets as of Dec. 10, 2011.

Poor asset-liability management, demographic trends, negotiated pension benefit increases and contribution holidays all played a part. Let’s consider each of these.

Liability risk
A pension plan’s liability risk tends to be positively correlated to fixed income, with additional exposure to inflation, longevity and other factors. When interest rates go down, liabilities increase. On the asset side of the equation, many pension funds invest primarily in equities, the returns on which are highly variable. When equities decrease and interest rates drop, which has occurred in the past few years, then assets are shrinking even as plan liabilities rise. This increase in the pension funding gap demands larger contributions by the fund sponsor, among other measures. But if the total pension fund liabilities are significant compared with the plan sponsor’s net capitalization, then the sponsor is ill-equipped to afford the contributions required to restore the fund’s financial health. This was the case with Hostess.

Demographics
How do many funds (and plan sponsors) end up in this situation? Since the 1970s, demographics and longevity have combined to increase the ratio of retirees to active plan members. Pension funds, many of which were established in the pre-baby boom era, benefited from a large workforce and a small number of retirees. Thus, the contributions of active members were sizable compared with the benefits drawn by retirees. Furthermore, the cost of the pension promise appeared small relative to such current costs as salaries. But as boomers aged and headed into retirement, pension costs skyrocketed compared with salary expenses. An unchanged retirement age further exacerbated the problem: the average North American now has a life expectancy almost 10 years longer than in the 1950s. This requires benefits to be paid for a longer period of time, even as pension funds are increasingly ill-equipped to do so.

Pension increases
Nor are demographics the sole force at work. The positive investment environment of the 1990s caused employees to demand pension increases. Management generally acceded to this in lieu of pay increases, since the pension fund appeared to be in solid financial shape at the time and the future implications of increased pensions were less obvious than the immediate impact of increased salaries. Unfortunately, actuarial pension calculations are based on long-term averages. In that sense, the poor equity market returns in the 2000s could be said to have averaged out the excellent returns of the prior two decades. In brief, when long-term actuarial assumptions confront short-term business decisions, the results can be disastrous. They can bring down the company.

Contribution holidays
Contribution holidays, which are also based on short-term funding ratios, are another source of the growing gap between assets and liabilities. Pension funding requires not only investment income but also regular contributions from plan sponsors to offset the growth of liabilities. When investment income exceeds actuarial expectations, a plan sponsor will often consider suspending contributions for that fiscal year. Regulatory and tax authorities encourage this decision by penalizing companies with excessive funding ratios. Although contribution holidays were more common in the ’80s and ’90s than in the past decade, their impact still resonates, since pension funds were left without necessary funding buffers when financial markets soured.

Funding shortfalls in a pension can put significant strain on the financial well-being of the plan sponsor; they can even drive the sponsor to the point of bankruptcy. While each of the above factors plays a role in causing larger pension deficits, the cumulative effect leaves little margin for error in today’s low interest rate, volatile equity environment.