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What Are The Costs Of Pension Underfunding?

By: Jim Helik

Almost every day brings us new estimates of the massive underfunding of North American pension plans. I lost track after some estimates topped the $1 trillion mark. In this case, what behavioural economists call ʻthe law of large numbersʼ applies – this total becomes so large that it becomes almost meaningless to most people.

So what does this number (whatever it actually is) all mean? It turns out that pension plan underfunding has far broader implications than just its impact on the pension world.

For companies with underfunded DB plans, the consequences are best expressed by Jim Owens, the chairman and chief executive officer of Caterpillar Inc., who said, “Companies cannot commit to building new plants, launching new research projects, or hiring new employees if that cash is needed to fund pensions.”

Attempting to quantify the repercussions of this underfunding is the subject of a new paper from Joshua Rauh, at the University of Chicago, titled ʻInvestment and Financing Constraints: Evidence for the Funding of Corporate Pension Plans.ʼ

Year-by-year Patterns

Rauh uses a large sample of more than 5,500 pension plans and looks at year-byyear patterns over the 1990-1998 period. As an aside, even though this sample time span does not cover the most recent period of underfunding brought about largely by the market declines since the year 2000, his sample still includes many firms that had to make economically substantial contributions to their pension plans. About onequarter of the companies in the sample had at least one annual period when the required pension contributions were at least 10 per cent of the firmʼs capital expenditures.

Rauh pinpoints the companies and times when substantial funding to the corporate pension plan was needed, and tests for the companyʼs ability to invest in new capital, conduct research and development, or make corporate acquisitions as compared to firms that were similar, but unconstrained by having to make pension contributions (there was either no pension plan or the plan was overfunded at that time).

Not surprisingly, capital expenditures (like research and development) fall as required pension contributions rise. Not all capital expenditures, or all companies, are exactly alike. For example, at companies that have to make mandatory pension funding contributions in a given year, the probability that a corporate merger or acquisition will take place is reduced, but the amount spent on an acquisition (if it is undertaken) is otherwise unchanged. On the whole, a company ʼs capital expenditures are estimated to decline by about 60 cents to 70 cents per dollar of pension funding required.

Again, not all firms face the same impact as the quality of a companyʼs balance sheet (and thus its ability to borrow money) will affect these expenditures.

The ʻlossʼ of funding for research and development and new capital purchases is greatest in younger firms, companies that have capital expenditures greater than their cash flows, firms with low dividend ratios, and firms with less cash on their balance sheets. Interestingly, what does not seem to make a difference is whether the underfunding contributions take place over many years (and are, therefore, more predictable) as compared to unexpected underfunding situations in one period as a result of sudden unexpected losses in value of pension assets.

Same Constraints

Companies that are perhaps more ʻforward- lookingʼ about their pension-related cash flows, seem to suffer from the same constraints on capital expenditures as do companies facing more sudden pension cash contributions.

Finally, there is the question of whether companies that do not sponsor DB pension plans (or firms with healthy DB plans) undertake some of the capital projects that are forsaken by those firms that are otherwise funding their DB plans. These ʻunconstrained ʼ firms do pick up some of the slack – companies without a DB plan undertake about 12 per cent of the capital spending that other firms in their industry leave on the table due to their necessity to fund their pension plans.

The take-away here is that pension funding issues have an impact broader than our pension world and that a companyʼs underfunded DB plan affects more than just that firmʼs shareholders. Money can only be spent once and cash needed to fund pension plans wonʼt be available for new capital spending, dividend payouts, new hiring, or new acquisitions.

Jim Helik is co-author of ʻEnergy Markets Risk Management,ʼ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.

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