1. PENSIONS MUST ACCOUNT FOR LONGEVITY RISK October 31, 2014
Will Becker
wbecker@behindthenumbers.com
1
Prior to the mid-19th
century, humans typically lived fewer
than 40 years. By 1900, life expectancy began to rise
globally, reaching 48 years in 1950, 60 years in 1980 and
close to 70 by 2010, according to data by the United
Nations and the International Monetary Fund (IMF).
According to Institutional Investor (8/25/14), this rise in life
expectancy can primarily be attributed to the decline in
infant mortality, which accounted for more than 70% of
improved life expectancies in the United States and
Canada from 1950 to 1970. Other health care benefits
aimed at people under 65 also helped and death from
infections was reduced. Then, starting around 1970, a
significant improvement in life expectancy for people over
65 began and this trend continues today.
Although health spending accounted for approximately
16.9% of GDP in the US in 2012, the highest share among
the 34 member countries in the Organization for Economic
Cooperation and Development (OECD) and nearly double
its average of 9.3%, the US ranked just 27th of these 34
countries in terms of life expectancy at birth. While the US
has made serious progress in reducing the proportion of
adults who smoke tobacco, with the rate of daily smokers
coming down from 19% in 2000 to 14% in 2012, the
country’s obesity rates continue to rise. Based on actual
measures of height and weight, obesity rates in the US are
the highest in the OECD, reaching 35.2% in 2012, up from
30.9% in 2000. Mortality from diseases, including
cardiovascular diseases and many cancers, increases
progressively once people become obese.
Key Points:
Pension plan costs should rise materially as
Americans live longer
OECD numbers show that US life expectancy
rates at birth have been steadily rising for
decades, increasing by approximately 2.1 years
just since 2000.
The IMF has long argued that forecasters have
consistently underestimated how long people will
live by an average of 3 years.
The Society of Actuaries (SOA) updated their
mortality estimates for the first time in 14 years,
showing life expectancies for 65-year-old
Americans is up more than 2 years.
Based off these longer estimated lives, the
Treasury and IRS are expected to revise industry
pension calculations for PBOs and minimum
contributions, respectively, likely in 2016.
Aon Hewitt estimates higher lives will increase
retirement liabilities by roughly 7% for most
corporate plans, while the SOA sees a 4-8% rise.
Although the S&P 500 pension funded status
improved significantly in 2013 off crisis levels,
these levels have likely deteriorated noticeably in
2014 based off old life expectancy estimates.
We screened for companies most vulnerable to rising
longevity risk
We pulled non-financial S&P 500 companies with
defined benefit plans that carry a large number of
employees and retirees, sorting those with largest
PBOs at the top.
Leaving those whose plans were underfunded by
at least $100 million over the last fiscal year and
had at least 30% of plan assets in equities, we got
the list down to 156 companies.
IBM has grown EPS primarily via share repurchases,
but higher pension contributions could hit cash flow
Sales growth has been non-existent and IBM has
taken on more debt to boost EPS through repos.
IBM carries largest combined PBO of S&P 500 at
just under $100 billion.
IBM increased its employee ranks at an average
annual rate of approximately 2.6% over last 20
years. However, IBM has slashed jobs in recent
years, putting more pressure on its pension as its
retiree base grows relative to current workers.
IBM’s women employee percentage is also rising,
which could put further strain on its pension since
women typically live five years longer than men.
Based off 12/31/13 numbers, should IBM’s US
PBO get raised 7% based on higher longevity risk,
we estimate its combined funded status goes from
-$6.2 billion to -$9.8 billion.
Pension contributions, which have been lower
over each of the last four years, could easily jump
to nearly $1 billion from an expected $600 million
for 2014. This would put a dent in IBM’s cash flow
and could curb repurchases.
CAT sales to miners are down and cost cuts and repos
have driven EPS gains; rising pension contributions
may come at a bad time
Strong sales to North American energy and
construction industries have been offset by weak
mining equipment sales, forcing CAT to slash
production costs involving thousands of layoffs.
CAT has been growing its employee base fast
over the last decade, but has been noticeably
cutting jobs since 2012 and thus putting more
strain on the future funding of its pensions.
CAT’s US plans had a big equities allocation at
61% as of 12/31/13.
Based off 12/31/13 numbers, should CAT’s US
PBO get raised 7% based on higher longevity risk,
we estimate its combined funded status goes from
-$2.7 billion to -$3.7 billion.
We believe depressed pension contributions could
easily jump to over $700 million from an expected
$510 million for 2014, putting a hit on cash flow.
In August 2012, CAT changed its U.S. hourly
pension plan, freezing pension benefit accruals for
certain hourly employees and making them
eligible for company-sponsored 401(k) plans.
2. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
2
DOW is performing well operationally, but its heavily
underfunded pension remains a concern
DOW’s Performance Plastics segment has been
driving solid results and should continue to benefit
from low cost feedstocks in North America which
result from the natural gas and liquids boom.
DOW has fewer employees today than it did 20
years ago and it is likely safe to assume that
DOW’s plans cover more retirees than workers.
While still under the S&P 500 average, DOW’s
women employee percentage continues to creep
higher.
Based off 12/31/13 numbers, should DOW’s PBO
get raised 7% based on higher longevity risk, we
estimate its combined funded status quickly goes
from -$6.2 billion to -$8.0 billion.
With pension contributions likely heading back up
much higher, DOW may have to pare back its
recently hyped share repurchase program.
APD has gotten a boost from price increases, but cash
flow deficits persist and higher pension contributions
won’t help
APD is a current BTN warning and dividend play
that has seen its stock price rewarded after
implementing new management and initiating
price increases to boost sales.
APD likely cut some jobs in FY14 and its
employment growth only increased by about 2.2%
annually over the prior 20 fiscal years, meaning its
plans likely cover more retirees than workers.
Based off 9/30/13 numbers, should APD’s US
PBO get raised 7% based on higher longevity risk,
we estimate its combined funded status goes from
-$593 million to -$790 million.
Even a small increase in pension contributions
could hurt APD, as it reported an adjusted free
cash flow deficit of $125 million in FY14, even
after ending its share repurchase program.
APD recently began offering certain workers lump-
sum buyouts to simplify operations and perhaps
unload some of the risk of running a pension.
According to the latest OECD report, U.S. life expectancy
in 2012 was 78.74 years, which is nearly nine more years
than it was in 1960 at 69.77 years. For U.S. men, the
current average life expectancy is about 76 years, while it's
81 for U.S. women. The following table shows average US
life expectancies from 1960-2012 and also breaks out
gender differences over this period, according to the
OECD:
U.S. Life Expectancy Table (1960-2012)
United States - Life expectancy at birth
Date
Life
expectancy
Life expectancy
- Men
Life expectancy -
Women
2012 78.74 76.40 81.20
2011 78.64 76.30 81.10
2010 78.54 76.20 81.00
2009 78.09 75.70 80.60
2008 77.94 75.50 80.50
2007 77.84 75.40 80.40
2006 77.59 75.10 80.20
2005 77.34 74.90 79.90
2004 77.34 74.90 79.90
2003 76.99 74.50 79.60
2002 76.84 74.30 79.50
2001 76.74 74.20 79.40
2000 76.64 74.10 79.30
1999 76.58 73.90 79.40
1998 76.58 73.80 79.50
1997 76.43 73.60 79.40
1996 76.00 73.06 79.08
1995 75.62 72.50 78.90
1994 75.57 72.35 78.96
1993 75.42 72.20 78.80
1992 75.64 72.33 79.12
1991 75.37 72.00 78.90
1990 75.21 71.80 78.80
1989 75.02 71.70 78.50
1988 74.77 71.40 78.30
1987 74.77 71.40 78.30
1986 74.61 71.20 78.20
1985 74.56 71.10 78.20
1984 74.56 71.10 78.20
1983 74.46 71.00 78.10
1982 74.36 70.80 78.10
1981 74.01 70.30 77.90
1980 73.66 70.00 77.50
1979 73.80 70.00 77.80
1978 73.36 69.60 77.30
1977 73.26 69.50 77.20
1976 72.86 69.10 76.80
1975 72.60 68.80 76.60
1974 71.96 68.20 75.90
1973 71.36 67.60 75.30
1972 71.16 67.40 75.10
1971 71.11 67.40 75.00
1970 70.81 67.10 74.70
1969 70.51 66.80 74.40
1968 69.95 66.00 74.10
1967 70.56 67.00 74.30
1966 70.21 66.70 73.90
1965 70.21 66.80 73.80
1964 70.17 66.80 73.70
1963 69.92 66.60 73.40
1962 70.12 66.90 73.50
1961 70.27 67.10 73.60
1960 69.77 66.60 73.10
Meanwhile, the IMF argues that forecasters have
consistently underestimated how long people will live, over
time and across populations, regardless of the techniques
they have used. A 2000 report called Beyond Six Billion:
Forecasting the World’s Population says that estimates
have been too low in many countries, including the United
States, by an average of three years.
Giving the IMF’s estimated 3-year discrepancy some
credence, we note that 2011 OECD numbers show that the
average American male and female are retired for 10 and
16 years, respectively.
3. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
3
So, with the average retirement age in America at 62 years
according to the US Census Bureau, this means that men
and women would finish their retirements at ages 72 and
78 years, respectively. However, when one goes off the
OECD numbers above, we see life expectancies at 76 and
81 years for males and females. This leaves us 3-4 years
short! The point we want to make is that many people think
3-4 years of additional life on a 79-year average is not a
significant discrepancy. However, drilling it down in terms
of years of actual retirement, 3-4 years against 10-16 years
of pulling money off a pension translates to an accounting
adjustment increase on the projected benefit obligation
(PBO) for companies’ defined benefit plans of about 40%
for males and 19% for females, respectively!
So, have these longer life expectancy averages been
factored into the determination of PBOs for most US
company plans? Last published 14 years ago in 2000,
mortality tables assembled by the nonprofit Society of
Actuaries (SOA) used to measure life expectancy were
finally updated on 10/27/14. This 2014 update has been
heavily anticipated. In fact, according to an October 2012
Prudential report, the SOA released a draft report in March
2012 indicating that the previous mortality improvement
scale it issued in 1995 for use by defined benefit plans
(Scale AA) was not tracking well with recent mortality
trends in the US and that a new Scale BB would be based
upon research into mortality improvements by “cohort”
(meaning for persons of a particular age and year of birth).
This two-dimensional analytical framework is a critical
advance in the measurement of U.S. longevity risk, as the
current Scale AA only has one dimension – the longevity
improvement of those turning a certain age (e.g., 65).
Scale BB will include a 1% long-term rate of mortality
improvement for all ages up to age 90.
As a result, these new SOA tables show that the average
65-year-old American is living approximately 2.2 years
longer than just 14 years ago. According to the WSJ
(10/27/14), SOA shows the average 65-year-old U.S.
woman is expected to live 88.8 years, up from 86.4 in
2000, while men age 65 are expected to live 86.6 years, up
from 84.6 in 2000.
Note: These SOA figures are markedly higher than the OECD
numbers because it only factors in deaths of Americans after they
reach the age 65.
This means that the average 65-year-old will live 22.7 more
years to the ripe old age of 87.7. In actuarial terms, this
rising longevity means pension fund sponsors and
individuals will need to put aside a larger chunk of assets,
before factoring in inflation. The new estimates released
Monday—based on data from corporate pension plans—
could eventually increase retirement liabilities by roughly
7% for most corporate plans, according to Aon Hewitt.
Meanwhile, the SOA predicts the increases could range
from 4% to 8%. In the US, using only the previous
estimates of mortality, actuarial liabilities include $3.6
trillion in the 126 largest public pension funds (closer to $4
trillion when one includes local and municipal funds), $3
trillion in private defined benefit plans and $24.3 trillion in
unfunded obligations to current workers and retirees within
the Social Security program, according to Institutional
Investor (8/25/14).
Thinking about this logically, it is not surprising that living
longer has a big effect on pensions. This is largely owed to
the fact that the amount of income paid to pensioners is
funded by working individuals. The life expectancy of a
retiree has a major effect on the pension amount paid by a
private pensions scheme. This is because the money that
a person saves prior to retirement will have to last for a
longer period of time if a retiree lives for long, unlike in a
case where a person has a short life expectancy.
Granted, it appears that this key longevity assumption is
already being discussed in terms of its impact on state
pensions. According to The News Tribune (6/22/14), in a
June presentation to the Legislature’s Select Committee on
Pension Policy, Washington State Actuary Matt Smith
broke the sobering news that those retiring today are living
a year longer than the state’s pension model had assumed
- and the life expectancy grows by another year or more for
those retiring in 2034. He said men turning 65 today are
estimated to live to 84.1 years under the new assumptions
and women to 86.4 years. To conclude, after members
thought last year that the state’s pension plans collectively
had a $544 million overall surplus, Smith warned that new
money needs to be paid into pension funds to erase what
now amounted to $4.4 billion in underfunding across all
plans over the long haul. Sen. Barbara Bailey, an Oak
Harbor Republican who chairs the Legislature’s Select
Committee on Pension Policy that heard Smith’s
presentation, said,
“I think the general consensus on the committee
was ‘wow.’ I guess we’ll have to study this for a
while. I think that everyone has genuine concern.
We’re trying to digest this and see how we are
going to work through this, and see how it is going
to affect policy work that we do.”
Smith’s outline showed employees in state and local
governments would need to pony up $408 million in the
next budget cycle, if the state tries to fix the problem
immediately. That would drive up contribution rates in
many plans - with some going up less than 1% of pay and
others going up more than 2%. Local governments also
would face a $556 million bill if a bite-the-bullet approach
were taken. Smith said his review looked at all of the
state’s pension assumptions, and of the changes he
made, life expectancy had the biggest impact.
4. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
4
Longevity risk is clearly becoming a major concern for the
IMF as it talked about necessary reform measures and
possibly a government mandate to increase retirement
ages and help stem future looming pension deficits. In an
April 2012 report, the IMF concluded,
“First, governments should acknowledge the
significant longevity risk the face through defined-
benefit plans for their employees and through old-
age social security schemes. Second, risk should
be appropriately shared between individuals,
pension plan sponsors and the government. An
essential reform measure would allow retirement
ages to increase along with expected longevity.
This could be mandated by governments, but
individuals could also be encouraged to delay
retirement voluntarily. Better education about
longevity and its financial impact would help make
the consequences clearer.”
The IMF report also cautioned that if it was not feasible to
increase contributions or retirement ages that benefits may
have to be trimmed. Finally, the report discussed the use
of risk transfer to capital markets.
One can certainly suspect that longevity risk has been on
the minds of some plan sponsors of private companies too.
The WSJ article notes that more companies are closing
their defined benefit plans and offering defined contribution
plans, such as 401(k)s, where employees are largely
responsible for saving and investment choices. It also talks
about how companies that are being hit with rising
insurance premiums and longer-living retirees are looking
to unload the risks of running a pension plan by offering
workers lump-sum pension buyouts or selling those
liabilities to insurance companies. Given what appears to
be coming at carriers of defined benefit plans, can you
blame them?
Regardless, it appears that major changes in terms of
accounting for higher longevity risk are coming for US
plans. Under the Pension Protection Act (PPA) of 2006, it
was specifically noted that defined benefit pension plans
have to base the computation of their liabilities on mortality
tables prescribed by the Secretary of the Treasury and that
these tables must be updated at least every 10 years. As a
result, the October 2012 Prudential report predicted that
the SOA’s new mortality improvement scale (Scale BB)
along with updated mortality base tables would be adopted
by the Treasury and subsequently used by DB plan
sponsors starting in 2014 or 2015. Obviously, this did not
happen in 2014, but given that the SOA just updated these
mortality tables on October 27th
, this Treasury adoption
could occur as soon as 2015. Should this adoption occur a
year later, it would likely fall in line with new minimum
funding calculations for corporate pension plans, which the
Internal Revenue Service (IRS) is expected to consider in
2016, according to the WSJ article.
What is perhaps most concerning with this looming impact
from higher longevity risk is the fact that Wall Street
appears to have regained a comfort level with current
pension funding ratios. After all, it was only a few years
ago when pension shortfalls were hitting record levels.
According to data released by S&P Dow Jones Indices,
plans of S&P 500 companies were underfunded by $451.7
billion at 12/31/12, a 27% increase from year ago levels.
However, according to Deutsche Bank estimates this
record deficit fell basically in half to approximately $225.0
billion by 6/30/13, primarily due to higher corporate bond
yields reducing PBOs rather than asset gains raising plan
assets. It also helped that the S&P 500 Index surged by
approximately 30% in 2013 and, by the end of the year, the
funded status remained fairly level from June levels,
resulting in fully-funded plans for 51 of the S&P 500
companies compared to just 18 at the end of 2012. The
following table shows the funded status, funding ratio and
average discount rate of defined benefit plans for the S&P
500 from 1998 to 2013:
S&P 500 Pension Status (in $bil)
FYE Funded Status Funding Ratio Discount Rate
2013 ($224.5) 89.8% 4.7%
2012 ($451.7) 77.3% 3.9%
2011 ($354.7) 78.8% 4.7%
2010 ($245.0) 83.9% 5.3%
2009 ($260.7) 81.7% 5.8%
2008 ($308.4) 78.1% 6.3%
2007 $63.4 104.4% 6.1%
2006 ($40.3) 97.3% 5.8%
2005 ($140.4) 90.4% 5.1%
2004 ($164.3) 88.5% 5.8%
2003 ($164.8) 87.1% 6.1%
2002 ($218.5) 81.3% 6.6%
2001 $2.9 100.3% 7.1%
2000 $226.0 122.3% 7.4%
1999 $280.0 128.2% 7.4%
1998 $126.0 112.4% 6.7%
Source: S&P Dow Jones Indices
To refresh, funding ratios measure a pension fund’s ability
to meet future payment obligations to plan participants.
The main factor’s impacting the funding ratio of a typical
US defined benefit plan are equity market returns, which
grow (or shrink) the asset pool from which plan participants
are paid, and liability returns, which move inversely to
interest rates. Meanwhile, the discount rate on pension
funds’ liabilities is based on the yield from investment-
grade corporate bonds. A higher discount rate for a stream
of future payments lowers the stream’s discounted present
value. At a higher interest rate, it’s possible to set aside a
smaller sum to meet a future savings goal, and vice versa.
However, it appears that the S&P 500 funding ratio is
heading back down again in 2014 as a result of slowing
growth in assets unable to keep up with liability values.
Wilshire Consulting said the aggregate funding ratio for
S&P 500 companies with defined benefit plans fell to
85.0% in September, down 4.8 percentage points from
89.8% at the end of 2013. According to Pension &
Investments (10/3/14), Jeff Leonard, managing director at
Wilshire Consulting, said,
“(Year-to-date) I'd say it's been a surprise both from
the asset and liability sides. Assets have done well,
generally speaking, but the liabilities have increased in
the face of declining interest rates so it's … a surprise
5. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
5
on both sides, one good surprise and one bad
surprise.”
Considering that Mercer estimated that the collective
deficit of the S&P 1500 was approximately $369 billion
at the end of August, coupled with the fact that the last
two months have been a total rollercoaster for equities,
we believe the current S&P 500 deficit could be
approaching $400 billion presently. (Note: Pension
plan deficits for the S&P 1500 and S&P 500 closely
mirror each other and were approximately $236 billion
and $225 billion, respectively, as of 12/31/13.)
To summarize, we believe most pension plans carry
grossly understated projected benefit obligations, while
plan assets may have taken a recent hit. While most S&P
500 companies benefited from having lower required
pension contributions in 2014 as their pension deficits were
slashed in 2013, it appears many of these same companies
will have to make much higher contributions in 2015 given
the lackluster equity performance recently as these funding
deficits have likely risen again in 2014. Additionally, should
plan sponsors begin to factor in rising longevity risk and
more accurately incorporate it into their PBO calculations,
required pension contributions may need to be adjusted
even higher as funding ratios fall. In turn, these higher
contributions should put a further squeeze on operating
cash flow and could force many of these companies to
reduce share repurchases and halt dividend increases that
have helped boost stock returns over the last five years.
Screening
For this exercise, we decided to look at non-financial S&P
500 companies with defined benefit pension plans that
currently employ a large number of employees and also
have a significant number of retirees. Obviously, these are
the companies whose plans carry the largest projected
benefit obligations and are the ones that could see their
PBOs rise the most should longevity risk be more
accurately accounted for and determined. As we laid out
earlier, PBOs could potentially soar once longevity risk
adjustments are made as the Treasury adopts new SOA
mortality improvement tables. While we believe this
adoption will likely occur in 2016 given that the SOA update
came so late in 2014, plan sponsors may try to adjust for
some of the impact early through higher company
contributions in 2015. Additionally, the IRS is expected to
consider new minimum funding calculations for plans in
2016, and we believe it is just a matter of time before most
plans require higher funding.
Additionally, given the generally lackluster performance of
the US stock market year-to-date, we focused on S&P 500
companies whose plans carry heavy equity exposure. Not
surprisingly, plans that have higher equity exposure
typically assume higher expected rates of return (8%+)
compared to the S&P 500 average (roughly 7%). These
return assumptions affect the company’s pension expense,
which ultimately impacts net income. While many of these
companies saw their plans’ funded status improve
markedly in 2013 following last year’s equity market surge
and have thereby enjoyed much lower required employer
contributions this year, this trend may reverse for many in
2015.
As a result of these impacts, we would not be surprised if
employer pension contributions for some S&P 500
companies approach those made in 2013 following the
height of the last pension deficit crisis. Using Bloomberg,
we pulled S&P 500 non-financial companies that had plans
that had at least 30% of their plan assets in equities and
were underfunded by at least $100 million over the last
fiscal year. We then sorted these 156 companies by
projected benefit obligation from largest to smallest. For
the table, we also showed companies current number of
employees to get an additional sense of size and burden
on these companies’ plans. We also added these plans’
most recently reported funded status compared to year ago
levels, as well as the recent equity allocation as a
percentage of plan assets. To determine financial health,
we also included adjusted free cash flow (after covering
dividends and share repurchases for the most current 12-
month period to compare with the previous 12-month
period, as well as a current net debt-to-EBITDA ratio.
9. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
9
Ticker Company PBO
Funded
Status
Funded Status
(-1) Contrib(0) Contrib(-1) Employees
Women
Employee%
Adjusted FCF
T12
Adjusted FCF
T12(-4)
Debt-to-
EBITDA
NDSN Nordson Corp 385 -104.675 -161.88 20.885 12.552 5,801 N/A 71 179 1.57
XRAY Dentsply Intl 359 -216.251 -230.882 12.718 12.144 11,800 N/A 274 219 2.03
TUP Tupperware Brand 246 -131.4 -147.3 14.3 16.9 13,100 N/A -36 -264 2.38
OMC Omnicom Group 186 -113.5 -125.7 5.5 9.1 71,800 N/A 291 239 2.04
10. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
10
INTERNATIONAL BUSINESS MACHINES
International Business Machines (IBM) provides computer
solutions through the use of advanced information
technology. The company's solutions include technologies,
systems, products, services, software, and financing. A
few weeks ago, IBM’s stock took a double-digit price hit
after company management abandoned its long-held
prediction of $20 in EPS for 2015. While IBM has been
very adept at buying back shares to boost EPS in recent
years, revenue growth has been non-existent. In fact,
revenues for 2013 were below those of 2012, 2011, and
2010, respectively. Meanwhile, EBITDA has gone
essentially nowhere from 2008 through 2013, with the small
improvement attributable to margin increases.
After posting five consecutive quarters of higher-than-
expected EPS results, IBM badly missed EPS for its third
quarter ended 9/30/14. The company reported adjusted
EPS of $3.68 for 3Q14, representing an 8% decline from
the $3.99 earned a year ago. Consensus estimates at
Bloomberg expected EPS of $4.32 for the quarter.
Revenue declined by 2% year-over-year in local currency
for 3Q14, with software down, services flat, and hardware
was down 15%. IBM blamed a number of factors for its
poor quarterly sales result, including sales execution issues
in software, below target productivity in services and
adverse FX and a slowdown in the month of September.
Meanwhile, gross margin was only up about 16bps year-
over-year as mix was unfavorable. However, margin
should get a boost soon as IBM recently agreed to sell its
microelectronics business, paying GlobalFoundries an
estimated $1.5 billion to take over the struggling, lower-
margin business.
Not surprisingly, with IBM’s sluggish operating performance
and huge share buyback program, the company’s adjusted
free cash flow deficits soared over the last twelve months
ended 9/30/14, as the company reported a huge $10.1
billion deficit compared to a $1.3 billion deficit for the year
earlier period ended September:
Adjusted Free Cash Flow Analysis (in $mil)
Twelve Months
Ended:
9/14 9/13 9/12 9/11 9/10
Cash from ops before
w/c $18,247 $18,781 $20,441 $20,194 $19,518
Working capital
impact ($912) ($1,477) ($104) ($649) ($314)
Cash from operations $17,335 $17,304 $20,337 $19,545 $19,204
CapEx $3,857 $3,559 $4,130 $4,027 $3,444
Free cash flow $13,478 $13,745 $16,207 $15,518 $15,760
Dividends $4,201 $3,990 $3,696 $3,401 $3,096
% FCF paid in
dividends 31.2% 29.0% 22.8% 21.9% 19.6%
Share repurchases $19,344 $11,069 $12,569 $15,066 $14,838
Surplus/(Shortfall)
after buyback ($10,067) ($1,314) ($58) ($2,949) ($2,174)
As one can see from above, IBM has reported combined
adjusted free cash flow deficits of an astounding $16.6
billion over the last five years ended 9/30/14. To make
matters worse, excluding working capital adjustments,
IBM’s cash flow from operations has been trending lower in
recent years. Additionally, while capital expenditures have
been held in check and dividend increases remain mild,
share repurchase activity continues to jump off the ledger.
As we will show later, these deficits are beginning to put
some strain on IBM’s balance sheet.
Next, we analyzed IBM’s pension situation. In many ways,
IBM is the 800 lbs. gorilla of US-based companies, and its
pension certainly qualifies for this status as the largest in
the S&P 500 with a combined plan PBO of $99.7 billion as
of 12/31/13. Additionally, while constantly evolving in the
technology business and recently reinventing itself away
from hardware to become more of a service company, IBM
has maintained a huge and growing employment base over
the last 20 years, as the following table shows the number
of employees at the end of the most recent year as well as
employment levels held 10 and 20 years ago, respectively:
Employment History - IBM
12/13 12/03 12/93
431,212 319,273 256,207
As one can see from above, IBM’s employment growth has
been pretty steady over the last 20 years, growing at an
average annual rate of approximately 2.6% over this
period. However, IBM has actually been cutting jobs over
the last few years, as IBM employed 434,246 people as of
12/31/12. Meanwhile, more jobs have been slashed so far
in 2014. According to Forbes (10/23/14),
IBM is hemorrhaging talent on a global scale across all
divisions. It cannot retain good people. IBMers, as
they call themselves, are underpaid, neglected, and
have been abused for years. Most of IBM’s 400,000+
employees are no longer working for the company.
Their jobs have become nightmares. They are
prevented from doing good work. They know IBM is
neglecting its customers, but they are powerless to do
anything. The best they can do is to try to survive until
reason returns to IBM’s leadership, if ever.
Every IBM staff cut now has a direct impact on
revenue. After the 1Q 2014 earning miss IBM hit its
sales support teams hard with layoffs, making it
immediately much harder for IBM to sell products and
services. Customers became frustrated and shopped
elsewhere. In 3Q 2014 revenue took a big fall as a
direct result of this bonehead move. Formerly growing
lines of business in IBM are now declining. After 10
years of continuous layoffs, any subsequent reduction
has a direct and immediate impact on business. IBM
can no longer afford to cut staff.
Thus, while IBM has grown its employment ranks over the
last two decades, aiding its pension plans by allowing a
larger current employee base to support its growing retired
employee base, we certainly are concerned about IBM’s
recent job cuts. And although IBM’s plans may still cover
more workers than non-workers, factoring in increased
longevity risk could cause IBM’s already mammoth PBOs
11. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
11
to jump even more, making its plans even more grossly
underfunded.
Another factor that could potentially work against IBM’s
plan sponsors in terms of their ability to fully fund its
pension in the future is the fact that the company’s
percentage of women employees, who typically live about
five years longer than men, has been rising steadily over
the last few years, as the following table shows:
Women Employee Percentage – IBM
12/13 12/12 12/11 12/10 12/09
30.1% 30.0% 28.5% 28.1% 28.7%
12/08 12/07 12/06 12/05 12/04
28.9% 28.8% 28.5% 28.4% N/A
Still, on a positive note, IBM’s current women percentage of
approximately 30.1% is below the S&P 500 average of
companies that carry a defined benefit plan, of roughly
34%, according to Bloomberg estimates.
Looking at IBM’s recent pension performance, the
combined funded status of US and non-US plans improved
significantly in 2013 from year ago levels as these plans
benefited from a solid performance from plan assets:
Key Pension Variables (Rounded in $mil)
12/13 12/12 12/11 12/10 12/09
Funded status ($6,236) ($14,441) ($10,366) ($7,895) ($8,088)
Employer
contributions $449 $557 $728 $801 $1,195
Pension expense/
(income) $297 $350 $345 $347 $350
Meanwhile, with IBM’s pension contributions falling to
approximately $449 million in 2013, marking the fourth
consecutive year they have fallen, they were not large
enough to have much impact on operating cash flow, which
was $17,483 million last year. Still, operating cash flow has
been trending lower in recent years for IBM and
contributions should head up soon and once again have
some impact on cash flow. Additionally, we note that
pension expense was lower by roughly $196 million in
3Q14 compared to year ago levels, even though this
benefit was unable to keep IBM from posting a hefty
declines in operating profits for the latest quarter.
Additionally, while certainly not a huge allocation, we
noticed that IBM’s US plans had increased their exposure
to equities in recent years. Equity securities for US plans
accounted for approximately 35% of qualified plan assets
as of 12/31/13, compared to 33% and 30% at 12/31/12 and
12/31/11, respectively. Meanwhile, we also noticed that
IBM had not adjusted its high 8% expected rate of return on
US plan assets over the last five years. However, IBM’s
sponsors made some changes to its US plan in March
2014. According to IBM’s 3Q14 10-Q,
In March 2014, the company initiated a change to the
investment strategy of its U.S. defined benefit plan.
The 2014 target asset allocation was modified,
primarily by reducing equity securities from 42 percent
to 32 percent, and increasing debt securities from 47
percent to 57 percent of total plan assets, respectively.
The asset allocation change was substantially
completed by March 31, 2014. This change was
designed to reduce the potential negative impact that
equity markets might have on the funded status of the
U.S. defined benefit plan. The change is expected to
reduce the 2015 expected long-term rate of return on
assets to approximately 7.75 percent.
While we certainly appreciate these sponsors’ intent to
minimize losses of US plans and lower equity exposure in
2014, we hardly considered its then 35% equity allocation
to be all that excessive. Meanwhile, considering that its US
plans already had another 48% of their assets in extremely
low-returning cash and fixed income instruments, we
wonder why they needed to go even higher. Thus, even
though IBM finally and rightfully lowered the assumption,
we still see an expected return rate of 7.75% to be way too
aggressive and should come down much more, especially
given the new target allocations. The following table shows
IBM’s weighted-average assumptions and allocation of plan
assets for its US qualified plans, which are about 40%
larger than assets for the non-US plans, over the last five
years:
Weighted-Average Assumptions and Allocation of US Plan
Assets
12/13 12/12 12/11 12/10 12/09
Discount rate 4.5% 3.6% 4.2% 5.0% 5.6%
Expected return on plan
assets 8.0% 8.0% 8.0% 8.0% 8.0%
Plan asset allocation
Equity securities 35% 33% 30% 36% 35%
Fixed income 44% 44% 48% 43% 45%
Other 17% 17% 17% 17% 14%
Cash 4% 6% 5% 4% 6%
In 2013, IBM contributed a combined $449 million towards
its US and non-US plans. Meanwhile, IBM expects to
contribute approximately $600 million to its non-US and
multi-employer plans in 2014. However, IBM is hardly on
pace, as it had only contributed $387 million to non-US
plans through the first nine months ended 9/30/14. Couple
these light non-US contributions with the likelihood that the
PBO of its US plans will be adjusted higher soon, and we
believe IBM could face much higher pension contributions
soon, hurting operating cash flow. For some perspective
as to how much higher IBM’s pension contributions could
get, we increased the PBO of IBM’s US plans by 7% in line
with Aon Hewitt’s estimates and then subtracted that
increase from IBM’s combined funded status at 12/31/13 to
calculate an adjusted funded status. We then took the
estimated 2014 contribution divided by the 12/31/13 funded
status and used that percentage off the adjusted funded
status to base our projected pension contribution for the
future:
12. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
12
PBO-Adjusted Impact on Funded Status and Contributions
(in $mil)
Combined PBO, 12/13 $99,654
US PBO, 12/13 $51,034
Reported funded status, 12/13 ($6,237)
2014 pension contribution $600
US PBO with 7% longevity adjustment $54,606
Adjusted funded status ($9,809)
Projected pension contribution based off adjusted
funded status $944
Based off these adjustments, the PBO for IBM’s US plans
would have increased by nearly $3.6 billion. Considering
that its US plans were considered overfunded by
approximately $2.9 billion at 12/31/13, this PBO change
would now make them underfunded by about $0.7 billion.
Additionally, IBM’s projected pension contributions would
increase by about 57% to $944 million off a still depressed
$600 million that is expected for 2014. Further, considering
how depressed IBM’s contribution levels have been in
recent years, we believe this projected $944 million may be
conservatively low. We would also add that IBM has a
large PBO for its non-US plans and that these plans may
be forced to account for higher longevity risk too at some
point, leading to even higher pension contributions in the
future.
Lastly, we doubt IBM can continue posting adjusted free
cash flow deficits and must become more cautious at
taking on more debt. Over the last year, the company’s
balance sheet has taken on more debt and expended cash,
causing its net debt-to-EBITDA ratio to reach 1.55 times as
of 9/30/14, compared to 1.06 a year earlier, as the following
table shows:
Balance Sheet (in $mil)
9/30/14 9/30/13
Cash 9,565 10,232
Total debt 45,697 36,180
TTM EBITDA 23,327 24,457
Net debt-to-EBITDA 1.55 1.06
While IBM’s debt load has increased, it is still considered to
have strong financial flexibility. In June, Fitch Ratings
affirmed it’s A+ ratings on approximately $54 billion of debt,
including IBM’s undrawn $10 billion credit facility. To
conclude, what IBM does have to show for its heavy
financial engineering and constant share repurchases is
loads of debt. Operating cash flow is already heading
lower and potentially much higher pension contributions
certainly won’t help. It appears to be a foregone conclusion
at this point that IBM will need to pull back hard on
repurchases if it wants to maintain some financial flexibility
in the future.
CATERPILLAR
Based in Peoria, IL, Caterpillar (CAT) is a leading
manufacturer of construction, mining and forest machinery.
The company also manufactures engines and other related
parts for its equipment, and offers financing and insurance.
CAT continues to get the majority of its recent sales growth
from the North American energy and construction
industries, which have been booming. However, this
growth has largely been offset by continued weak sales of
its earth-moving machines to the mining industry, a market
CAT bet on heavily through acquisitions in 2010 and 2011 -
right before a slump in commodity prices prompted
resource companies to slash their investment in new
equipment. Since then, CAT has focused on cutting
production costs and boosting margins, a process that has
involved thousands of layoffs but permitted the company to
grow earnings even as sales have flattened.
For the third quarter ended 9/30/14, CAT reported EPS of
$1.63, representing a 7% increase from the $1.45 earned a
year earlier. Consensus estimates at Bloomberg had CAT
reporting EPS of just $1.36. Still, overall sales advanced
by just 1% year-over-year for 3Q14, aided by a 15%
increase in North American sales, driven by demand for
equipment and diesel and gas engines from oil and gas
companies and builders. In particular, CAT benefited from
railroads buying diesel-electric locomotives ahead of tough
US emissions rules that take effect in 2015. Meanwhile,
CAT experienced a 21% sales decline in Latin America, a
7% sales drop in most of the Asia-Pacific region, and flat
sales in China, Europe, the Middle East and Africa for the
quarter. For 2015, CAT projected revenue to come in
essentially flat, warning that a number of “significant risks”,
including tensions in the former Soviet Union and the
Middle East and slowing growth in China, could hurt
business confidence and sales.
Meanwhile, CAT’s free cash flow was unable to cover the
dividend and share repurchases over the last twelve
months ended 9/30/14, as the following table shows:
Adjusted Free Cash Flow Analysis (in $mil)
Twelve Months Ended: 9/14 9/13 9/12 9/11 9/10
Cash from ops before w/c $8,768 $8,570 $5,498 $7,745 $5,244
Working capital impact ($2) $1,007 ($785) ($53) ($316)
Cash from operations $8,766 $9,577 $4,713 $7,692 $4,928
CapEx $3,665 $4,713 $4,951 $3,535 $2,639
Free cash flow $5,101 $4,864 ($238) $4,157 $2,289
Dividends $1,578 $1,410 $1,234 $1,142 $1,067
% FCF paid in dividends 30.9% 29.0% -518.5% 27.5% 46.6%
Share repurchases $4,238 $2,000 $0 $0 $0
Surplus/
(Shortfall) after buyback ($715) $1,454 ($1,472) $3,015 $1,222
To be sure, CAT’s cash flow from operations has been
strong and continues to head higher, recently aided by a
decline in receivable and inventory levels. However, cash
commitments have been going up too. After taking a
number of years off, CAT has ramped up its share buyback
program over the last two years, repurchasing $4.2 billion
of stock so far in 2014. Last June, the company also
announced an increase of 17% in the quarterly dividend.
On the plus side, capital expenditures are heading down.
On the 3Q14 call, management noted that CAT generally
had the capacity it needed given the current demand
environment and that CapEx expectations were less than
$2 billion for 2014.
13. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
13
Next, we will give CAT’s pension a thorough look. CAT is a
huge equipment manufacturer that maintains a big pension,
with its combined US and non-US plans carrying PBOs of
approximately $19.0 billion as of 12/31/13. Certainly, its
US plans are significantly bigger and make up the majority
of CAT’s total PBOs at approximately $14.4 billion.
Additionally, despite downsizing its operations in recent
years, CAT has maintained a hefty employment base over
the last 20 years, as the following table shows the number
of employees at the end of 2013 as well as employment
levels held 10 and 20 years ago, respectively:
Employment History - CAT
12/13 12/03 12/93
118,501 69,169 51,250
What is somewhat concerning to us is that CAT had
125,341 employees at the end of 2012 and started to
downsize in 2013, trimming its ranks by approximately
5.5% last year. Meanwhile, the company has announced
thousands of layoffs for 2014 and with mining CapEx still in
the doldrums we doubt many of these jobs come back any
time soon. For 3Q14, CAT cut more than 6,000 jobs,
roughly three quarters of them non-US employees. Still,
CAT’s current employment levels are about 60% higher
than they were just 10 years ago. As a result, CAT has a
much larger current employee base to help support its
growing number of retirees. Thus, at least for now, CAT
likely has more workers helping to support its pension than
retired workers depleting funds off of it. Regardless, once
longevity risk is more accurately factored into the
calculation of PBOs, we believe CAT’s PBOs could jump
noticeably given the sheer size of CAT’s plans and its
heavy retired base.
Next, looking at recent performance, the combined funded
status of CAT’s US and non-US plans improved
significantly in 2013 from year ago levels as these plans
benefited primarily from a strong performance from plan
assets:
Key Pension Variables (Rounded in $mil)
12/13 12/12 12/11 12/10 12/09
Funded status ($2,684) ($6,243) ($6,266) ($3,251) ($3,780)
Employer
contributions $844 $1,026 $446 $977 $1,149
Pension expense/
(income) $732 $723 $665 $677 $620
Meanwhile, even as the company’s pension contributions
fell to approximately $854 million in 2013, they are still
large enough to have some impact on operating cash flow,
which was a record $10,191 million last year. Additionally,
we note that pension expense has been lower by roughly
$60 million over each of the last three quarters compared
to year ago levels, even though this benefit was unable to
prevent CAT from posting declines in operating profits for
1Q14 and 2Q14, respectively.
Additionally, it should be noted that CAT’s plans had a
large exposure to equities going into 2014 and we would
expect that the company’s funded status might have
deteriorated some year-to-date. Of course, this could lead
to even higher contributions in 2015. Equity securities for
US and International plans accounted for approximately
61% and 53% of qualified plan assets, respectively, as of
12/31/13, compared to 66% and 54% at 12/31/12.
Granted, it appears that CAT’s plan sponsors have
prudently been lowering their equity allocations to try to
minimize risk. Meanwhile, even though CAT has lowered
its expected rate of return on US plan assets over the last
two years down to 7.8% last year, this rate is still somewhat
aggressive and we believe this assumption may need to
come down even more to approach realistic levels. The
following table shows CAT’s weighted-average
assumptions and allocation of plan assets for its US
qualified plans, which are about three times the size of its
non-US plans, over the last five years:
Weighted-Average Assumptions and Allocation of US Plan
Assets*
12/13 12/12 12/11 12/10 12/09
Discount rate 4.6% 3.7% 4.3% 5.1% 5.7%
Expected return on plan
assets 7.8% 8.0% 8.5% 8.5% 8.5%
Plan asset allocation
Equity securities 61% 66% 68% 74% 72%
Debt securities 34% 30% 27% 22% 24%
Real estate 0% 0% 0% 0% 0%
Cash and other 5% 4% 5% 4% 4%
Facing sluggish equity markets and slightly lower discount
rates, it seems safe to assume that CAT’s funded status
has begun to suffer again so far in 2014. We also know
that CAT won’t be contributing nearly as much this year as
in prior years, as the company’s 9/30/14 10-Q noted that
CAT anticipated its full-year 2014 contributions would be
approximately $510 million, all of which are required. This
compares to the $844 million it contributed in 2013, a 40%
decline. Couple CAT’s light 2014 contributions with the
likelihood that the PBO of its US plans will be adjusted
higher soon, and we believe CAT could face much higher
pension contributions soon, hurting operating cash flow.
For some perspective as to how much higher CAT’s
pension contributions could go, we increased the PBO of
CAT’s US plans by 7% in line with Aon Hewitt’s estimates
and then subtracted that increase from CAT’s combined
funded status at 12/31/13 to calculate an adjusted funded
status. We then took the estimated 2014 contribution
divided by the 12/31/13 funded status and used that
percentage off the adjusted funded status to base our
projected pension contribution for the future:
PBO-Adjusted Impact on Funded Status and Contributions
(in $mil)
Combined PBO, 12/13 $19,028
US PBO, 12/13 $14,419
Reported funded status, 12/13 ($2,684)
2014 pension contribution $510
US PBO with 7% longevity adjustment $15,428
Adjusted funded status ($3,693)
Projected pension contribution based off adjusted
funded status
$702
14. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
14
Based off these adjustments, the PBO for CAT’s US plans
would have increased by approximately $1.0 billion.
Considering that its US plans were considered
underfunded by approximately $2.0 billion at 12/31/13, this
PBO change would now make them underfunded by about
$3.0 billion, a 50% jump. Additionally, CAT’s projected
pension contributions would increase by about 38% to
$702 million off a very depressed $510 million that is
expected for 2014.
Interestingly, it appears that CAT plan sponsors are
becoming more concerned about their ability to adequately
fund their defined benefit plans, pushing more of its US
employees into 401(k) plans. According to its 9/30/14 10-
Q,
In August 2012, we announced changes to our U.S.
hourly pension plan, which impacted certain hourly
employees. For the impacted employees, pension
benefit accruals were frozen on January 1, 2013 or will
freeze January 1, 2016, at which time employees will
become eligible for various provisions of company
sponsored 401(k) plans including a matching
contribution and an annual employer contribution. The
plan changes resulted in a curtailment and required a
remeasurement as of August 31, 2012.
Finally, CAT does not appear to have the financial standing
to continue posting adjusted free cash flow deficits. The
company’s net debt remains near peak levels, with cash
and debt levels fluctuating only slightly over the last year.
Meanwhile, trailing EBITDA increased by about $100
million year-over-year, allowing the company’s net debt-to-
EBITDA ratio to settle at 3.73 times as of 9/30/14, little
changed from 3.77 a year earlier, as the following table
shows:
Balance Sheet (in $mil)
9/30/14 9/30/13
Cash $6,082 $6,357
Total debt $39,282 $39,537
TTM EBITDA $8,909 $8,800
Net debt-to-EBITDA 3.73 3.77
CAT management seems to be very comfortable with the
company’s heavy debt load. On the 3Q14 call, Vice
President of Strategic Services Michael Lynn DeWalt
stated,
Our balance sheet remains strong, with the Machinery,
Energy and Transportation debt-to-total capital ratio
less than 35%, which is comfortably towards the low
end of our desired range.
It currently holds an A-2 credit rating by Moody’s, so it is far
from disaster. However, an upcoming rating downgrade
would not shock us, as Moody’s noted in July that CAT’s
$2.5 billion share repurchase announcement was credit
negative. Certainly, if the company’s net debt/EBITDA ratio
continues to move much higher, we would expect the credit
rating to begin to suffer. To conclude, CAT does not have
the operating cash flow to cover all of its cash
commitments, especially its recently burgeoning share
repurchase program. Additionally, we believe CAT’s cash
flow could face a major headwind from rising company
contributions should the company’s underfunded pension
snaps back to recent deficit levels.
DOW CHEMICAL
The Dow Chemical Company (DOW) is a diversified
chemical company that provides chemical, plastic and
agricultural products and services to various essential
consumer markets. The company serves customers in
countries around the world in markets such as food,
transportation, health and medicine, personal care and
construction. Dow's profits are dominated by its
Performance Plastics segment, which now accounts for
over 45% of the company's operating segment EBITDA.
Dow is one of the largest ethylene and ethylene derivative
producers in the world, with roughly 70% of its cracker
capacity located in the cost-advantaged Americas and
Middle East. To be sure, DOW is benefiting from low cost
feedstocks in North America which result from the natural
gas and liquids boom.
For 3Q14, DOW reported EPS from operations of 71 cents,
representing a 42% jump from the 50 cents earned a year
ago. This quarterly EPS result easily beat Bloomberg’s
consensus estimate of 67 cents. Meanwhile, sales
increased by roughly 5% year-over-year to $14.4 billion in
3Q14. This sales increase was comprised of 2% volume
growth and 3% higher pricing. Margin expansion was
huge, as the company's adjusted EBITDA margin improved
by over 240 basis points year-over-year in 3Q14 due to
higher net pricing and cost savings through productivity
improvements and higher capacity utilization.
Despite improved operating performance, DOW’s adjusted
free cash flow was unable to cover dividends and share
repurchases over the last twelve months ended 9/30/14, as
the company reported a big $2.6 billion deficit:
Adjusted Free Cash Flow Analysis (in $mil)
Twelve Months Ended: 9/14 9/13 9/12 9/11 9/10
Cash from ops before w/c $5,697 $6,482 $4,719 $3,231 $4,805
Working capital impact $281 $659 ($174) $462 ($1,134)
Cash from operations $5,978 $7,141 $4,545 $3,693 $3,671
CapEx $3,350 $2,427 $2,672 $2,562 $2,046
Free cash flow $2,628 $4,714 $1,873 $1,131 $1,625
Dividends $1,972 $1,853 $1,584 $1,139 $1,011
% FCF paid in dividends 75.0% 39.3% 84.6% 100.7% 62.2%
Share repurchases $3,273 $134 $0 $19 $14
Surplus/
(Shortfall) after buyback ($2,617) $2,727 $289 ($27) $600
Cash flow from operations got a slight boost from lower
pension contributions, yet was still noticeably lower for the
twelve months ended 9/30/14 compared to the same year-
ago period. Meanwhile, capital spending has been at
record levels over the last twelve months, primarily due to
investments to expand ethylene production capacity on the
15. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
15
US Gulf Coast. Dividend payments continue to be steadily
increased and share repurchases have been stout, as the
company has already spent approximately $3.3 billion on
buybacks from its current program to-date. Finally, in an
effort to drum up cash, DOW completed the sale of a
substantial portion of its North America railcar fleet in
3Q14, raising more than $400 million in proceeds.
Next, we will focus on DOW’s pension plans that cover
employees in the US and a number of other countries. Not
surprisingly, the US qualified plan covering the parent
company is the largest plan and All Significant Plans
combined carry a PBO of approximately $25.0 billion as of
12/31/13. Additionally, despite restructuring its operations
in recent years, DOW has maintained a hefty employment
base over the last 20 years, as the following table shows
the number of employees at the end of 2013 as well as
employment levels held 10 and 20 years ago, respectively:
Employment History - DOW
12/13 12/03 12/93
53,000 46,372 55,400
What is particularly interesting with DOW is that today it is
actually a smaller company in terms of employment than it
was 20 years ago. As of 12/31/13, DOW had
approximately 53,000 employees, compared to 55,400 at
12/31/93. Additionally, only a year earlier, DOW had
54,000 employees as of 12/31/12. According to the
company’s 10/23/12 press release,
Dow will shut down a high density polyethylene facility
in Tessenderlo, Belgium, a sodium borohydride plant
in Delfzijl, the Netherlands, as well as a number of
Performance Materials manufacturing facilities,
including: an Automotive Systems Diesel Particulate
Filters manufacturing facility in Midland, Michigan;
Formulated Systems manufacturing facilities in
Ribaforada, Spain, Birch Vale, United Kingdom and
Solon, Ohio; and an Epoxy resins facility in Kina Ura,
Japan. Additionally, the Company will record an
impairment charge related to the write-down of Dow
Kokam LLC’s assets, reflecting weak global demand
for lithium-ion batteries; and will consolidate certain
assets in its Oxygenated Solvents business, as well as
shut down a number of other small manufacturing
facilities. These actions are expected to take place
over the next two years.
Thus, we are somewhat concerned that DOW’s relatively
stagnant employee base must continue to support a
growing number of retirees. As a result, it is likely safe to
assume that DOW’s plans now cover more non-workers
than workers. Thus, should longevity risk become a bigger
contributing factor in terms of calculating PBOs in the
future, we believe DOW’s PBOs could increase significantly
given its hefty retiree base relative to current employment.
Another factor that could potentially work against DOW’s
future pension funding is the fact that its percentage of
women employees, who typically live about five years
longer than men, has been rising fairly fast over the last
few years, as the following table shows:
Women Employee Percentage – DOW
12/13 12/12 12/11 12/10 12/09
27.4% 27.0% 30.0% 27.0% 26.0%
12/08 12/07 12/06 12/05 12/04
26.5% 26.0% 25.0% 24.0% N/A
Still, on a positive note, DOW’s current women percentage
of approximately 27.4% is well below the S&P 500 average
of companies that carry a defined benefit plan, of roughly
34%, according to Bloomberg estimates.
Checking out the recent performance of DOW’s pension,
the funded status of All Significant Plans improved
noticeably in 2013 from year ago levels as these plans
benefited from generous employer contributions and solid
performance from plan assets:
Key Pension Variables (Rounded in $mil)
12/13 12/12 12/11 12/10 12/09
Funded status ($6,200) ($9,115) ($6,644) ($5,307) ($5,325)
Employer
contributions $865 $903 $806 $708 $355
Pension expense/
(income) $1,053 $754 $561 $502 $247
Meanwhile, even as DOW’s pension contributions fell to
approximately $865 million in 2013, they were still large
enough to have some impact on operating cash flow, which
was a record $7,823 million last year. Additionally, it is
certainly worth noting that a decline in pension costs
accounted for about 15% of DOW’s reported increase in
operating income in the 3Q14 quarter. This impact is
shown in the table below:
Pension Expense Impact on Operating Income (in $mil)
9/14 6/14 3/14
Operating income $1,359 $1,295 $1,444
Increase in operating income $571 $69 $90
Net periodic benefit cost $177 $174 $181
Decline from year ago period $84 $87 $81
% improvement in operating income 14.7% 126.1% 90.0%
9/13 6/13 3/13
Operating income $788 $1,226 $1,354
Net periodic benefit cost $261 $261 $262
Additionally, compared to recent years, DOW’s plans
carried a larger exposure to equities going into 2014 and
we would expect that the company’s funded status has
likely deteriorated some over the year. This could lead to
even higher contributions in 2015. Equity securities
accounted for approximately 43% of qualified plan assets
as of 12/31/13, compared to 40% at 12/31/12. Looking at
target allocation percentages posted in the 2013 10-K,
equity securities are targeted at 39%, while fixed income is
nearly identical at 38%. Thus, DOW’s plan sponsors have
clearly been taking on more equity risk over the last few
years to achieve higher returns. Meanwhile, even though it
16. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
16
has been lowered in recent years, we find the 7.5%
expected return for plan assets to be somewhat aggressive
and we believe this assumption may need to be adjusted
even lower to approach attainable levels. The following
table shows DOW’s weighted-average assumptions and
allocation of plan assets for its qualified plans over the last
five years:
Weighted-Average Assumptions and Allocation of All
Significant Plan Assets
12/13 12/12 12/11 12/10 12/09
Discount rate 4.54% 3.88% 4.93% 5.38% 5.71%
Expected return on plan
assets 7.47% 7.60% 7.86% 7.74% 8.03%
Plan asset allocation
Equity securities 43% 40% 38% 42% 43%
Fixed income 30% 36% 37% 34% 36%
Alternative investments 18% 18% 18% 16% 13%
Cash 7% 3% 5% 5% 6%
Other investments 2% 2% 2% 3% 3%
In 2013, DOW contributed $865 million to its pension plans,
including contributions to fund benefit payments for its non-
qualified supplemental plans. However, DOW expects to
contribute approximately $800 million to its pension plans
in 2014 and is certainly on pace with $756 million in
contributions through 9/30/14. Yet, with DOW’s pensions’
funded status possibly taking a hit in 2014 due to the plans’
fairly high equity exposure as well as the likelihood that the
PBO of its plans will be adjusted higher soon, we believe
DOW could see higher pension contributions soon, hurting
operating cash flow. For perspective on how much higher
DOW’s pension contributions could get, we increased the
PBO of DOW’s plans (plans outside the US are not
significant) by 7% in line with Aon Hewitt’s estimates and
then subtracted that increase from DOW’s funded status at
12/31/13 to calculate an adjusted funded status. We then
took the estimated 2014 contribution divided by the
12/31/13 funded status and used that percentage off the
adjusted funded status to base our projected pension
contribution for the future:
PBO-Adjusted Impact on Funded Status and Contributions
(in $mil)
Projected benefit obligation, 12/13 $25,027
Reported funded status, 12/13 ($6,200)
2014 pension contribution $800
PBO with 7% longevity adjustment $26,779
Adjusted funded status ($7,952)
Projected pension contribution based off adjusted
funded status
$1,026
Based off these adjustments, the PBO for DOW’s US plans
would have increased by nearly $1.8 billion. Considering
that its plans were considered overfunded by approximately
$6.2 billion at 12/31/13, this PBO change would now make
them underfunded by about $8.0 billion. Additionally,
DOW’s projected pension contributions would increase by
about 28% to just over $1 billion off a slightly depressed
$800 million that is expected for 2014.
Lastly, we believe DOW cannot afford to continue posting
adjusted free cash flow deficits for long and must be careful
not to further compromise its already levered balance
sheet. Over the last year, the company’s balance sheet
has remained relatively unchanged and its net debt-to-
EBITDA ratio was 1.81 times as of 9/30/14 from 1.99 a
year earlier, as the following table shows:
Balance Sheet (in $mil)
9/30/14 9/30/13
Cash $5,768 $5,272
Total debt $19,782 $18,619
TTM EBITDA $7,728 $6,697
Net debt-to-EBITDA 1.81 1.99
Stemming from its $12 billion acquisition of Rohm and
Haas in April 2009, DOW certainly carries some debt. Still,
the company has worked it down in recent years, as debt
levels have fallen from $23.8 billion at 6/30/09 to $19.8
billion at 9/30/14. In September, Fitch Ratings assigned a
BBB rating to DOW’s proposed $2 billion new senior
unsecured notes with 10-, 20- and 30-year maturities. The
proceeds will be used to repay debt and for general
corporate purposes. Looking ahead, DOW needs to
continue growing its operating cash flow to cover rising
cash commitments. This will need to be monitored
somewhat closely, as cash flow could take a hit from rising
company contributions should the company’s underfunded
status deteriorate further.
AIR PRODUCTS AND CHEMICALS
Air Products and Chemicals (APD) is a leading provider of
atmospheric and specialty gases for industrial use as well
as performance materials and equipment. The recent
spike in APD’s price is a result of the announcement of its
new CEO Seifollah Ghasemi in July. Mr. Ghasemi was one
of three independent directors placed on the board in late
2013 at the behest of Bill Ackman whose Pershing Fund
bought just shy of 10% of the company in July of 2013.
Growth in the base business is less than inspiring as well.
Much has been made of planned maintenance outages
pulling down volumes in Tonnage Gases, but volume
growth in Merchant Gases is in the low single-digits and
facing tougher comps. Revenue growth for the latest fiscal
fourth quarter ended 9/30/14 got a boost from one-time
price increases to recoup weather-related costs from prior
quarters. An increase in sweeter shale oil may stunt the
demand for hydrogen among refiners. Supply and pricing
in China may also be a drain on growth.
However, while we believe there may be room to improve
APD’s operations over the long haul, our main concern
revolves around the company’s dividend. APD is a
“Dividend Aristocrat” meaning it has increased its dividend
every year for at least 25 years. The increases have
ranged between 10-15% over the last four years and
according to Bloomberg, analysts expect the dividend to
grow at compound annual rate of almost 7% over the next
three years. Yet, we fear that may be overly optimistic, as
17. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
17
APD’s free cash flow has been insufficient to cover its
dividend over the last five fiscal years ended September:
Adjusted Free Cash Flow Analysis (in $mil)
Twelve Months
Ended: 9/14 9/13 9/12 9/11 9/10
Cash from ops before
w/c $2,221 $1,514 $1,626 $1,657 ($106)
Working capital impact ($34) $53 $166 $97 $892
Cash from operations $2,187 $1,567 $1,792 $1,753 $786
CapEx $1,684 $1,524 $1,514 $1,309 $779
Free cash flow $503 $43 $279 $444 $7
Dividends $628 $566 $515 $457 $476
% FCF paid in
dividends 124.8% 1309.3% 184.8% 102.9% 7213.6%
Share repurchases $0 $462 $53 $649 $22
Surplus/(Shortfall) after
buyback ($125) ($984) ($289) ($662) ($492)
Cash flow from operations received one-time boosts from
lower pension contributions and the timing of capital lease
payments. This was partly offset by lower cash
restructuring costs, but this simply reminds investors of the
fact that APD has been restructuring for years and cash
costs are a regular drain on resources. Capital spending
ramped higher in FY14, but given the rising average age
and comments made by management, we would not
expect much of a decline to free up cash in the future.
Finally, in an effort to lower cash commitments, APD
discontinued its share buyback program last year.
However, this move has led to an increase in share count
that not only dilutes the dividend per share, but also
resulted in a 1-cent per share drain on EPS in 4Q14.
Next, let’s look at APD’s pension situation. While the
company is easily the smallest of our examples, APD
maintains a fairly large pension, with its combined US and
International plans carrying PBOs of approximately $4.4
billion as of 9/30/13. Additionally, while still growing at a
decent clip, APD has had a good-sized employment base
over the last 20 years, as the following table shows the
number of employees at the end of the most recent fiscal
year as well as employment levels held 10 and 20 years
ago, respectively:
Employment History - APD
9/13 9/03 9/93
21,600 18,500 14,075
As of 9/30/13, APD had approximately 21,600 employees,
compared to 18,500 employees at 9/30/03 and 14,075
employees at 9/30/93. Thus, APD’s employment growth
has been pretty steady over the last 20 years, growing at
an average annual rate of approximately 2.2% over this
period. While it is certainly encouraging that APD has
continued to grow its employment ranks over the years,
allowing a larger current employee base to help support its
growing retired employee base, this growth has not been
significant and APD’s plans likely now cover more non-
workers than workers. It should be noted that APD’s
employment remained flat in FY13, as APD had 21,600
employees at 9/30/12. Additionally, while we don’t know
APD’s current employment number as the company has
not come out with its FY14 10-K yet, we know that new
management has continued to focus on cost-cutting and on
the 4Q14 call, CEO Ghasemi added,
“Our safety and financial performance in the last
quarter demonstrates the power of the 20,000 people
in Air Products coming together and delivering results
that exceed expectations.”
While the “20,000 people” comment was likely not precise,
this would indicate that APD may have lowered its
employee base by roughly 7% over the last fiscal year.
Thus, should longevity risk become a bigger factor in terms
of calculating PBOs in the future, we believe APD’s PBOs
could increase significantly given its weighty retired base
relative to current employment.
Looking at recent performance, the combined funded
status of the company’s US and International plans
improved noticeably in FY13 from year ago levels as these
plans benefited from higher employer contributions and
solid performance from plan assets:
Key Pension Variables (Rounded in $mil)
9/13 9/12 9/11 9/10 9/09
Funded status ($593) ($1,247) ($942) ($1,042) ($1,135)
Employer
contributions $301 $76 $241 $407 $185
Pension expense/
(income) $170 $120 $114 $109 $110
Meanwhile, with the company’s pension contributions
ramping up in FY13 to approximately $301 million, they are
certainly large enough to materially impact operating cash
flow, which was $1,567 million for the fiscal year.
Additionally, it is certainly worth noting that a decline in
pension costs accounted for about 32% of APD’s reported
increase in operating income in the 3Q14 quarter. This
impact is shown in the table below:
Pension Expense Impact on Operating Income (in $mil)
6/14 3/14 12/13
Operating income $413.8 $384.7 $385.6
Increase in operating income $30.7 ($5.0) $13.2
Net periodic benefit cost $32.7 $32.9 $32.5
Decline from year ago period $9.8 $3.3 $6.8
% improvement in operating income 31.9% (66.0%) 51.5%
6/13 3/13 12/12
Operating income $383.1 $389.7 $372.4
Net periodic benefit cost $42.5 $36.2 $39.3
The bulk of the decline was from a lower amortization of
actuarial loss, likely related to the lowering of the discount
rate. Regardless, a decline in pension expense of this
magnitude cannot continue to help APD’s profits.
Another major consideration is that APD’s plans had a
large exposure to equities going into FY14 and we would
expect that the company’s combined funded status might
18. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
18
have deteriorated some so far in FY14. This could lead to
even higher contributions in FY15. Equity securities
accounted for US and International plans accounted for
approximately 71% and 61% of qualified plan assets,
respectively, as of 9/30/13, compared to 70% and 57% at
9/30/12. Thus, it appears that APD’s plan sponsors have
recently been taking on more equity risk to try to get higher
returns. Even though it was lowered from 8.8% last fiscal
year, we find the 8.3% expected return for US plan assets
to be particularly aggressive and we believe this
assumption may need to come down even more to
approach more realistic levels. The following table shows
APD’s weighted-average assumptions and allocation of
plan assets for its US qualified plans, which are more than
twice the size of its International plans, over the last five
fiscal years:
Weighted-Average Assumptions and Allocation of US Plan
Assets
9/13 9/12 9/11 9/10 9/09
Discount rate 4.8% 3.9% 4.9% 5.1% 5.7%
Expected return on plan assets 8.3% 8.8% 8.8% 8.8% 8.8%
Plan asset allocation
Equity securities 71% 70% 66% 70% 68%
Debt securities 23% 24% 28% 25% 26%
Real estate/other 5% 5% 5% 4% 3%
Cash 1% 1% 1% 1% 2%
Even though lackluster equity performance and slightly
lower discount rates have likely caused APD’s funded
status to deteriorate some in FY14, the company appears
to be on pace to achieve its planned pension contributions
of $80-100 million for FY14, a 67-73% decline from the
$301 million contributed in FY13. Through nine months
ended 6/30/14, APD had contributed $64.7 million to its
pension plans, just a fraction of the $258.6 million it spent
over the same nine-month period a year ago. Couple
these tiny contributions with the likelihood that the PBO of
its US plans will be adjusted higher soon, and we believe
APD could see much higher pension contributions in its
near future, hurting operating cash flow. For some
perspective as to how much higher APD’s pension
contributions could get, we increased the PBO of APD’s US
plans by 7% in line with Aon Hewitt’s estimates and then
subtracted that increase from IBM’s combined funded
status at 9/30/13 to calculate an adjusted funded status.
We then took the estimated FY14 contribution divided by
the 9/30/13 funded status and used that percentage off the
adjusted funded status to base our projected pension
contribution for the future:
PBO-Adjusted Impact on Funded Status and Contributions
(in $mil)
Combined PBO, 9/13 $4,394
US PBO, 9/13 $2,809
Reported funded status, 9/13 ($593)
FY14 pension contribution $90
US PBO with 7% longevity adjustment $3,006
Adjusted funded status ($790)
Projected pension contribution based off adjusted
funded status $120
Based off these adjustments, the PBO for APD’s US plans
would have increased by approximately $200 million.
Considering that its US plans were considered overfunded
by approximately $275 million at 9/30/13, this PBO change
would now make them underfunded by about $472 million.
Additionally, APD’s projected pension contributions would
increase by about 33% to $120 million off a very depressed
$90 million that is expected for FY14. Further, considering
how depressed APD’s contribution levels have been over
the past fiscal year, we believe this projected $120 million
may be extremely low.
Interestingly, in an effort to simplify the organization and
reduce costs according to management, ADP took a
pension settlement loss after providing lump sum payments
in 4Q14. As we noted in the introduction, more companies
are trying to unload the risks of running a pension by
offering workers these lump-sum buyouts. According to
last week’s 4Q14 earnings release,
Our supplemental pension plan provides for a
lump sum benefit payment option at the time of
retirement, or for corporate officers six months
after the participant’s retirement date. We
recognize pension settlement losses when cash
payments exceed the sum of service and interest
cost components of net periodic pension cost of
the plan for the fiscal year. We recorded pension
settlement expense of $5.5 ($3.6 after-tax, or $.02
per share) during the fourth quarter of 2014. We
expect that settlement losses will also be
recognized in 2015.
Lastly, APD does not appear to have the financial standing
to continue posting adjusted free cash flow deficits. The
company’s net debt is now approaching all-time high levels,
but EBITDA remains strong, allowing the company’s net
debt-to-EBITDA ratio to settle at 2.22 times as of 9/30/14
from 2.61 a year earlier, as the following table shows:
Balance Sheet (in $mil)
9/30/14 9/30/13
Cash $337 $450
Total debt $6,119 $6,274
TTM EBITDA $2,608 $2,231
Net debt-to-EBITDA 2.22 2.61
While not crippling, APD’s debt load is substantial.
Management has indicated on recent calls that it is
important for it to maintain its investment grade credit
rating. It is currently rated A-2 by Moody’s, so it is far from
the edge. Nevertheless, if debt/EBITDA reverses back
towards three, we would expect the credit rating to suffer.
In addition, it is worth noting that while APD has over $300
million of cash on hand, virtually all of that is tied up
overseas and cannot be tapped without paying taxes on it.
Certainly, APD must continue to grow its operating cash
flow and find a way to cover cash commitments. Going
forward, we would not be surprised if APD’s cash flow
faces a heavier burden from rising company contributions
should the company’s already underfunded status worsens.
19. Pensions Must Account For Longevity Risk Behind the Numbers
Will Becker October 31, 2014
19
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Jeffery B. Middleswart (214) 378-4186
Bill E. Whiteside, CFA (682) 224-5715
William N. Becker (636) 821-1319
Jeffrey N. Dalton (214) 378-4176
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JR Riddlehoover, CPA (817) 447-7067
