When pensions hit earnings
For many companies that still have the plans, the current market turmoil threatens to trim their bottom lines.
NEW YORK (Fortune) -- Middle-class Americans aren't the only ones worried about how the market has drop-kicked their retirement funds. U.S. companies are also looking at big losses in their pension funds - losses that could force them to dip into earnings to cover their employee obligations.
Research from Mercer, a division of consulting giant Marsh & McLennan, says that U.S. corporate pension funds started 2008 with a surplus of $60 billion: They could more than pay employees what is owed to them over the lifetimes of their pension plans.
But the same research shows companies ended 2008 with a deficit of $409 billion, as equities markets collapsed and the cost of paying future benefits rose due to falling interest rates. (A dollar saved today is worth less tomorrow when rates fall.)
David Zion, an equity analyst at Credit Suisse who reports frequently on pensions, estimates that up to 10% of U.S. earnings in 2009 could be eaten up by companies using cash to shore up their pension funds.
That means investors need to tread carefully: Even if a business is fundamentally strong, it might have legacy pension obligations or a poor pension investment strategy that forces it to move cash from earnings into pension contributions.
Fortunately, you don't just need to cross your fingers and hope that doesn't happen. There are warning signs aplenty to watch for.
A pension shortfall leading to an earnings hit can only happen to a company with a defined-benefit pension plan where employees contribute from their paychecks into a fund managed by the company, which then pays out preset amounts to retirees - as opposed to a personal investment plan, like a 401(k).
About 500 companies do still have active defined-benefit plans. Many aim to keep them, either because of a union agreement, or it's a key recruiting tool. Other companies have plans they inherited through an acquisition, or where they stopped allowing new employees to join. Even if they aren't adding more liabilities, they still need to cover existing obligations.
The status of a pension plan is typically disclosed by a company in its quarterly reports, though it can be tricky to get exact numbers without the help of financial research tools. Zion of Credit Suisse has compiled the numbers and finds 360 companies in the S&P 500 with plans that didn't have enough assets to meet their liabilities in 2008. Most of them are over 80% funded, but 83 companies have pensions that are less than 60% funded.
On a list of the 25 most underfunded plans put together by analysts at Citigroup, Exxon Mobil (XOM, Fortune 500) is number one, with a shortfall of about $6 billion. A profit-machine like Exxon, however, could close that gap pretty quickly without being a huge drag on earnings - which were $40 billion in 2007.
But number two on the list, Ford (F, Fortune 500), needs to come up with $3.3 billion for its fund, according to Citi, but it already lost $2.7 billion last year. With a market cap of $4.4 billion, the company is barely worth enough to cover its obligations.
"For a company with a pension plan in the same size range of its market cap of the company," says Adrian Hartshorn, a financial-strategy consultant with Mercer, "it will have a big impact on the business, materially affecting earnings, cash flow, and capital expenditure decisions."
"Overall, there is not a pension crisis in corporate America," says Robert Collie, director of investment strategy at institutional asset-manager Russell Investments. "The great majority of pension plans just aren't that big relative to corporations, but there are cases where the plan is large enough that you need to watch it closely."
Credit Suisse's Zion found four examples of companies whose increases in pension-plan contributions are likely to outpace their consensus earnings estimate for 2009 by more than 20%: Scripps (SSP), Goodyear Tire & Rubber (GT, Fortune 500), Ashland (ASH, Fortune 500), and Northrop Grumman (NOC, Fortune 500).
Bernstein Research analyst Douglas Harned warned in a recent note that Northrop and other defense contractors with large pension obligations, like General Dynamics (GD, Fortune 500) and Raytheon (RTN, Fortune 500) could see earnings-per-share fall 6% to 8% in 2009.
There are defensive measures a company can take to delay or spread out the pain of a pension plan free-fall. Many have already gone to Congress and successfully asked to delay the implementation of tighter funding rules passed in 2006 that would've required huge new contributions in 2009.
Companies can also freeze their pension plans and prevent new employees from joining, which is what IBM (IBM, Fortune 500), Verizon (VZ, Fortune 500), and others have done in recent years. Accounting rules even provide some leeway for funds to "smooth" their gains and losses over different fiscal periods in a defined-benefit plan, according to Credit Suisse's Zion. Companies like FedEx (FDX, Fortune 500), Aon (AOC, Fortune 500), and Exelon (EXC, Fortune 500), have switched to "smoothed" pension plan calculations and reduced the amount they will need to pay into their plans in 2009.
You can also watch out for strategy changes in company announcements, such as reallocating the asset-class within funds. Several years ago General Motors (GM, Fortune 500) switched away from stock-picking, hedge funds, and private equity investments in favor of more conservative index funds and bonds, which paid off by keeping the company's fund afloat in 2008.
But many other corporate pension funds - usually the most underfunded ones - still invest aggressively, chasing "alpha" returns from alternative assets.
"We're seeing that pension funds still want to use alternative investments to get to where they're going," says Cary Stier, a practice leader in asset-management services at Deloitte. "They may not reduce their 10% to 15% exposure to hedge funds and private equity, but they're definitely asking if they're backing the right managers." 
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