By Ken Wieland

This is the second article in a series on pension liabilities. See also BT pension liabilities may hit £11 billion

The stock market havoc wreaked by the credit crunch has pushed the US telecoms sector into the pension-fund red for the first time in years.

According to a report from Standard & Poor’s, published in June 2009, defined benefit pension schemes in the S&P 500 Telecommunications Services sector were underfunded to the tune of 9.56% - or $9.1 billion - by the end of 2008. A defined benefit pension is where employees are guaranteed an income based on a proportion of their final salary once they retire. As it stands at the moment, the large US telcos have insufficient funds to cover their defined benefit pension commitments – a far cry from the end of 2007 when the combined pension funds of the S&P 500 Telecommunications Services sector were overfunded by a healthy 29.3%.

Telcos, inevitably, got caught up in the devastating minus 37% return on pension fund assets during 2008, leaving an overall S&P 500 pension fund shortfall of $308.4 billion at the end of 2008 on assets worth $1.1 trillion. A year before, the pension funds of the entire S&P 500 membership had been overfunded by $63.4 billion.

Perhaps the only consolation for Telecommunications Services is that the pension funds of other industry sectors have fared much worse as a result of the sharp decline in share prices during 2008. Pension funds in the S&P 500 Energy sector, the worst performing of all the industry sectors tracked, had a massive shortfall of 39.46% as of the end of 2008. Health Care – the second worst performing industry sector – was off the pace by 29.25% in terms of meeting its pension fund obligations.

Bad for your health

Where Telecommunications Services does much worse than most other S&P 500 industry sectors is in the funding of other post employment benefits (OPEB), which covers such things as medical and dental care. According to the authors of the Standard & Poor’s report – S&P 500 2008: Pensions and Other Post Employment Benefits – the Telecommunications Services sector, because it had often used OPEB as a carrot to persuade people to take early retirement in order to trim down the workforce, was facing an enormous OPEB funding deficit of $55.2 billion by the end of 2008. Only the Consumer Discretionary sector in the S&P 500 had a bigger OPEB funding shortfall ($57 billion) at the end of last year.

“OPEB has become a major, major issue for US telcos,” says Howard Silverblatt, senior index analyst for Standards & Poor’s and co-author of the pension and OPEB report. “It is really hurting them now, much more than pensions.”

Of the entire end-2008 $257.2 billion OPEB shortfall calculated by Standard & Poor’s among the S&P 500, only four companies accounted for 39% of the deficit and two of these come from the telecom sector: AT&T and Verizon had racked up OPEB shortfalls of $27.4 billion and $24.5 billion respectively by the end of 2008. The other two firms making up the four most badly affected by OPEB underfunding come from the beleaguered US automotive industry: General Motors ($32.9 billion shortfall), which is now removed from the S&P 500, and Ford (a $16.3 billion OPEB deficit). The extent of OEPB shortfalls make the entire Telecommunications Services pension fund deficit of ‘only’ $9.1 billion (end 2008) appear small by comparison.

A main reason why OPEB underfunding has spiralled so alarmingly out of control is that, unlike pension scheme funding, there are no regulation or tax-break incentives to ensure the allocation of funds in the first place. OPEB costs in the US have largely been met on a pay-as-you-go basis with very little put aside for investment in order to meet rising insurance costs to cover ever more costly health care and a bigger health care bill in the future simply because people are living much longer. The average US life expectancy today is 78, up from 72 in 1974, and while the official pension age is 66 many people take early retirement – the average retirement age is 64.

This all adds up to higher OPEB costs, which US telcos are trying to minimise through capping their contributions to employees’ health care insurance schemes once they retire. Three years ago, the big US telcos managed to come to an agreement with the Communications Workers of America (CWA) to limit the annual increase of their health care insurance contributions to five per cent. If the health care insurance rises higher than 5% per year, the retiree has to make up the difference through their own share of insurance contributions.

That deal is now up for review as the CWA is currently going through another round of negotiations with telcos – and health care is one of the key issues for the union. “Pensions don’t seem be a priority,” says Silverblatt. “The priorities are medical and job security.”

The whole issue of health care reform has become highly political in the US with president Obama keen to extend health care insurance coverage to more than 46 million Americans - who currently do not have any health care insurance - through a government-run scheme. US telcos would no doubt be keen to hand over some of their OPEB costs to the government, but it remains to be seen if this will happen under the new US administration.

What is for certain is that the amount allocated to both pensions and OPEB by US telcos need to increase drastically. AT&T, which clearly states its pension and post-retirement costs, reports that these two items combined increased by an eye-watering $958 million to $1.12 billion in the six months ended 30 June 2009 compared to H1 2008. The increase, says AT&T, was largely down to a lower than expected return on assets.

The outlook doesn’t look any brighter, at least in the short term. “Because of the scale of the [asset] loss over the last year and a half, even if we get good returns for this year – nice double-digits – it will still not make up the funding shortfall,” says Silverblatt. “The numbers are working against the companies and former employees are living longer.”

Worse than it looks

As bad as the funding deficit figures look, the scale of the problem is probably a lot bigger. The discount rates used by S&P 500 companies have been creeping up over the last few years, which, although they have the happy effect of reducing the size of the projected benefit obligations, are beginning to look increasingly unrealistic.

Discount rates are usually a reflection of the expected return on pension fund assets. By applying a discount rate on the size of their future obligations – since the value of the pension or OPEB fund today is assumed to grow by at least the same rate as the discount rate – companies, theoretically, can more accurately work out how big or small their fund shortfall - or surplus - is. Of course, the higher the discount rate used the smaller the funding deficit - or bigger the surplus - appears.

In 2005 the average S&P 500 discount rate used was 5.11%; by 2008 that had risen to 6.29%. To achieve the higher rates of return to justify the higher discount rates, there may be a temptation for companies to invest in riskier, higher-yield products. But that is not a trend that Standard & Poor’s reports.

At the end of 2007, the size of the combined pension funds in Telecommunications Services stood at $129 billion with 60% of the asset value parked in equities and 27.1% allocated to fixed income products. One year later the telecoms pension fund had shrunk to $87.5 billion with only 47.3% allocated to equity assets and 28.7% allocated to fixed income. The large US telcos have a much proportion of their pension fund value wrapped up in real estate, 9.7% end-2008, up from 4.4% the year before, than their industry sector counterparts.

Although a move away from equities seems sensible in the wake of the economic downturn, and even allowing for the fact there has been some return back to equities during H1 2009 as stock markets have picked up slightly, the general move to lower-yield products makes it harder to justify rising discount rates; it might suggest that S&P 500 companies across the board are storing up bigger funding problems for the future. While S&P 500 pension fund assets declined in value from $1.5 billion to $1.1 billion during 2008, liabilities – handily aided by a higher discount rate – were actually reduced by 2.6%, going down to $1.41 trillion from $1.44 trillion.

In an attempt to help cash-strapped companies during the economic downturn, the US government in December 2008 suspended for one year the phased-in funding requirements laid out by the Pension Reform Act (2006). Although a useful short-term measure to ease tightening pressure around cash-flow, the pension funding gap can only get wider as a consequence.

The good news for the US telco sector is that it is still profitable. Verizon’s free cash-flow (cash flows from operations minus capex) for H1 2009 totalled $6 billion, up an impressive $1.8 billion compared to H1 2008. AT&T did even better, helped by lower capex. Its free cash-flow jumped from $3.9 billion during H1 2008 to $8.4 billion for the six months ended 30 June 2009.

The scale of the pension problem seems surmountable for the US telco heavyweights. OPEB, however, looks a much more formidable opponent. Government help will probably be needed to bring it under control, if not slay it. GTB