Beware of pension liabilities

Question

Should investors consider a company’s pension obligations before buying its stock?

Answer

Companies that trade on the public markets face a wide range of risks: economic, political, currency, environmental and market risks, to name a few. All of these risks can put significant pressure on shares. And to your question, pension risk should also be on that list.

Understanding pension risk

Investors look for stocks that they believe are undervalued or growing earnings. Some may also want to buy into companies that distribute a nice juicy dividend, providing income instead of—or in addition to—share price appreciation.

Pension obligations can weigh on a company’s financials because, when fully reported, the issue is included as a liability on the balance sheet. There is also the risk that the company might have to use some of its own cash to fill pension gaps, putting that juicy dividend at risk or at the very least impeding the company’s ability to invest its cash to grow the business.

Changing accounting rules

It can be hard to assess the pension liability given the complexity of accounting rules. Al and Mark Rosen, who run Accountability Research, a company that provides independent equity research, follows this issue very closely and recently wrote an article for Advisor.ca that flags a couple of key issues; “Two big factors investors need to pay attention to are changing accounting rules and fluctuating interest rates. Significant risks to valuation continue to exist, and the impacts can be quite material.”

The second issue the Rosens flag is low interest rates. Low rates are a problem because they put pressure on a pension fund’s ability to grow its assets. And as more retirees start drawing on their pension, the performance of the fund itself becomes more relevant.

Quantifying the risk

It is a lot of work to quantify the risk of pension deficits to specific companies. What you need to look at is the pension expense, less the pension funding to come up with the pension deficit. Then look to see how that deficit is changing over time and put it in the context of the company’s market capitalization.

A recent report by Vertias Research on the state of Canadian defined benefit pension plans included a list of companies with pensions portfolios that are the most affected by low interest rates and market volatility. The report says, “Bombardier is most likely to experience a material hike in cash contributions. BCE, Canadian Pacific Railway, Imperial Oil and George Weston may also face higher than average contribution requirements, given the size of their pension deficits relative to their market capitalization.”

Finding the right level of complexity

It is a lot of work to assess pension risk, not to mention the many other variables that go into buy and sell decisions on individual stocks. So before you do that work, ask yourself if you are you sure that this level of complexity is right for you and your circumstances? I often talk to investors who are buying individual stocks when they really shouldn’t be. Instead they should be working with an awesome financial adviser or buying ETFs to get diversification at low cost.

About Bruce Sellery

Bruce Sellery is the CEO of Credit Canada, the country’s longest-standing non-profit credit counselling agency. He is a former MoneySense columnist.