Boeing (NYSE: BA) retirees and investors should be very worried that the aerospace giant is stuffing its pension plan with company stock. With the plan suffering from a massive $20 billion shortfall, Boeing is making a risky bet with its workers' futures that it can maintain the torrid growth pace it's been on, transferring some $3.5 billion worth of stock into the plan, including shares it had previously bought back.
Rather than ease the risk associated with having such an unconscionable underfunding of its pension obligations, it's quite possible that Boeing will instead crash and burn and take with it the value of its retirees' benefits.
A bad case of turbulence
Over the past few years, Boeing's underfunded pension obligations have spiraled wildly out of control as it chose to buy back company stock instead of make payments to the pension plan. A decade ago, the plan was actually overfunded by some $4.7 billion, but beginning in 2008 it began to become underfunded, and today, of all the S&P 500 companies, only General Electric has a worse pension funding shortfall.
By taking the shortsighted tack of buying back company stock instead of making contributions to its pension -- it bought back some $30 billion worth of shares over the past three years -- Boeing chose to boost the value of its stock by financial engineering. Now it wants to use those gains as the basis for making a contribution, but one that still leaves it with a gargantuan $15 billion underfunded liability.
Wearing rose-colored glasses
In the past, Boeing used unreasonable assumptions about how the plan would perform, which let it set aside less for pension obligations while lowering the hit it took to earnings.
Pension accounting involves two numbers: the rate of return a company earns on its investments, and the discount rate, which it uses to discount future obligations back to a present value. Changing one or the other (or both) allows management to massage the results more to its liking.
As it has for many years now, Boeing says it expects its pension managers can earn around 7% or more on their investments (last year it lowered that expectation to 6.8%). Because the stock market has historically returned around 10%, it's a seemingly conservative number, except that around three-quarters of the market's returns are derived from dividends and inflation. Earnings growth is actually the smallest contributor to the total.
Historical bond returns are much lower than that, and like many companies', Boeing's pension plan is appropriately dominated by fixed-income investments. In fact, 48% of its plan's total assets are fixed-income. Equity investments comprise a third, a wholly reasonable split in what should be a conservative program.
What is unreasonable is to expect that the plan managers can make 7% returns with investments heavily weighted toward fixed assets.
Discounting the possibilities
The second part of the equation is the discount rate, and Boeing uses a 4% rate to discount its future obligations. That's slightly better than the 4.2% rate it used in 2015, and certainly more appropriate than the 5.3% rate from 2010, but even though the aerospace giant has lowered its expectations, that number, too, is still too high. In a world where 10- and 30-year Treasury bonds go for 2.2% and 2.8%, respectively, Boeing's 4% rate still seems ambitious.
Yet there's good reason Boeing has only slowly lowered the discount rate: Decreases in the rate cause pension obligations to rise even further.
Moreover, because Boeing couldn't or wouldn't fund the plan with cash, it also filled its ailing plan with so-called alternative assets such as farmland and timber resources, real estate, and hedge funds. And now it wants to add more company stock to the mix.
Doing so obviously makes retirees even more dependent upon Boeing's stock continuously rising. Yet the aerospace and defense industries are notoriously cyclical, and after the big run-up in its shares -- Boeing's stock has nearly doubled over the past year -- they're trading at all-time highs and valuations.
It is possible Boeing could get lucky and its stock could continue its ascent, allowing it to make up the shortfall. But betting on the benefits of its retirees is a much too risky play, and one that should scare those who have to rely upon it.
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