Many companies with defined benefit pension plans are using unrealistic projections for the future income from portfolio investments, which in turn conceals the extent of underfunding.  Last month David Zion of Credit Suisse issued a report on the defined benefit pensions of S&P 500 companies.   Zion described the impact of today’s low interest rate environment:

“Even with all of the changes to pension asset allocations over the past few years, it appears as if many plans continue to make big bets on interest rates (hoping they go up) and on the stock market (around 50% of plan assets are still in equities). Therefore, unless we see a spike in yields on high-grade bonds or a stock market rally in the fourth quarter (the last few weeks have helped) it looks like the health of most pension plans will deteriorate in 2010. We estimate the funded status of the S&P 500 companies’ pension plans may have dropped by $134 billion this year and are now $402 billion underfunded (75% funded). To put that into perspective, we are estimating the pension plans are in worse shape now then they were at the end of 2008, when the underfunding reached $326 billion (78% funded).”

Many companies are still using long-term earnings assumptions of around 8% per year for pension investment portfolios.  It is hard to imagine where the 8% returns will come from, given that the 10-year Treasury rate is currently around 2.5% and the annualized return on the S&P 500 for the past ten year is -1.38% (www2.standardandpoors.com/spf/pdf/index/SP_500_130-30_Strategy_Index_Factsheet.pdf).  Year after year directors have accepted the optimistic earnings projections provided to them by HR consultants and investment managers.  Sooner or later—probably sooner—there is going to be an awakening (or more challenges from Boards) and those advisers and managers will be presenting much lower projections.  This will necessitate a recognition of much greater underfunding in defined benefit pensions and cause a big hit to earnings at some companies as they try to close the funding gap.  When companies play ‘catch up’ it will be fertile ground for the lawyers who bring class action lawsuits alleging misleading financial information in past SEC filings.  Why misleading?  The lawyers will allege that directors should have known that they were using unrealistic projections when they approved pension funding levels.