As a mega-merger is announced, one of the last things investors pry open are the pension and retirement obligations. In the case of the United Technologies (UTX) and Raytheon (RTN) deal, it is worth considering.
Defined Benefit Burden
Defined benefit pension plans are by and large a thing of the past, and for good reason.
Larger workforces to support retirees with payments into existing pensions is no longer an expectation, which has made the system more unpredictable than ever. Additionally, as interest rates plummeted in the post-Volcker era, pensions became more reliant on equities and alternative assets that are far more volatile than traditional fixed income instruments.
For companies like General Electric (GE) and Sears (SHLDQ) , the pension issue has been a headline risk, but only once it became an existential threat.
Eddie Lampert finally moved blame to the pension plan for his struggles at Sears as his company teetered on the brink of collapse.
"In the last five years, we contributed almost $2 billion, and since 2005 we have contributed over $4.5 billion, to fund our Pension Plans," Lampert wrote one month before Sears declared bankruptcy. "These funding levels have been significantly higher than they otherwise would have been because of the historically low interest rates driven by Federal Reserve policy since the 2008 financial crisis, increases in Pension Benefit Guaranty Corporation fees, and required changes in mortality assumptions. Had the Company been able to employ those billions of dollars in its operations, we would have been in a better position to compete with other large retail companies, many of which don't have large pension plans, and thus have not been required to allocate billions of dollars to these liabilities."
Certainly, the situation of United Technologies and Raytheon is nowhere near as dire as the over $30 billion unfunded liability that drew attention to the dividend paying GE and the recently collapsed Sears. However, it is important to say that it need not get to this level before appropriate attention is paid.
Parsing the Pension
The proposed merger would combine an enormous amount of pension assets under one umbrella, with more than $90 billion in pension assets across benefit plans set against an even larger obligation total. For reference, that is about nine Beyond Meats (BYND) worth of pension assets.
As of its last 10-K filing, Raytheon carried an unfunded pension liability for its defined benefit plans at over $6 billion, while UTX carried an unfunded liability of over $2.5 billion.
While the absolute terms of the obligations appear large, both pensions are relatively well positioned, with funded ratios over 75% for both entities (Raytheon being the laggard) after significant contributions to shore up each plan in recent years. While not ideal, as the Pension Protection Act of 2006 notes that the PBGC monitors pensions trailing an 80% funded rate, the combined company should be able to keep above this mark.
"As part of our long term strategy to derisk our defined benefit pension plans, we made discretionary contributions of approximately $1.9 billion to out domestic defined benefit pension plans in the quarter ended September 30, 2017," United Technologies' 10-K filing states.
The company also outlined its recent strategy of lump sum payments, which totaled payments of $1.5 billion to further de-risk the obligations. A similar strategy was also employed tied to Rockwell Collins' pension plans following its acquisition in 2018.
The funded ratio of qualified plans overall for UTX was noted to be exactly 97% at the close of 2018, but its Rockwell acquisition added a more needy 75% funded pension plan to the complicated balance sheets. Though, this was noted to be a correctable issue based on its far smaller size compared to the existing UTX plans and can be aided by the lump sum strategy.
Raytheon's situation is improving as well, about a 79% funded ratio, according to SEC filings. The company noted discretionary contributions grew from $500 million in 2016 to $1.25 billion in 2018 in order to better the funded ratio and take advantage of tax benefits associated with the contributions.
Still, the issue of the pension performance being tied to the performance of both alternative and equity investments rather than more stable fixed income investments could be a lingering concern.
For example, Raytheon's largest allocations are in international and U.S. equities, dwarfing its other holdings. As a result of the portfolio strategy, 2017 marked a gangbusters gain for the pension of 15%. However, market turmoil into the back half of last year left the portfolio at a loss of about 4% for the full year 2018.
The volatility of returns as required contributions remain high is something to monitor, especially if the market comes against further corrections in coming years and returns are pressured.
Turning to a Tailwind?
Moving forward, J.P. Morgan estimates that Raytheon should have about $1.5 billion in pension income on the P&L, while UTX will accrue $500 million.
"For cash flow, UTX expects to contribute $100 million to pensions in 2019 while RTN contributes $1.5 billion less than it gets back from the government, making pension a source of cash," the firm's defense analyst Seth Seifman said. "The government owes RTN $7 billion, and this should be a net source of cash for years, though a decreasing one as contributions rise."
"Longer-term the RTN pension obligation is more or less zero due to these government reimbursements, although they can be a major swing factor for cash flow in the coming years," he added.
In that context, what is often seen as a significant burden to companies like UTX and RTN could end up being a tailwind.
"Pension is complex, as always," J.P. Morgan's Seifman commented.
That fact is not likely to change any time soon for aging giants like Raytheon and United Technologies, but investors can breathe easy for the time being, as its not a major headache just yet.
This article has been updated to reflect updated Rockwell Collins figures
