Last week, we looked at the problem looming in many established blue-chip companies that pay dividends now and may not later. They have heavy pension obligations bearing down on them.

These problems should be stated in financial reports. But sometimes they are hidden in plain sight.  A bit of dubious padding in pension plan earnings projections can neatly camouflage millions in shortfall.

By the way—even if you are not buying dozens of stocks for their dividends, this is something good to know. It will help you evaluate those slick plans that brokers, bankers and insurance salesmen hold out to you when you take out life insurance, buy an annuity, set up a 401(k) or do any long-term planning yourself.

Let’s start with a choice: Which would you rather have? $311.80 today to put in a 20-year bond that pays 6% a year? Or would you rather have $1,000 on Nov. 13, 2028?

They are the same. The $1000 is the “future value” of taking $311 today and investing it for 6% per annum for 20 years.

Or to reverse the order, assuming 6% a year return, $214 is the “present value” of $1000 in 2028.

And the 6% assumption? That is the “discount rate.”

The problem with Lockheed Martin and several other companies is that the potential for big pension shortfalls is craftily understated in the discount rates they use in their projections. Lockheed has been using a discount rate of 7.5% for its pension plan returns.

Is that reasonable? No way! Nor should you accept a rate like that in an annuity or life insurance plan’s projections.

First of all, a pension plan should be conservative. It should hold bonds along with blue-chip stocks, and bonds do not pay anything near 7.5% unless they are of poor credit quality and highly risky.

For reality, we’ll go to the guidelines Charles Schwab has published—a 20-year average return for large-cap stocks is 8.2%, and for bonds it’s 4%. If the pension fund is half stocks and half bonds, a reasonable discount rate would be 6.1%. In truth, the balance for pension funds today according to Watson Wyatt and several other firms is 60% stocks. With a 60-40 ratio (bonds to stocks), the discount rate should be 6.5%.

Jiggling with this number makes a huge difference. A million dollars worth of obligation in 20 years can be fully covered with $235,000 in the pension plan today if it really can average a 7.5% return. But if the proper discount rate is only 6.5%, then the fund should have $283,000 in it. That’s 20% more money.

On top of this, many pension fund managers have been switching to more bonds in the past year. If the ratio turns back to 60% bonds rather than 60% stocks, the discount rate should fall to 5.7%, and Lockheed’s pension fund would need 40% more money in it today than it would at a 7.5% discount rate. Ditto any other companies using high discount rates.

This isn’t hard to check. It’s all in a company’s annual report, and often in the quarterly reports. If a company says that it needs to add to its pension fund, or is barely covered, take a second look at the discount rate it is using to be sure it is stating the full measure of the problem.

And you can tell your broker, banker, and insurance salesman to use a reasonable rate in his projections the next time you’re doing some financial planning, too.

Source: Pension Problems Part II