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Some blue-chip stocks could be dragged down by pension deficits in 2006

by Wayne Cheveldayoff, 2005-10-13

In blue-chip stock investing, it is not enough to focus on earnings, dividends and growth prospects, since for some companies, there may be a major pension deficit lurking in the wings and threatening, if interest rates stay low, to be a drag on the company’s performance in 2006.

The importance of pension deficits and the impact of low interest rates was highlighted in a recent report by UBS Securities investment strategist George Vasic, who believes that for some companies, “the effect of lower bond yields could provide a shock to (earnings) results released in early 2006.

“In sum, we think that investors should not become too complacent about the possibility of stronger equity markets moving the pension issue to the background, as the plunge in Canadian bond yields could lead to sharp upward revisions to estimates of funding deficits early next year.”

Among the Toronto Stock Exchange’s top 60 companies with large underfunded defined-benefit pension plans are Bombardier, Abitibi, Alcan, Quebecor World, Nortel, Novelis, Domtar, CPR, Inco, BCE, Nova Chemicals and Imperial Oil.

These companies had high funding deficits, particularly as a percentage of their market capitalization, as of the end of 2004.

A company’s pension funding position is calculated at the end of its fiscal year. For most companies, that is December 31. Thus, for the 2005 fiscal year, the calculations will be reported when the fourth-quarter earnings are announced in January and February 2006.

The funding position is influenced by a number of factors, including how well the pension fund’s investments have performed.

But one of the most important factors is the assumption of future investment returns (discount rate assumption), which is heavily influenced by bond yields.

A higher assumed bond yield will improve a pension fund’s position because it means there will be higher investment returns in the future to pay for the promised pensions.

On the other hand, a lower assumed bond yield will have the effect of reducing potential investment earnings and causing a worsening the funding position.

Any upward or downward revision in a company’s defined-benefit pension position is reflected to a large degree in the company’s reported earnings.

The UBS study notes that the corporate bond yield is an influential rate that pension fund actuaries look to in setting a discount rate assumption. The average corporate bond yield, which stood at 5.9 per cent at the end of 2004, has posted a decline to 5.1 per cent by September 2005. If it stays there or goes lower, “the result will be further upward pressure on the value of pension obligations and so funding deficits.”

The aggregate pension underfunded position of the TSX 60 has been stable near $15 billion up to 2004, according to the study.

But the shortfalls remain highly skewed, with the eight largest deficits in absolute terms accounting for 80 per cent of the total, and nine companies having a pension deficit exceeding 5 per cent of their market capitalization. The size and distribution is broadly comparable to the U.S. situation, the study says.

The dozen Canadian companies with the highest deficits as a percentage of market capitalization include Bombardier, with a 2004 funding deficit of $1.93 billion (36 per cent of market capitalization), Abitibi $779 million (32 per cent), Alcan $2.9 billion (17.5 per cent), Quebecor World $400 million (17 per cent), Nortel $2.2 billion (11.5 per cent), Novelis $260 million (10.7 per cent), Domtar $172 million (8.9 per cent), CPR $604 million (8.3 per cent), Inco $776 million (6.8 per cent), BCE $1.3 billion (4.5 per cent), Nova Chemicals $162 million (4.2 per cent) and Imperial Oil $1.3 billion (2.9 per cent).

Others with a 2004 pension funding deficit include Celestica $62 million (2 per cent), George Weston $252 million (1.9 per cent), Falconbridge $181 million (1.5 per cent) and Petro-Canada $330 million (1.3 per cent).

Among the big-five chartered banks, Royal Bank had the largest pension deficit at $436 million, or 0.8 per cent of market capitalization, followed by the CIBC $130 million (0.5 per cent). The Bank of Montreal, TD, and Bank of Nova Scotia reported surpluses.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2005 Wayne Cheveldayoff