In this third part of a four part series of articles based on this Fidelity piece, which focused on the beneficiaries of rising rates, I will target companies with large pension obligations benefiting from an environment of higher interest rates.
Why should we look for companies with large pension obligations? The answer is two-fold. First of all, higher interest rates increase the expected growth of plan assets. That’s a good thing. In addition, the discount rate used to calculate the present value of plan liabilities will move higher in concert with interest rates. This shrinks the present value of the pension liability. More assets, less liabilities, that’s a real good thing!
Who stands to benefit the most? Many companies have large pension plans in various industries. My prior installment in this series discussed sectors that can benefit directly from higher rates and an improving economy. As luck would have it, there are companies in these sectors which also have large pension obligations giving them the opportunity to double dip on higher rates.
Industrials
With its stock already flying high, Air Canada (TSX: AC.B) has one of the largest pension plans of any Canadian company. Not only is it one of the largest plans, but it’s also one of the worst funded. The airline was recently thrown a lifeline by the federal government which will cap funding obligations for the next seven years. This should allow the company to stay solvent while a potential rise in interest rates should help narrow the funding gap.
Sticking with the business of flight, aircraft manufacturer Bombardier Inc. (TSX: BBD.A, BBD.B) is also sitting on a large pension deficit and also stands to benefit from an interest rate lift.
Financials
The bottom line of banks should benefit from a slow and steady climb in interest rates, but some of Canada’s largest financial institutions also stand to gain from reduced pension obligations. It should be no surprise that Canada’s largest financial institution, Royal Bank of Canada (TSX: RY), also has a sizable pension fund. As interest rates have declined, Royal Bank has experienced funding shortfalls. In 2011, the bank modified its plan to only offer new employees a defined contribution plan and not the existing defined benefit plan making required contributions going forward more predictable.
Like Royal Bank, The Bank of Nova Scotia (TSX: BNS) is also experiencing funding shortfalls on its sizable pension fund. During the second quarter the bank continued to see increased pension and benefit costs as a result of low interest rates, but was still able report earnings of nearly $1.8 billion including record earnings of $590 million from its Canadian banking operations. Armed with strong capital ratios and earnings, Scotiabank would seem poised to further benefit from higher rates and expanding earnings going forward.
Life Insurers
Several life insurance companies also have underfunded pensions and Canada’s largest insurer, Manulife Financial Corporation (TSX: MFC), is no exception. An improved pension funding situation is just one of the multiple ways rising rates will help these insurers. Like Manulife, Sun Life Financial Inc. (TSX: SLF) also has its own internal pension shortfall. However, as mentioned in my previous article, certain products of insurers should benefit directly from rising rates, but one product in particular takes advantage of the current pension funding fears being experienced by several organizations throughout the world.
Many companies are facing large pension obligations that have been exacerbated by low interest rates and longer life expectancies, but insurers have a product to help ease the pain. The product is referred to as “pension risk transfer” and the timing could not be better for the insurers. The pain appears to be peaking just as interest rates appear to be ready to climb. The product works by transferring the pension obligation risk to the insurer and in exchange the company purchases annuities from the insurer for a price, of course. In addition to the upfront cost of the annuities, the insurer is also locking in annuity rates while interest rates remain low.
Final Thoughts
There are many sectors and companies who carry large pension obligations and will benefit from higher rates. However, why not focus on companies that can benefit from multiple angles. Life insurance companies may be the winner when it comes to the benefits as they will see reduced pension obligations, higher product sales and the ability to help other organizations lower their burden through pension risk transfer while locking in low annuity rates.
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Fool contributor Alex Gray does not own shares in any of the companies mentioned. The Motley Fool does not own shares in any of the companies mentioned.
