Pension obligations could require cash outlay by Northrop.

Northrop Grumman Corp.'s underfunded pension obligation that's been three years in the making now has some analysts wondering whether the defense giant will need to infuse more cash into the program.

At the end of 2002, Northrop's pension plan--coveting more than 100,000 employees--was underfunded by $3 billion, or 14 percent of its $21.5 billion obligation, according to Securities and Exchange Commission filings. That's a $7 billion swing from its overfunded position of $4.1 billion at the end of 1999.

Add another $3.8 billion for post-retirement benefits, such as health care, and Northrop's underfunded pension obligations total $6.8 billion, or 32 percent.

Put another way, Los Angeles-based Northrop had only two-thirds of the necessary funds put aside to meet its pension obligations.

It's unclear whether additional cash contributions would have any short-term impact on profits. Some analysts think the best option is to use cash to increase assets and lower next year's pension expenses, which would not impact earnings. Another possibility is to take advantage of low interest rates to finance pension plan payments, which would hurt the bottom line.

Northrop is hardly alone in its pension troubles. Nearly every U.S. company with traditional defined-benefit pension plans has seen those obligations skyrocket and funds depleted in the past few years.

In the last decade, companies booked income from their pension plans and used those profits to offset other benefit costs. Now they face the gloomy prospect of actually having to fund the plans.

But Northrop's pension problems are perhaps the largest of any company in the L.A. area. By comparison, Walt Disney Co. had an underfunded pension obligation of $223 million as of Sept. 30, 2002, the most recent data available.

Stock market rise

Any number of variants could reverse Northrop's pension requirements. Companies must only report the numbers once a year, and a rising stock market--the S&P 500 Index was up 14 percent through Sept. 25--has eased a good number of pension-fund shortfalls. On the other hand, interest rates have fallen this year, cutting into returns.

A Northrop spokesman declined comment for this story.

Robert Friedman, a defense industry analyst at Standard & Poor's, said underfunded pensions are probably a short-term issue that will be erased by recent stock market gains.

"It will probably reverse in the next year," said Friedman, who has a sell rating on Northrop's stock because he believes long-term defense spending will grow at a more moderate rate, below 10 percent. "Just because a plan is underfunded one year doesn't mean they have to fund it for that year. I don't think it will be a big deal."

Nevertheless, Northrop's fund is dangerously close to the point where the company would need to shore it up with an extra contribution--something most companies try to avoid.

Federal regulations require that when a pension plan is underfunded by 15 percent or more the employer must contribute to the fund to bring it back to more than 85 percent in funding.

"Putting money in a pension plan is a costly maneuver," said Nicolas Owens, an analyst at Morningstar. "People get criticized about not putting money in a plan when they're in trouble, but they need that money to run their business."

Pension shortfalls are the subject of intense debate in boardrooms and actuarial firms--as well as at the White House.

The Pension Benefit Guaranty Corp., the federal agency that insures pension plans, has warned of the risks from pensions that currently are underfunded by $300 billion nationwide.

In July, the Bush administration proposed changes that would address how interest rates are used to determine how fast a pension will grow. Low interest rates mean a company needs more cash on hand to fund future obligations.

To reduce that requirement and help businesses avoid paying into their plans, the administration and business groups have suggested switching from a benchmark based on the 30-year Treasury bond to an index of high-grade corporate bonds.

Some experts suggest the change would be more reflective of the economy rather than the more volatile swings in interest rates.

"Because interest rates have plummeted to historical lows it has inflated the liabilities," said Wade MacQuarrie, principal of Crews MacQuarrie, an actuarial firm. "The lower the interest rate, the higher the liability."

Many pension funds have lost from 25 to 30 percent of their value in the past few years, leading companies to take measures to shore up their funds. In June, General Motors Corp. said it would issue $13 billion in bonds and other securities to put into its pension trusts.

Bond experts believe the rising number of underfunded pensions has created more volatility in the capital markets. Unless the markets recover soon, the gaps will become larger and could contribute to debt downgrades or stock price declines.

MacQuarrie said pension plan funding is important from a financial perspective because companies have used pension income to artificially inflate their books. "Most analysts are starting to discount the value of pension income since it's not really money in the bank," he said. "But on the other side of the fence you have pension expenses. If you discount the value of pension income, you should also discount the value of pension expense."

Use of cash

Northrop generates at least $1 billion in cash a year, and as a defense contractor, the government already pays for some of the obligations. Nevertheless, some analysts have suggested that Northrop put some of its cash into its pensions.

"One of their uses of cash should be to shore up the plan, but they're not going to do it because they can wait for the assets to catch up a bit," said Owens. He described Northrop's projected return on assets, 9 percent, as a red flag. "Everyone assumes they'll have to make it up someday soon," he said.

At a time when sales and earnings have been hurt by the weak economy, many companies are loath to contribute extra cash to their pension funds.

"Companies seem to be taking a sort of Scarlet O'Hara approach, where they'll think about it tomorrow," said Bonnie Baha, managing director of investment grade corporate bonds at TCW Inc. "At some point they will have to fund those plans. Instead, people are waiting for a turn in the market that's long in coming. In Vegas, they would call that betting on the come."

Another wrinkle: while pension finance theory suggests companies invest primarily in the bond market, many companies plowed pension money into stocks to take advantage of the bull market. Pension trusts also became more aggressive in their asset allocation.

The assumptions of the 1990s--rates of return in the 9 percent to 10 percent range-appear unsustainable in today's market. But scaling back the return rates has its problems as well. When firms cut their expected returns, it increases their future pension costs and puts pressure on profits and cash flow.