Potential Pension Problems Loom For These ETFs

Many younger workers, say those that have entered the workforce from the 1990s through today, probably will not receive a defined benefit pension when they retire. Younger workers are not unfamiliar with defined pension plans. They have heard of them, probably by way of their parents or grandparents.

That is to say the number of U.S. companies paying defined benefit pensions has dwindled over the years. Unfortunately for investors, companies' pension obligations have not dwindled and underfunding of pensions is on the rise. One culprit is the low interest rate environment.

"Discount rates for pension liabilities dropped from 7.4% in 1999 to 4.7% in 2011 This translates to a 190% increase in liabilities for a typical plan," according to J.P. Morgan research.

Return assumptions that were too rosy are another culprit. Some companies left plans underfunded assuming the go-go days of the 1990s equity markets would return.

"If pension assets had grown at the typical plan's expected rate of return, the assets would have increased by 182%, resulting in minimal shortage. In contrast, pension assets grew only by 69%," J.P. Morgan noted.

As of the third quarter of 2012, 338 S&P 500 companies paid defined benefit pension plans, but only 18 were fully funded while seven were underfunded by $10 billion or more, the New York Times reported.

Indicating that misery often loves companies, some of the most egregious pension offenders can be found in the same sector. That means ETF investors need to be aware of which sector funds have potential pension problems.

Industrial Select Sector SPDR (NYSE:XLI) The Industrial Select Sector SPDR is littered with companies that trying to deal with underfunded pensions. Alone, Dow component General Electric (NYSE:GE) represents 12.2 percent of XLI's weight and that company's defined benefit pension plan was underfunded by $21.6 billion as of the third quarter of last year, according to the New York Times.

Fellow Dow components 3M (NYSE:MMM) and Boeing (NYSE:BA) saw their pensions underfunded by $2.4 and $2.6 billion in 2011. Those stocks combine for over eight percent of XLI's weight.

Lockheed Martin (NYES: LMT), another XLI constituent, is among the U.S. firms that had a pension plan underfunded by $10 billion or more as of last year.

Market Vectors Steel ETF (NYSE:SLX) The Market Vectors Steel ETF does not focus exclusively on U.S.-based companies. Three foreign companies Rio Tinto (NYSE:RIO), Vale (NYSE:VALE) and Posco (NYSE:PKX) combine for over 31 percent of the ETF's weight and are the fund's top three holdings. That does not mean SLX does not have pension issues of its own.

Timken (NYSE:TKR) said on its most recent earnings call its underfunded pension liabilities were almost $400 million at the end of last year. That stock accounts for over five percent of SLX's weight and is a top-10 holding in the fund.

AK Steel (NYSE:AKS) paid about $170 million in pension obligations last year and that number is expected to jump to $180 million this year and to $240 million in 2014.

The cases of Timken and AK Steel pale in comparison to US Steel (NYSE:X), which has $5.2 billion in pensions and other post-employment benefits to deal with.

Alarmingly, US Steel assumes a stout rate of return on assets with which to fund the pension. In 2011 the company expected an eight percent return on plan assets. That is high by any standard and those returns are likely not achievable year in and year out.

iShares Dow Jones U.S. Telecommunications Sector Index Fund (NYSE:IYZ) Earlier this month, AT&T (NYSE:T) said it would take a $10 billion charge against its fourth-quarter earnings related to its pension plan. Citing an uncertain economic outlook for 2013 the telecommunications giant lowered its expected return on plan assets.

AT&T is not the only telecommunications pension offender. At the end of 2011 one analyst estimated Verizon could see pension liabilities of $31.6 billion.

In the case of Verizon, the company said it planned to contribute $1.26 billion to the underfunded plan last year, up from $400 million in 2011. The added problem for both companies is that if they cannot get above the 80 percent funded requirement, the Pension Protection Act mandates employer contributions to bring the plan closer to full funding. AT&T and Verizon combine for over 19 percenet of IYZ's weight.

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