Earlier this spring, I presented my short call on Kroger (KR), arguing that America’s largest supermarket chain was feeling the increased pressure of an intensely competitive food retail environment. That’s the plain vanilla rationale behind my bear case. But there’s more.
One of the more distressing risks lurking beneath the surface—one that represents a threat not only to shareholders, but to pensioners as well—is Kroger’s exposure to a large number of multi-employer pension plans (MPPs). The company intentionally keeps these plans in an underfunded status and this has the potential to backfire on the company. In addition to increasing annual costs, the company’s total exposure to these plans, in another downturn, is potentially debilitating.
Kroger’s woes are emblematic of an affliction plaguing pension funds across the country. It’s the same old story – chronic underfunding, as the swelling ranks of retirees overtake a smaller base of currently contributing employees.
To underscore the issue at hand, MPPs are the primary source of retirement income for over ten million active, inactive and retired workers and their survivors. A number of these pension plans, much like their state-run brethren, are severely underfunded. In a report to Congress in 2013, the Pension Benefit Guaranty Corporation (PBGC) estimated that MPPs have $757 billion in pension benefit liabilities, $391 billion of which are unfunded obligations. No small potatoes.
Kroger is one of the largest unionized employers in the United States. About 375,000 of their employees are covered by roughly 300 collective bargaining agreements. Kroger employees participate in 36 multi-employer pension plans (MPP), with a combined $70 billion in assets and $100 billion in associated liabilities.
Therein lays the problem.
A survey conducted by Segal Consulting found that 53% of the retail food MPPs in the survey were in the “red zone.” This means the plans either had “immediate and significant funding problems” or would be unable “to pay benefits within 15 to 20 years.” Underscoring the severity of the issue, in testimony before Congress in 2014, Kroger’s Vice President of Pension Investments and Strategy, Scott Henderson, called “the uncertain fate of the multiemployer system” a “huge concern.”
Here’s what’s even more disconcerting. Projected MPP shortfalls don’t account for what could happen to the plans in a protracted financial market downturn. Get this: Milliman data shows that every 4% decline in asset returns pushes MPP funding status down by 15% to 20%. That’s an enormous amount of sensitivity. And it’s significant cause for concern.
The story gets worse as a protracted stock market downturn may be imminent. Consider a comprehensive study of historical equity returns conducted by hedge fund founder Cliff Asness of AQR. Asness shows that over the next 10 years, stock returns will likely only average around 0.5% plus inflation. So call it 2% per year. In this scenario, these pension plans would see their funding ratios precipitously drop by 20% to 30%. In other words, an 80% funded plan today, will drop to 50% to 60% funding within a few years, just as the number of inactive retirees begins to go parabolic.
A perfect storm.
Making matters worse, the Government Accountability Office (GAO) found that if a major MPP becomes insolvent the Pension Benefit Guaranty Corporation’s insurance fund would exhaust within two or three years. This means that if (and when) MPP-participating employers fail to pay for the full withdrawal liabilities, due to reasons such as a bankruptcy or going out of business, the responsibility for the unfunded liabilities shifts to the employers that remain active in the plan. As a result, the remaining employers in the multi-employer pension plan are forced to pick up the tab of many people who never even worked for the company and may have worked for a competitor or in a different industry.
In Kroger’s case, the company’s rising healthcare and pension costs can’t be swept under the rug. Just last month, the Treasury Department denied an application put forth by a critically-impaired MPP, the Central States Plan, in which Kroger employees participate, to reduce benefits for covered employees arguing that the plan did not “satisfy the statutory criteria.” Investment return assumptions of 7.5% were deemed “not reasonable” and the benefit cuts not “equitably distributed.”
This is not an issue that can be kicked down the road. Unless something drastic is done, millions of Americans counting on their pensions will be left outside in the cold.
Kroger’s investors haven’t yet grasped the gravity of the situation. In 2015, Kroger’s pension liability ballooned 61% to $2.9 billion. That number will go even higher this year, hindering the company’s ability to grow and likely leading to lower equity value.
Little is being done right now to solve Kroger’s many issues. Investors would do well to get out before it’s too late. We see 20%-40% downside for shares of Kroger from current levels. Not to mention the massive potential pain ahead for pensioners.
Howard Penney is a managing director and restaurants analyst for Hedgeye, an independent investment research and online financial media firm based in Stamford, Connecticut.