True or false? Low interest rates are bad for pension plans.
Well, mostly true – particularly if a plan has maintained a traditional investment strategy that does not hedge the interest rate risk in the liability. Falling rates will lower the discount rate applied to future benefit payments and increase the measured value of the liability, almost certainly without a correspondingly large gain in the plan’s assets.
Unfortunately, that is a good description of the strategies employed by many plan sponsors over the past few decades. We can observe the significant losses in funding that have accompanied periods of low interest rates, most notably in 2001-2002 and in the post-2008 crisis period. In the recent period, plans have had to deal with not just the direct assault of the financial crisis and lingering recession, but also the collateral damage caused by the Federal Reserve’s quantitative easing policy.
Looking for the silver lining
But there is a possible upside to the current environment, one in which a plan sponsor can proactively take advantage of the low rates to strategically improve the solvency of the pension plan while simultaneously lowering the costs to the corporation – by issuing debt in the market and contributing the proceeds to the pension.
Pension underfunding (i.e., the portion of the present value of long-term liabilities that is not offset by plan assets) is functionally equivalent to debt on the balance sheet of the sponsor. Sponsors often carry this “debt” at a cost that is quite high relative to the comparable cost of financing the pension obligation directly in the marketplace.
Broadly speaking, the use of corporate borrowing to finance pension contributions has several potential benefits:
- Allowing the plan sponsor to immediately shift the plan’s funded status to a desired level (such as 100%) without increasing the net obligations of the firm.
- Making use of the improvement in the plan’s funded status by shifting to a less risky investment strategy that is better aligned with liabilities.
- Using a range of regulatory, tax and accounting incentives designed to reduce costs and strengthen the balance sheet.
Setting plan funding at the level desired by the sponsor
Many plans today have embraced a “glide path” strategy that envisions a patient de-risking of the asset allocation over time as the plan’s funding improves. Under a normal glide path strategy, a plan sponsor must implicitly be comfortable waiting for the combination of favorable market movements and/or sponsor contributions to improve the funded status of the plan until it reaches a level sufficient to allow de-risking.
The downside of this patient approach is uncertainty: a plan may take longer to reach its desired level of risk, or possibly see a loss in plan funding and increased contributions, if markets move in the wrong direction. Depending on the sponsor’s view of economic and market risks, and potentially compounded by the cyclical sensitivity of the operating business of the sponsor, this uncertainty around the pension may be unacceptable.
The strategy of issuing debt to fully fund the pension plan allows a sponsor to de-risk their pension strategy immediately without needing to wait for market events or cash contributions to reach the level of funding that will trigger a shift in asset allocation. In an unusually uncertain macroeconomic environment, this can add significant defensive flexibility to a plan.
The increase in plan funding – on its own – has a material impact on the amount of surplus risk, for the simple reason that there are more assets available to offset changes in the value of the liability. However, taking the additional step of shifting the asset allocation away from risky assets (e.g., equities) and towards Liability-Driven Investing (LDI) with long-term bonds can result in an additional risk reduction. Figure 1 illustrates this point. A generic, hypothetical plan we’ll call Plan X moves from 80% funded to 100% funded, and either (a) keeps the current asset allocation; (b) shifts to a less risky mix of stocks and long bonds; or (c) completely de-risks by shifting entirely to LDI.
The difference between risk in the three options is striking: Plan X can reduce surplus volatility from 16.1% to 14.2% without changing the asset allocation (and preserving the high level of expected return in a 70% equity allocation). Shifting the portfolio towards LDI allows for a more complete reduction in risk – with the 100% LDI strategy approaching the hypothetical minimum. (A plan that is fully funded and invests 100% of its assets in an LDI strategy will not have eliminated all risk to changes in funded status. Non-market risk factors such as the timing of beneficiary retirement and longevity will pose some amount of residual risk that cannot be hedged in the asset portfolio. We use a baseline of 1.5% surplus volatility to represent this irreducible minimum.) Importantly, the immediate shift in plan funding that this transaction delivers can allow a sponsor to significantly reduce risk versus liabilities by shifting to a liability hedging investment program.
Caution: credit rating concerns
Raising capital to fund the pension plan via debt issuance should not be considered if the end result would be a downgrade to the firm’s credit rating. Fortunately, under current accounting and ratings practices, the underfunded pension plan is treated as debt already – so the net result of such a financing is to replace one form of debt (pension underfunding) with another (senior unsecured bonds).
Importantly, this equivalence extends only so far. Pension obligations are commonly quoted on one of two metrics: a smaller accrued benefit obligation (ABO) or a larger projected benefit obligation (PBO). The former includes only benefits earned to date, while the latter includes benefits earned but also projected to the date of retirement of the individual employee, and including the expected increase in salary or wages over that time horizon. Under the current pension funding rules, the contribution requirement is based on an ABO-like measure.
A plan sponsor would be able to swap its underfunding – relative to the ABO target – for marketable debt without increasing the net indebtedness of the firm. The same cannot be said of funding the PBO target, because this would exchange a more tenuous obligation (the portion of the PBO liability linked to future salary growth) with a “hard” form of marketable debt that carries a very strict legal standard. We should not make too much of this distinction, however. Many plans have the significant underfunding relative to ABO and would benefit from the contributions to that level. |
The corporate finance benefits of accelerated funding
There are a number of ways in which sponsor firms may benefit from replacing inefficient “debt” in the form of a pension deficit with the tax and accounting advantages of marketable debt:
- Terming-out the burdensome cash flow obligations of the Pension Protection Act funding rules.
- Replacing a higher-cost form of debt with a lower-cost form of debt.
- Reducing the cost of mandated insurance premiums paid to the Pension Benefit Guaranty Corporation.
- Reducing the tax liability of the plan sponsor.
- Increasing the accounting net income of the plan sponsor. Protecting the credit rating of the sponsor.
We will briefly examine each of these benefits in turn, and then provide a specific example of how these benefits would apply in total to the corporate sponsor of a defined benefit pension plan. In this analysis we will use our Plan X with the following characteristics:
Cash flow relief
Since the burden of higher cash contributions has been front and center in discussions of the deleterious impact of low rates, we will start here. Under the rules of the Pension Protection Act (PPA) of 2006, plan sponsors must make steady annual contributions that put them on a path to 100% funding over a seven-year horizon (“deficit amortization”). Importantly, subsequent losses in plan funding create additional deficit amortization requirements, while gains in funding do not reduce required annual contributions until the plan actually reaches the 100% target. While the seven-year horizon may not have seemed overly burdensome at the time of the PPA’s enactment, the massive loss in funded status that has occurred during the financial crisis has changed that view.
Recently, the governing law for pensions, ERISA, was modified to allow pension sponsors some relief with respect to the minimum required contributions. Plans now have the option of using a 25-year smoothed average yield on high-quality corporate bonds, instead of the more current (and much lower) 2-year average. Plans that make use of this option will gain a significant – though temporary – benefit as the calculated level of funding will improve and required contributions will fall. (Importantly, however, this change has no impact on the accounting treatment of plan funding.) This benefit is temporary in nature and we estimate that within four or five years the calculated level-funded status will return to its current level and required contribution will increase.
Even after the legislative change, required contributions over the next several years may be in the hundreds of billions of dollars, and the corporate parents of defined benefit pension plans are rightly concerned over the impact this will have on their operations. Using the simplified plan in our example, under the old rules the sponsor could be required to make contributions of approximately $143 million per year in order to amortize the $1 billion deficit over the seven-year horizon. Fortunately, there is a readily available source of relief: the debt capital markets.
Companies have the option of fully funding their pension plans immediately with the proceeds of the issuance of marketable debt. If the burden of the PPA’s seven-year schedule is too onerous, the ability to swap that obligation with 10-, 20- or 30-year bonds should be an attractive form of cash flow relief. The current level of interest rates – held “artificially” low by the actions of the Federal Reserve – presents an opportunity to fund pension contributions at historically attractive levels. Further, demand from pension and insurance investors for long-term corporate debt makes this a particularly auspicious moment to be issuing.
Cost of capital
If the pension deficit is economically identical to debt on the balance sheet, then it is reasonable to evaluate the costs of the two forms of debt with an eye on seeking the lowest cost of capital. While this comparison will vary from firm to firm, we can make the following observations:
- The “cost” of the underfunded pension obligation is essentially the discount rate applied to the future liabilities: a high-quality corporate bond yield.
- The true cost of the marketable debt alternative is the firm’s cost of borrowing adjusted to reflect the pre-tax nature of interest payments.
- Firms have the option of structuring the financing to emphasize cash flow relief by issuing longer-term debt, or to emphasize near-term savings by issuing very low coupon shorter-term debt.
For example, if the discount rate on the liability and the firm’s long-term market borrowing cost are assumed to be an identical 5%, after accounting for the tax benefit (assuming a 25% effective tax rate), the firm’s effective cost of after-tax financing is only 3.75% – significantly cheaper than the cost of the unfunded pension obligation. If the firm wanted to maximize short-term financing costs it could issue 5-year bonds at 3% (2.25% after tax).
Put slightly differently, the same firm would have to face a borrowing rate of more than 6.6% before the after-tax cost of marketable long-term debt becomes more costly than the burden of the underfunded pension obligation accruing at 5%. The tables below illustrate current market yields across a variety of credit ratings and maturities, before and after adjustment for a 25% effective tax rate.
The higher the quality of the firm, and the higher the effective tax rate paid, the more attractive the cost differential between marketable debt and pension debt. Conversely, a lower-quality (and higher marketable borrowing cost) or a lower tax rate will tend to diminish the benefits.
Reducing insurance costs
Pension sponsors are required by law to pay insurance premiums to the Pension Benefit Guaranty Corporation, and these were increased as a result of the recent legislative change to ERISA. These premiums take two forms: a flat rate assessed on each plan participant and a variable rate premium assessed on the dollar amount of plan underfunding.
To put this in perspective, our Plan X with $5 billion liability and 10,000 participants would pay a flat rate premium of $300,000 per annum today, rising to $490,000 in 2014. If the plan is 80% funded (assets of $4 billion, and therefore underfunding of $1 billion) the variable rate premium would be $9 million today, but would then be limited by the cap to $4 million (given Plan X’s population of 10,000 beneficiaries). Although these numbers are not typically large enough to materially impact the financial health of the plan sponsor, they can and should be factored into the discussion of whether to make accelerated contributions to the plan.
The simplest way to incorporate this cost is to consider it part of the current carrying cost of the pension “debt” – over and above the cost that we derive from the discount rate. To continue with the example, the unfunded portion of the pension liability – the “debt” of our Plan X – is carried at a combined rate of 5.9% today (5% interest cost and 0.9% insurance cost). The additional cost of the variable insurance can be eliminated if the plan is fully funded.
Our simplified approach to Net Pension Expense
The accounting line item NET PERIODIC PENSION COST contains several individual subcomponents. Of these, the largest are usually Interest Expense (a cost to the sponsor) and Expected Return on Assets (income to the sponsor). We have focused on these two items not only because of their size and importance in the calculation, but also because they are the only two subcomponents that relate directly to the discussion of financing a plan and the allocation of plan assets.
For the sake of completeness, the other subcomponents typically contained in the Net Pension Expense calculation are:
- Service Cost
- Amortization of Prior Service Costs
- Amortization of Actuarial Losses
- Early Retirement Benefits
- Settlements/Curtailments
Generally, these items reflect the structure of the plan benefit design and/or past changes in the liability. They are not related to the funded status of the plan or the financing cost of the unfunded liability. Each item in the list above is typically a cost to the plan sponsor, and so their collective impact is to increase the Net Periodic Benefit Cost. |
Reducing the tax liability of the plan sponsorSince the realm of corporate taxation is a forbidding place to non-specialists, we will tread lightly here. Nonetheless, it is broadly true that contributions to qualified pension plans are tax deductible under most circumstances.
For this reason, a plan sponsor that makes accelerated contributions can receive a significant deduction in the year
of the contribution, thereby reducing the firm’s taxable net income and overall tax payment. If we think of corporate cash as fungible, then the reduced tax payment can be thought of as subsidizing the pension contribution.
Following through on our earlier example, assume that the firm pays taxes at a rate of 25%. The contribution of $1 billion can reduce taxable income by an equivalent amount, generating a potential $250 million cash gain. From an accounting standpoint, the retained cash would offset a portion of the debt issued to fund the pension contribution (resulting in a total net balance sheet improvement, as the pension underfunding is reduced by $1 billion but the on-balance net debt is increased by only $750 million).
Increasing the accounting net income of the plan sponsor
The current method of accounting for pensions on the
income statement consolidates a number of metrics in the single Net Pension Expense line item. The two most significant components are the Expected Return on Plan Assets and the Interest Expense on the plan liability, and we will ignore the others for the time being.
Returning once again to the simple example of the plan with
a $5 billion liability and $4 billion in assets, we get the relevant income statement numbers by applying the liability discount rate (5%) and the expected rate of return on plan assets (7.5%). In dollar terms, the numbers work out to $250 million of interest expense and $300 million of expected return on assets for a net pension expense (ignoring the various other elements) of $50 million.
If the sponsor issues $1 billion in debt to fund the plan, the position improves: interest expense remains the same ($250 million) but the expected return on plan assets is now $375 million, resulting in a net position of $125 million.
Of course, the firm has taken on $1 billion in debt to finance the pension contribution, and at a borrowing cost of 5% this will reduce income elsewhere by $50 million (less if one counts the after-tax cost of debt). Nonetheless, the overall income of the firm has improved by at least $25 million.
Conclusion
Low interest rates have put the sponsors of defined benefit pensions in a difficult position with respect to plan funding and contributions. Nonetheless, the current environment does offer at least one prospect for improving the financial condition of the pension – and the firm overall – quickly and decisively. Firms that have the ability to issue debt at today’s attractive rates can substitute this financing for the underfunding in their pension plan – potentially realizing a number of financial benefits along the way.