It is not quite a “perfect storm,” the simultaneous drop in equity markets and decrease in interest rates that torpedoed the funding levels of
corporate defined benefit (DB) plans in 2000–2002 and 2007–2008. But to many plan sponsors, it sure feels like one.
Consider that despite the rally in equities, declining bond yields (and thus liability discount rates) have kept funding ratios low. The return
potential on stocks and bonds may seem unattractive. Plan demographics limit inflows of fresh injections of cash and shorten investment horizons. And,
if that is not enough, another gust is coming: Next year, and again in 2016, the premiums charged by the Pension Benefit Guaranty Corporation (PBGC) on
unfunded liabilities are set to jump.
Given these conditions, we believe plan sponsors should evaluate whether the time is ripe to reduce or eliminate a funding deficit by issuing debt to
boost funding levels and invest in strategies that may help reduce surplus volatility. With some advanced techniques, plans also may be able to
mitigate their concerns about rising rates.
Of course, many plans have already been considering de-risking through immunization or “annuity buyouts” – risk transfers of part or all of a liability
to an insurance company. In the near term, we believe that immunization through bond purchases will be significantly less expensive and therefore the
more common path for sponsors that choose to fully fund their plans.
Interesting math of the PBGC variable-rate premium
The hike in PBGC premiums is quite interesting from a corporate finance perspective. In 2015, variable-rate premiums will be assessed on the
underfunded portion of the liability at a rate of $24 per $1,000 of underfunding (increasing to at least $29 in 2016). Over the long run, a pension
liability should grow at an annual rate that is more or less in line with its discount rate, which is derived from high quality corporate bonds (rated
A to AAA under the rules of the Pension Protection Act (PPA) of 2006). Underfunding a plan is therefore economically similar to borrowing at the
average PPA discount rate of the plan.
By 2016, the PBGC variable-rate premium effectively raises the cost of carrying underfunded balances to 290 basis points (bps) above the plan’s PPA
discount rate. As can be seen in Figure 2, for a 10-year maturity this would imply a financing cost of 6.78% using today’s PPA segment rates as a
proxy. Given current corporate spread levels, it is difficult to find any investment-grade-rated firms that would have to pay similar rates on newly
issued debt. In fact, more than 99% of the constituent firms in the Barclays Investment Grade Index have a lower yield on their debt of any maturity.
(For the Barclays Investment Grade Index, only 10 bonds out of 5,212 had a yield greater than 6.78% as of 28 November 2014.)
In addition, it should be noted that the yield curve continues to be steep and pension liabilities typically have cash flows extending decades into the
future. Therefore, the average liability yield is heavily driven by the long end of that steep curve. In contrast, most corporations could borrow at
five- or 10-year maturities, providing an attractive yield advantage (funds could be borrowed at five- or 10-year rates, beneath the rate at which
liabilities are growing). Therefore, it appears that issuing debt to finance the deficit and investing proceeds into a liability-matching asset
(immunizing the liability) could make sense1.
To be sure, PBGC variable-rate premiums will be capped at $500 per participant (including terminated vested and retired participants) in 2016. Thus,
depending on plan circumstances the variable-rate premiums may apply only to part of the unfunded liability. As a hypothetical example, if a plan has a
liability of $750 million and 10,000 participants, the PBGC variable-rate premium would be limited to $5 million (10,000 x $500). This would correspond
to a $172 million – or 23% – pension deficit (2.90% x $172 million = $5 million). In other words, if the plan in our example were more than 77% funded,
the entire underfunding would be assessed the 290-bp premium (and if the plan were less than 77% funded, the premium would be assessed only on the
first 23% of underfunding). Plans with lower per-participant balances would be worse off in this respect, in that the cap would not apply unless
greater levels of underfunding existed. (Generally speaking, frozen plans with long-tenured employees will have the highest per-participant balances.)
Fully funding a plan with borrowed funds may provide shelter from the coming PBGC rate hikes. However, that protection may prove temporary unless it is
done in conjunction with significant risk reduction. In other words, plan sponsors should take advantage of an inflow of fresh money into the plan to
improve the match between assets and liabilities and reduce overall plan risk.
Many investors consider current yields on fixed income securities unattractive and may be tempted to wait for fairer weather and higher yields to
deploy a de-risking strategy. However, several arguments support more-immediate de-risking for plans to achieve full funding through borrowing,
- There would be lesser need for excess returns if the plan were fully funded. Excess funding cannot easily be used for other purposes by a sponsor;
therefore, the allocation of return-seeking assets should be reduced as the plan achieves full funding.
- A steep yield curve means that sponsors hiding in shorter-duration instruments in anticipation of higher interest rates would incur a significant
carry disadvantage relative to their liabilities. (For example, holding cash instead of 10-year bonds would translate into an annual yield shortfall of
250 bps – coincidentally, a cost similar to the PBGC variable rate premium!)
- Corporate spreads at the long end of the curve continue to be wider than pre-crisis historical averages, suggesting that the long credit market is
not necessarily overstretched. Hence, considering long duration corporate credit, potentially with an added interest rate hedge, could be a fair
- Lastly, fixed income investments within the pension trust would be tax exempt, whereas bonds issued to finance voluntary contributions would be tax
deductible. This differential would also enhance the economic value of the pension plan and accrue benefits to the financial statements on an after-tax
In summary, the overall strategy to consider is the following:
- Issue bonds to finance the pension deficit. Interest expense is tax deductible.
- Make a voluntary contribution to the plan to cover part or all of the underfunding. Part or all of the contribution will also provide tax
- If you believe that interest rates will rise in the short run, consider investing proceeds of the debt issuance in long-dated credit bonds while
hedging their interest rate risk exposure (for now) using swaps or futures. (Bear in mind that hedging the rate exposure on the asset side is a
speculative move as rates could stay low for a longer time than anticipated or even fall further.)
- If you want to try something even more advanced, consider selling payer swaptions on top of the swaps or futures used to shorten duration. This way
you could collect income until rates rise and more or less automate your transition back into pure long credit bond exposure as rates rise.
Given the confluence of factors described in this note, we expect many plans to consider funding through voluntary contributions. We believe it is
important to consider appropriate investment strategies now, before any decisions on funding are made, to be able to execute effectively. While
significant uncertainty remains for plan sponsors in the current environment, a well-thought-out investment strategy tailored for both the pension plan
and its sponsor can significantly increase the likelihood of weathering the storm.
1 Note that de-risking the plan arguably delevers the balance sheet. The corporation could use that flexibility to relever toward the initial level
by effectively “buying equity” outside the plan. By focusing on buying back the firm’s own equity, the corporation may enhance shareholders’ value.