Years of historically low rates have taken their toll on corporate pension plans, but low rates also offer a solution to the pension dilemma that will only become more attractive over the next few years.
“As rates drop, pension liabilities go up. So the gap between pension assets and liabilities tends to widen,” said Ajay Khorana, global head of Citibank’s financial strategy and solutions group, adding that the bank has engaged in numerous discussions about the issue with corporate clients. “Underfunded pension plans can end up being a drag on companies’ valuations.”
Low rates depress the earnings of pension fund assets, creating or worsening gaps in terms of what they owe in workers benefits. Several major corporates including International Paper, Motorola and most recently General Motors have issued debt at historically low rates to plug those gaps, but the strategy would likely also benefit companies that are not behemoths and may have lower credit ratings, whether their plans are frozen or ongoing.
The main benefit, arguably, is that companies are replacing a variable and potentially volatile debt obligation—the underfunded pension—with a known, certain amount of debt that has a fixed funding cost. Sweetening the pot is that the premium companies must pay on the underfunded portions of their pensions to the Pension Benefit Guaranty Corp. (PBGC) is gradually rising through 2019 to 4.1%, from .9% in 2013.
“So effectively a company may pay for the unfunded portion of plan at a higher rate than if it were to borrow and reduce the pension deficit,” said Scott Kaplan, head of Prudential Retirement’s pension risk transfer team. “Our view is that this is absolutely something that is important and probably should be considered by most plan sponsors, if it hasn’t been already.”
In addition, the contribution from the borrowing that companies make to the pension plan is tax deductible, as is the interest on the issued debt.
“So when you look at this through the lens of the treasurer and the net present value of the moving parts, even with companies in different tax rate positions there’s a tremendous advantage to this strategy,” Mr. Kaplan said.
In an analysis done earlier this year, Prudential found that companies across the ratings spectrum would benefit from the move. And while companies accrued economic benefits by using debt across the maturity spectrum, longer-term debt in the range of 10 years was more effective, especially debt with bullet maturities. In fact, given the rating agencies view pension deficits as debt-like, Mr. Kaplan noted, they should see replacing volatile pension debt with a fixed amount of leverage as credit neutral and perhaps even positive.
The downsides are few, Mr. Kaplan said, although treasurers must be mindful of existing covenants that limit the company’s leverage. If the company hasn’t treated the pension deficit as debt from an accounting perspective, replacing it with actual debt could breach those covenants.
Once the debt is used to plug the pension plan gap, the funding is no longer coming from the pension plan itself, and it is immunized against future changes in rates and the need to pay back the debt becomes a corporate obligation. Treasurers typically have a schedule for which they normally fund the pension plan, and they would set that money aside to ultimately retire the debt.