Borrowing to Fund Pensions Could Enhance Shareholder Value

A Step Toward a Lower Risk Future

The enduring low interest rate environment offers a unique opportunity for plan sponsors to fund their pension plans. Sponsors of underfunded plans can borrow at attractive rates and contribute the proceeds to their pension plan, thereby reducing—or even eliminating—their pension deficit, while having the potential to create shareholder value.

When borrowing to fund pension plan shortfalls, companies replace a variable and potentially volatile debt obligation—the underfunded pension—with a known, certain amount of debt with a fixed funding cost. Recent rounds of Pension Benefit Guaranty Corporation (PBGC) premium increases highlight another important benefit of funding the plan—the elimination of variable PBGC premiums, which are scheduled to rise to 4.1% of unfunded liability in 2019. The combination of increasing annual PBGC premiums and the low rate environment make borrowing to fund a very attractive potential opportunity for plan sponsors.
 
The borrow-to-fund strategy is beneficial to a wide range of plan sponsors: large or small, with frozen or ongoing plans. Once the pension plan becomes well-funded, the sponsor faces an asymmetric risk-reward tradeoff—greater downside risk, and limited upside potential.1  Complementing plan design and investment strategy enhancements aimed at pension risk reduction, borrowing to fund is an integral tool for plan sponsors to use in the context of an overall risk-reduction strategy.

To illustrate the benefits of this approach, we have analyzed a sample pension plan sponsor’s borrow-to-fund strategy, comparing two scenarios:

 

  1. Pay Over Time: Plan sponsor funds the plan with equal payments over a 10-year period.
  2. Borrowing to Fund: Plan sponsor issues debt today and immediately contributes the proceeds to fund the plan.

 

Our analysis explores key variables affecting the outcomes of this approach and suggests that companies across the ratings spectrum can generate economic benefits from a borrow-to-fund strategy. The net economic benefit can still be significant even if the plan sponsor is not a full taxpayer, or if the costs of borrowing rise.  

Analysis for a Sample Company

Sponsors consider several funding liability and asset measurement frameworks when determining appropriate contributions to their plan. One option is the funding target liability set out in ERISA rules, but this measurement relies on a complex comparison to current and 25-year average rates, and also allows for some smoothing of asset gains and losses. In the current environment, the funding measure of liability would fall short of the basis used by the PBGC to determine variable premiums. Our analysis instead focuses on the more straightforward GAAP accounting basis. Under this basis, full funding is achieved when the fair value of plan assets is equal to or greater than the plan’s projected benefit obligation, with both assets and liabilities calculated based on market conditions as of the measurement date. Another benefit of using the GAAP accounting basis is that it is quite close to the PBGC measure of liability for purposes of variable premium calculation.

To examine the economic implications to plan sponsors, we model the impact on a BBB-rated company sponsoring a $7 billion pension plan that is 85% funded. The plan’s population is assumed to be split evenly among retirees and non-retirees; the average age of plan participants is 65; and plan participants receive an average annual benefit of approximately $8,200.2
 
To simplify the comparison of the borrow-to-fund and pay-over-time scenarios, we assume a low risk investment strategy such that for each scenario the plan’s assets are invested using a liability-driven investment (LDI) strategy with very limited equity allocation. Consequently, we assume the return on plan assets is equal to the liability discount rate, as assets are intended to closely match the liability characteristics. All current market conditions are carried forward through the analysis.

Finally, we assume that the hypothetical plan sponsor’s base case borrow-to-fund scenario is leverage neutral to the pay-over-time scenario. The alternative to a leverage neutral comparison is for the sponsor to retire debt sooner using the tax benefit from the sponsor’s plan contribution. We address potential implications of a leverage reduction scenario in the rating agency section of this paper.

To assess the net economic benefit or cost, we compare the plan sponsor’s projected cash flows under two distinct scenarios:

* Debt issued is 10-year amortizing debt with principal repayments that correspond to the timing of annual plan contributions under the pay-over-time scenario.

 

Exhibit 1 shows that borrowing to fund yields a net present value (NPV) economic benefit of $150 million, compared to the pay-over-time strategy. The economic benefit is driven by (i) avoidance of variable PBGC premiums, (ii) lower after-tax debt service as compared to annual plan contributions, and (iii) acceleration of tax benefits on pension contributions. In our example, value is also created if the plan sponsor issues 10-year bullet debt rather than amortizing debt.

Exhibit 1
(In USD millions)

(click here for larger chart)

1 Year 0 represents the plan funded status deficit, while Year 1 through Year 10 represents the outstanding principal balance of debt issued to fund the plan.

 

An important driver of the economic benefit is the avoidance of annual variable PBGC premiums. Over the last four years, PBGC premium increases have been included in three separate acts passed by Congress. As a result, the variable premium has increased by over 450%; from 0.9% of unfunded liability in 2013, to 4.1%3  in 2019. These increases impose a significant burden on plan sponsors with underfunded pension plans.

Plan sponsors that are currently taking advantage of minimum funding requirements resulting from recent legislation4 could generate a much higher economic benefit by borrowing and accelerating discretionary plan contributions. By availing themselves of funding relief, these sponsors are deferring pension contributions and associated tax deductions, and are paying increasing variable PBGC premiums. Therefore these sponsors could create significant shareholder value by borrowing to fund discretionary contributions to their plans.

 

 
Strategy is Effective for Lower-Rated and Low Marginal Tax-Paying Issuers

We also analyze the viability of the borrow-to-fund strategy based on changes to several key variables, including issuer credit ratings, changes to debt issuance costs, issuance tenors, form of debt issuance (i.e., amortizing versus bullet maturity), and corporate tax rates. In the following charts, our base case scenario is circled.

Exhibit 2 shows that borrowing to fund may be optimal for companies across the ratings spectrum based on current debt market conditions. We further note that sponsors who elect to fund the pension plan over a shorter time horizon still generate a positive economic benefit, albeit at slightly lower levels than the 10-year funding horizon.

Exhibit 2
NPV Economic Benefit and (Cost) of Borrowing to Fund vs. Pay Over Time (USD millions)

Plan sponsors typically generate a significant upfront tax shield by making a cash contribution to the plan today. Therefore, tax rates are an important consideration when engaging in a borrow-to-fund strategy. Exhibit 3 suggests that borrowing to fund continues to generate positive economic benefits even with lower tax rates.

Exhibit 3
(In USD millions)

Strengthening the case for employing a borrow-to-fund strategy today are the increasing calls for tax reform. The potential for tax reform that could eventually result in lower corporate tax rates will reduce the future value of realized tax benefits on pension contributions and PBGC premiums if corporate tax rates are significantly lowered in the future.  



Rating Agencies Should Likely View Borrowing to Fund as Credit-Neutral or Positive

Given that rating agencies view pension deficit as debt-like, replacement of volatile pension debt with a fixed amount of leverage should be viewed, at worst, as credit-neutral.  

Under Moody’s methodologies,5  a gross pension deficit is considered as debt, so a substitution of contractual debt with pension debt would be viewed as a pure debt-for-debt exchange. On the other hand, Standard & Poor’s methodologies adjust debt to include the after-tax pension deficit;6 companies therefore receive upfront credit for future tax savings from pension contributions in their adjusted leverage metrics.

As Exhibit 4 illustrates, companies that issue 10-year amortizing debt under the borrow-to-fund strategy can use net cash savings from tax deductions to reduce other existing corporate debt or borrow less debt upfront, to maintain leverage neutral credit metrics under Standard & Poor’s methodologies. Plan sponsors who use net cash savings to reduce leverage or borrow less upfront can still continue to enjoy an economic benefit from the borrow-to-fund strategy.



Exhibit 4
(In USD millions)

(click here for larger chart)

(1)Year 1 principal repayment assumes the plan sponsor uses its $300M plan contribution tax deduction generated in the base case scenario. Subsequent year repayments have been rebalanced to reflect a lower initial amortizing borrowing balance versus the borrow-to-fund base case.

We believe such a strategy is optimal for most plan sponsors, except in situations where a restrictive leverage covenant in credit facilities could become adversely impacted by the issuance of contractual debt.

While rating agencies view pension debt as comparable to other senior unsecured debt on the balance sheet, recent evidence from corporate bankruptcies and restructurings suggests that pensions fare significantly better than unsecured creditors. Pension promises are “certain” rather than “conditional,” even during times of stress.

 

Funding Transaction Should Occur in Conjunction with a Pension De-risking Strategy

A plan sponsors’ end goal regarding de-risking should affect its funding strategy. We believe a borrow-to-fund strategy is an important first step to consider in the context of an overall de-risking strategy.

General Motors recently issued debt to fund its pension plans, joining a growing list of companies that have pursued a borrow-to-fund strategy that used all, or a portion, of the amount issued to make contributions to their pension plans.

Reduce Leverage / Borrow Less

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Year 9

Year 10

Ending Principal Balance (Reduce Leverage)

 $1,000

$700

$635

$568

$497

$423

$346

$265

$181

$92

0

Interest Payment (1)

0

(46)

(32)

(29)

 (26)

(23)

(19)

(16)

(12)

(8)

(4)

Principal Repayment

0

(300)

(65)

(68)

(71)

(74)

(77)

(81)

(84)

(88)

(92)

Tax Deduction – Plan Contributions

 0

300

0

0

0

0

0

0

0

0

0

Tax Deduction – Interest Payments

 

 14

10

9

8

7

6

5

4

2

1

Net Cash Flows 

 

 $(32)

$(87)

$(88)

$(89)

$(90)

$(91)

$(92)

$(93)

$(94)

$(95)

NPV Cash Flows (Reduce Leverage)

$(659)

                   

NPV Benefit (Reduce Leverage)

$137

                   

 

In USD millions

Notes
(1) Company filings.
(2) Debt issued to fund pension contributions and / or for general corporate purposes.

Conclusion

The confluence of increasing PBGC premiums and the low interest rate environment can provide attractive opportunities for companies to reduce pension risk and costs through a borrow-to-fund strategy. The economic benefits resulting from the borrow-to-fund approach can be substantial, which in turn enhances shareholder value. We believe borrowing by a plan sponsor to fund a pension plan is a key component of plan sponsors’ de-risking alternatives, and should be leveraged within the context of a plan sponsor’s end goal for pension de-risking.

 

 

The analysis provided above is a general communication that should not be construed as tax, legal or investment advice to any individual or entity. Any individual or entity that has questions as to the tax and other legal implications of the matters discussed above based on its particular circumstances should consult with and rely on its own advisors and legal counsel. This document does not constitute an offer or an agreement, or a solicitation of an offer or an agreement, to enter into any transaction (including for the provision of any services).

 

1 For more insight on the asymmetric risk-reward tradeoff, please read the Prudential Retirement® perspective paper titled Is Now the Right Time to De-Risk? 

2 For this plan, the PBGC variable rate premium per participant cap will not be triggered. 

3 Actual variable rate premium may be higher due to inflation. 

4 Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21), the Highway and Transportation Funding Act of 2014 (HATFA), and the Bipartisan Budget Act of 2015 (BBA). 

5 For more insight, please see Moody’s Investor Service Cross-Sector Rating Methodology, Financial Statement Adjustments in the Analysis of Non-Financial Corporations (December 22, 2015). 

6 For more insight, please see Standard & Poor’s Corporate Ratings Criteria, Corporate Methodology: Ratios And Adjustments (November 19, 2013).