Debunking Myths of Borrowing to Fund Pensions

Perspectives, January 2017

Defined benefit pension plan sponsors continue to struggle with ever-increasing costs of managing underfunded plans.  Despite recent interest rate increases and strong equity markets, the funded status ratio of the Milliman 100 stands at 80.3%, which is below 82.7% observed at year-end 2015. Pension deficits, no matter how small or large, come with significant costs to plan sponsors.  A borrow-to-fund strategy complements plan sponsors’ de-risking strategies by reducing the economic costs of plan underfunding, enhancing security for plan participants and unlocking value for sponsors and their shareholders.

The borrow-to-fund strategy involves issuing debt today to fund up a pension plan.  Our research suggests that such a strategy provides meaningful benefits for companies rated “BB” or better. Many companies have borrowed to fund their pension plans; in fact, there has been increased activity following recent increases in Pension Benefit Guaranty Corporation (PBGC) variable-rate premiums (VRP).

Debt Issued to Fund Plan

(Including PRT Transactions)

CompanyDebt Issuance (1)(2)Related Plan Contribution (1)
AmountDate
FedEx Corp $1,200 1/6/17 TBD (3)
Northrop Grumman Corporation $750 12/1/16 TBD (3)
CSX Corp. $2,200 10/18/16 $220
Altria Group, Inc $2,000 9/16/16 $500
Cox Communications, Inc $1,000 9/13/16 Not Disclosed (4)
Premier Health Partners $300 8/31/16 Not Disclosed(4)
International Paper Company $2,300 8/11/16 $500
General Motors Company $2,000 2/23/16 $2,000
International Paper Company $ 2,000 5/26/15 $750
Kimberly-Clark Corporation $ 500 2/27/15 $410
Northrop Grumman Corporation $ 600 2/6/15 $500
Raytheon Company $ 600 12/2/14 $634(5)
Motorola Solutions, Inc. $1,400 8/19/14 $1,100
Ford Motor Co. $2,000 1/8/13 $1,200
CSX Corp. $300 2/28/12 $275
The Kroger Co. $450 1/19/12 $450
Raytheon Company $1,000 12/6/11 $425
NiSource Finance Corp $ 250 11/23/11 $250

In USD millions>

(1)   Company filings.
(2)   Debt issued to fund pension contributions and / or for general corporate purposes.
(3)   Prospectus indicates debt issuance amount and use of proceeds for plan contributions. Company filing showing pension contribution amount has not yet been released.
(4)   Private company that does not issue public financial statements.  Intended use of proceeds from Fitch rating report dated 8/10/16 and 9/8/16 for Premier Health Partners and Cox Communications, respectively.
(5)   4Q14 includes $34M required pension contributions and $600M discretionary pension contributions.

Nevertheless, there are sponsors who hesitate to employ a borrow-to-fund strategy because the mechanics and implications of the strategy may not be clear.  We address some of these myths and explain why sponsors could consider borrowing to fund their pensions.

Myth 1: “Borrowing to fund adds debt and weakens my balance sheet”

Some plan sponsors believe that using debt to fund their pension plan negatively impacts the financial strength of their companies. This view, however, ignores the fact that pension underfunding is actually considered a debt-like obligation of the company that carries greater risk to financial flexibility in terms of its volatility and cost, the PBGC variable rate premium. Issuing debt to cure plan underfunding simply replaces volatile pension debt—the plan underfunding—with a stable, fixed amount and potentially less expensive debt.  By borrowing to fund, the plan sponsor employs a strategy that lowers financial risks and economic costs.  There is no evidence borrowing to fund is unfavorable to a sponsor’s credit ratings. Credit rating agencies generally view borrowing to fund as credit neutral. It is important to note that pension liabilities are in fact senior to other unsecured debt, and fare better in the event of bankruptcy. Pension promises are “certain” rather than “conditional,” and replacing pension debt by contractual debt, is viewed as a pure debt-for-debt substitution.

Borrowing to fund could adversely affect a sponsor’s financial flexibility if financial covenants in their credit agreements are impacted by substitution of pension debt for contractual debt. While this could deter sponsors from issuing debt to fund their plans, we believe lenders are willing to entertain amending credit agreements to increase headroom under leverage covenants to allow sponsors to replace pension debt with contractual debt.

A notable example is NCR.  Over the past four years, NCR has successfully negotiated amendments to financial covenants in their credit facility with a consortium of banks led by JP Morgan. Its 2012 amendment provided NCR a 1.0x increase to its consolidated leverage ratio covenant for new borrowings that are used to contribute to fund its plan deficit. In 2013 when NCR moved to mark-to-market accounting for its pensions, the covenants were amended to include pension related adjustments in the calculations of leverage and coverage ratio requirements which continued to allow NCR flexibility in the ratio for new debt issued to make plan contributions. 

Myth 2: “Why borrow to fund now while I can take advantage of pension funding relief?”

Some sponsors take advantage of lower required minimum pension contributions afforded under various pension funding relief rules. These funding rules introduced by Congress under MAP-21 and further extended under HAFTA and the BBA  give plan sponsors the option of using a more favorable discount curve to calculate their plan’s funding target. In general, deferring plan contributions into the future reduces, and even eliminates, near-term required sponsor plan contributions. This approach conserves sponsor cash in the near term. However, companies that avail funding relief will maintain a pension deficit for longer and consequently pay significant variable rate premiums for a longer time period until the plan remains in deficit.  Therefore, these sponsors could also create shareholder value by borrowing to fund discretionary contributions to their plans.
 
Additionally, plan contributions, interest expenses and PBGC premiums are tax deductible. With an increased likelihood of lower corporate taxes under the Trump administration, plan sponsors are better off making tax deductible contributions today at higher tax rates than in the future.

Conclusion

Our article invalidated some myths related to a borrow-to-fund strategy which will help DB sponsors consider such an approach in the context of their overall goals to reduce pension risk. Today’s interest rate environment and increasing PBGC premiums provide an attractive opportunity for companies to reduce pension risk and costs through a borrow-to-fund strategy.

For more information please read Borrowing to Fund Pensions Could Enhance Shareholder Value


1  For details please refer to Prudential’s white paper “Borrowing to Fund Pensions Could Enhance Shareholder Value.”

2  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).