The Increasing Cost of Hope

"Hope springs eternal" is a familiar saying, and the sentiment is no stranger to the world of corporate pensions. The fortified interests which inspire hope and maintain the status quo are quite prevalent in the pension world. Unfortunately, for many plan sponsors, simply maintaining the status quo could result in an expensive discontinued operation on the balance sheet well into the future.

High Hopes Yield Lost Opportunity

We believe that connecting the dots related to changing external factors will lead CFOs and decision makers to different ways of thinking. Those dots are not being connected today because those who advise on pensions are not positioned to weave the complete story together. Today, many effectively preach hope as a strategy. Of course, it is not phrased that way and hope is not a strategy. Current strategies are however, fraught with risk and increasing expenses and opportunity costs such that the strategy of hope now has a significantly increased cost.

The elements of the story that need to be woven together, or the individual “dots,” are not foreign to CFOs. Each, in turn, is told individually in different conference rooms by different groups of Investment Bankers, Actuarial Advisors, Asset Managers and Insurance Companies. They include:

  • Continued low interest rates
  • Proposed corporate tax rate changes
  • Potential changes in the optimal capital structure for corporations
  • Rising PBGC premiums
  • The need to close funded status gaps
  • Future increase in cost of lump sums  
  • Increasing amounts of benefit payments for retirees
  • Continued funded status volatility

We believe when finance professionals and Boards, people who are responsible for safeguarding the balance sheet, see the complete picture they will chart a different course; one that can reduce both cost and risk.


Capital Markets Alone Are Not Likely To Close Funding Gaps


Plan sponsors could consider funding pension plans now and purchase either long-duration fixed income, utilizing increased liability-driven investment (LDI) strategies, or eliminate their discontinued operations, either partially or entirely through a combination of lump sum programs and buy-outs.

The reasons why this is perhaps a better and sound financial strategy are plentiful. It starts with how difficult and improbable it is for a plan sponsor to earn its way out of funded status deficits. As shown in Figure 1, for a plan that is 80% funded today with a 60/40 equity/fixed income allocation, there is only a 15% probability of achieving full funding in five years!

Figure 1: Funded Status in 5 years for a plan that is 80% funded today

This image shows there is only a 15% chance of reaching fully funded in five years for an 80% funded plan that makes no contributions and waits for capital markets to close its funding gap.

Notes:
1. Plan asset allocation assumed to be 60% equities and 40% fixed income
2. No contributions were made in this analysis
3. Population of 50% M and 50% F, average age of 70.
4. Analysis based on 1,000 Monte Carlo simulations over a 5-year period. Barrie and Hibbert economic scenario generator used to determine the scenarios.
Source: Prudential calculations.

Table Summary: Beginning at 80% funded, a plan that is 80% funded is not likely to close its funding gap by waiting for capital markets alone

Table caption: The probability of an 80% funded plan reaching a certain funded status in five years

Funded Status

Probability of reaching funded status in five years

85%

51% probability of reaching 85% funded

90%

34% probability of reaching 90% funded

95%

23% probability of reaching 95% funded

100%

15% probability of reaching 100% funded

Once you conclude there is a remote possibility that sponsors can earn their way to fully funded status, then two points become obvious. First, sponsors will need to make pension contributions to the plan over time and second, with the availability of a borrow-to-fund strategy the ongoing cost of PBGC premiums will be an inefficient and unnecessary burden. A third point, then logically follows; it makes sense to fund now.

Today’s low borrowing rates together with the current value of tax deductions make borrowing to fund an appealing option for many plan sponsors. For many, if not most, borrowing to fund and eliminating the PBGC premiums in concert with the current tax deductions produces a highly positive net present value. In “Borrowing to Fund Pensions Could Enhance Shareholder Value,” we demonstrate that borrowing to fund at today’s high corporate tax rates, and eliminating the PBGC premiums, is a positive net present value transaction. More and more corporate sponsors are taking advantage of this strategy, as shown in Figure 2. With the possibility of lower tax rates on the horizon, contributions to the plan now, which take advantage of today’s rates, provide an additional positive expected net present value rather than the lower deductions that would accompany the current path of contributions over time.

Figure 2: Borrow to Fund Continues to be Viable

Company Issue Date Amount Issued Related Plan Contribution
International Paper 8/9/2017 $1,000 $1,250
Valvoline Inc. 8/8/2017 $400 $395
The Kroger Co. 7/24/2017 $1,500 $1,000
E. I. du Pont de Nemours and Company 5/1/2017 $2,000 $2,000
Verizon Communications 3/16/2017 $6,500 $3,400
Delta Air Lines 3/14/2017 $2,000 $2,000
FedEx Corp. 1/6/2017 $1,200 $1,000
Northrop Grumman Corp. 12/1/2016 $750 $20
CSX Corp. 10/18/2016 $2,200 $220
Altria Group, Inc. 9/16/2016 $2,000 $500
Cox Communications, Inc. 9/13/2016 $1,000 $1,000(1)
Premier Health Partners 8/31/2016 $300 $217(2)
International Paper 8/11/2016 $2,300 $500
General Motors Company 2/23/2016 $2,000 $2,000
Company Issue Date Amount Issued Related Plan Contribution
International Paper 8/9/2017 $1,000 $1,250
Valvoline Inc. 8/8/2017 $400 $395
The Kroger Co. 7/24/2017 $1,500 $1,000
E. I. du Pont de Nemours and Company 5/1/2017 $2,000 $2,000
Verizon Communications 3/16/2017 $6,500 $3,400
Delta Air Lines 3/14/2017 $2,000 $2,000
FedEx Corp. 1/6/2017 $1,200 $1,000
Northrop Grumman Corp. 12/1/2016 $750 $20
CSX Corp. 10/18/2016 $2,200 $220
Altria Group, Inc. 9/16/2016 $2,000 $500
Cox Communications, Inc. 9/13/2016 $1,000 $1,000(1)
Premier Health Partners 8/31/2016 $300 $217(2)
International Paper 8/11/2016 $2,300 $500
General Motors Company 2/23/2016 $2,000 $2,000

In USD millions; Debt issuance detail and related plan contribution information from company SEC filings, plan DOL 5500 filings, company press releases, Bloomberg, and Prudential estimates.
1 Intended use of proceeds from Fitch and Moody's reports dated 9/8/16. Related plan contribution from the Cox Enterprises, Inc. Pension Plan 2015 DOL Form 5500 filing dated 10/16/16.
2 Intended use of proceeds from Fitch report dated 8/10/16. Related plan contribution from the Premier Health Partners Employee Retirement Plan 2015 DOL Form 5500 filing dated 10/11/16.

De-risk Ahead of Potential Corporate Tax Changes

Lower corporate tax rates could impact the optimal capital structures for U.S. corporations. Under the proposals from the Trump administration, the new corporate tax is likely to be reduced to 20%1 from the current 35%. If the corporate tax rate is lowered, and interest deductions are reduced, companies may look to de-lever their balance sheets. Several Investment Banks have commented on the likelihood of firms adjusting to a lower, more optimal debt-to-equity ratio. It’s possible new corporate debt issuance may decline, which could also happen if companies repatriate overseas earnings to fund domestic operating needs.
 
There will, however, continue to be high demand for high-quality fixed income securities. Pension plans with increasing proportions of their liabilities in pay-out mode, as well as insurance companies assuming those obligations through risk transfers have a voracious appetite for corporate debt obligations. As noted in  “Accelerate Pension Funding and De-risking Ahead of Tax Reform: A Less Taxing Exercise,” these factors may lead to a supply and demand imbalance and affect the “technicals” in the corporate bond market. It’s possible that waiting to acquire corporate fixed income securities could increase the future cost of supporting pension obligations. We believe that borrowing to fund makes sense on its own merits. Borrowing to fund and using the proceeds to acquire the appropriate duration fixed income assets in advance of the proposed changes to tax policy would be “connecting the dots.”

A pension buy-out or other risk transfer transaction with an insurer could also be more beneficial today than in a post-tax reform world. Sponsors that have delayed asset portfolio repositioning may find it more difficult to find the “right” bonds for its asset portfolio due to increased market competition for the same securities. It may make sense to acquire those bonds today, regardless of whether a sponsor plans an immediate group annuity purchase.  Sponsors can use assets-in-kind that are already part of their corporate bond portfolio to satisfy an insurer’s premium in the future.

Conclusion

Relying on hope and waiting to see if interest rates are going to rise has been an appealing “strategy” for plan sponsors who are not fully hedged today, and who may benefit from an interest rate increase. It is understandable that CFOs have not wanted to be second guessed for locking in the economics of a “hedge” when rates are low. However, CFOs and decision makers who see the entire picture, and connect the dots will likely chart a different course – to both reduce costs and manage risk. Hope, now, is likely to be a far more expensive proposition.