The 5 Myths: Myth No. 5, The Impact on Shareholder Value
The 5 Myths Holding Back Plan Sponsors
Myth FiveRisk Transfer and Shareholder Value
Prudential believes that the cost of reducing DB risk should be evaluated against the potential benefit to shareholders.
- Myth Reducing DB risk reduces shareholder value.
- Fact Reducing DB risk can increase shareholder value.
There are two major things to consider during this evaluation:
Reducing DB risk typically narrows the projected range of required plan contributions in the future.
In particular, DB risk reduction reduces the likelihood of very high levels of plan contributions caused by factors such as poor equity market returns, persistently low interest rates and longer life spans. As a result, DB risk reduction can raise the lower end of the valuation range of a firm, assuming a valuation is derived by discounting the projected future cash flows of the company.
DB risk reduction measures can positively impact a company’s valuation by lowering its weighted average cost of capital (WACC).
This is because a firm’s stock beta typically reflects the riskiness of the company, including its DB plan. All else being equal, a company with a higher stock price beta will have a higher WACC. Jin, Merton, and Bodie (2006) were the first to empirically demonstrate the relationship between the riskiness of a company’s DB plan and its equity risk.1 The riskiness of a DB plan is based on how the plan’s assets are invested and the composition of the plan’s liabilities.
This empirical finding makes intuitive sense, because a pension deficit is a form of leverage, and the more highly levered a company is via traditional forms such as corporate debt, the higher its stock beta.
Morgan Stanley recently analyzed the relationship between the DB plans of the companies in the S&P 500 and these firms’ equity betas and WACC.
Among the findings:
The magnitude of a company’s pension obligations impacts equity beta. Stock prices of “pension- heavy” companies—those with pension liabilities in excess of 25 percent of market capitalization— tend to be more correlated with the equity markets, and hence have higher equity betas.2 A “pension- heavy” company that permanently settles even a portion of its DB obligations may be able to lower its stock beta.
DB plans add about 73 basis points to the WACC of the S&P 500, for the median company.
Pension deficit is riskier than traditional corporate debt because of its volatility and the unpredictable contributions required to service the deficit.
Risk Reduction Impact Scenario
The impact of pension risk reduction on the potential valuation of the DB plan sponsor introduced earlier in this paper is presented in Exhibit 5.
Exhibit 5:Company Valuation Ranges Based on Discounted Cash Flow
|Current Strategy||Buy-in (assuming no changes in equity beta)||Buy-in (assuming equity beta decreases)|
|Highest value: $62.53 and Lowest value: $54.22||Highest value: $62.43 and Lowest value: $57.85||Highest value: $72.11 and Lowest value: $67.53|
- 65% equities
- 30% fixed income (Barclays Aggregate Index)
- 80% funded status
Buy-in, No Equity Beta Change:
- Equity beta: 1.35
- WACC: 10.7%
Buy-in, Equity Beta Decrease:
- Equity beta: 1.16
- WACC: 9.7%
Firm valuation based on discounted cash flows related to the company’s business operations and the DB plan. Forecasted operating cash flows do not change with the execution of the buy-in. Source: Prudential analysis.
This presents the impact of de-risking on the company’s stock price valuation from two perspectives.
No impact of the buy-in on the company’s equity beta.
The buy-in reduces the upper end of the company’s valuation range by only 10 cents per share, but increases the lower end of the company’s valuation by approximately $3.63 per share. This reflects the fact that the buy-in significantly lowers the upper end of the projected range of plan contributions over 10 years, though with a modest increase in the lower end of the projected range of contributions.
Reduction in equity beta.
The buy-in is estimated to reduce the company’s equity beta from 1.35 to 1.16. The reduction in equity beta is driven by the decreased riskiness of the company’s DB plan as a result of the buy-in execution; this transaction lowers the beta of the plan’s assets from 0.70 to 0.37 by replacing a significant portion of the plan’s equities with the buy-in contract, whose value has a lower expected volatility than that of equities. The lower equity beta reduces the company’s WACC from 10.7 percent to 9.7 percent, a reduction of approximately 100 basis points. As shown in Exhibit 5, if the execution of the buy-in results in a lower equity beta, the buy-in dramatically improves the company’s valuation range compared to the option of maintaining the DB plan’s current investment strategy.