Take Bold Steps to Fund and Meaningfully Reduce Liabilities:
What CFOs Need to Know

Summary

Despite recent historically strong asset performance, many companies with underfunded pension plans are finding it difficult to earn their way out of pension deficits. One contributing factor is that retirees comprise roughly 50% of total liabilities for the average plan. To fulfill these obligations, a significant amount of benefit payments need to be made each year from plan assets. The impact is a deterioration of funding levels, the severity of which is directly related to the degree of underfunding. Relying on capital markets alone to close these funding deficits is unrealistic. It will take contributions to close this gap and now is the time to fund. Most plan sponsors have until September 2018 to take advantage of the larger deduction offered by 2017 tax rates, which offers meaningful savings and creates shareholder value.

Plan funding is the important first step that should be taken to improve and stabilize funding status in conjunction with an overall de-risking strategy. Underfunded plan sponsors have thus far focused on “pruning” pension risk by settling small benefit retirees. However, as sponsors fund their plans, CFOs should take bold steps to meaningfully shrink the size of their liabilities to improve their financial flexibility. This will allow a greater focus on their company’s core business, position them to better endure the next economic downturn, and enable them to pursue growth initiatives at a time when their competitors may be unable to do so. 

Capital markets alone are unlikely to close funding gaps

Sponsors witnessed a modest improvement in funded status during 2017 from an average of 83.3% to 84.1%.1  One may have expected a larger boost given the average 2017 return of 11.5%. But the impact on funded status was muted because falling rates drove up liabilities, and significant payouts to retirees (as much as 10-15% of plan liabilities) require outsized asset returns or contributions to merely maintain funded status.  

Over the past several decades there has been an uptick in pension plan freezes and closings that accelerated with the financial crisis. By 2015, 39% of plans were frozen and another 24% stopped offering their primary DB plan to new hires.2 This trend has contributed to the maturing of pension plans, with retirees now representing roughly 50% of plan liabilities. Rapidly increasing PBGC premiums represent another drag on plan funding levels.

To illustrate the challenge faced by plan sponsors, we ran 2,000 stochastic simulations to project the funded status over the next four years for an “average” pension plan that is 84% funded at the beginning of the period and makes no contributions during the projection period. As shown in Exhibit 1, in 80% of the scenarios this plan would see a funded status deterioration of more than 4% over the next four years. The median funded status at the end of the period is 76%, while 20% of the time funded status would decline to less than 72%. In fact, even if the plan achieves the average expected return on assets (EROA) of 7.25% in each of the next four years, which is 2.65% higher than this simulation predicts, the overall funded status of the plan would remain virtually unchanged. 

Not surprisingly, as we show in Exhibit 2, if the same plan had a starting funded status of 74%, the median funded status at the end of four years would be 63%, significantly lower than today’s level. Even under the scenario where the plan earns its EROA of 7.25%, funded status would decline to 71%. This is because benefit payments consume an even larger percentage of plan assets versus the 84% funded scenario, thereby requiring the plan to earn higher returns on its assets (even more than the EROA) to close its funding gap. 

Exhibit 1: Funded Status Deterioration for an Average Plan – 84% funded 

Notes:
1. Plan asset allocation assumed to be 40% equities, 40% fixed income and 20% other assets 
2. No contributions were made in this analysis 
3. Analysis based on 2,000 Monte Carlo simulations over a 4-year period. Ortec economic scenario generator used to determine the scenarios.
Source: Prudential calculations. 

Alternate text for graphic: The chart shows how funded status for an average plan that is 84% funded today may drop over the next four years if no contributions are made in that time period.  

Table caption: Funded status outcomes over the next four years for a plan that is 84% funded today and makes no contributions.

Table summary: Shows the funded status outcomes over the next four years for a plan that is 84% funded today and makes no contributions.

Funded status if plan earns 7.25%

Funded status in 80th percentile

Funded status in 50th percentile

Funded status in 20th percentile

December 2017

84%

84%

84%

84%

December 2018

84.20%

83.30%

82.20%

81.30%

December 2019

84.40%

82.40%

80.30%

78.40%

December 2020

84.50%

81.40%

78.00%

75.00%

December 2021

84.50%

80.30%

75.50%

71.40%

Exhibit 2: Funded Status Deterioration for an Average Plan – 74% funded

Notes: 

1. Plan asset allocation assumed to be 40% equities, 40% fixed income and 20% other assets
2. No contributions were made in this analysis
3. Analysis based on 2,000 Monte Carlo simulations over a 4-year period. Ortec economic scenario generator used to determine the scenarios.
Source: Prudential calculations. 

Our analysis above suggests that the average plan sponsor has virtually no chance of earning its way to fully funded status,3 and therefore plan contributions are inevitable. 

Alternate text for graphic: The chart shows how funded status for an average plan that is 74% funded today may drop over the next four years if no contributions are made in that time period. 

Table caption: Funded status outcomes over the next four years for a plan that is 74% funded today and makes no contributions.

Table summary: Shows the funded status outcomes over the next four years for a plan that is 74% funded today and makes no contributions.

Funded Status if Plan Earns 7.25%

Funded status in 80th percentile

Funded status in 50th percentile

Funded status in 20th percentile

December 2017

74%

74%

74%

74%

December 2018

73.40%

72.60%

71.70%

70.90%

December 2019

72.80%

71.00%

69.20%

67.50%

December 2020

71.90%

69.20%

66.30%

63.70%

December 2021

70.80%

67.10%

63.10%

59.40%

When should CFOs contribute? New tax law provides opportunity to fund now

On December 22, 2017, the President officially signed the “Tax Cuts and Jobs Act” into law for tax years beginning 2018. Under the new law, the corporate tax rate was reduced from 35% to 21% for tax years starting after December 31, 2017. Per IRS rules, sponsors with a plan year that ended on December 31, 2017 can make contributions up until September 15, 2018, and take advantage of the 35% tax rate if these contributions are attributed for the 2017 plan year. Funding the plan now also yields additional savings by reducing PBGC variable rate premiums (VRPs) incurred, which have increased three times over the last five years, and now equal 3.8% of the plan’s underfunded balance. In addition, VRPs are scheduled to increase further to 4.2% in 2019. Plan sponsors can create significant shareholder value by accelerating pension contributions to the 2017 plan year, as shown in Exhibit 3. 

Exhibit 3: Net Present Value (NPV) Benefits of Funding Today versus Funding Over Time ($1B Plan, 85% funded today)

Source:  Prudential calculations. For illustration only. In USD millions.

THE FOLLOWING IS OFF-SCREEN:

Fund Over 10 Years

Forgone Earnings on Cash

Contribution Tax Benefit Savings

PBGC Variable Rate Premium Savings

Fully Fund Today

NPV Savings

$145.5 million

$10.5 million

-$21.9 million

-$26.1 million

$108 million

$37.5 million

 

Table caption: Shows the Net Present Value (NPV) impacts of fully funding a defined benefit pension plan today at a 35% tax rate for a $1 billion plan, as opposed to funding it over a 10-year period.

Table summary: Shows the potential $37.5 million savings of fully funding a $1 billion pension plan today vs. funding over time.

Using repatriated cash to fund pensions 

Under the new territorial tax system, companies are deemed to repatriate pre-2018 accumulated deferred earnings that are held in cash or cash equivalents, estimated at $1.2 trillion to $1.4 trillion,4 and pay a low rate of 15.5%. Companies will consider several alternative uses of this cash—for example, capital expenditures, mergers and acquisitions (M&As), paying down debt, or returning capital through share buybacks or dividends. Returns from each of these uses of cash should be analyzed on a risk-adjusted basis. For example, hurdle rates for M&A can be very high, since they reflect the inherent riskiness of those investments. Similarly, share repurchases may be prudent if management believes shares are undervalued; returns from repurchasing shares should exceed the company’s cost of equity, which is the appropriate measure of risk for such an investment. 

A sponsor with a $1 billion plan that is 85% funded could generate a $37.5 million NPV benefit by fully funding its plan today versus funding the plan deficit over a 10-year period. These savings are generated by eliminating variable PBGC premiums and deducting the contribution made today for a 2017 plan and tax year at a 35% tax rate, versus at 21% over 10 years.

According to a survey conducted by Bank of America,5 a majority of companies plan to pay down debt with repatriated earnings. Pension deficits are a form of debt, and reducing them is equivalent to paying down debt. For many investment-grade issuers, paying down pension debt will generate greater NPV savings since it’s volatile and more expensive than traditional debt. 

Lower tax rates may result in reduced issuance of high-quality debt in the future

Lower tax rates, and new tax law changes impacting the deductibility of interest expense, make it less attractive to issue debt.6  High yield companies are more likely to reduce debt issuance in the near term, but over the longer term, investment grade issuers will also adjust their capital structures and reduce reliance on debt. While the reduction in supply of high quality bonds will be gradual and muted relative to our expectation last year when the tax reform proposal was being debated, we nonetheless believe that waiting to acquire corporate fixed income securities could increase the future cost of supporting pension obligations. It may make sense for sponsors that are contemplating a risk transfer transaction, either now or in the future, to acquire fixed income securities today. Sponsors can use these assets to satisfy an insurer’s premium in the future. 

Take bold steps to meaningfully reduce risk

Several prominent sponsors have made significant contributions to their plans over the past year – UPS ($7.3B), Verizon ($4B), and Boeing ($4B), to name a few. We expect many more will do so in the near term to maximize tax deductions while they can. As funded status improves through increased contributions, plan sponsors face an increasingly asymmetric risk and reward profile. Sponsors that retain risk assets receive diminishing economic benefits as excess funds generally cannot be used for other business purposes and are disregarded by rating agencies in their evaluation of leverage, while downside risk grows. Because of this asymmetrical risk, sponsors should consider significant de-risking as their plan nears full funding. CFOs now have a unique opportunity to distinguish themselves from their industry peers by implementing bold risk management strategies while they have the financial incentive to do so, enabling a strong defense that will position them well to prosper even during a downturn. 

We have recently observed a trend where plan sponsors have implemented pension risk transfer solutions to “manage expenses” by pursuing targeted, small benefit retiree buy-outs. These transactions provide economic value because they eliminate significant PBGC premiums, but they do not transfer significant risk.

Many studies,7, 8 show that pension risk weighs on stock prices of pension heavy companies; these companies underperform those that are pension light – with either small or no DB pensions. Based on research by Merton, Jin and Bodie,9  reducing pension risk can positively impact a company’s valuation, by reducing firm beta, and lowering the weighted average cost of capital. 

Exhibit 4: De-risking Pensions Reduces Firm Beta and Cost of Capital 

Financial markets reward organizations that proactively manage risk.10 As we highlight in Exhibit 5, companies that meaningfully reduced pension risk have experienced stock price outperformance relative to the market on the date of the de-risking announcement. 

Alt text for graphic: Firm beta consists of operating beta and pension beta. A pension buy-out reduces the size of a pension plan relative to the firm’s core operations (lowering beta), and the cost of capital becomes more consistent with true underlying operations.

Exhibit 5: Companies that Meaningfully Reduce Risk Exhibit Strong Stock Price Outperformance Relative to the Market 

Positive Correlation between Announcement Day Stock Returns relative to S&P 500, and the Magnitude of Risk Reduced (measured by pension benefit obligation (PBO) reduction as a % of market capitalization)

Company Name De-risking Transaction Announcement Date*  PBO Reduction as a % of Market Cap Stock Returns Relative to S&P 500 Transaction PBO Size ($ billion) PBO to Market Cap pre-transaction Funded Status
General Motors 6/1/2012 75% 1.61% 25.0 315% 90%
J.C. Penney 10/2/2015 58% 5.58% 0.8 172% 104%
Motorola 9/25/2014 26% 2.33% 3.1 47% 83%
WestRock 9/9/2016 22% -1.08% 2.5 51% 106%
Timken 11/19/2015 18% 1.35% 0.5 46% 100%
The Hartford Financial Services Group 6/26/2017 8% 1.08% 1.6 30% 85%
Verizon 10/18/2012 6% 2.61% 7.5 24% 80%
Philips 10/1/2015 6% 0.65% 1.1 139% 85%
PPG Industries 6/28/2016 6% 0.12% 1.6 20% 87%
Kimberly-Clark 2/23/2015 6% 0.06% 2.5 17% 86%
Molson Coors Brewing Company 12/1/2017 5% 1.75% 0.9 35% 96%
International Paper 10/2/2017 5% 0.60% 1.3 59% 75%
CBS Corporation 11/2/2017 4% 1.42% 0.8 21% 70%
NCR 12/17/2014 4% -1.21% 0.2 68% 92%
Bristol-Myers Squibb 10/1/2014 2% 0.75% 1.4 5% 102%
United Technologies 10/6/2016 2% -1.14% 0.8 31% 88%

 

Company Name De-risking Transaction Announcement Date*  PBO Reduction as a % of Market Cap Stock Returns Relative to S&P 500 Transaction PBO Size ($ billion) PBO to Market Cap pre-transaction Funded Status
General Motors 6/1/2012 75% 1.61% 25.0 315% 90%
J.C. Penney 10/2/2015 58% 5.58% 0.8 172% 104%
Motorola 9/25/2014 26% 2.33% 3.1 47% 83%
WestRock 9/9/2016 22% -1.08% 2.5 51% 106%
Timken 11/19/2015 18% 1.35% 0.5 46% 100%
The Hartford Financial Services Group 6/26/2017 8% 1.08% 1.6 30% 85%
Verizon 10/18/2012 6% 2.61% 7.5 24% 80%
Philips 10/1/2015 6% 0.65% 1.1 139% 85%
PPG Industries 6/28/2016 6% 0.12% 1.6 20% 87%
Kimberly-Clark 2/23/2015 6% 0.06% 2.5 17% 86%
Molson Coors Brewing Company 12/1/2017 5% 1.75% 0.9 35% 96%
International Paper 10/2/2017 5% 0.60% 1.3 59% 75%
CBS Corporation 11/2/2017 4% 1.42% 0.8 21% 70%
NCR 12/17/2014 4% -1.21% 0.2 68% 92%
Bristol-Myers Squibb 10/1/2014 2% 0.75% 1.4 5% 102%
United Technologies 10/6/2016 2% -1.14% 0.8 31% 88%
 *When the transaction was announced after stock market close, stock return relative to S&P 500 was evaluated as of the next trading date.
Source: Bloomberg/company press releases
 THE FOLLOWING IS OFF-SCREEN:Table caption: Shows a list of companies who have executed a pension buy-out where many experienced a positive stock price reaction on the announcement date.Table summary: Shows a number of companies that have executed a pension buy-out. The transaction size, announcement dates, pension benefit obligation as a percentage of market cap, funded status and stock returns are included.

*When the transaction was announced after stock market close, stock return relative to S&P 500 was evaluated as of the next trading date. 

Source: Bloomberg/company press releases

The time to act is now 

The current financial market landscape and tax reform offer sponsors a unique opportunity to contribute to their pension plan in the coming months to take advantage of the higher deduction rate.  Along with funding, sponsors should formulate detailed plans to significantly reduce the size of their plans to prepare for a lower-risk future.

The analysis provided 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 communication 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). Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances. Insurance and reinsurance products are issued by either Prudential Retirement Insurance and Annuity Company (PRIAC), Hartford, CT, or The Prudential Insurance Company of America (PICA), Newark, NJ. Both are wholly owned subsidiaries of Prudential Financial, Inc. Each company is solely responsible for its financial condition and contractual obligations.

REFERENCES

  • 1 Milliman 100 Pension Funding Index.

    2 A Continuing Shift in Retirement Offerings in the Fortune 500, Willis Towers Watson, June 2016.

    3 Less than 1% probability for the average plan that is 84% funded today.

    4 “Repatriation Update: Trapped Earnings Surpass $3 Trillion,” Morgan Stanley, April 21, 2017.

    5 “Corporate Tax Reform = Less Debt,” Bank of America Merrill Lynch, November 28, 2016.

    6 Interest deductions are generally limited to 30% of EBITDA for tax years beginning before 1/1/2022, and to 30% of EBIT for subsequent tax years.

    7 Long, C., Bronsnick, E., and Zwiebel, H., Pensions in Practice, How Corporate Pension Plans Impact Stock Prices, Morgan Stanley, October 2010.

    8 Mathur, R., Kaplan, S., and Ramirez, R., Means and Markets Have Aligned, Why You Should Consider De-risking Now, Prudential Financial, 2017

    9 Jin, L., R. Merton, and Z. Bodie. “Do a Firm’s Equity Returns Reflect the Risk of Its Pension Plan?” Journal of Financial Economics 81, No. 1 (July 2006): 1-26.

    10 Positive market reaction is notwithstanding one-time charges and cash contributions required to restore funded status. Companies that currently do not follow mark-to-market accounting may have to recognize a one-time charge to reflect actuarial losses in proportion to pension liabilities that are settled.