Erin Lyons of Citigroup is out with a new report on Corporate Pensions. As part of a discussion on Corporate Pensions, Citi presents the first of a two-part series. The report serves as a primer on pensions and how to think about current trends." Erin addresses the effect of the ongoing low rate environment that has brought corporate pension plans to the forefront. Most corporate pensions are underfunded and when the obligations are considered as debt, leverage increases.
Corporate Pensions and obligations: analysts and investors know that they exist and that they represent a future outlay of cash, but in most cases they are regarded as a footnote to the company’s financial profile. However, with returns running below average for the past few years, these obligations are beginning to garner more attention.
Citi first discusses the trends that have made pensions more relevant, including the rate-driven increase in underfunding. The question if obligations should be treated as debt and used in leverage calculations, as the ratings agencies think about them? Is now the best time for corporates to take advantage of an open bond market and low rates and issue to fund shortfalls? The second section of the piece discusses trends in de-risking, including increased lump sum payments or purchases of annuities from an insurer, and their impact on spreads.
The Corporate Pensions:
Of the roughly 1,500 credits in the IG and HY indices, about 40% have corporate pension plans, and these plans are generally the result of strong unions and a long corporate history of generous benefit programs. According to Bloomberg data gleaned from the companies’ annual filings, pension obligations currently total nearly $2.7 trillion, backed by about $2.1 trillion of assets. The ten largest plans account for about $730 billion of obligations, with General Motors Company (NYSE:GM), International Business Machines Corp. (NYSE:IBM), and Ford Motor Company (NYSE:F) the leading the list in terms of size (Figure 2).
The Impact of Low Rates On Corporate Pensions
Historically pension liabilities have been discounted using the currently prevailing rate, and given the low rate environment, pension obligations have increased significantly. This coupled with lower-than-expected returns on assets have left many credits with much larger deficits than normal (Figure 3 shows rates over the past ten years). The chart on the front page shows how quickly the median obligation has grown over the past few years, while median asset values have not kept pace.
The Employee Retirement Income Security Act (ERISA) sets minimum funding standards for US corporate pensions. This methodology primarily stipulates two things: that companies must fully fund their pension plans within seven years and that the discount rate was determined using either a current-market corporate curve or a 24- month average, which in theory is fine during stable, normal economic cycles.
However, the recent economic period resulted in asset returns that have lagged historical averages, and record low rates, including the discount rate that is used to value liabilities. As a result, funding shortfalls increased and required cash contributions jumped. S&P quantifies the impact of the dropping rates, and notes that in general, for each 100bp drop in discount rates, the liability increases by at least 10%, or by as much as 15% to 20%, largely depending on the demographics
of the pension plan.
Corporate Pensions: In general, for each 100bp drop in discount rates, the liability increases by at least 10%, and by as much as 15-20%.
In an effort to help corporate pension plans, a new discount rate calculation was introduced to stem the impact low rates have had on corporate pension funding. As part of the Transportation Spending Bill (Moving Ahead for Progress in the 21st Century, or MAP-21) signed into law in July 2012, key aspects of the change involve the use of a corridor around the 25-year smoothed corporate rate, calculated by the US Treasury each year. As a result, the rate that corporates are allowed to use to discount their pension obligations increases (estimated to be a 120-160bp benefit in 2012). The smoothed rate results in lower liabilities and often diminished shortfalls, which in turn lowers funding requirements and cash outlays. Moody's estimated that the new discount rate would reduce required contributions by 15-25%, which could result in meaningful near-term cash savings. This benefit is reduced annually and then expires in 2016, with the expectation that rates will have risen and current rates are closer to long-term averages.
Although the rate change allows greater flexibility in “catching up,” the obligations are still on the books. Citi analysts are cautious that as some credits move to de-risk their investment portfolios away from equities and more heavily weighted toward fixed income, the company could in effect “lock in” their underfunding. But with about 40% of portfolios comprised of equity holdings, the companies still have some time before they eventually require cash contributions to reach a funded status.
Corporate Pensions are Underfunded = Debt, But Does it Matter?
With pension obligations growing at such a fast rate, rating agencies have taken an increased interest in these liabilities, and see them as an important factor in assessing credit quality. The treatment tends to be sector driven, and the capital goods and auto industries tend to garner the most attention. S&P considers three primary factors when evaluating the relevance of pension obligations to the issuer’s overall financial risk profile. They include: 1) the nominal dollar amount of defined benefit pension obligations, 2) funding ratios, and 3) relative measures of the funding status to reported total debt. Other considerations include rate and return assumptions, investment allocations, and plan contributions.
When Citi adjusts leverage for underfunded obligations, we see that rather intuitively, leverage really only increases for the largest corporate pensions. If we look at the 20 largest plans, median leverage increases by a full turn of leverage. But when looking at the top 300 plans, median leverage only moves by 0.3x. So by and large, underfunded pension plans do not materially increase leverage, but that it does matter for credits at the margin.