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Tipping the Scales: The Asymmetric Risk of Pension Plans

 

Nida Ozair

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Caitlin Cleveland

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The financial relationship between a plan sponsor’s pension plan and its operating company is complicated, prompting our interest into how sell-side equity analysts incorporate this complexity when valuing a company.

After conducting research on the methods that various analysts employ to account for pensions across operating, leverage, and earnings metrics,1 the asymmetric risk of a pension plan is evident:

The cash flow risks of the plan impact the entire company, while potential upside is trapped within the pension plan itself.

The risks were largely highlighted by analysts for plan sponsors that already have a “pension problem” and typically went unnoticed for sponsors with well-funded plans. However, this unpredictability should encourage stakeholders to consider the risks presented to all pension plans, including well-funded and smaller ones, to identify potential problems before they arise.

We first focus on two components most commonly highlighted by analysts: pension expense/income and pension debt.

  • Pension gains remain in the plan, so most analysts exclude pension income from operating metrics, while some completely disregard these earnings when valuing a company.
  • Pension debt, conversely, is generally accepted as a risk to the entire company, with the primary concern being the potential need for future cash flow injections into the plan.

De-risking for the Greater Good: With these two components in mind, it’s clear that analysts’ views on the limited benefits, coupled with the systemic risks of a pension plan, provide strong support for sponsors to de-risk, despite the one-time cost of a settlement accounting charge, which is mostly disregarded by analysts. The modest cost of de-risking becomes immaterial, relative to the long-term benefits shareholders gain.

 

The False Perception Behind the “Benefits” of Pension Income

What Do Analysts Say? Many analysts exclude pension expense/income from operating earnings, which includes removing pension “income” from corporate earnings multiples and metrics. In fact, some analysts take it a step further and exclude pension income completely from bottom line net income and earnings per share (EPS) estimates.

One reason for this exclusion is that, ultimately, plan asset gains are limited to the plan itself: asset gains are trapped in the plan, with the sole purpose to fund pension liabilities. Per Internal Revenue Service (IRS) rules, plan sponsors cannot use gains from plan assets to pay for other operations of the company, providing further support that pension income/gains should not be conflated with earnings performance.

The only case in which the plan sponsor can remove assets from the plan is if it has been fully funded and terminated, in which case any excess funds are subject to extremely unfavorable tax treatment, incurring both excise and federal/state taxes before they can be transferred back to the operating company. High expected returns on plan assets can fall under the guise of a source of earnings that contribute to the overall income of a company, when in reality, as many analysts have also concluded, this number does not provide such benefit and may be excluded to better understand an operating company’s earnings profile.

 

The Burden of Managing Volatile Pension Debt

What Do Analysts Say? Analysts largely agree that unfunded pensions are leverage with a twist—unlike fixed debt, pension debt is volatile. Many analysts include pension debt, calculated as the deficit between pension assets and liabilities at a given time, in leverage ratios. This amount will change year-to-year, making it impossible to predict future pension debt levels.

 

Bar chart comparing annual contributions and funded status levels from 2007 to 2019. The two rarely align, demonstrating that funding status is relatively unaffected by contributions.

Since 2007, plan sponsors have disbursed almost $600 billion in contributions resulting in minimal impact to funded status

This bar chart compares annual contributions and funded status levels from 2007 through 2019 and is from the Milliman 2020 Corporate Pension Funding Study. Funded status is more than annual contributions in 2007, 2008, 2015, and 2019, when it was at 88%. Funded status is less than contributions in 2009 thru 2012 and 2016 through 2018. In 2013, funded status starts below annual contributions, goes above annual contributions in the middle of the year, and comes back down toward the end of the year, becoming slightly less than annual contributions. In 2014, funded status starts slightly above annual contributions, then moves slightly below for the remainder of that year.

Source: Milliman 2020 Corporate Pension Funding Study

 

The unpredictability of pension deficit fluctuations explains why our findings also show that many analysts view the borrow-to-fund strategy as a favorable way to mitigate the risk of ballooning pension debt; the substitution of volatile pension debt for fixed debt is more predictable and far easier to manage if the proceeds are invested in a low-risk asset strategy.

Ultimately, corporate cash flows are used to fund shortfalls in the plan when funded status declines. Projected contributions are deducted from corporate cash flows by analysts, reducing financial flexibility for the operating company. Unlike peers without a pension plan, plan sponsors often must sacrifice growth initiatives or shareholder distributions in order to make required contributions.

In addition to pension deficits, stakeholders should understand the gross pension liability (particularly in relation to the company’s market capitalization) and asset allocation to provide further insight into the potential volatility associated with the plan. However, our research shows that many analysts overlook the size of the liability and the asset strategy of the pension fund, which are both critical components to understanding the true upper bound of ballooning pension debt.

 

Don’t Let the Optics of De-risking Hinder Prudent Risk Management Efforts

Analysts recognize the limited benefits resulting from pension income, while also factoring in the risky components of volatile pension debt that affect the entire company.

If this asymmetric risk of retaining a pension plan is evident, why do plan sponsors hesitate to shed pension risk or transfer it to an insurer via a buy-in or buy-out?

One common answer is an accounting technicality: settlement accounting associated with buy-out transactions. The immediate recognition of a settlement accounting charge and the premium paid to an insurer deters some plan sponsors from undertaking de-risking activities. However, our research shows that, increasingly, more analysts appreciate the benefits of pension buy-outs and often exclude the one-time settlement accounting charge from the earnings of the company in the period incurred.

 

Steps to De-risk Continue to Benefit Pensioners and Shareholders

Ultimately, plan sponsors are not economically rewarded for retaining a pension plan. The benefits of favorable plan asset performance are limited to the plan alone. Despite the inclusion of “pension income” on income statements, plan assets do not generate profit for the operating company; rather, any gains of the plan are strictly required to be used to fund pension liabilities.

Conversely, the downside impact of a drop in funded status impacts both the plan and the operating company. The need for corporate cash flows to be redirected to the plan, as opposed to growth initiatives relating to the primary operations of the business or shareholder buybacks, pose an ongoing challenge. The costs associated with managing volatile pension debt are exponentially worse during difficult economic times, similar to what we experienced in the first half of 2020.

This asymmetric risk continues to provide strong motivation for plan sponsors to take bold steps to de-risk their plans. De-risking has many benefits and is a cost-effective strategy to mitigate risk, while also providing security for pensioners and long-term benefits for shareholders.

 

Footnote

1Prudential Pension Analyst Study includes coverage by JPMorgan, Bank of America, Citi, Deutsche Bank, and Credit Suisse of 30 plan sponsors from multiple industries with varying funded status, liability size, and deficit levels.

 

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