Dear Corporate Pension Plan Sponsors,
With the first quarter of 2016 ending, the agenda of corporate treasurers has four items pertaining to the defined-benefit pension plans you sponsor: (1) another decline in funded status, (2) higher PBGC premiums starting to bite, (3) return of debt-funded pension contributions in the market, and (4) capital structure scenario planning, as negative interest rates appeared in more countries around the world during Q1.
1. Funded status declined yet again: should you do anything?
The average S&P 500 company’s pension plan ended Q1 2016 approximately 3 percentage points lower than at year-end.
As a result, corporate treasurers should think about two factors: (a) PBGC premiums, to ensure the plan’s funded status will not trip a trigger to become a variable-rate PBGC premium payer, and (b) a discretionary plan contribution, which may make financial sense. We examine both of these next.
2. PBGC premium increase: what can you do to minimize the cost?
PBGC premiums are effectively a tax on the plan sponsor that does not benefit the plan itself, which is why many companies seek to minimize the cost. What can a treasurer do? This year’s 12% jump in PBGC premiums means that, for most companies, this cost now equals 0.75-1.00% of the pension obligation in present value terms—and higher for companies that face unfunded vested benefits, which adds variable-rate premiums on top of the base cost. In other words, PBGC premiums are starting to bite.
Treasurers that face variable-rate premiums should consider making discretionary plan contributions, which keeps the company’s money in the plan rather than surrendering it to the PBGC.
Companies have two options for reducing fixed-rate premiums: settle the obligation either via (1) a lump sum payment or (2) purchase of an annuity for the participant.
3. Debt-funded discretionary contributions: return of a market trend?
Something interesting happened during the first quarter: a company that has a history of setting trends in the corporate pension arena issued debt to fund a discretionary contribution to its pension plan (as a disclosed use of proceeds in the bond offering documents).
In February, General Motors issued $2 billion of 20- and 30-year maturities to fund a discretionary contribution to its U.S. hourly plan. GM has a history of being the first company to take major pension actions that other companies later also take (e.g., the first major debt-funded pension contribution in 2003, and the first large-case retiree annuitization in 2012).
Debt-funded contributions by large plan sponsors have been few and far between for the past couple of years, but as interest rates have resumed their downward trend it’s likely that other companies will pursue this option as well. For most companies, debt-funded pension contributions generate positive net present value economics—but the math is always company-specific.
4. Negative interest rates: have you done scenario planning for your capital structure?
Imagine would happen to your company’s capital structure if interest rates go negative and your pension deficit balloons. I’m not predicting that this will happen, but I am encouraging corporate treasurers to think about this scenario because the amount of global bonds with negative yields recently topped $7 trillion. Could your company’s capital structure handle a much higher pension liability without investor and rating agency ramifications?
As a reminder, U.S. corporate pension obligations rank “super-senior” within corporate capital structures (i.e., they come first in line, pretty much). When interest rates drop and the pension liability grows, the pension’s implicit claim on corporate assets grows—and if the pension liability grows faster than corporate assets grow, it means fewer corporate assets would be available to the debtholders and stockholders (who rank below the pension). This explains why stock prices and bond spreads of companies with big pension liabilities tend to correct when interest rates drop.
It’s good to ponder the impact on your capital structure—not just on the pension plan itself—of negative interest rate scenarios. That allows you to plan.
Let’s hope you never need that plan!.