THE BOTTOM LINE CORPORATE PENSIONS: A Look Beyond the Funded Status of Corporate Pensions EXECUTIVE SUMMARY. Dan Kutliroff Head of Solutions Strategy

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1 CORPORATE PENSIONS: THE BOTTOM LINE A Look Beyond the Funded Status of Corporate Pensions EXECUTIVE SUMMARY The damage done to corporate pension plans sits high on the list of many lasting impacts of the 2008 financial crisis. Most corporate pensions were funded at over 100% in 2007 but have yet to recover to these levels despite stock markets reaching historic highs. This is because interest rates have caused pension plans to remain significantly under-funded and have brought about other financial implications. Dan Kutliroff Head of Solutions Strategy Brad Nelson Associate Strategist Corporations are allocating cash away from their business operations into pension plans, pension expenses are eating up corporate earnings, and debt obligations are higher when they include unfunded pension obligations. In a world with an uncertain regulatory landscape, geopolitical risks, and large pension deficits, we believe it is critical to understand how pensions fit into overall corporate financial strategies. To this end, we conducted an analysis of the 340 companies in the S&P 500 with pension obligations at the end of. The data presentation that follows includes all global pension obligations for funded and unfunded pensions as reported in publicly disclosed SEC filings. This analysis incorporates a corporate finance view, identifies trends over the last several years, draws out notable observations by industry, and endeavors to make bold predictions about the future impact of funded status on pensions. FUNDED LEVELS HOW DID THE SURPLUS DISAPPEAR WITH STRONG MARKET RETURNS? At the end of 2007, the average pension plan was overfunded to the tune of 104% of assets needed to meet obligations, but dropped to 78% at the end of 2008 and has yet to recover. This is in spite of the S&P 500 Index earning 14.5% annually since then. 1

2 EXHIBIT 1: HISTORICAL S&P 500 FUNDED STATUS 104% 78% 80% 83% 78% 76% 87% 81% 81% 80% In fact, the average asset value of the 340 plans we studied increased from $3.4 billion in 2008 to $4.9 billion in (44% growth). However, liabilities also increased at almost the same growth rate. In 2008 average liabilities were $4.3 billion and in liabilities were $6.1 billion (42% growth). The reason for this growth in liabilities is partially due to participant accruals, but the primary cause is the drop in interest rates used to determine pension liabilities from 2008 to from 6.25% to 3.61%. Pension liabilities are determined by discounting expected benefit payments using the interest rate in effect. So as the interest rate drops, the liability climbs. EXHIBIT 2: HISTORICAL S&P 500 ASSETS & LIABILITIES (BILLIONS) Assets Liabilities $7 $6 $5 $ $3 $2 $1 $ THE DIFFERENCE IN PENSION BURDENS AMONGST INDUSTRIES Of the $407 billion in pension deficits, over $150 billion comes from the Industrials sector alone, which represents 38% of the deficit, but only 16% of the companies in the S&P 500. On average this industry has over $11 billion in pension obligations that are funded at only 75%. Perhaps this is because Industrials are older companies with larger legacy union populations that have maintained pensions longer than non-union populations. Also, this industry has struggled with lower margins and cash generation, potentially 2

3 Billions minimizing cash contributions to their pensions over the years. On the other end of the spectrum are companies in the financial industry, which represent 16% of S&P 500 companies, but only 3% of outstanding pension deficits. This is likely because Financials generally have greater and less costly access to capital, which they use to fund pension benefits more liberally than other industries. EXHIBIT 3: OBSERVATIONS BY INDUSTRY Funded % Total Deficit ($B) 100% 95% 90% 85% 80% 75% 80% 94% 84% 84% 83% 82% 82% $152 75% 75% 75% 74% % 65% 60% 55% $13 $31 $27 $26 $44 $28 $28 $29 $ % 0 WHAT OPTIONS DO COMPANIES HAVE TO INCREASE FUNDED RATIOS? Plan sponsors essentially have three ways to make up pension deficits: Wait for higher interest rates. This approach has been tried over several years to no avail. Even though the Federal Reserve Bank began increasing interest rates in 2017, these increases are at the short end of the yield curve, whereas pensions are more impacted by the long end of the yield curve. Given the macro-economic environment, including the level of global interest rates, we don t believe the long end of the curve will rise dramatically any time soon. Earn your way out of it. While we believe there is an opportunity for investment earnings in markets, the expectations of growth are not what they used to be. Our expectation for a 60/40 portfolio of stocks and bonds is only 5.7%, which will not be enough to cover the current pension deficit any time in the near future. Fund it. Companies will to have to allocate cash to help make up this deficit. They can do this by using existing cash on their balance sheets, by allocating operating cash, or issuing debt. In any case, we believe it is necessary to develop a holistic strategy that incorporates both investment and funding and is aligned with corporate finance implications and a view of markets. 3

4 WHERE IS ALL THE CORPORATE CASH GOING? Corporations generate a lot of cash that gets redistributed throughout the economy. Companies can use cash for new plants, innovations, other improvements, to fund acquisitions, or return to investors through dividends or share repurchases. However, a portion of cash is allocated to pension plans to partially cover the aforementioned $407 billion pension deficit. For instance, in, the 340 companies generated an average of just over $3.4 billion in cash from operating activities, up from $3.3 billion in. However, during, they allocated $180 million of cash into their pension plans. That represented 5.3% of cash they generated from operating activities. This is a significant increase from the 4.3% of cash generated that was contributed to the pension plan in, as well as an increase from the relative 4.9% in. EXHIBIT 4: AVG. S&P 500 CONTRIBUTION AS % OF CASH (MILLIONS) Operating Cash Contributions $3, % $3,298 $3,6 4.3% 5.3% $174 $1 $180 It is important to note that while some pension plans are completely frozen, many are still open. For pension plans that are still incurring new accruals in benefits, our data show these companies are making cash contributions to their pensions that are significantly more than the cost of pension accruals. For example, the service cost in the chart below reflects the growth in pension accruals. In each of the last three years, corporations made contributions higher than this service cost, putting an average of 49% more cash into their pension plans than the cost of new pension accruals. EXHIBIT 5: SERVICE COST VS. PENSION CONTRIBUTIONS (MILLIONS) Service Cost Pension Contribution $174 $1 $108 $119 $106 $180 4

5 WHAT DOES THE FUTURE HOLD FOR PENSION CONTRIBUTIONS? A significant concern for plan sponsors is the expectation of future contributions to their pensions. As mentioned earlier, we do not believe interest rate increases or market gains will solve the pension deficit problem in the near future. We expect to see the relative cash contributions to pensions grow in the coming years, primarily due to the following reasons: Funding relief is wearing away. The Pension Protection Act (PPA) was enacted in 2008 and tightened the requirement for funding pension plans. Even though Congress has provided funding relief for plan sponsors, it is set to wear away as we head into 2017, 2018 and later years, which will result in larger required contributions to fund deficits. People are living longer. This means pensions are becoming more costly because rules require plan sponsors to increase liabilities to reflect longer life expectancies. In fact, the IRS is set to implement new mortality tables in 2018 that will result in higher required contributions. Discretionary contributions to minimize penalties. Another implication of the PPA was higher administrative costs for underfunded pensions, including additional PBGC premiums. Organizations have been making contributions above their required amounts to eliminate or minimize these premiums. Anticipating tax reform. While the legislative outlook remains uncertain, tax reform is a high priority item for the Trump administration. Pension contributions are taxdeductible. So to the extent organizations expect tax reform to include lower corporate tax rates, they will get more bang for their buck by making tax-deductible contributions before tax reform is enacted. Low cost of borrowing. With the expectation of rising rates, some organizations are trying to lock in low rates by issuing debt today to fund their pension plan contributions. For example: Delta issued $2 billion in debt of which $1.5 billion was allocated to the pension plan Verizon issued debt to make contributions of $4 billion to their pension plan, of which $3.4 billion was discretionary to minimize PBGC premiums DuPont issued debt to make a $2 billion contribution to their pension plan Cash is not hard to come by for most companies. In fact, of the 340 companies studied, there was a combined $444 billion in free cash flow at the end of, which was more than the collective $407 billion pension deficit. So there is enough cash available to fund pension deficits with cash on hand in the aggregate, but companies obviously see better uses for this capital in their operations. This would seem to indicate that they are counting on market gains and rising rates to solve their pension deficits rather than allocate corporate cash. 5

6 EXHIBIT 6: FREE CASH FLOW VS. PENSION DEFICIT (BILLIONS) $444 $407 Free Cash Flow Pension Deficit WHY PENSION COSTS ARE DROPPING AS A PERCENT OF OPERATING INCOME Cash is one way of viewing the cost of a pension plan, but how much of a company s operating income is taken up by pension expense, as reported under US GAAP, tells a very different story. Over the last three years, operating income has decreased for S&P 500 companies, but the pension expense has decreased by a larger amount. As a result, when we look at the percent of operating income that is being allocated to pension expense, the relative percent is trending down, having dropped from 5.4% in to 4.8% in as shown in the chart below. EXHIBIT 7: PENSION EXPENSE VS. TOTAL OPERATING INCOME (MILLIONS) Expense Operating Income 3,500 3,000 $3,002 $2,892 $2,842 2, % 5.0% 4.8% 2,000 1,500 1, $162 $146 $136 - We believe a brief explanation of the differences between pension cash and expense requirements is worthwhile. Cash contribution requirements are: Governed by the IRS and DOL, and changes require new legislation from Congress Based on smoothing techniques that average interest rates and asset values Mitigated by funding relief that extended the average interest rates over 25 years; however, this benefit is already beginning to wear away Generally equal to the additional cost of accruals plus 7-year amortization of the pension deficit 6

7 Pension Expense determination is: Governed by the Financial Accounting Standards Board (FASB) Based primarily on mark-to-market measurements of interest rates and asset values Consists of two primary elements: 1. The expected annual growth in funded status including new accruals 2. Amortization of accumulated gains/losses resulting from funded status being different than expected With this explanation in hand, it is worth exploring the decreasing trend of pension expense relative to operating income and to understand why we expect this trend to continue. Over the last three-year period, the expected annual growth in the funded status has decreased to the point where it was actually an income-generating item in. This resulted from the trend of corporations freezing or closing their pension plans and slowing additional accruals. Furthermore, while the low interest rates have increased pension liabilities, they also resulted in a lower expected growth in liabilities with lower interest costs. Because of these factors, the expected growth in plan assets has been growing faster than the expected growth in plan liabilities. The second component of pension expense, the amortization of accumulated losses, has been a primary drag on corporate earnings for some time given low levels of funded status. However, that number has been getting smaller as the accumulated losses that are not yet recognized are getting chipped away either through normal amortizations, or the acceleration of settlement payments. Additionally, many organizations took advantage of a recent accounting interpretation that allows them to use the full yield curve to determine expected growth in liabilities, rather than the aggregated approach of using a single effective rate. This resulted in a pension expense reduction that began in for many corporations. For the following reasons, we see this decreasing trend in pension costs continuing. Very few, if any, plans are re-opening, so we expect to see new accruals continue to fall, especially as many older employees retire. As such, we expect to see the growth in liabilities to stay low. With the expectation of higher contributions as alluded to earlier, we expect to see asset growth continue to outpace liability growth, resulting in improvements in the funded status. Finally, the accumulation of losses that are sitting on pension balance sheets is getting smaller through amortizations and/or are accelerated with settlement payments. PENSION SETTLEMENTS ARE TRENDING HIGHER, BUT REMAIN SOMEWHAT LOW Another aspect of pensions that has gotten publicity lately is pension settlements, also referred to as pension risk transfers, which allow for completely removing liabilities from the corporate balance sheet by offering a lump sum payment or by purchasing an annuity for former employees. Many corporations have elected for this option given the cost of maintaining pension liabiities has increased with significant PBGC premium increases in recent years. 7

8 EXHIBIT 8: SETTLEMENTS AS % OF BENEFIT OBLIGATION (MILLIONS) Benefit Obligation Settlements $5, % $6, % $5,935 $6, % 2.6% $158 $98 $105 $ There are some notable observations from the chart above: The trend toward settlements is clearly increasing. The percent of liabilities settled has risen significantly from 2013 to, with the average dollar amounts more than tripling. While the trend is increasing, the absolute percentage of liabilities settled is still low at just 2.6%. There are three likely reasons the total settlement percentage is lower than one might expect: Plan sponsors have been targeting lower-benefit participants for settlements. For example, a retiree might be getting a $50/month pension check, but the plan sponsor is paying the PBGC an annual premium of $69 to maintain that participant on their pension payroll. So plan sponsors are getting a good deal when they focus on these participants. However, while they might be taking out a larger portion of participants, they are not actually off-loading much from a liability perspective. Lump sums over a certain low threshold amount cannot be forced upon a participant. The take-up rate can vary substantially with many participants choosing to keep their money in the plan depending on how the activity is communicated and perceived by plan sponsors. While there have been some notably large employer annuity purchases that have gotten media coverage, purchasing an annuity from an insurance company requires a premium above and beyond the full funding level of the liability. Companies sitting at 80% funded levels have to come up with the 20% deficit AND the premium that the insurer will charge. While the actual settlement percentages have not been that high over the last four years, we do expect to see the trend continue as PBGC premiums continue to rise and funded levels improve, requiring less additional cash to execute annuity purchases. 8

9 PENSION COSTS ARE IMPACTING CERTAIN INDUSTRIES MORE THAN OTHERS EXHIBIT 9: PENSION CONTRIBUTIONS AND EXPENSES ACROSS INDUSTRIES 3 Yr Avg Contribution as % of Cash Generated (as of 12/31/16) 3 Yr Avg Pension Expense as % of Revenue (as of 12/31/16) 14% 12% 10% 8% 6% 4% 2% 0% 12.6% 9.9% 4.8% 5.0% 2.1% 0.4% Financials S&P 500 Industrials We would like to point out a few notable observations for how the cash contributions and expense of pension plans are impacting corporate bottom lines. Industrials have the largest cost impact for their pension plans amongst S&P 500 sectors. The 3-year average of cash contributions relative to operating cash is 9.9% The 3-year average of pension expense relative to operating income is higher at 12.6%. Conversely, Financials pension contributions relative to cash generated averages at 2.1% over the last three years, while pension expense relative to operating income is only 0.4%. When it comes to managing pension risk, corporations generally appreciate the stability of pension costs. For example, the health care industry s pension contributions relative to cash generated has been steady at 5% the last three years, while the pension expense has stayed between 2% 4% of earnings. Finally, with respect to settlements, most industries are about the same with an average of 2.6%. The two industries that stand out are: The Materials sector, which had a settlement rate of over 7% of obligations in. Utilities settlement activities have been at less than 1% over the last three years, which is likely the result of their pension costs being included in their rate-setting and not having the same pension cost structures as other industries. LIABILITY DRIVEN INVESTING AND ALTERNATIVES ARE GAINING POPULARITY Given the trends discussed about how pensions are impacting corporations financially, it is worth exploring what plan sponsors have been doing from an asset allocation perspective to earn their way out of a $407 billion hole. There has been much written about the shift corporate pensions have made into Liability-Driven Investing (LDI): investing in bond structures that behave similarly to the pension liabilities to limit volatility. As the chart below demonstrates, LDI seems to be gaining in popularity as there has been an upward trend over the last ten years into greater allocations to bonds; an increase from 31% in 2007 to % in. 9

10 EXHIBIT 10: S&P 500 AVG. ASSET ALLOCATION Bonds Equities Other 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 9% 12% 14% 13% 14% 14% 15% 15% 16% 20% 60% 51% 51% 51% 46% 46% 46% 42% % 39% 31% 37% 35% 36% 40% 40% 39% 42% 42% % Upon closer inspection, this shift seems to have slowed the last three years, presumably because the funded status of pension funds have dropped from 87% in 2013 to 80% in. This would indicate that even though corporations want to limit volatility, they are still accepting it to earn their way out of their pension deficits. Another interesting observation is the growth in Other assets, which includes alternative asset classes such as hedge funds, private equity, and real estate. The trend to these asset classes has grown steadily over the last ten years, with a particularly notable jump in. This indicates that corporations are looking for other areas to earn returns and are recognizing that in order to climb out of the $407 billion hole, it is necessary to seek investments beyond traditional public equity and bond markets. An item that has always been noteworthy in pension asset management is how much sponsors expect to earn from their portfolios. The chart below tracks how these assumptions have evolved the last ten years. Return assumptions have trended down every year, which is expected with the increase in LDI strategies, as bonds generally earn less than stocks. EXHIBIT 11: EXPECTED LONG TERM RETURN RATE ON PLAN ASSETS 7.8% 7.8% 7.7% 7.6% 7.3% 7.1% 6.9% 6.8% 6.6% 6.4%

11 However, we would also note that bond allocations have stagnated the last three years, while the expected return on assets has continued its decline. This appears to indicate recognition from plan sponsors that they cannot expect to earn the same returns from the markets as they have in years past. This qualifies as further evidence that corporations will be challenged in earning their way out of the $407 billion deficit solely through investment returns. HOW DOES FUNDED STATUS AFFECT ASSET ALLOCATION? When we analyzed asset allocation and funded status for each S&P 500 industry, a few things stood out. The average bond allocation for the S&P 500 is %, and the funded status for these plans is 80%. The following five industries with funded status below 80% all have bond allocations less than %, which means industries that have more ground to make up are willing to accept more risk: Consumer Staples Industrials Materials Telecommunications Energy EXHIBIT 12: ASSET ALLOCATION BY INDUSTRY Bonds Equities Other 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 20% 20% 20% 26% 39% 46% % % 34% 40% 37% 36% 38% S&P 500 Consumer Staples 36% 33% 31% 20% 42% Industrials Materials Telecomm Energy The magnitude of a company s pension obligations to their market cap may also play a role. For example, Industrials pensions are a large portion of the size of their companies. Given they have a 40% allocation to bonds while their funded status is only 75%, it appears they may be less risk-tolerant given the impact pensions could have on their business results. 11

12 EXHIBIT 13: PENSION BENEFIT OBLIGATION AS % OF MARKET CAP 36% 27% 21% 20% 14% 16% 8% 11% 8% 8% 8% As shown in the chart below, there are only two industries that are still expecting to earn over 7% on average from their pension portfolios Telecommunications and Utilities. Both have a high allocation to return-seeking assets at 64% and 63%, respectively compared to the S&P 500 s average of 59%. EXHIBIT 14: EXPECTED RETURN ON ASSET ASSUMPTION BY INDUSTRY 7.3% 7.3% 6.4% 6.4% 6.3% 6.1% 6.6% 6.8% 6.7% 5.5% 5.4% 12

13 SO WHAT DOES ALL THIS MEAN? Setting pension strategy is not a trivial exercise. Great care and prudence should be taken to understand how a pension fits into the overall corporate finance position. This involves more than just the relative size of the pension and requires the following thoughtful analysis: How much cash that the company is generating needs to be allocated to the pension plan? How much earnings are getting taken up by the pension? How much additional debt is the pension causing? How will all these metrics change over the short and long-term? This thoughtful analysis will help develop an overall pension strategy to fill the $400 + billion gap that exists today and will include the following: Incorporate views of interest rates. While there is certainly room for upward movement here, we don t believe rates will rise to the level of solving a pension deficit of this size. Earn your way out of it. Develop a well-diversified portfolio that will allow you to benefit from market opportunities, but recognize that markets alone will likely not get you there. Fund it. Develop a funding strategy based on corporate cash flow needs and set the appropriate levels for pension contributions. If transferring pension risk is appealing, incorporate that as well, but recognize that it will not help to solve the pension deficit, and in cases where annuitizing the plan is considered, it will likely increase the pension deficit due to the premiums that need to be paid to insurance companies. The most important point is to look at all these aspects holistically. Don t consider any one method in a vacuum. They all intertwine and should be considered within the corporate finance context so there are no negative surprises for the Executive Team, the Board of Directors, or Shareholders 13

14 APPENDIX APPENDIX 1: ASSET ALLOCATION BY INDUSTRY Equity Debt Other % 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 14

15 APPENDIX 2: CONTRIBUTIONS AS A % OF OPERATING CASH Utilities Telecomm Materials Information Technology Industrials Health Care Financials Energy Consumer Staples Consumer Discretionary S&P % 5.7% 6.0% 3.3% 2.5% 4.4% 7.9% 7.6% 5.9% 2.4% 2.4% 4.1% 7.4% 4.9% 5.1% 4.9% 2.6% 2.2% 1.6% 8.0% 3.3% 3.2% 4.1% 2.8% 3.6% 6.8% 5.6% 8.3% 5.3% 4.3% 4.9% 9.8% 12.5% APPENDIX 3: PENSION EXPENSE AS A % OF REVENUE Utilities 5.6% 7.4% 7.8% Telecomm -1.7% 6.0% Materials 10.9% 6.9% 6.2% Information Technology 2.0% 2.6% 3.7% Industrials 13.2% 14.0% 10.6% Health Care 2.2% 3.9% 3.9% Financials 0.3% 0.4% 0.4% Consumer Staples 2.4% 3.5% 3.6% Consumer Discretionary 2.4% 2.7% 3.3% S&P % 5.0% 5.3% 26.9%. Note: energy Sector not depicted due to scaling reasons. 15

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