TAKE BOLD STEPS TO FUND AND MEANINGFULLY REDUCE LIABILITIES:

Transcription

1 TAKE BOLD STEPS TO FUND AND MEANINGFULLY REDUCE LIABILITIES: What CFOs Need to Know By Rohit Mathur, Scott Kaplan, CFA and Margaret McDonald, FSA

2 TABLE OF CONTENTS Summary...3 Capital markets alone are unlikely to close funding gaps...4 When should CFOs contribute? New tax law provides opportunity to fund now...6 Take bold steps to meaningfully reduce risk...7

3 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. 3

4 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 10 was muted because falling rates drove up liabilities, Liabilities and significant Assets payouts to Benefit Liabilities Benefits Assets after Funded retirees (as much as 10-15% of plan liabilities) require before outsized asset beforereturns or Payments after benefits status after contributions to merely maintain funded status. 100benefits paid paid 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 defined benefit (DB) plan to new hires. 2 This trend has contributed to the maturing of pension plans, Liabilities Assets Liabilities Assets 100% funded 100% funded with retirees now representing roughly 50% of plan liabilities. Rapidly increasing Pension Benefit Guaranty Corporation (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 Liabilities Assets Benefit Liabilities 10 Assets Funded average pension plan that is 84% funded at the beginning of the period and before before Payments after benefits Benefits after status after makes no contributions during the projection period. As shown in Exhibit 1, in paid benefits 80% of the scenarios this plan would see a funded status deterioration of more paid 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 100 would decline 80 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 Liabilities Assets Liabilities Assets this simulation predicts, the overall funded status of the plan would remain 80% funded 77.8% funded 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. If a plan is 80% funded and 10% of liability is paid in benefit payments, the plan loses more than 2% of funded status per year. This is why it s difficult for a mature plan to earn its way out of a deficit. Our analysis 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. 1 Milliman 100 Pension Funding Index. 2 A Continuing Shift in Retirement Offerings in the Fortune 500, Willis Towers Watson, June Less than 1% probability for the average plan that is 84% funded today. 4

5 Exhibit 1: Funded Status Deterioration for an Average Plan 84% funded Funded status if plan earns 7.25% Funded status in 80th percentile Funded status in 50th percentile YEAR Funded status in 20th percentile % 84% 84% 84.2% 84.4% 84% 84.5% 84.5% 84% if plan earns 7.25% % 83.30% 82.20% 81.30% FUNDED STATUS % 84% 82.40% 83.3% 82.4% 80.30% 81.4% 80.3% 78.40% 80th percentile % 81.40% 78.00% 75.00% % 80.30% 75.50% 71.40% 84% 82.2% 80.3% 78.0% 75.5% 50th percentile 84% 81.3% 78.4% 75.0% 71.4% 20th percentile 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 four-year period. Ortec economic scenario generator used to determine the scenarios. Source: Prudential calculations. Exhibit 2: Funded Status Deterioration for an Average Plan 74% funded Funded Status if Plan Earns 7.25% Funded status in 80th percentile Funded status in 50th percentile YEAR Funded status in 20th percentile % 74% 73.4% 74% 72.8% 71.9% 74% 70.8% 74% if plan earns 7.25% % 72.60% 71.70% 70.90% FUNDED STATUS % 72.80% 72.6% 71.00% 71% 69.2% 69.20% 67.1% 67.50% 80th percentile % 69.20% 66.30% 63.70% % 70.80% 71.7% 67.10% 69.2% 66.3% 63.10% 63.1% 59.40% 50th percentile 74% 70.9% 67.5% 63.7% 59.4% 20th percentile 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 four-year period. Ortec economic scenario generator used to determine the scenarios. Source: Prudential calculations. 5

6 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 in Under the new law, the corporate tax rate was reduced from 35% to 21% for tax years starting after December 31, 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 Plan sponsors can create significant shareholder value by accelerating pension contributions to the 2017 plan year, as shown in Exhibit 3. Using repatriated cash to fund pensions Under the new territorial tax system, companies are deemed to repatriate pre 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&As 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. Exhibit 3: Net Present Value (NPV) Benefits of Funding Today Versus Funding Over Time ($1B Plan, 85% funded today) Fund Over 10 Years $145.5M Fund Over 10 Years Forgone Earnings on Cash $10.5M Forgone Earnings on Cash Contribution Tax Benefit Savings Contribution $(21.9M) Tax Benefit Savings PBGC Variable PBGC VRP Rate Premium Savings Savings $(26.1M) NPV Savings $37.5M Fully Fund Today Fully Fund Today $145.5 million $10.5 million -$21.9 million -$26.1 million $108 million $37.5 $108M million A sponsor with a $1 billion plan that is 85% funded could generate NPV a $37.5 million NPV Savings 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 21% over 10 years. Source: Prudential calculations. For illustration only. In USD millions. 4 Repatriation Update: Trapped Earnings Surpass $3 Trillion, Morgan Stanley, April 21,

7 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 derisking 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. 5 Corporate Tax Reform = Less Debt, Bank of America Merrill Lynch, November 28, Interest deductions are generally limited to 30% of EBITDA for tax years beginning before January 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 Mathur, R., Kaplan, S. and Ramirez, R., Means and Markets Have Aligned, Why You Should Consider De-risking Now, Prudential Financial, June 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):

8 Exhibit 4: De-risking Pensions Reduces Firm Beta and Cost of Capital Firm Beta Pension Beta Operating Beta LOWER BETA Buy-out reduces size of pension plan relative to the firm's core operations LOWER COST OF CAPITAL Becomes more consistent with true underlying operations 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. 10 Positive market reaction is notwithstanding one-time charges and cash contributions required to restore funded status. Companies that currently do not follow markto-market accounting may have to recognize a one-time charge to reflect actuarial losses in proportion to pension liabilities that are settled. 8

9 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 percentage of market capitalization). Company Name COMPANY NAME DE-RISKING De-risking PBO TRANSACTION PBO REDUCTION Transaction ANNOUNCEMENT Reduction AS A % OF Announcement DATE* as a % of MARKET 500 CAP Date* Market Cap Stock Returns Transaction STOCK RETURNS Relative to S&P RELATIVE PBO Size TO S&P 500 TRANSACTION PBO SIZE ($ BILLION) PBO TO MARKET CAP PRE-TRANSACTION General Motors 6/1/ % 1.61% % 90% ($ billion) PBO to Market Cap Funded JCPenney pre-transaction 10/2/2015 Status 58% 5.58% % 104% General Motors 6/1/ % 1.61% % 90% Motorola 9/25/ % 2.33% % 83% J.C. Penney 10/2/ % 5.58% % 104% WestRock Motorola 9/25/2014 9/9/ % 22% 2.33% -1.08% % 83% 51% 106% WestRock 9/9/ % -1.08% % 106% Timken Timken 11/19/ /19/ % 18% 1.35% 1.35% % 46% 100% 100% The The Hartford Financial 6/26/2017 8% 1.08% % 85% 6/26/2017 8% 1.08% % 85% Services Financial Group Services Group Verizon 10/18/2012 6% 2.61% % 80% Verizon 10/18/2012 6% 2.61% % 80% Philips 10/1/ /1/2015 6% 6% 0.65% 0.65% % 85% 139% 85% PPG Industries 6/28/2016 6% 0.12% % 87% PPG Industries 6/28/2016 6% 0.12% % 87% Kimberly-Clark 2/23/2015 6% 0.06% % 86% Kimberly-Clark Molson Coors 12/1/2017 2/23/2015 5% 6% 1.75% 0.06% % 96% 17% 86% Brewing Molson Coors Brewing Company 12/1/2017 5% 1.75% % 96% Company International 10/2/2017 5% 0.60% % 75% International Paper Paper 10/2/2017 5% 0.60% % 75% CBS 11/2/2017 4% 1.42% % 70% CBS Corporation 11/2/2017 4% 1.42% % 70% Corporation NCR 12/17/ /17/2014 4% 4% -1.21% -1.21% % 92% 68% 92% Bristol-Myers 10/1/2014 2% 0.75% 1.4 5% 102% Bristol-Myers Squibb Squibb 10/1/2014 2% 0.75% 1.4 5% 102% United United Technologies 10/6/ /6/2016 2% 2% -1.14% -1.14% % 88% 31% 88% Technologies *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. FUNDED STATUS 9

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11 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. 11

12 pensionrisk.prudential.com Rohit Mathur Senior Vice President, Head of Global Product and Market Solutions e. p Scott Kaplan, CFA Senior Vice President, Head of Pension Risk Transfer e. p Margaret McDonald, FSA Senior Vice President, Actuary, Head of Pension Risk Transfer U.S. New Business and Distribution Support e. p 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 respective financial condition and contractual obligations Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo, the Rock symbol and Bring Your Challenges are service marks of Prudential Financial, Inc. and its related entities, registered in many jurisdictions worldwide PRTBRRE12_ /2018