The Benefits of Voluntary Corporate Pension Contributions

leadership series investment insights June 2013 The Benefits of Voluntary Corporate Pension Contributions In 2012, the U.S. House of Representatives and the Senate passed the Moving Ahead for Progress in the 21st Century Act. It contained new pension rules, referred to as pension funding stabilization (PFS). The legislation enables U.S. corporate defined benefit pension plan sponsors, under Pension Protection Act (PPA) rules, to use a discount rate based on a 25-year average of interest rates versus the previously used 24 months. This change has resulted in an increase in discount rates, which has lowered liability valuations, and improved 2013 PPA funding ratios for plans by approximately 15% to 20%. 1 While the legislation lowered the minimum required contribution, in our view corporations should not let the change deter them from staying on course to meet their pension obligations. Whenever possible, voluntary contributions should be made to strengthen a corporation s pension funding ratio. This paper demonstrates that this can be especially true when considering the alternatives for putting cash to work namely investing in a low-yield environment and/or capital spending projects. Obligation Remains the Same While the new legislation appears to have lowered plan commitments, it has not, in fact, changed the obligations sponsors have to their current and former employees. Comparing a more realistic mark-tomarket calculation relative to the former and current calculation rules highlights how different a plan s funding position can appear (see Exhibit 1). EXHIBIT 1: While higher discount rates improve funding ratios, they do not change plan sponsors obligations. $ in Millions $1,000 $800 $600 $400 $200 $0 Theoretical Funding Ratios Using Three Reporting Methods Assets Liabilities Surplus/Deficit François Pellerin, CFA, FSA, EA, CERA, MAAA LDI Strategist key takeaways Pension legislation passed in 2012 increased the discount rate used to calculate pension funding obligations. While a higher discount rate has seemingly improved plan sponsors positions, it has not changed their ultimate obligations to plan participants. Plan sponsors should weigh the economics of alternative capital spending projects and cash investing in a low-yield environment relative to the potential economic return on voluntary plan contributions. Indeed, favorable tax treatment and lower PBGC variable premiums associated with voluntary contributions may result in tangible savings. Funding ratio = 80% (mark-to-market) Funding ratio = 88% (prior rules based on 24-month avg.) Funding ratio = 105% (current method based on 25-year avg.) Chart is illustrative and is based on estimates as of Jan. 1, 2013. For institutional use only

EXHIBIT 2: In a low-yield environment, CFOs should consider the opportunity costs of conservative cash investing. cash and short-term investments of russell 1000 companies compared with 3-month treasury bill yields 6% 1,400 Alternatives for putting corporate cash to work Corporations continued to amass significant cash on their balance sheets in 2012. Russell 1000 Index companies posted a record $1.3 trillion in cash and short-term investments at the end of 2012, a roughly 65% increase since the financial crisis began (see Exhibit 2, left). In light of the low-yield environment, with shortterm rates pegged at zero and the expiration of FDIC insurance for commercial bank accounts, corporate finance officers are grappling with how to invest their large cash balances productively and within an acceptable risk framework. Yield 4% 2% 1,200 1,000 800 600 400 200 $ Billions Some companies have accepted the prospect of increased volatility and have invested cash in higher-yielding strategies, including municipal bonds, high-yield short duration-bonds, and even emerging-markets debt. Such moves indicate a willingness by investors, unsatisfied with low to negative yields, to assume potentially higher portfolio volatility in order to generate increased yields (see the Fidelity Leadership Series article Stretching for Yield in the Fixed-Income Market, November 2012). On the other hand, there are investors who are uncomfortable with changing their risk profile despite the low-rate environment. 0% 0 2007 2008 2009 2010 2011 2012 Cash and short-term investments for Russell 1000 companies 3-Month Treasury Bill Yields (Annualized) Source: FactSet, Bloomberg. As of Dec. 31, 2012. Assume that a plan has $800 million in assets and $1 billion in mark-to-market liabilities. 2 Based on the most recent PPA rules, the plan s funding ratio is 105%. However, using mark-to-market assumptions, the plan is only 80% funded. Measuring a pension s funded status using a mark-to-market approach is particularly important for plan sponsors who are (a) implementing plan terminations or annuity purchases to eliminate pension risk, (b) utilizing a liability-driven investment (LDI) approach or dynamic pension risk management in some way, or (c) employing mark-to-market accounting. Realistic asset and liability calculations are critical to the success of these strategies. It is understandable that plan sponsors may want to take advantage of the contribution flexibility offered by the higher discount rates incorporated in the legislation, especially for those with minimal cash holdings. However, the change in calculation parameters does not alter a company s ultimate funding obligation. Therefore, consideration should be given to voluntary contributions to a pension plan especially by those entities that have built up large cash balances in the midst of the economic uncertainty of the past five years. Corporate deployment of cash to capital projects has gained some momentum. However, while the U.S. economy progresses in its slow growth pattern, with some highlights in the housing sector and employment picture, it does so in the midst of fiscal indecision. This backdrop has somewhat restrained the impetus for capital expenditures by corporations. The new funding legislation has put less demand on corporations cash balances at a time when entities are already struggling with how to efficiently deploy cash balances. Against this backdrop, we believe corporations should consider voluntary contributions of cash to their pension plans and take advantage of the economic returns and tax benefits they can provide. For example, tax-sensitive corporations with large cash balances are in a position to reap advantages from putting low-yielding cash investments to work in tax-favorable pension accounts. As a result, economic returns on investment can be enhanced. 3 Favorable tax treatment for pension contributions represents an opportunity cost because pension contributions and returns on pension assets are tax deductible. Therefore, when corporations are deciding how much to contribute to their pension plans, they should take into account the potential amount of tax deductions they could receive. In fact, PFS is projected to generate in excess of $9 billion in revenue over the next 10 years for the U.S. government. 4 This revenue represents what could be returned to plan sponsors as tax breaks given the tax-exempt status of plan contributions and asset accumulations within the plans. In our view, corporate America will be bearing the expense of PFS by not employing tax deductions. 2 For institutional use only

When is the right time to fund a pension obligation? The low-yield environment, a persistent trend since 2008, has many plan sponsors trying to time their contributions. At issue is the potential for rising interest rates to lower funding requirements in the future. The PFS legislation has reinforced the idea of delaying contributions. However, awaiting higher interest rates presents opportunity costs for sponsors, because they are not benefiting from: Tax-free accumulation within the pension trust Tax deduction on contributions Lower annual Pension Benefit Guaranty Corporation (PBGC) variable premiums (currently 0.9% of pension deficit on a PBGC liability basis, increasing to 1.8% by 2015) Improved operations of the plan under PPA through better funding levels, which may result in: 1. Avoidance of underfunding filings to PBGC and disclosure to participants 2. Creation of credit balances, which can later be used as a contribution cushion The potential cost savings of voluntary contributions These opportunity costs can be illustrated by comparing alternative investments by a sponsor (see Exhibit 3, below). Consider a tax-paying company that is eligible to receive a tax deduction for plan contributions. If the company made a voluntary $100 million contribution to the plan (i.e., higher than the PPA minimum) that returned 7.0%, the after-tax return would be 7.0%. If the same company decided to make a capital investment with the same risk and return parameters as an investment in the pension plan and also returned 7.0%, the after-tax return would be 4.55%. 5 EXHIBIT 3: A voluntary plan contribution can increase a sponsor s economic return on investment (ROI) by 3.35%. Assumptions ($ in millions) Plan assets $800 Plan liabilities $1,000 Plan surplus/(deficit) ($200) Plan funded status 80.0% Corporate tax rate 35.0% Corporate project IRR 7.0% Expected return on plan assets 7.0% Investment to corporate project $65 Net contribution outlay after tax PBGC variable premium $65 ($100 pretax) 0.9% of deficit $65 million investment in project would have a 7% taxable return and a 4.55% after-tax economic ROI* Sponsor 7.0% return (taxable) Corporate Project $65 investment $100 contribution to the pension plan ($65 after tax-deduction) results in 7.90% after-tax economic ROI Sponsor $100 contribution (tax deductible) Pension Plan $100 contribution Capital Markets 35% tax deduction on $100 contribution 7.0% return (tax exempt) IRS PBGC (Avoid 0.9% variable premium on $100) Net result: 3.35% additional tax-adjusted economic ROI by contributing to the plan * 7.0% x (1-35%) = 4.55% 7.0% + 0.90% = 7.90% 7.90% 4.55% = 3.35% 3 For institutional use only

Additionally, the PBGC, which ensures that pension plans can meet their obligations in the event of a sponsor bankruptcy, charges premiums based on a plan s deficit. 6 For 2013, this annual premium will be 0.9% of the plan s deficit. Therefore, a plan with a $200 million deficit for the 2013 plan year would pay $1.8 million in variable premiums a cost that translates into no value, economic or otherwise. Combining the tax and insurance premium implications, we estimate that the sponsor s plan contribution generates an economic ROI of 7.9%, versus 4.55% for the capital investment, a gain of 3.35%. (See Endnote 7 for economic ROI calculation details.) The annual compounding effect of the tax-exempt returns and lower PBGC premiums can be significant. A sponsor s voluntary contribution today could generate sizable long-term economic benefits. It is reasonable to expect the additional economic benefits of voluntary contributions to grow in the future. PFS calls for sizable increases in PBGC variable premiums over time (the current rate of 0.9% is expected to at least double by 2015). Based on the analysis in Exhibit 3, we estimate that the additional economic return on investment of voluntary contributions could climb from 3.35% to 4.40% (see Exhibit 4, below). 8 Because it is tax deductible, the actual cost of a $100 million improvement in funded status is only $65 million. While this advantage is not included in the ROI calculation in Exhibit 3, we do believe there are economic benefits to receiving a tax break sooner versus later. We recognize that the return on contributions to a plan does not directly benefit a sponsor; however from an enterprise perspective, the extra return provided is beneficial, as it will result in lower cash outlays at the firm level. EXHIBIT 4: Expected increases in PBGC variable premiums could translate into additional economic ROI. Estimated additional economic ROI 2013 3.35% 2014 3.77% 2015 4.32% 2016 4.35% 2017 4.40% The income statement benefits from reduced pension expense Looking at accelerated contributions through the lens of current pension accounting rules, voluntary contributions have the potential to reduce a sponsor s pension expense (or increasing its pension income) and therefore can have a positive influence on the income statement. A plan s expected return on assets (EROA) assumption directly affects the pension expense/income. For example, a $100 million contribution for a sponsor with a 7% EROA assumption would result in a reduction in annual pension expense (or increase in pension income) of $7 million. Simply put, additional cash contributions could contribute to higher earnings per share (EPS) for many sponsors. Before committing to accelerating pension contributions, sponsors should consider other factors, such as alternative uses of company cash, eligibility for tax deductions, and the risks of trapped pension surpluses. Could debt capacity provide cash for accelerated plan contributions? Plan sponsors lacking the necessary cash to make accelerated contributions might consider their debt capacity as a source of funds. Exhibit 5 (page 5), shows how issuing debt to fund a pension plan can create additional economic return on investment. In this illustrative plan, the expected return on assets and cost of debt were projected to be 5%; therefore any potential for arbitrage was removed. This is not to suggest that sponsors would have to lower their plans EROAs to equal their cost of debt. We used a conservative scenario to demonstrate how debt-financed contributions could add value for plan sponsors and plan participants without increasing risk. A debt-financed contribution Assuming a borrowing rate of 5% (3.25% after tax assuming a corporate tax rate of 35%), a sponsor could borrow and then contribute $100 million of debt proceeds into a pension trust and immediately reduce its plan deficit. Such a scenario assumes that the debt-financed contribution does not weigh on the sponsor s credit rating because the firm s net obligation pension plan deficit versus outstanding debt is unchanged. However, a sponsor should have a ratings specialist fully assess the influence of such a transaction on the firm s rating profile. Our analysis assumes that the $100 million contribution would generate a $35 million tax deduction and an economic contribution of approximately $65 million. (We presume that the tax deduction is used to retire or offset the debt issued.) Once the contribution is invested in assets with a similar risk/ return profile as the debt issued by the sponsor (as mentioned, to avoid any arbitrage assumptions), we estimate that it will increase at a tax-exempt rate of 5%. 4 For institutional use only

EXHIBIT 5: In certain situations, debt-financed contributions can benefit a plan. Assumptions ($ in millions) Plan assets $800 Plan liabilities $1,000 Plan surplus/(deficit) ($200) Plan funded status 80.0% Corporate tax rate 35.0% Sponsor s cost of debt 5.0% Expected return on plan assets 5.0% Immediate investment/ contribution $100 PBGC variable premium 0.9% of deficit $100 proceeds $100 contribution Capital Markets 5.0% coupons on debt (tax deductible) Sponsor Pension Plan $100 contribution 5.0% return (tax exempt) Capital Markets 35.0% tax deduction on $100 contribution IRS PBGC (Avoid 0.9% variable premium on $100) Result: 2.65% tax-adjusted economic ROI on debt issuance With the reduction in the plan s deficit, PBGC variable premiums would be lower, resulting in an immediate $0.9 million savings (0.9% x $100 million, assuming that the PBGC-based plan deficit was at least $100 million). With variable premiums expected to double by 2015, the additional economic benefits would increase yearly in the near future, holding everything else constant. Exhibit 5 (above), demonstrates how a debt-financed plan contribution could increase a sponsor s economic ROI by 2.65%. (See the hypothetical example at Endnote 9 for economic ROI calculation details.) Summary Plan sponsors have an obligation to provide favorable retirement outcomes for their employees. For certain plan sponsors, PFS relieved them from the pressure of funding their obligations at a time when they needed to finance other parts of their business. However, for those companies with excess cash on hand or the ability to access the debt markets at favorable rates the longterm benefits of making voluntary contributions to their pension plans should be considered. The resulting economic costs or benefits of funding a pension plan deficit with proceeds from a debt issuance would depend on a sponsor s specific circumstances. Author François Pellerin CFA, FSA, EA, CERA, MAAA LDI Strategist François Pellerin is an LDI strategist in the Fixed Income division at Fidelity Investments. François is a member of the Liability Driven Investment (LDI) Solutions team and is responsible for developing and implementing pension risk management solutions. He is a member of the CFA Institute, Fellow of the Society of Actuaries, an Enrolled Actuary, a Chartered Enterprise Risk Analyst, and a Member of the American Academy of Actuaries. 5 For institutional use only

Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Past performance is no guarantee of future results. Endnotes 1 2 Based on Fidelity Investments plan estimates as of Jan. 1, 2013. 3 In this paper, we use economic return on investment to represent a project s fundamental return based on cash flow. 4 Federal Tax Weekly, Issue Number 28, Jul. 12, 2012. 5 Other non-pension-related projects could benefit from favorable tax treatment (e.g., research and development projects). For the purpose of this example, we have assumed that the corporate project was fully taxable. Other tax-sheltered opportunities should be assessed before accelerating contributions to the pension plan. 6 Plan deficits are calculated using specific PBGC assumptions. 7 Hypothetical economic ROI through a voluntary pension contribution: Opportunity cost on contribution PBGC savings on avoided premiums Expected annual tax-free benefits earned on contribution Benefit/ (cost) $ millions Details ($2.96) ($100 x (1-35%)) x (7% x (1-35%)) $0.59 ($100 x 0.9%) x (1-35%) $4.55 ($100 x 7%) x (1-35%) Total benefits $2.18 Sum of benefits/(costs) Additional economic ROI 3.35% ($2.18/($100 x (1-35%))) Source: Fidelity Investments Technically, the return earned on investment within the plan should be adjusted for the risk of default. We assumed that the entire contribution is tax deductible. Assumes liability used to calculate PBGC variable premiums exceeds $900 million. 8 Based on pension funding stabilization provisions and an estimated annual indexation of 2%. Note that the irregular pattern of additional economic ROI growth over time stems from the nonlinear schedule increase in future PBGC variable premium rates. 9 Hypothetical additional economic ROI through a debt-financed pension contribution: Benefit/ (cost) $ millions Details Cost of debt ($2.11) ($100 x (1-35%)) x (5% x (1-35%)) PBGC savings on avoided premiums $0.59 ($100 x 0.9%) x (1-35%) Expected annual tax-free benefits earned on contribution $3.25 ($100 x 5%) x (1-35%) Total benefits $1.72 Sum of benefits/(costs) Additional economic ROI 2.65% ($1.72/($100 x (1-35%))) Note: We assumed that the tax deduction associated with the contribution is used to retire or offset the debt issued. Technically, the return earned on investment within the plan should be adjusted for the risk of default. We assumed the entire contribution is tax deductible. Under ERISA, a sponsor may be able to invest 10% of assets in its own securities. We purposely set the EROA as equal to the sponsor s cost of funds to enumerate the potential tax benefits and to avoid inflating results with a riskier allocation and a higher expected return. Assumes that the liability used to calculate PBGC variable premiums exceeds $900 million. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. Important Information Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Index or benchmark performance presented in this document do not reflect the deduction of advisory fees, transaction charges and other expenses, which would reduce performance. Investing directly in an index is not possible. Certain data and other information in this research paper were supplied by outside sources and are believed to be reliable as of the date presented. However, Pyramis has not verified and cannot verify the accuracy of such information. The information contained herein is subject to change without notice. Pyramis does not provide legal or tax advice, and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. These materials contain statements that are forward-looking statements, which are based upon certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different than those presented. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. For Canadian Investors For Canadian prospects only. Offered in each province of Canada by Fidelity Investments Canada ULC in accordance with applicable securities laws. (P) 619739.1.0 (F) 662402.1.0 61.110383 2013 FMR LLC. All rights reserved. 6 For institutional use only