TOPICS IN Pension risk management Developments in Defined Benefit Plan Funding: Theoretic and Practical Arguments for Risk Reduction for DB Plans The past several years have been challenging for plan sponsors on almost every front. As the U.S. continues a slow climb out of recession, and pension plan funding improves, many plan sponsors and finance officers are asking themselves and their advisors some tough questions: > What is the plan s optimal funding level? Why is that so? How might the answer change if our business prospers or suffers a setback? > How do I plan to get there is my primary strategy contributing or waiting for a market rally and increasing interest rates? > Should I maintain my current asset allocation or move to a liability sensitive investment strategy? Why? How? When? > Should I use annuities to reduce the risk of the plan and the size of the plan? Why? > Should I borrow to fund up my plan and exchange more predictable debt for volatile pension debt while rates are still low? How would this fit in with other corporate capital priorities? > If our firm has a large cash position, should some of it be used for pension funding? > What are the financial statement impacts of taking such actions? Can I minimize them? Can I explain them to analysts? These and other questions can only be answered after a review of a plan sponsor s situation. What s right for a large cash-rich company with stable earnings may be wrong for a company with a high cost of capital. This Topic provides a commentary of the views of many acknowledged experts on two macro level issues funding and asset allocation policy. They sometimes question the conventional wisdom that s prevailed for decades in the industry. We hope this commentary will help plan sponsors and their advisors develop a sustainable decision-making framework capable of supporting informed decision making among sponsors, their stakeholders and their advisors.
A Selected Review of Academic Articles on Plan Funding and Asset Allocation There has been a clear and consistent theme for decades on our two fundamental questions: how well to fund the plan and how to allocate plan investments. For most plan sponsors, the academics suggest that the plan should be fully funded and its assets invested in an immunized portfolio or annuities. Consider the following: > Fischer Black, known for his work on the Black Scholes pricing model, stated in 1980: My message is simple: almost every corporate plan should be invested in fixed-income investments a pension fund s special tax status has great value if the pension fund is invested in short-term paper, long-term bonds or insurance contracts. He went on to say this value might be enhanced by fully funding the plan. Additionally, Because they are profitable investments in their own right, the firm should be able to borrow or issue stock to finance these investments. (Black, 1980) > Jack Treynor (writing as Walter Bagehot, 19th century English essayist) introduced the concept of a corporate balance sheet augmented by pension assets and liabilities in 1972 demonstrating that pension underfunding was functionally a debt of the corporation, reducing shareholder equity. Moody s has long treated underfunding of private plans this way in rating the plan s sponsor, and more recently began treating underfunding of public plans the same way. (Bagehot, 1972) > Irwin Tepper approached the issue of maximizing the value of a plan s pension tax shelter in 1981, taking the view of the shareholder (Black s work analyzed the tax arbitrage only at the corporate level) and came to the same conclusion the tax benefits offer an arbitrage opportunity that is maximized by fully funding and investing in fixed income (or surrogates like - quoting Black - insurance contracts ). (Tepper, 1981) > Lawrence Bader s 2004 article in the Financial Analysts Journal has a title which speaks for itself Pension Deficits: An Unnecessary Evil which argues for full funding 1. He argues that, if the plan is poorly funded, the sponsor should borrow in the capital markets from willing lenders to refinance its inefficient debt to employees. (Bader, 2004) > Bill Sharpe (Nobel Prize,1990) introduced the concept of the PBGC put in papers written in 1976 and 1982. He shows that, in a world where risk of default is not borne fully by the sponsoring corporation (that is, where PBGC coverage is not correctly priced based on the risk of the plan) and where IRS and PBGC follow simple and naïve policies, underfunding and aggressive investing maximizes the value of the put option to shareholders. Mentioning important papers by Black and Tepper, he states that, if one assumes no probability of default, then shareholder wealth may be maximized by funding to the greatest extent possible and holding assets (such as bonds) taxed highly for other investors. (Sharpe,1982) We note that these papers are silent on fiduciary responsibility and do not point out that exercising the PBGC put almost invariably involves a bankruptcy that would obliterate share value. > robert Merton (Nobel Prize,1997) stated in October 2004 that the major concern regarding pension plans was risk mismatch between liabilities (which behave like long bonds) and assets (generally equities and intermediate bonds). He pointed out that research indicated that both underfunding and risk mismatch were captured by the market in lower P/Es and higher Betas. Addressing the use of equity investments to back fixed liabilities, he asked the reader to imagine a CEO of a $15 billion company announcing: Our strategy for the coming year is to buy $60 billion of equities and finance the purchase with $60 billion of long-term debt. (Merton, 2006) > Jeremy Gold, in a 2005 paper entitled Never Again (subtitled A Transition to a Secure Private Pension System ), asks a question that has haunted many sponsors and their advisors: Don t we wish today that in 2000 we had adopted rules to maintain full funding for plans that were then fully funded? He also refers to and expands on Tepper s augmented balance sheet, re-validating...the view that unfunded liabilities amount to a borrowing by the sponsor from the plan. (Gold, 2005)
Until the millennium, most plan sponsors and their advisors generally dismissed the above ideas as ivory tower theories. In the real world, most sponsors believed that it was optimal to ride out tough times in order to earn the equity risk premium associated with high-equity allocations. However, following the dot-com bust, the perfect storm and the great recession, many plan sponsors are now developing approaches to transition to the lower-risk strategies referenced above. Sponsors recognize the need to use a well-thought-out process to determine their ideal funding level and asset allocation and to move towards that position. The Funding Question: Practical Considerations Given that many analysts and rating agencies view pension plan underfunding as a type of debt, one logical question might be: Is this the most efficient type of debt to issue? Should the sponsor float new debt or use excess cash to retire the pension debt? Turning first to the question of debt, key issues to consider about pension debt versus corporate debt include: > Unlike most traditional corporate debt, the principal amount of pension debt will vary, perhaps significantly: a 1% fall in the discount rate might move a plan from fully funded to 10%-15% underfunded. Disappointing market returns will also increase pension debt. > Unlike traditional corporate debt, the payment terms associated with pension debt are uncertain: PPA requires that underfunding be addressed over a rolling seven-year period, whether or not these payments represent the sponsor s best use of capital at that time. This makes budgeting difficult (as became obvious when contribution holidays suddenly ended). > Use of traditional debt to fund the plan offers tax advantages (deductibility of pension contributions and interest payments on the debt elements of Black arbitrage ), a fixed principal amount and payment schedule and, if desired, a longer financing period. There are arguments both for and against accelerated funding. Principal among these are the following: Arguments For > Viewing Pension Plan underfunding as debt can be helpful in clarifying the cash flow impact a plan sponsor may experience due to the plan. Substituting the pension debt with corporate debt, combined with a risk-transfer transaction, can eliminate much of the volatility associated with a plan and enable negotiation of predictable payment terms that best meet the sponsor s needs. > The papers referenced above and financial economics view this as a debt refinancing, not an issuance of new debt. Borrowing capacity, adjusted leverage ratios and credit ratings should not be affected. There is, however, significant discussion about the effects of refinancing on leverage and borrowing capacity. Sponsors will want to discuss their plans openly with analysts and bankers. > Tax advantages exist both for the sponsor (Black Arbitrage) and shareholders (Tepper Arbitrage) for debt owed to the capital markets compared with debt owed to the Pension Plan, among them the deductibility of plan contributions and of interest paid on debt held outside the plan.
Arguments Against > Underfunding is viewed by some as soft debt that can be retired by strong asset performance or higher interest rates. While a 1% fall in rates may devastate funding because of its effect on liabilities, a 1% rise in rates will clearly improve funding dramatically. > as Gold points out,...not every employer can borrow so much at one time. Even those able to borrow may not easily be persuaded to do so > If corporate debt proceeds are used to more fully fund a pension plan, and the plan subsequently enjoys better-than-expected asset returns, the excess capital arising inside the plan may not be cross-applied to retire the corporate debt. Sponsors may wish to target a level of funding and an asset allocation that eliminates most volatility and limits the chance of leaving excess assets stranded in the plan. Practical Considerations Regarding Asset Allocation There are classic arguments both for and against adopting a liability matching strategy: For Immunization and Annuitization: > reducing the volatility of pension funded status stabilizes plan metrics; reduces or eliminates risk of changes in funded status. > LDI and annuitization are simply tools to hedge meaningful risks interest rate and mortality risk, for example. Most companies hedge some risks. For example, airlines hedge fuel costs; Starbucks hedges the obvious coffee prices and the not-so-obvious foreign exchange rate risk. 2 > annuitization in some forms reduces the size of the plan; a Morgan Stanley report (2010) confirms the academics hypothesis that plans that are large relative to the sponsor increase the sponsor s Beta and Weighted Average Cost of Capital, and that investors view pension underfunding as riskier than debt. > a Liability Driven Investment ( LDI ) strategy can be introduced in phases, first lengthening the duration of the existing bond portfolio, then increasing its size, then buying annuities generally for retirees and finally (for frozen plans) terminating the plan and offering lump sums or annuities. Moving to a less-risky investment approach is not an either/or decision it is a continuum. Against > moving from a 60/40 equity/fixed portfolio to an all-bond portfolio will decrease the Expected Return on Plan Assets (EROA). All else being equal, this will increase pension expense and decrease reported earnings. > moving from LDI to an annuity settlement will generally cause recognition of a portion of the plan s accrued actuarial loss. But Jeremy Gold warned of...corporate managers focused on earnings under FAS 87 rather than on shareholder value. Regardless of this, if the market rewards earnings and a firm s peer group does whatever it can to maximize that metric, some firms will not be willing or able to absorb the impact on stock price when doing what may be best in the long run reduces short-term quarterly earnings. > The base case asset allocation referenced above worked well for several decades. While we believe most plan sponsors will reduce risk when they become adequately funded, many want to stay the course until that time.
Conclusion While the optimal level of pension funding and the related issue of optimal investment policy are simple and theoretical to academics, both are a matter of considerable debate at the plan sponsor level understandably so, as no two corporations have an identical financial position. Sponsors have both an overriding fiduciary duty to their employees and a responsibility to their other stakeholders stock and bond holders, for example to consider their alternatives wisely and elect the course that both meets their fiduciary duties and maximizes stakeholder value. There is a difference between staying the course because we ve always done it this way and because one recognizes that regression to the mean occurs continuously, and that arguably, it s imprudent not to expect a return to the mean. It s important that plan sponsors be clear about both costs and risks in order to make the most appropriate long-term decisions for their plans. For example, moving to an LDI strategy reduces returns on an absolute basis but stabilizes funded status. Similarly, moving to an annuity will appear to increase the cost, but much of this apparent extra cost represents recognizing investment risks as well as investment and mortality costs that the plan will ultimately bear but that are not reflected in current accounting numbers. For many plan sponsors particularly those with excess cash, a low cost of capital or well-funded plans there is abundant academic and practical support for reducing or eliminating the risk the plan inflicts on the sponsor by fully funding the plan and implementing an LDI- and annuity-based investment strategy. > please contact your MetLife representative or call 1-888-217-1858 if you would like to discuss these ideas in greater depth.
Bader, L. N. (2004, May/June). Pension Deficits: An Unnecessary Evil. Financial Analysts Journal, 15-21. Bagehot, J. T. (1972). Risk and Reward in Corporate Pension Funds. Financial Analysts Journal. Black, F. (1980). The Tax Consequenses of Long-Run Pension Policy. Financial Analysts Journal. Gold, J. (2005, Fall). Never Again. The Journal of Portfolio Management, 92-97. Merton, R. C. (2006, Winter). Allocating Shareholder Capital to Pension Plans. Journal of Applied Corporate Finance. Sharpe, W. F. (1982, July). Optimal Funding and Asset Allocation Rules for Defined-Benefit Plans. NBER Working Paper 935. Tepper, I. (1981). Taxation and Corporate Pension Policy. NBER Working Paper Series #661. Like most group annuity contracts, MetLife group annuities contain certain exclusions, limitations, reductions of benefits and terms for keeping them in force. A MetLife group representative can provide costs and complete details. 1 In this context, full funding is defined as a condition in which an immunizing bond portfolio secures all benefits to which employees would be entitled upon service termination. 2 Starbucks Form 10k dated 22-Nov-2010, Item 1A Risk Factors. 1310-3009 L0717497318[exp0718][All States][DC] 2013 METLIFE, INC. Metropolitan Life Insurance Company 200 Park Avenue New York, NY 10166 www.metlife.com