The Strategic Benefits of Funding Pensions Today
Citi GPS Opinion Article
22 June 2017 – After years of low interest rates, corporate pension plans globally remain significantly underfunded. In Europe, the median STOXX 600 plan’s funded status was 73 percent at year-end 2016. In the U.S., the median S&P 1500 plan’s funded status was 76 percent, with one-third of the plans below 70 percent. Unrealized expectations of higher rates have increased the pressure to proactively address pension underfunding rather than hope for higher rates and equity prices to eliminate the deficit.
Companies’ financial incentives to fund their plans are stronger than ever before. In the U.S., in particular, rising pension insurance premiums and the possibility of tax reform have dramatically increased the financial benefits from funding the deficit. Many companies have taken note and made large, often debt-funded, contributions to their plans as DuPont and Delta did in 2017.
In addition to the direct financial benefits, pension funding can also help achieve multiple strategic corporate finance objectives, including enhancing valuations, facilitating strategic transactions, increasing financial flexibility, and decreasing risk.
A smaller pension deficit may improve the plan sponsor’s M&A prospects. Large pension liabilities create uncertainty for a potential acquirer, especially when they are not fully funded. In our analysis of S&P 1500 firms since 2005, we found that companies with large deficits were almost 25 percent less likely to be acquired than those with small deficits (or no pension obligations at all). Specifically, the likelihood of being acquired in a given year was 2.9 percent for companies whose pension deficit (as a fraction of total assets) was in the top quartile of their industry peers, while it was 3.8 percent for the bottom quartile. Academic research has found similar effects for U.K. companies.
Companies with smaller pension deficits receive higher premiums when they are acquired. Our analysis also shows that, on average, companies with large pension deficits received takeover premiums that were 18 percent lower than those of companies with small deficits. Compared to the unaffected stock price one day prior to announcement, companies with large deficits received an average premium of 25 percent, compared with 30 percent for companies with small deficits.
Large pension liabilities can add substantial complexity to M&A transactions. Additional regulatory approvals and the valuation of pension assets and liabilities introduce more layers of due diligence. This is especially true in cross-border transactions with multiple pension plans in different jurisdictions, each subject to its own regulations, actuarial methods, and demographic dynamics. Pension liabilities can be costly to evaluate and the acquirer may have less information than the seller on value-relevant information such as employee mobility and longevity. Pension regulators may also step in to block or influence particular transactions. In the U.K., the Conservative Party’s election platform calls for giving the pension regulator broader powers to impose conditions on (or even block) M&A transactions. Reflecting these complexities, our analysis shows that the time from announcement to closing was, on average, 20 percent longer for acquisitions of companies with pension plans.
Pension deficits can limit a company’s financial flexibility, impairing its ability to grow. A drop in interest rates or stock prices can lead to an increase in the deficit, limiting a company’s financial flexibility and ability to invest in its business. In our analysis, we also found that companies with large pension deficits were less likely to acquire other companies and tended to invest less than companies with small deficits. Funding the pension also facilitates de-risking through asset allocation or outright transfer of the plan to an insurer.
A large pension deficit can be a drag on valuation. We find that companies with large pension deficits suffered, on average, a valuation discount, in part reflecting the strategic disadvantages listed above. Companies with pension deficits (as a percentage of total assets) in the top quartile relative to their industry peers trade, on average, at a firm value-to-EBITDA multiple that is 0.4 lower than those in the bottom quartile. We also find that companies with large pension deficits experienced substantially lower shareholder returns over the last 10 years.
In addition to the strategic benefits, funding the pension plan also offers a significant direct financial benefit. This benefit has rarely been greater than it is today.
Why Fund Today?
Pension insurance premium rates are higher than ever. Pension benefits in the U.S. are partially guaranteed by the Pension Benefit Guaranty Corporation (PBGC). In return, the PBGC charges plan sponsors a mandatory premium that is proportional to the funding deficit. This premium has increased from 0.9 percent of the deficit in 2013 to 3.4 percent in 2017, and is scheduled to increase to 4.1 percent by 2019. These increases have made waiting for higher interest rates or a further rally in stock prices far more expensive than it was in the past. We estimate that PBGC premium savings alone account for over $65 million of the net present value (NPV) of contributing $500 million to a representative underfunded pension plan today, rather than contributing later.
Investment income on pension contributions is tax-free. Defined-benefit pension plans in the U.S. (and many other jurisdictions) offer a tax shelter, in that assets inside the plan grow tax-free, while the interest cost of funding a contribution is tax-deductible. This means that a hypothetical A-rated company can, quite literally, borrow at an annual rate of 1.95 percent (3.00 percent less 35 percent tax), contribute the proceeds to its pension plan and invest them in A-rated bonds, and earn tax-free interest at an annual rate of 3.00 percent. For our representative plan, we estimate an NPV of $17 million from this benefit alone.8 This tax benefit remains relevant for those plans that are fully funded from a PBGC premium perspective, but not fully funded on an actuarial basis.
Tax reform could sharply curtail the tax benefits of later contributions. The prospect of a lower corporate tax rate (if U.S. tax reform comes to pass) creates another benefit that is unique to today’s environment. A lower future tax rate creates a large advantage to contributing to a pension plan while the contribution still generates a deduction at a rate of 35 percent, rather than making it in later years at a lower rate. We estimate that the NPV of fully closing a $500 million gap today would jump from $81 million to $160 million if the corporate tax rate falls to 20 percent in 2019.8
Two arguments are often made against pension funding.
“Rising interest rates will solve the problem.” Some corporates still hold out hope that rising interest rates will close (or at least narrow) the funding gap. In our view, however, rising rates are unlikely to solve most companies’ underfunding problem. For the median S&P 1500 pension plan to become fully funded, we estimate that rates would have to rise by 300 basis points. Under Citi’s current forecast of an 85 basis point increase in the 10-year Treasury yield from 2016 to 2017 (and if stock prices remain constant), the median plan would reach only 81 percent funded status, compared to 76 percent today.For more on Citi GPS, including additional views on Pensions, please visit our website at <www.citi.com/citigps>.
Authors: Ajay Khorana,Gabriel Kimyagarov,Gustav Sigurdsson,Guocheng Zhong,