Although the subject matter below is based on real-world experience, all characters, figures, and settings are fictitious and are not based on the financial situation or strategy of any specific company.
From: CFO, Industrial Manufacturer
To: Treasurer
Priority: High
Subject: How can we get control of our defined benefit pension plan?
Good Morning, Boss:
So I see that you are worried about our defined benefit pension plan. Is it the rapidly deteriorating funded status caused by a nose dive in the discount rate that has you concerned? Or maybe it’s the big jumps in pension expense each year that financial analysts keep asking about? Then again, it might be the millions upon millions of cash we have already contributed to the pension over the last few years, to no avail, that has incited your disquiet?
No matter the root cause, treasury has a strategy that scratches multiple itches:
1. Issue long-term debt at incredibly attractive rates: Corporate borrowing costs are at levels not seen, well, not seen in the history of corporate borrowing. An investment-grade company like us can raise 10-year and 30-year debt at well inside 3% and 5%, respectively. There has never been, and may never be, a better time for a financially sound company to take advantage of the debt capital markets.
2. Contribute the borrowed cash to the pension plan’s asset portfolio, bringing funded status closer to 100%: This has a whole host of benefits. First, pension contributions are tax deductible, so at a 30% marginal tax rate a $100 million cash contribution really only requires $70 million of cash. Second, the cash would be invested in a diversified pension portfolio with an expected return above the interest on the debt, resulting in lower pension expense and potential earnings accretion. Third, a higher funded status means lower pension insurance premiums paid to the Pension Benefit Guaranty Corporation. Last, the debt-funded contribution would be neutral to our debt leverage, as rating agencies treat unfunded pension liabilities just like balance sheet debt when calculating credit metrics.
3. Adjust the allocation of the plan assets: We have done some math with our actuaries and are confident that a well-funded pension asset portfolio comprised of 85% fixed income, 10% equity, and 5% other asset classes (like hedge funds or real estate) would be more than two-thirds less volatile than the portfolio we have today. This means that once we are 100% funded, we can stay close to 100% funded, even in volatile market conditions. You might know this tactic by its code name “LDI,” which stands for liability driven investing. We back-tested this approach and it really works if done right. Had companies with defined benefit plans moved to LDI back in 2005 – when markets were stable and many plans were fully funded – their plans would be much closer to being fully funded today. And they would not have needed significant cash contributions along the way.
4. Offer lump sum payments to participants: New rules allow pension plan administrators to calculate lump-sum pension payouts differently. We can now use discount rates closer to the rates used to value the ongoing liabilities, so the company can buy out $100 of liability with just slightly more than $100 of assets. A lump-out program serves to shrink the whole pension problem, giving companies more control over a financial risk that is highly volatile.
It is hard to understand why defined benefit plans continue to plague Corporate America when there are great opportunities to alleviate the problem. Perhaps everyone is waiting for market conditions to improve (that is, discount rates to rise and equities to rally). After all, the market got everyone into this mess, it can certainly pull everyone out. However, waiting for markets to do the work has proved to be both futile and expensive. I recommend we take action now and make the markets work for us.
The Treasurer
Patrick Guido is vice president and treasurer of publicly held VF Corp., a $10 billion global apparel and footwear company with brands that include The North Face®, Vans®, and Timberland®. Patrick has more than 17 years of experience in corporate finance. He earned an undergraduate degree from Georgetown University and an MBA from Vanderbilt University.
