To the ever-expanding list of pension headaches, add this one: credit ratings.
The Pension Protection Act of 2006, an almost 1,000-page bill that President Bush signed into law in August, sets a funding target of 100 percent for defined-benefit pension plans. It also requires companies to make increasingly large contributions to their pension programs if their balances fall below the required level.
Those potential payments have caught the eye of credit analysts, who are already scrambling to decide how to factor unanticipated cash outlays into corporate credit ratings. A report released by Standard & Poor’s states that employers that retain a defined-benefit pension program will be subject to special scrutiny. According to the report, “The implications for [plan] sponsors will vary widely, and be fact- and plan-specific. It is impossible to discern potential trends from information currently available in financial reports.”
“If you’re a healthy company,” says S&P managing director and chief accountant Neri Bukspan, the new rules “may put a little strain on your cash flow.” Bukspan doesn’t think the requirements will be crippling for any companies. But, he says, “if you’re an unhealthy company, they will not help you maintain your rating and in many cases may weaken the rating.”
A comparable report from Moody’s Investors Service noted that while it does not expect any ratings surprises, the firm “expects to have discussions with our rated issuers to better understand their funding plans.”
Credit-rating scrutiny is understandable, considering the sweeping nature of the law. The act changes smoothing of interest rates to two years for both assets and liabilities (down from five and four years, respectively), creating uncertainty regarding the year-to-year cost of funding retirement plans. In addition, the new funding requirements will cause many CFOs to consider “liability-driven” investment strategies, predicts Dale Wallis, CFO of Aerospace Corp., meaning they will opt for more-cautious investments, accepting lower returns in order to avoid unexpected shortfalls.
For companies with significantly underfunded pensions, one option may be to switch to a cash-balance program rather than try to make up the difference under the law’s expedited schedule. (Most companies must comply with the provisions relevant to defined-benefit plans by 2008.) The new reform act will give cash-balance plans a legal boost by declaring them permissible under the law, which could short-circuit lawsuits that have challenged the legitimacy of such plans. The law also helps 401(k) sponsors by giving them more leeway to offer investment advice to participants.
Still, the credit-rating issue may be one more reason companies opt to bail out of the pension business altogether. “Funding reform will expose the inherent volatility of defined-benefit plans,” says Rohit Mathur, one of the authors of the Moody’s report. — Rob Garver
Companies that have scaled back their DB plans since pension legislation passed in August.
DB plan closed to new employees on January 1; pension contribution reduced to one-third of current level
DB plan frozen as of January 1; company expects to save $11 million annually
3. Blount International
DB plan frozen as of January 1; company expects to save between $16 million and $23 million over next five years