In November, several companies south of the border issued bonds and the proceeds of the sale were used to help fund pension deficits. These companies include such venerable names as United Parcel Service Inc (UPS), Dow Chemical Co. and Northrop Grumman Corp.
Is such a strategy sound, given the potential outcomes? What are its risks? What implications exist for the various stakeholders in the company’s capital structure? Finally, what are the implications for public employers and their pension plans?
The first consideration for any pension fund in a deficit position is meeting its regulatory obligations. Companies with pension funds in a solvency deficiency position are generally required to contribute an amount to the fund on an annual basis that will eliminate the deficiency over a period of five years.
Due to the exceptional circumstances of the 2007-2008 credit crisis, firms have been granted extensions to this obligation and deficiencies must be made up over 10 years. For a company with insufficient cash flow, issuing debt may be the only way to meet the mandated minimum contribution to its pension plan.
Financial risk management has never been more critical to pension funds and their sponsors. As bond yields dropped along with equities in 2008, most pension funds saw the asset side of their balance sheet decrease even as liabilities increased. Liability cash flows of a pension fund are considered fixed and therefore the liability risk is considered equivalent in asset terms to fixed income risk. Therefore, a pension fund is considered to be short fixed income from the liability side.
Now consider the situation where a sponsoring entity has chosen to issue bonds to fund the pension fund. The corporation which was short fixed income in its pension fund has become short fixed income at the corporate level as well by issuing bonds.
If the new contribution to the pension fund is invested in equities then the risk is additive to the current asset mix found in the pension plan, which was likely heavily invested in equities prior to the bond issue. If, on the other hand, the new contribution to the pension fund is invested in bonds, then one must question the value of the transaction to issue bonds.
After investment bank issuance fees and the spread paid by the corporation on the bond issue, can a new investment in fixed income produce a yield superior to that being paid on the bond issue? Therefore, the bond issue either increases corporate risk or is not a sensible economic decision.
Corporate capital structure cannot be considered a motivation for issuing bonds to contribute to the sponsor’s pension plan. Since bondholders rank higher than pensioners in the capital structure of a corporation (consider Nortel’s bankruptcy and legal attempts to change this ranking), the bond issuer that uses proceeds to fund its pension plan has moved its liability up the capital structure. We can safely assume that the current bond issue does not carry restrictive indentures or the corporation would not have performed the transaction.
For future issues, however, increased indebtedness may carry more punitive clauses and conditions. In the event of bankruptcy, the ultimate burden of the transaction is borne by the bondholders, whereas an underfunded pension plan of a bankrupt corporation generates some funding from the pension insurer and may cause benefit cutbacks to the beneficiaries of the plan.
Corporations considering this transaction must consider the fact that bondholders tend to be more vigilant with respect to the creditworthiness of their investments than employees are of the funding ratio of the pension fund. Capital structure does not provide justification for corporations to issue bonds in order to fund their pension funds.
There are many factors to consider when entering into a transaction including the economic benefits, the impact the transaction has on portfolio risk, and the regulatory and tax implications of the transaction. Unless a corporation’s management is exceedingly bullish on equities, it is clear that economic benefits are not a motivation for issuing bonds to fund a pension plan.
From a risk point of view, the transaction is likely economically risk additive and certainly adds risk to bondholders who rank high on the corporation’s capital structure. Therefore, the only reason for the bond issue is to satisfy regulatory requirements or exploit a regulatory loophole.