The past decade has seen significant funded status volatility for defined benefit (DB) plans around the world, prompting many plan sponsors to take action toward managing the financial risk these plans present to the corporation. Generally, plan sponsors have three levers they can use to control the financial risk inherent in a DB plan.

Many plan sponsors of underfunded DB plans that have access to low-interest financing in the capital markets have the opportunity to consider additional borrowing to accelerate the funding of pension plan obligations. This option can be complex, and a careful analysis should be carried out to optimize a sponsor's sources and uses of capital.

This article outlines a strategy to guide sponsors through the analysis and the decision-making process, in order to help them determine the advantages of issuing corporate debt to fund pension obligations and the resulting ramifications for investment policy. 

Pension debt

From a purely economic perspective, pension debt – the excess of the plan's liabilities over plan assets – is the equivalent of any other long-term debt found on a corporation’s balance sheet. For accounting purposes, the valuation of pension liabilities is based on the equivalent yield of a hypothetical portfolio of high-quality bonds (typically, AA or higher) with cash outflows that approximate the plan's estimated benefit payments. These payments are unique to the plan’s demographics, which adds another layer of complexity to the evaluation of this debt.

The corporation has a number of choices regarding the timing of financing the pension debt, ranging from contributing the annual minimum required contribution, which varies by jurisdiction, to financing the debt immediately, subject to tax-deductibility considerations.

Decision path

For purposes of this article, we will not consider the use of available or excess cash that a corporation may have to accelerate funding of the plan. Use of excess cash to fund a pension deficit must be considered against other options for these funds, such as buying back existing debt, financing share repurchases or investing in higher return-on-equity projects elsewhere in the business. Therefore, the decision to advance fund pension debt from cash reserves will depend on the specific circumstances and objectives of the corporation. Here, we focus on the impact of issuing new debt to finance pension debt. 

There are two key decision points to address when considering whether to borrow to fund pension debt. The first decision point revolves around the rationale to fund beyond the required minimum contribution. The second one involves how much to fund, and how to invest the existing and new plan assets. Below we explore these two decisions in more detail.

Decision 1 – Funding beyond statutory minimums

Key to the first decision point is that the new debt has essentially no impact on the overall balance sheet of the company. Issuing debt to fund the pension plan is essentially a reorganization of existing balance sheet debt, with a transfer of pension debt to long-term debt.

Although there is no significant impact on the balance sheet, the decision needs to be looked at from an economic perspective as well as an accounting perspective to determine the merits of such a strategy.

From an economic perspective, the transaction does not affect the overall amount of the plan’s debt. The pension funding can yield a tangible benefit in the form of greater economic value because of the tax deduction associated with issuing debt and making the pension contribution immediately, in contrast to present-value equivalent contributions spread over several years. Additionally, in many jurisdictions, unfunded plans trigger insurance premiums (for example, from the US Pension Benefit Guaranty Corporation) based on the amount of the unfunded liability. Borrowing to fund a pension plan may decrease or eliminate these premiums, which can be of significant value to a corporation.

The economic value created from such a transaction ultimately lies in the benefit of accelerated tax deductions and, where applicable, in the elimination of insurance-like premiums on unfunded liabilities. These benefits need to be weighted against agency costs, such as the transaction costs involved in issuing such debt, and other considerations, such as financial strain arising from the additional debt or negative perceptions from analysts or rating agencies.    

Decision 2 – How much to fund and how to invest?

If we consider pure corporate finance theory only, it would be sensible to keep the pension plan fully funded on an accrued-liability basis and to invest the assets entirely in liability-matching assets. However, as many pension plans have large existing deficits and significant allocations to growth assets (for example, equities), decisions about how much debt to issue and where to invest the assets become more closely tied together. Many factors can influence the sponsor’s decision, including:

Additionally, the specifics of the plan and the details of the relevant regulations are important, as outlined in the table below.

From an economic perspective, as the plan’s funded status gets closer to 100%, there is little, if any, value in carrying risky assets, as risk becomes asymmetrical once assets are sufficient to meet plan obligations. This asymmetry stems from the fact that corporations generally cannot recoup plan surplus and that they are fully responsible for any pension deficit.

In addition, funding in excess of the accrued liability might not be considered a neutral liability transfer from the pension balance sheet to the corporate balance sheet by creditors. A corporation can always freeze the plan and release any liabilities in excess of the accrued benefit obligations, whereas debt is a more definite obligation for the sponsor.

From an accounting perspective, borrowing to fund will typically result in an increase in reported earnings, as the investment income in the pension fund (which is generally tax-free) on the additional funding will typically be greater than the after-tax interest cost associated with the debt. However, as a plan becomes better funded, the investment policy must be considered, and many plan sponsors will move toward less-volatile (and lower-returning) asset allocations, which can dilute the effect on accounting results.  

For those companies concerned about the impact of the pension investment strategy on balance sheet leverage, one way to compensate the negative accounting impact of de-risking plan assets is to buy back shares to maintain earnings per share (EPS). This allows the company to replace the lost leverage from the pension fund through re-engineering the balance sheet. Again, while this option needs to be weighted against the corporation’s financial objectives and constraints, the overall impact should be positive, due to the maximization of available tax deductions.

Consider the options carefully

Below is a table summarizing for each activity the corporation’s leverage and the impact on the economic and financial statements, as discussed above.

Even though borrowing to fund the plan’s liabilities may not change the corporation’s overall balance sheet debt, the transaction does move financial risk from plan participants to bondholders and shareholders, as pension plan benefits are largely protected upon bankruptcy. The company will therefore need to ensure that the specifics of the transaction lead to a net benefit for existing stakeholders while meeting its fiduciary responsibilities to the participants.

A thorough analysis needs to be conducted to confirm the economic benefit and accounting implications of borrowing to fund plans, but when combined with a de-risking strategy and thoughtful communication to plan participants, investors, analysts and rating agencies, it can be an economically sound alternative for many corporations.