Pension Derisking in Regulated
Industries
Wesley Smyth, Vice President – Senior Accounting Analyst
October 31, 2014
Agenda
» Analytical Approach for Defined Benefit Pension Plans
» Recent history of volatility
» Credit Impact of Derisking Strategies
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Analytical Approach For Defined
Benefit Pension Plans
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Analytical Approach to Defined Benefit Pension Plans
»
Because of the contractual nature of pension obligations, we view
underfunded pension liabilities as “debt-like”
»
We adjust three primary financial statements to show pension underfunding
as debt
»
Artificial smoothing distorts the measurement of pension expense
»
Adjust Income Statement to remove “Accounting Noise”
»
Pensions only one of many factors in rating process
-
Unlikely to drive a downgrade/upgrade in isolation
Can constrain a rating
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Defined Benefit Pensions – Balance Sheet
»
Reclassify pension liability from long term liability to senior debt
»
Imputed debt equal to the gross underfunding of all trusts
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Defined Benefit Pensions – Income Statement
»
Service cost the operating cost to providing a pension
»
Remove “Accounting Noise”
»
Service cost is only cost reflected in adjusted Pretax Income
»
If plan is underfunded add implied interest
»
Interest is calculated as follows
Underfunded Pension Debt
x Marginal Borrowing rate
=Implied interest cost
XXXX
x%
XXXX
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Defined Benefit Pensions – Cash Flow Statement
»
Any contributions in excess of service cost to be reclassified to financing activities
»
Service cost $20
»
Cash contribution $100
»
CFO
»
Cash from financing activities
$80
$80
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Defined Benefit Pension Plans - Summary
THE REPORTING PROBLEM
HOW MOODY’S ADJUSTS
» Because of the contractual nature of
pension obligations, we view
underfunded pension liabilities as “debtlike”
Balance sheet
We adjust to record the underfunded pension
obligations (i.e. PBO less FMV of pension trust
assets) as debt
» Artificial smoothing distorts the
measurement of pension expense
Income statement
We adjust pension expense to eliminate
smoothing, and to exclude net periodic pension
income if any
Add implied interest expense on pension debt
Cash flow statement
We change the classification of
cash contributed to the pension trust on the
cash flow statement under certain
circumstances
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Recent History of Volatility
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Funding Status
» Regulated utilities went from 98% to 72% - back to 92% at end of 2013
» Went to 82% in 2010
» Local natural-gas distributions companies (LDC) funding levels fell from 96% in
2007 to 70% in 2008 – Recovered to 88% by end of 2013
» Never went above 73% in intervening years
» Other corporates fell from 102% to 77% with subsequent recovery to 91%
» Also recovered to 82% in 2010
» Utilities exhibited greater volatility than LDC’s or other corporate issuers
» Slump was deeper and lasted longer for LDC’s
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Pension funding status
LDC's
Utilities
Non-Financial corporates
105%
100%
95%
90%
85%
80%
75%
70%
2007
2008
2009
2010
2011
65%
2013
2012
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Imputed Pension Debt
» Pensions as % of reported debt lower than corporates
˗ 3.9% for LDC’s
˗ 3% Utilities
˗ 6.8% other corporates
˗ Similar trends for prior 6 years
LDC's
Utilities
Non-Financial corporates
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
2007
2008
2009
2010
2011
2012
2013
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Pensions larger drain on regulated entities
» LDC’s contribute highest % of CFO to service pension debt
» LDC pension contributions averaged 8.5% 2008-2013 period
» Utilities 7.9%
» All others 6.9%
LDC's
Utilities
Non-Financial corporates
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
2007
2008
2009
2010
2011
2012
2013
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Regulated entities’ pensions more expensive
» Electric utilities most expensive plans
» Utilities not addressing benefits
» LDC’s historically had most generous packages
» LDC’s started freezing plans just as financial crisis hit
» This trend is similar to other corporates, but are still expensive
Service cost as LDC's
a % of prior year
PBO
Utilities
Non-Financial corporates
2.5%
2.4%
2.3%
2.2%
2.1%
Service cost % of
prior year PBO
2.0%
1.9%
1.8%
1.7%
1.6%
2008
2009
2010
2011
2012
1.5%
2013
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Regulated entities slow to change asset allocations
» 2008 most companies had traditional 60% equity, 30% fixed income, 10% other
» This is a recipe for volatility
» 2008- 2012 time frame LDC’s asset returns similar to utilities but diverging for
corporates
» Corporates gradually moved over to fixed income during this period
» Utilities started moving to fixed income in 2013 – still remain higher than corporates
Asset returns
LDC's
Utilities
Non-Financial corporates
25.0%
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
-20.0%
-25.0%
2008
2009
2010
2011
2012
-30.0%
2013
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Diverging de-risking strategies
» LDC’s reducing service costs but not changing asset allocations strategy
» Leads to less expensive plan but leaves door open to volatility
» Utilities starting to shift asset allocation but not reducing benefits
» Less volatility but more expensive
» All other corporates reducing service cost and shifting asset allocations
» Less volatility cost neutral*
*Over all cost may be higher or lower dependent on the amounts of assets reallocation and benefit cuts
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Credit Implications of Pension DeRisking
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Credit Impacts of Pension De-Risking
»
De-risking long term strategy
»
Observing more companies implementing de-risking strategies
»
Expect to see more
»
De-risking generally positive – however ultimately a cost benefit analysis
»
Regulatory support will ultimately determine credit impact for regulated entities
»
»
Pace of de-risking slower for regulated entities
Regulatory support will be major determinant in derisking trajectory for regulatory entities
Pensions only one of many factors in rating process
»
-
Unlikely to drive a downgrade/upgrade in isolation
Can constrain a rating
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Pension De-Risking – Voluntary Contributions
»
Pension contributions in excess of required
»
Akin to pay down of debt
»
Credit impact dependent on source of cash
»
-
Debt – Neutral
-
Excess FCF – Positive
-
Own Stock – Positive
Tax deduction – If used to reduce leverage - positive
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Pension De-Risking – MAP – 21
»
MAP – 21 substantially reduced required contributions
»
Benefit extended by Highway and Transportation Funding Act
»
We continue to use GAAP funded number for imputing debt
»
We are observing differing approaches to the relief offered
-
“We will put in the lowest required amount to the dollar”
-
“MAP – 21 will not impact how we fund our plan”
»
We view MAP – 21 to be credit positive from a liquidity perspective
»
Main benefit is for liquidity constrained companies
»
Is betting on interest rates and equity markets good risk management?
»
Underfundings will need to be addressed
»
Potential for MAP-21 to turn credit negative if underfundings are higher than would
otherwise have been when relief expires
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Pension De-Risking – Liability Driven Investing
»
Offsetting interest rate and asset performance risk
»
Achieved through direct or synthetic means
»
Theoretical sacrifice of higher returns for lower volatility/risk
»
Generally neutral for solidly positioned companies with well funded plan
»
Demonstrates pro active approach to risk management
»
If helps improve metrics on a lagging basis then naturally positive
»
Regulatory support will be key determinant of credit implication for regulated
industries
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Pension De-Risking – Plan Freezes
»
Reduce or eliminate service cost going forward
»
Generally positive
»
Asset and interest rate risk still retained for benefits earned to date
»
Any benefits earned going forward must still be funded
»
Levels of risk retained will determine how positive
»
Cost of providing alternative will also factor in equation
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Pension Annutizations
»
Credit impact generally neutral – Benefit of lower volatility versus sacrifice of liquidity
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Lump Sum Settlements
»
Arbitrage in Interest rates allows lump sum settlement at less than GAAP liability
»
Akin to getting a discount on paying down debt
»
Source of cash to achieve funding level may offset any benefit
»
Potentially credit positive
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Pension De-Risking – Other Considerations
Labor Relations
»
Any change in pension strategy will impact labor relations
»
Could be negative from a credit perspective
Mark to Market Accounting
»
Mark to Market accounting no impact on credit
»
Mark to Mark accounting precursor to LDI?
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Regulatory scrutiny expected
» Pensions benefits higher
» Contributions higher
» Natural area for regulators to focus on
» Will a regulator prefer utility approach or LDC approach?
» Will they dislike both?
» Dependent on regulatory recovery, potential for credit positive outcome
» If full recovery of higher cost while volatility lower then positive (utility model)
» Could be neutral – recovery lowered by same amount of cost savings (LDC
model)
» Negative outcome also possible
» Utilities not given full recovery as not attacking benefit packages
» LDC’s recovery cut by more than cost savings due to retained volatility
» Ultimately all comes down to the regulator
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Wesley Smyth, Vice President – Senior Accounting Analyst
7 World Trade Center
250 Greenwich Street
New York, NY 10007
212 553 2733
[email protected]
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