BORROWING TO FUND
PENSIONS COULD ENHANCE
SHAREHOLDER VALUE
By: Rohit Mathur, Scott Kaplan and Peter Kahn
A Step Toward a Lower Risk Future
The enduring low interest rate environment offers a unique opportunity for plan sponsors to
fund their pension plans. Sponsors of underfunded plans can borrow at attractive rates and
contribute the proceeds to their pension plan, thereby reducing—or even eliminating—their
pension deficit, while having the potential to create shareholder value.
When borrowing to fund pension plan shortfalls, companies replace a variable and potentially
volatile debt obligation—the underfunded pension—with a known, certain amount of debt
with a fixed funding cost. Recent rounds of Pension Benefit Guaranty Corporation (PBGC)
premium increases highlight another important benefit of funding the plan—the elimination of
variable PBGC premiums, which are scheduled to rise to 4.1% of unfunded liability in 2019.
The combination of increasing annual PBGC premiums and the low rate environment make
borrowing to fund a very attractive potential opportunity for plan sponsors.
Borrowing to fund is
an integral tool for plan
sponsors to use in the
context of an overall
risk-reduction strategy.
The borrow-to-fund strategy is beneficial to a wide range of plan sponsors: large or small,
with frozen or ongoing plans. Once the pension plan becomes well-funded, the sponsor faces
an asymmetric risk-reward tradeoff—greater downside risk, and limited upside potential.1
Complementing plan design and investment strategy enhancements aimed at pension risk
reduction, borrowing to fund is an integral tool for plan sponsors to use in the context of an
overall risk-reduction strategy.
To illustrate the benefits of this approach, we have analyzed a sample pension plan sponsor’s
borrow-to-fund strategy, comparing two scenarios:
Pay Over Time:
Plan sponsor funds the plan with
equal payments over a 10-year period.
Borrowing to Fund:
Plan sponsor issues debt today and
immediately contributes the proceeds to
fund the plan.
For more insight on the asymmetric risk-reward tradeoff, please read the Prudential Retirement® perspective paper titled “Is Now the Right Time to De-Risk?” found at
http://pensionrisk.prudential.com/insights.
1
Borrowing to Fund Pensions Could Enhance Shareholder Value
Our analysis explores key variables affecting the outcomes of this approach and suggests that companies across the
ratings spectrum can generate economic benefits from a borrow-to-fund strategy. The net economic benefit can still
be significant even if the plan sponsor is not a full taxpayer, or if the costs of borrowing rise.
Analysis for a Sample Company
Sponsors consider several funding liability and asset measurement frameworks when determining appropriate
contributions to their plan. One option is the funding target liability set out in ERISA rules, but this measurement
relies on a complex comparison to current and 25-year average rates, and also allows for some smoothing of asset
gains and losses. In the current environment, the funding measure of liability would fall short of the basis used by the
PBGC to determine variable premiums. Our analysis instead focuses on the more straightforward GAAP accounting
basis. Under this basis, full funding is achieved when the fair value of plan assets is equal to or greater than the
plan’s projected benefit obligation, with both assets and liabilities calculated based on market conditions as of the
measurement date. Another benefit of using the GAAP accounting basis is that it is quite close to the PBGC measure
of liability for purposes of variable premium calculation.
To examine the economic implications to plan sponsors, we model the impact on a BBB-rated company sponsoring
a $7 billion pension plan that is 85% funded. The plan’s population is assumed to be split evenly among retirees and
non-retirees; the average age of plan participants is 65; and plan participants receive an average annual benefit of
approximately $8,200.2
To simplify the comparison of the borrow-to-fund and pay-over-time scenarios, we assume a low risk investment
strategy such that for each scenario the plan’s assets are invested using a liability-driven investment (LDI) strategy
with very limited equity allocation. Consequently, we assume the return on plan assets is equal to the liability
discount rate, as assets are intended to closely match the liability characteristics. All current market conditions are
carried forward through the analysis.
Finally, we assume that the hypothetical plan sponsor’s base case borrow-to-fund scenario is leverage neutral to
the pay-over-time scenario. The alternative to a leverage neutral comparison is for the sponsor to retire debt sooner
using the tax benefit from the sponsor’s plan contribution. We address potential implications of a leverage reduction
scenario in the rating agency section of this paper.
To assess the net economic benefit or cost, we compare the plan sponsor’s projected cash flows under two distinct
scenarios:
Plan Contribution Funding
Source
Frequency
Full Funding
Reached by
Plan Investment
Strategy
Pay Over Time
Cash from operations
Level amount, annually
Year 10
LDI Strategy
Borrowing to Fund
$1 billion* debt issuance
Single amount
Year 1
LDI Strategy
Scenario
*Debt issued is 10-year amortizing debt with principal repayments that correspond to the timing of annual plan contributions under the pay-over-time scenario.
For this plan, the PBGC variable rate premium per participant cap will not be triggered.
2
Borrowing to Fund Pensions Could Enhance Shareholder Value
Exhibit 1 shows that borrowing to fund yields a net present value (NPV)
economic benefit of $150 million, compared to the pay-over-time
strategy. The economic benefit is driven by (i) avoidance of variable
PBGC premiums, (ii) lower after-tax debt service as compared to annual
plan contributions, and (iii) acceleration of tax benefits on pension
contributions. In our example, value is also created if the plan sponsor
issues 10-year bullet debt rather than amortizing debt.
Over the last four years, PBGC
premium increases have been
included in three separate acts
passed by Congress. As a result,
the variable premium has
increased by over 450%.
Exhibit 1 (In USD millions)
Pay Over Time
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Variable Rate Premium (VRP)
2.40%
3.00%
3.30%
3.70%
4.10%
4.22%
4.35%
4.48%
4.61%
4.75%
4.90%
Funded Status (%)
85%
87%
89%
90%
92%
93%
95%
96%
98%
99%
100%
Funded Status Deficit (Surplus)
$1,000
$918
$833
$744
$651
$554
$452
$346
$236
$120
$-
$-
Funded Status (End of Year)
Cash Flows
Plan Contributions
$(120)
$(120)
$(120)
$(120)
$(120)
$(120)
$(120)
$(120)
$(120)
$(120)
Variable PBGC Premiums
(30)
(30)
(31)
(30)
(27)
(24)
(20)
(16)
(11)
(6)
Tax Deduction - Plan Contributions
36
36
36
36
36
36
36
36
36
36
Tax Deduction - Variable PBGC Premiums
9
9
9
9
8
7
6
5
3
2
$(105)
$(106)
$(106)
$(106)
$(104)
$(101)
$(99)
$(96)
$(92)
$(88)
Net Cash Flows
NPV Cash Flows
$(796)
Borrowing to Fund
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Funded Status (%)
85%
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
Ending Principal Balance(1)
$1,000
$919
$834
$745
$653
$556
$454
$348
$237
$121
$-
Debt Issued
$1,000
$-
$-
$-
$-
$-
$-
$-
$-
$-
Plan Contributions
(1,000)
-
-
-
-
-
-
-
-
-
Interest Payments
(46)
(42)
(38)
(34)
(30)
(25)
(21)
(16)
(11)
(6)
Principal Repayments
(81)
(85)
(89)
(93)
(97)
(101)
(106)
(111)
(116)
(121)
Tax Deduction - Plan Contributions
300
-
-
-
-
-
-
-
-
-
Tax Deduction - Interest Payments
14
13
11
10
9
8
6
5
3
2
$187
$(114)
$(115)
$(117)
$(118)
$(119)
$(121)
$(122)
$(124)
$(125)
Funded Status (End of Year)
Cash Flows (Leverage Neutral)
Net Cash Flows
NPV Cash Flows (Leverage Neutral)
$(646)
NPV BENEFIT (Leverage Neutral)
$150
Year 0 represents the plan funded status deficit, while Year 1 through Year 10 represents the outstanding principal balance of debt
issued to fund the plan.
(1)
An important driver of the economic benefit is the avoidance of annual variable PBGC premiums. Over the last four
years, PBGC premium increases have been included in three separate acts passed by Congress. As a result, the
variable premium has increased by over 450%; from 0.9% of unfunded liability in 2013, to 4.1%3 in 2019. These
increases impose a significant burden on plan sponsors with underfunded pension plans.
Actual variable rate premium may be higher due to inflation.
3
Borrowing to Fund Pensions Could Enhance Shareholder Value
Plan sponsors that are currently taking advantage of minimum funding requirements resulting from recent legislation4
could generate a much higher economic benefit by borrowing and accelerating discretionary plan contributions.
By availing themselves of funding relief, these sponsors are deferring pension contributions and associated tax
deductions, and are paying increasing variable PBGC premiums. Therefore these sponsors could create significant
shareholder value by borrowing to fund discretionary contributions to their plans.
Strategy is Effective for Lower-Rated and Low Marginal Tax-Paying Issuers
We also analyze the viability of the borrow-to-fund strategy based on changes to several key variables, including
issuer credit ratings, changes to debt issuance costs, issuance tenors, form of debt issuance (i.e., amortizing versus
bullet maturity), and corporate tax rates. In the following charts, our base case scenario is circled.
Exhibit 2 shows that borrowing to fund may be optimal for companies across the ratings spectrum based on current
debt market conditions. We further note that sponsors who elect to fund the pension plan over a shorter time horizon
still generate a positive economic benefit, albeit at slightly lower levels than the 10-year funding horizon.
Exhibit 2 - NPV Economic Benefit and (Cost) of Borrowing to Fund vs. Pay Over Time (USD millions)
Funding Period / Debt Tenor
Issuer Credit Rating
5 Year
7 Year
10 Year
AAA
$104
$149
$217
AA
$101
$141
$200
A
$97
$135
$191
BBB
$78
$107
$150
BB
$51
$73
$104
B
($4)
($4)
Cost
$1
$18
NPV Economic Benefit
Cost
NPV Benefit in the base case scenario
Plan sponsors typically generate a significant upfront tax shield by making a cash contribution to the plan today.
Therefore, tax rates are an important consideration when engaging in a borrow-to-fund strategy. Exhibit 3 suggests
that borrowing to fund continues to generate positive economic benefits even with lower tax rates.
Exhibit 3 (In USD millions)
Borrowing Cost
4.56%
Tax Rate: 30% +/-
-15%
$143
-10%
$146
-5%
$148
0%
$150
+5%
$152
+10%
$154
NPV Economic Benefit
NPV Benefit in the base case scenario
Strengthening the case for employing a borrow-to-fund strategy today are the increasing calls for tax reform.
The potential for tax reform that could eventually result in lower corporate tax rates will reduce the future value of
realized tax benefits on pension contributions and PBGC premiums if corporate tax rates are significantly lowered
in the future.
Moving Ahead for Progress in the 21st Century Act of 2012 (MAP-21), the Highway and Transportation Funding Act of 2014 (HATFA), and the Bipartisan Budget Act of 2015 (BBA).
4
Borrowing to Fund Pensions Could Enhance Shareholder Value
Rating Agencies Should Likely View Borrowing to Fund as
Credit-Neutral or Positive
Given that rating agencies view pension deficit as debt-like, replacement of volatile
pension debt with a fixed amount of leverage should be viewed, at worst, as creditneutral.
Replacement of volatile
pension debt with a fixed
amount of leverage should
be viewed, at worst, as
credit-neutral.
Under Moody’s methodologies, a gross pension deficit is considered as debt, so a
substitution of contractual debt with pension debt would be viewed as a pure debtfor-debt exchange. On the other hand, Standard & Poor’s methodologies adjust debt
to include the after-tax pension deficit;6 companies therefore receive upfront credit for
future tax savings from pension contributions in their adjusted leverage metrics.
5
As Exhibit 4 illustrates, companies that issue 10-year amortizing debt under the
borrow-to-fund strategy can use net cash savings from tax deductions to reduce
other existing corporate debt or borrow less debt upfront, to maintain leverage neutral
credit metrics under Standard & Poor’s methodologies. Plan sponsors who use net
cash savings to reduce leverage or borrow less upfront can still continue to enjoy an
economic benefit from the borrow-to-fund strategy.
Exhibit 4 (In USD millions)
Reduce Leverage / Borrow Less
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
Ending Principal Balance
(Reduce Leverage)
$1,000
$700
$635
$568
$497
$423
$346
$265
$181
$92
$-
Interest Payments(1)
(46)
(32)
(29)
(26)
(23)
(19)
(16)
(12)
(8)
(4)
Principal Repayments
(300)
(65)
(68)
(71)
(74)
(77)
(81)
(84)
(88)
(92)
Tax Deduction - Plan Contributions
300
-
-
-
-
-
-
-
-
-
Tax Deduction - Interest Payments
14
10
9
8
7
6
5
4
2
1
$(32)
$(87)
$(88)
$(89)
$(90)
$(91)
$(92)
$(93)
$(94)
$(95)
Cash Flows (Reduce Leverage)
Net Cash Flows
NPV Cash Flows (Reduce Leverage)
$(659)
NPV BENEFIT (Reduce Leverage)
$137
(1) Year 1 principal repayment assumes the plan sponsor uses its $300M plan contribution tax deduction generated in the base case scenario. Subsequent year repayments have been rebalanced
to reflect a lower initial amortizing borrowing balance versus the borrow-to-fund base case.
We believe such a strategy is optimal for most plan sponsors, except in situations where a restrictive leverage
covenant in credit facilities could become adversely impacted by the issuance of contractual debt.
While rating agencies view pension debt as comparable to other senior unsecured debt on the balance sheet,
recent evidence from corporate bankruptcies and restructurings suggests that pensions fare significantly better than
unsecured creditors. Pension promises are “certain” rather than “conditional,” even during times of stress.
For more insight, please see Moody’s Investor Service Cross-Sector Rating Methodology, Financial Statement Adjustments in the Analysis of Non-Financial Corporations (December 22, 2015).
For more insight, please see Standard & Poor’s Corporate Ratings Criteria, Corporate Methodology: Ratios and Adjustments (November 19, 2013).
5
6
Borrowing to Fund Pensions Could Enhance Shareholder Value
Funding Transaction Should Occur in Conjunction with a Pension De-risking Strategy
A plan sponsors’ end goal regarding de-risking should affect its funding strategy. We believe a borrow-to-fund strategy
is an important first step to consider in the context of an overall de-risking strategy.
General Motors recently issued debt to fund its pension plans, joining a growing list of companies that have pursued a
borrow-to-fund strategy that used all, or a portion, of the amount issued to make contributions to their pension plans.
Debt Issuance(1)(2)
Amount
Date
Related Plan
Contribution (1)
General Motors Company
$2,000
2/23/16
$2,000
International Paper Company
$2,000
5/26/15
$750
Kimberly-Clark Corporation
$500
2/27/15
$410
Northrop Grumman Corporation
$600
2/6/15
$500
Motorola Solutions, Inc.
$1,400
8/19/14
$1,100
Ford Motor Co.
$2,000
1/8/13
$1,400
CSX Corp.
$300
2/28/12
$275
The Kroger Co.
$450
1/19/12
$450
$1,000
12/6/11
$425
Company
Raytheon Company
In USD millions
Notes:
(1)
Company filings.
(2)
Debt issued to fund pension contributions and / or for general corporate purposes.
Conclusion
The confluence of increasing PBGC premiums and the low interest rate environment can provide attractive
opportunities for companies to reduce pension risk and costs through a borrow-to-fund strategy. The economic benefits
resulting from the borrow-to-fund approach can be substantial, which in turn enhances shareholder value. We believe
borrowing by a plan sponsor to fund a pension plan is a key component of plan sponsors’ de-risking alternatives, and
should be leveraged within the context of a plan sponsor’s end goal for pension de-risking.
The analysis provided above is a general communication that should not be construed as tax, legal or investment advice to any individual or entity. Any individual or entity that has
questions as to the tax and other legal implications of the matters discussed above based on its particular circumstances should consult with and rely on its own advisors and legal
counsel. This document does not constitute an offer or an agreement, or a solicitation of an offer or an agreement, to enter into any transaction (including for the provision of any services).
Prudential Financial, its affiliates, and their financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances.
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