“De‐risking” Corporate Pension Plans: Options for CFOs

Until the stock market bubble burst in 2000–2002, most CFOs viewed their defined benefit pension plans as profit centers and relatively risk‐free sources of income. Since neither pension assets nor liabilities were reported on corporate balance sheets, and expected returns on pension stocks could be substituted for actual returns when reporting net income, the risks associated with DB plans were masked by GAAP accounting and thus assumed to have no bearing on corporate capital structure. But when stock prices and corporate profits fell together, the risks associated with conventional stock‐heavy pension plans showed up first in reduced pension surpluses (or, in many cases, deficits) and then later in higher required cash contributions and lower reported earnings. As a consequence, today's investors (and rating agencies) are viewing pension and other legacy liabilities as corporate debt, and demands for transparency and increased funding have triggered accounting changes and proposed legislative reforms that will further unmask the economics. This article aims to provide both private‐sector and public‐sector CFOs with suggestions for reducing and controlling the cost of providing for the retirement of their employees. Profitable, tax‐paying companies with DB plans should consider (1) funding any unfunded liabilities (if necessary, by issuing debt) and (2) reducing pension equity and interest rate exposures by shifting some (if not all) pension assets into bonds and defeasing the pension liability (achieving a tax arbitrage in the process). And in cases where the expected costs of maintaining DB plans outweigh the benefits, companies should consider freezing or terminating their plans and switching to a defined contribution (DC) or some form of hybrid plan. The authors also propose similar changes for public pension plans, where underfunding and mismatch problems are greater, less transparent, and in some ways less tractable than those of corporate DB plans.     

How does the Funding Status of Defined Benefit Pension Plans Affect Investment Decisions of Firms in the United States?

We investigate whether the flexibility in making contributions towards defined benefit pension plans sponsored by firms in the United States allows managers to save cash and increase investments. Firms invest more at higher levels of pension deficit, defined as pension benefit obligations less pension assets, and scaled by total assets. At the median level (90^th percentile) of pension deficit, investments increase by 6.7 cents (9.4 cents) for every dollar increase in cash. As the pension deficit increases, firms deviate more from the predicted level of investment. These findings suggest that the incremental investments are more likely to represent overinvestment by managers. Our results are robust to alternative model specifications and endogeneity concerns that may arise if investments are jointly determined with the funding policy of pension plans and the firm's target cash level. We repeat our main analysis for the United Kingdom and also find for that country that, at a fixed cash level, total investment increases as pension deficit increases.     

Impact of Replacing a Defined Benefit Pension with a Defined Contribution Plan or a Cash Balance Plan

Abstract

Four pension plan conversions are examined to determine the impact on retirement benefits of workers. The study was based on interviews with top management, employee surveys, and actuarial analysis of retirement benefits under the old and new pension plans. In general, workers who leave the firm prior to the age of early retirement can expect increased benefits under the new defined contribution and cash balance plans, whereas older, more senior workers can expect to accrue smaller benefits after the plan conversions. Recognizing these potential adverse effects, the employers in our studies provided various types of transition benefits to existing workers or gave employees the choice of remaining in the old defined benefit plan. Employee surveys reveal that younger workers are more supportive of the new pension plans than are older workers. These case studies also indicate that communication by managements with their employees is very important to the successful implementation of plan conversions.     

Pension Contributions and Firm Performance: Evidence from Frozen Defined Benefit Plans

We study the impact of freezing defined benefit (DB) pension plans and replacing them with defined contribution (DC) plans on liquidity, financial leverage, investment, and market value of a sample of firms over 2001‐2008. We find evidence that the pension freeze tends to attenuate the drain on corporate liquidity and relieve the pressure to borrow to pay for mandatory contributions (MCs) associated with underfunded DB plans. Although investors seem to favor the pension freeze as evidenced by positive announcement abnormal stock returns, there is little reliable evidence that the freeze increases investment efficiency and long‐term stock performance.     

Do Managers of U.S. Defined Benefit Pension Plan Sponsors Use Regulatory Freedom Strategically?

We use historical particularities of pension funding law to investigate whether managers of U.S. corporate defined benefit pension plan sponsors strategically use regulatory freedom to lower the reported value of pension liabilities, and hence required cash contributions. For some years, pension plans were required to estimate two liabilities—one with mandated discount rates and mortality assumptions, and another where these could be chosen freely. Using a sample of 11,963 plans, we find that the regulated liability exceeds the unregulated measure by 10% and the difference further increases for underfunded pension plans. Underfunded plans tend to assume substantially higher discount rates and lower life expectancy. The effect persists both in the cross‐section of plans and over time and it serves to reduce cash contributions. We further show that plan sponsor managers use the freed‐up cash for corporate investment and that credit risk is unlikely to explain the finding.     

What determines corporate pension fund risk-taking strategy?

Corporate sponsors of defined benefit pension plans generally assume low investment risk when they have low funding ratios and high default risk, consistent with the risk management hypothesis. However, for financially distressed sponsors and sponsors that freeze, terminate, or convert defined benefit to defined contribution plans, the risk-shifting incentive (moral hazard) dominates. Pension fund risk-taking is also affected by labor unionization and sponsor incentives to maximize tax benefits, restore financial slack, and justify the accounting choices of pension assumptions. Sponsors shift toward an aggressive risk strategy when their pension plans emerge from underfunding, bankruptcy risk is reduced, or marginal tax rate decreases. Overall, we show that corporate sponsors adopt a dynamic risk-taking strategy in their pension fund investments.     

Do Markets Like Frozen Defined Benefit Pensions? An Event Study

An increasing number of North American companies are freezing or terminating their traditional defined benefit (DB) pension plans. In this article we document a positive announcement effect when a publicly traded company discloses that it has partially or fully frozen its DB plan and replaced it with—or enhanced—the 401(k) defined contribution (DC) plan. This positive risk‐adjusted return is greater for firms with higher beta and/or lower return on equity (ROE) prior to the freeze. In other words the positive impact is more pronounced for firms that are likely to face financial distress if they maintain their traditional pension plan and the associated long‐term promises.     

The Shift to Defined Contribution Pension Plans

Abstract

There has been a strong shift away from defined benefit (DB) pension plans toward defined contribution (DC) pension plans in the United States over the last 20 years. A variety of reasons for this shift have been proposed. In another paper in this issue, Krzysztof Ostaszewski presents a new hypothesis to explain the shift to DC plans in the United States. He argues that the decline in importance of DB plans is due to a shift in the way relative returns to macroeconomic factors of production, that is, capital and labor, are being rewarded in the national economy.

This paper attempts to test the Ostaszewski hypothesis using Canadian data. In Canada there has been only a slight decrease in DB plan coverage. It is shown that the Ostaszewski theory does not fit the Canadian experience well. Instead, it is argued that pension regulation and tax legislation play a crucial role in pension design and reform. It is also argued that the difference in pension regulation and taxation in Canada versus the United States has directly influenced plan sponsors in considering their pension objectives, costs, and risks. Differences in the proportion of the workforce that is unionized may also be important. The paper concludes that pension regulation and taxation are more important variables than are macroeconomic reward systems in the use of DB versus DC pension plans.     

Comparing Costs and Risks of Retirement Plans for Sponsors

This stochastic simulation analysis compares funding costs and volatilities for private sponsors of traditional defined benefit (DB), pension equity (PE), cash balance (CB), and defined contribution (DC) retirement plans. Plan provisions of equivalent benefit generosity in the different plan types are determined. The modeling includes current funding requirements and practices as well as a comprehensive set of uncertainties in asset and labor markets. The results show that costs and risks for sponsors vary significantly with plan types, investment and funding strategies, and participant demographics. The hybrid PE and CB plans exhibit characteristics of cost efficiency, as in the DB plan, and risk reduction, as in the DC plan, for plan sponsors under conventional investment strategies. These features are more saliently observed in the CB plan, but it is also more difficult to implement effective asset–liability management strategies for it.     

Pension Funding Regulations and Actuarial Gains and Losses

With pervasive pension funding deficits, Korean firms have been under pressure to improve their funding levels. We examine whether firms have incentives to set obligation‐decreasing pension assumptions when they have large pension deficits (pension obligations in excess of plan assets) and when they make insufficient contributions to external pension funds. We find that firms report larger actuarial gains (or smaller actuarial losses) associated with the remeasurement of pension liabilities when their pension funding ratio (the ratio of the fair value of plan assets to defined benefit obligations) is lower and when contributions to plan assets relative to pension service costs are smaller. Next, upon the introduction of a minimum pension funding guideline, we find that the effect of the funding ratio and contributions to pension funds on actuarial gains and losses is more pronounced for firms whose funding ratios are slightly below the minimum funding ratio than it is for firms whose funding ratios exceed or fall short of the minimum by a large margin. Our results indicate that firms opportunistically exercise discretion regarding corporate pension accounting under International Financial Reporting Standards to comply with pension funding regulations, thereby reducing perceived pension deficits.     

Guaranteeing Defined Contribution Pensions: The Option to Buy Back a Defined Benefit Promise

After a long commitment to defined benefit (DB) pension plans for U.S. public sector employees, many state legislatures have introduced defined contribution (DC) plans for their public employees. In this process, investment risk that was previously borne by state DB plans has now devolved to employees covered by the new DC plans. In light of this trend, some states have introduced a guarantee mechanism to help protect DC plan participants. One such guarantee takes the form of an option permitting DC plan participants to buy back their DB benefit for a price. This article develops a theoretical framework to analyze the option design and illustrate how employee characteristics influence the option's cost. We illustrate the potential impact of a buy‐back option in a pension reform enacted recently by the State of Florida for its public employees. If employees were to exercise the buy‐back option optimally, the market value of this option could represent up to 100 percent of the DC contributions over their work life.     

The Effect of Regulations on Pension Risk Shifting: Evidence from the US and Europe

This paper provides evidence that pension regulations can incentivize or curb risk shifting in the investment of defined benefit plan assets. We document that in the US, where the pension insurance premium charged by the Pension Benefit Guaranty Corporation is largely flat, financially distressed firms with severely underfunded plans shift pension investment risk. We further find that risk shifting is mitigated in the UK after the implementation of risk‐adjusted pension insurance premiums, and in the Netherlands where full pension funding is mandatory. Overall the results in this paper lend support to the view that structural flaws in the US statutory pension insurance scheme incentivize high‐risk sponsors to gamble their pension assets when distress terminations of their plans become foreseeable.     

Were internal capital markets affected by the ‘perfect’ pension storm?

We examine capital expenditures in multi-segment firms before and after the “perfect storm” that affected pension plans between 2000 and 2002, when bond yields and stock prices both fell precipitously. Our sample of firms went from having overfunded to underfunded pension plans as a result of the storm. We examine the segment-level relation between investment, Tobin's q, and cash flow both before and after the event. We find mixed evidence on the change in the relation between investment and q, which may be a result of measurement error in q. We find stronger evidence for the conclusion that after the pension storm, firms with underfunded pension plans directed more investment towards segments that produce higher cash flow.     

Risk Allocation in Retirement Plans: A Better Solution

The corporate world is reconsidering the cost‐effectiveness of defined benefit pension plans while contemplating a change to defined contribution plans. This article begins by examining the three primary risks faced by sponsors of most DB pension plans—investment risk, interest rate risk, and longevity risk—and shows how shifting these risks to employees through a DC plan would affect both the corporation and the individual. Although DC plans clearly help companies manage risks, they provide at best an incomplete solution for individual participants. This article describes an innovation in pension design—the Retirement Shares Plan (RSP)—that combines many of the best features of DB and DC plans. An RSP provides:

• ? predictable and stable cost to the plan sponsor, with little chance of unfunded liabilities;
• ? lifetime income, guaranteeing that retirees will never outlive their benefits;
• ? a benefit accrual pattern comparable to that of traditional pension plans that preserves value for older, long‐service employees; and
• ? potential inflation protection for retirees.

The RSP accomplishes this by allocating risk to sponsors and individuals differently than either a traditional DB plan or a DC plan. Unlike most DB plans, the RSP shifts investment and interest rate risks from plan sponsors to participants. Unlike DC plans, the RSP keeps longevity risk with the sponsor.     

INVESTOR EVALUATION OF OVERFUNDED PENSION PLAN TERMINATIONS

Hundreds of large firms have terminated overfunded pension plans and obtained substantial cash reversions in the past few years. This study reveals a positive and significant market reaction at the time of the termination announcement. The strongest stock price reaction is for firms with large terminations relative to prereversion income. This study demonstrates that real economic gains result from the termination. Specifically, firms terminating overfunded pension plans tend to have tax loss carryforwards that effectively increase the after-tax returns from termination.     

Allocating Shareholder Capital to Pension Plans

This article discusses the corporate challenge of providing retirement income to employees while limiting the costs and risks of pension plans to the companies themselves by addressing five main questions:

• ? What are the major issues and challenges surrounding pensions? Although the pension shortfalls have been the focus of attention, the author argues that the more serious concern is the risk stemming from the mismatch between pension assets and pension liabilities— that is, the funding of debt‐like liabilities with equity‐heavy asset portfolios.
• ? To what extent do the equity market and equity prices reflect the shortfall in value and the mismatch in risk? While the author describes some evidence of the market's ability to capture pension risk, analysts' P/E multiples and management's assessments of cost of capital may still be distorted by failure to take full account of the risks associated with pension assets.
• ? How should management analyze and formulate strategic solutions? Without offering specific solutions, the author presents a framework for analyzing the problem from a strategic perspective that can be used in formulating a company's pension policy. In particular, the article recommends that companies take an integrated perspective that views pension assets and liabilities as parts of the corporate balance sheet, and the pension asset allocation decision as a critical aspect of a corporate‐wide enterprise risk management program.
• ? If a company chooses to make a major change in its pension policy, such as a partial or complete immunization accomplished by substituting bonds for stocks, how would you communicate the new policy to the rating agencies and investors?
• ? What are the major issues to be thinking about when contemplating a change from a DB plan to a defined contribution, or DC, plan? The author argues that DC plans without some corporate oversight or responsibility for results are not a long‐term solution.

     

Making a successful transition to cash balance. Using employee choice and financial education

As employee work patterns change, the need for flexible plan design has increased. Hybrid plans such as cash balance plans offer a plan design variation that incorporates elements of the traditional defined benefit plan as well as those of defined contribution plans. This article examines plan design trends and discusses both negative and positive reactions to those trends. Finally, the solution of offering choice to plan participants is suggested, and the issues that must be considered are discussed.     

Organizational capital,corporate tax avoidance,and firm value

We show that firms with higher levels of organizational capital (OC) exhibit higher levels of tax avoidance and that shareholders view tax avoidance of high OC firms as value-enhancing. We also show that the OC-tax avoidance relation mainly manifests in firms with good internal governance and information environment and in firms that face tight financial constraints. In addition, we document that tax avoidance by high OC firms increases future cash flow and that high OC firms are more likely to invest in tax haven subsidiaries. Overall, our evidence suggests that OC enhances firms' tax efficiency.     

Legal issues in cash balance pension plan conversions

Replacing a traditional pension with a cash balance plan raises a number of complicated and unsettled legal issues, including the protection of accrued benefits, the rate of benefit accrual, age discrimination and notice requirements. This article discusses those issues and concludes that routine conversions to cash balance plans appear to be legal both currently and into the foreseeable future.     

An Explanation of Negative Swap Spreads: Demand for Duration from Underfunded Pension Plans

The 30‐year U.S. swap spreads have been negative since September 2008. We offer a novel explanation for this persistent anomaly. Through an illustrative model, we show that underfunded pension plans optimally use swaps for duration hedging. Combined with dealer banks' balance sheet constraints, this demand can drive swap spreads to become negative. Empirically, we construct a measure of the aggregate funding status of defined benefit pension plans and show that this measure helps explain 30‐year swap spreads. We find a similar link between pension funds' underfunding and swap spreads for two other regions.