Corporate Pension Risk Management And Corporate Finance
Corporate PensionRisk Managementand CorporateFinance:Bridging the Gap betweenTheory and Practice inPension RiskManagementAugust 2015
Corporate Pension Risk Managementand Corporate Finance:Bridging the Gap between Theory and Practice in PensionRisk ManagementSPONSORSPension Section Research CommitteeAUTHORSLiaw Huang, Ph.D., FSA, MAAAMinaz Lalani, FSA, CERA, FCIACAVEAT AND DISCLAIMERThe opinions expressed and conclusions reached by the authors are their own and do not represent any official positionor opinion of the Society of Actuaries or its members. The Society of Actuaries makes not representation or warranty tothe accuracy of the information.Copyright 2015 All rights reserved by the Society of Actuaries Society of Actuaries, All Rights ReservedHuang and LalaniPage 2
AcknowledgmentsThe authors would like to thank the Project Oversight Group for their insight andguidance: Gavin Benjamin (Chair), Ian Genno, Cindy Levering, Andrea Sellars, AndyPeterson, Steve Siegel, and Barbara Scott.IntroductionSince the 2007-2008 recession, de-risking has become the most discussed topic incorporate pension risk management. Despite this trend, the authors believe that theactuary’s role in decision-making at a corporate strategic level regarding defined benefit(DB) pension plans has typically been confined to the pension silo; in other words, theactuary’s advice regarding decision-making on corporate DB plans is often limited tostatutory and accounting requirements and typically without regard to corporate financeconsiderations at an enterprise level. However, over the past 10 years, major decisionsregarding corporate DB pension plans, such as freezing of defined pension plans ortransferring pension risks to insurers, have been made in a corporate finance frameworkat an enterprise level. Similarly, corporate pension funding policies and investmentpolicies are being analyzed within a set of corporate finance metrics. Therefore, there is aneed for actuaries to understand current corporate finance practices and be able toprovide strategic and holistic solutions for corporate decision-makers. This paper surveyscurrent literature to fill this void for pension actuaries.Recent examples of corporate finance involvement in strategic pension decision-makinginclude the three largest annuity buyouts in corporate pension history: General Motors’announcement on June 1, 2012 of transferring approximately 26 billion of pensionobligations to insurers (General Motors Company, 2012); Verizon’s announcement onOct. 17, 2012 of transferring approximately 7.5 billion of pension obligations to insurers(Verizon Communications Inc., 2012); and Motorola Solutions’ announcement on Sept.25, 2014 of transferring the pension obligations for approximately 30,000 companyretirees to insurers (Motorola Solutions Inc., 2014). Coincident with the announcement ofthe annuity buyout, General Motors and Motorola Solutions also announced lump-sumofferings to their retirees.The objectives stated in the GM 2012 announcement were: “These actions represent amajor step toward our objective of de-risking our pension plans and will furtherstrengthen our balance sheet and give us more financial flexibility going forward,” whilethe VZ 2012 announcement stated that “the transaction is expected to further Verizon’sobjective of de-risking the pension plan while improving the company’s longer termfinancial profile.” In an interview with Pensions and Investments, Robert O’Keef,Motorola Solutions’ corporate vice president and treasurer, indicated that the pensiondiscussion started after Motorola Solutions decided to divest its enterprise business toZebra Technologies Corp, and the pension buyout and lump-sum offering was related toright-sizing the pension obligations relative to its remaining business: “This is a companythat has gotten smaller over the last decade and a half, so if you rewind 15 years, thecompany had 45 billion in sales, six major businesses, (and) 150,000 employees. What Society of Actuaries, All Rights ReservedHuang and LalaniPage 3
we’re going to be left with after the divesture is a monoline business with about 6billion in revenue and about 15,000 employees. And this business is still saddled with alegacy pension.” (Kozlowski, 2014)Thus, balance sheet, financial flexibility and financial profile, including corporateleverage and the relationship between the size of the pension plan and the size of theoperating business, are corporate finance considerations important to corporate decisionmakers. Moreover, such actions taken on corporate pension plans are not expected toimpact the corporation’s credit rating (Kozlowski, 2014).Corporations raise capital, borrow money and then invest the proceeds in their operationsto generate a profit. Modern corporate finance sees a corporation as a pass-through entity,and the corporation is managed to maximize shareholder value. In this context, pensionplans are pass-through entities as well, where shareholders assume the risk of a pensionplan (Enderle et al., 2006; Exley, Mehta & Smith, 1997; Peskin & Hueffmeier, 2008).Corporate pension plans are managed to enhance and, at a minimum, not to destroyshareholder value. Although this shareholder-centric perspective may not be the onlyperspective of a corporate decision-maker, the authors believe that increasingly it is theframework within which many of the pension decisions are made; such decisions includewhich pension risk to retain, which pension risk to transfer, and what corporate capitalstructure should be maintained to optimize risk-taking.This calls for actuaries to understand important corporate metrics used by the corporatedecision-makers. From a literature search, the authors identified three key corporatefinance metrics and measures impacted by corporate pension plans that are increasinglybeing used by corporate decision-makers. The first is corporate leverage. There arevarious financial metrics related to corporate leverage—for example, the debt-to-equityratio (Coughlan, 2003; Kuipers, 2014; Turnbull, 2013). The augmented or holisticbalance sheet, where pension assets and liabilities are integrated with other operatingassets and liabilities, is an important determinant in calculating corporate leverage. Thesecond is accounting adjustments made by rating agencies to income statements and cashflow statements. In our research, we surveyed adjustments made by rating agencies asexamples of how the economics of the pension plans flow through the income and cashflow statements (Smyth, 2013; Standard & Poor’s, 2002). The third is the weightedaverage cost of capital (WACC) where it is felt that the calculation of the WACC frommarket data may be biased if corporate pension plans are ignored (Gallagher & McKillop,2010; Jin, Merton & Bodie, 2006; Mckillop & Pogue, 2009; Merton, 2006).Another important aspect of the corporate risk management framework is the trade-offbetween holding equity capital and mitigating risk. Corporations may hold a certainamount of money, credit or equity to cover potential losses from unforeseen events. Themore risks a corporation assumes, the more capital is required. This trade-off is madeexplicit with financial companies that have capital requirements. Here the concept ofvalue at risk is used. For example, a company may hold enough capital to survive a 1-in200 year event with respect to its pension plans; that is, a company may want to have Society of Actuaries, All Rights ReservedHuang and LalaniPage 4
enough liquid assets or can raise additional funds to cover pension shortfall at the 99.5percent level, so that the pension shortfall would not bankrupt the company.More generally, pension risks give rise to volatility in corporations’ financial statements.How do corporations evaluate this volatility and decide how much to spend to mitigatepension risks? This is generally described as risk budgeting. Besides using value at risk,we have identified two other approaches described in the literature. One is the traditionalsensitivity analysis, where pension volatility is translated into its impact on corporateearnings and cash flows. The impact on earnings or cash flows is multiplied by a marketmultiple to estimate its impact on a corporation’s stock price. Alternatively, the netpresent value of contributions is calculated. This provides an estimate of the impact ofpension risks on shareholder value (Mathur, 2013). The other approach is based on thebeta of a corporation’s stock. Pension risks increase the beta of a corporation. Bytargeting a fixed beta, one can calculate how much equity capital is needed for a givenlevel of pension risk. This approach is presented by Merton in his analysis of the WACC(Merton, 2006).Equally important is to look for empirical evidence on how corporate pension plansimpact shareholder value. While theoretical analysis can provide prescriptive solutions onhow pension plans should fit into a corporation’s financial profile, empirical studies lookat how a corporation actually behaves and how the market values corporate pensionplans. Here we identified literature discussing the following questions:1. How does a corporation’s pension plan impact its stock price?2. How does a corporation’s pension plan impact its credit rating or creditspread?3. How does a corporation manage its pension plan in the presence of pensioninsurance (i.e., Pension Benefit Guaranty Corporation (PBGC) in the UnitedStates)?The empirical studies provide additional insight on how corporations should manage theirpension plans. By combining the empirical findings of the key corporate financial metricsimpacted by pension plans, and the analysis of the trade-off between capital and risk, weassembled a body of corporate finance knowledge that will be valuable to actuaries.The following diagram illustrates how pension plans and other corporate strategies can beintegrated into an enterprise-wide decision framework. Society of Actuaries, All Rights ReservedHuang and LalaniPage 5
Figure 1: Enterprise-Wide Decision FrameworkIn our view this decision framework involves various financial metrics and the process ofallocating capital to risks, with pension strategies interacting with and impacting both ofthem. Different corporations may employ different processes for risk management andstrategic planning, but they almost always involve financial metrics and capital allocationprocedures.Throughout this paper, by pension plans, we mean corporate DB pension plans. We onlyconsider corporate pension risk management at a strategic level—that is, at the level ofhow much pension risk a corporation should take and where on the corporation’s capitalstructure should the risk be taken. Once these questions are answered, objectivesregarding a corporation’s pension plans can be set, and different de-risking strategies canbe evaluated and implemented against these objectives. There is a large body of literatureon the evaluation and implementation of de-risking strategies, but this is outside thescope of this paper. Additionally, we did not survey pension risk management literaturerelated to public pension plans.The rest of the paper is organized as follows. In Section 1, we evaluate how wellcorporations and consultants who advise corporations have accepted key corporatefinance concepts. The emphasis is not on evaluating the prescriptive conclusions reachedby financial economists, but on themes and principles that have increasingly beenincorporated into the corporate pension plan decision-making process. In Section 2, wepresent the calculation of key corporate metrics and show how corporate pension plansimpact these key corporate metrics. In Section 3, we discuss different approaches toquantifying the trade-off between risk and capital. In Section 4, we present findings fromempirical studies on how pension plans impact shareholder value. In Section 5, wediscuss the result of a survey we conducted of pension plan sponsors on the application ofrisk management concepts to pension plans. In Section 6, we provide our conclusion. Society of Actuaries, All Rights ReservedHuang and LalaniPage 6
Section 1. Principles from Financial EconomicsModern corporate finance is part of financial economics. A discussion of financialeconomics principles as they are applied to corporate pension plans can be found in theSociety of Actuaries’ (SOA’s) “Pension Actuary’s Guide to Financial Economics”(Enderle et al., 2006). We begin our commentary by examining themes and principlesfrom financial economics that have gained increasing acceptance by corporate decisionmakers. We also point out areas where they have not been adopted.1. Both the corporations’ view and the pension plan’s view of DB pension plans areimportant.The business of pension, apart from fiduciary responsibilities, should take shareholdervalue into account. At a minimum, corporate pension plans should not destroyshareholder value. However, because of corporations’ responsibilities to their retireesand other pension plan stakeholders, strategic pension decisions are not made solelybased on shareholder interest.A main conclusion reached by financial economists is that corporate pension planinvestments should be in bonds. This argument is based on the fact that, in the UnitedStates, returns from bonds are taxed at a higher rate than returns from equities. If acorporation shifts pension investments from equities to bonds, a shareholder of thecompany can make the opposite shift in her personal portfolio and realize tax savings(Gold & Hudson, 2003). Therefore, a corporation can increase shareholder value byinvesting in bonds. This is known as the Black-Tepper tax arbitrage.De-risking pension plans often involves shifting pension investment from equities tobonds; however, there is little evidence that more investments in bonds are motivatedby the Black-Tepper tax-arbitrage arguments. De-risking strategies are made in thecontext of overall corporate strategy and their impact on shareholder value, as well astheir impact on retirees and other stakeholders.The strategic pension initiatives—such as pension buyout, lump-sum offerings, orchange to mark-to-market accounting (unless required by international accountingrules)—are unlikely to be undertaken by corporations if they result in adverseinvestor reactions, or negative analyst and rating agency responses. This is especiallyimportant if a corporation is required to spend cash to complete the pensiontransaction. For example, in Motorola’s pension buyout transaction, maintaining thesame credit rating was a necessary condition for any pension transactions (Kozlowski,2014).In a study of mark-to-market accounting for corporate pensions, SEI conducted eventstudies around accounting change announcements. SEI also reviewed analyst andrating agency reactions. Its conclusion was that a change to mark-to-market pensionaccounting has no direct impact on share prices, and has a negligible impact on thecorporation’s credit rating (SEI Investment Management Corporation, 2013a). This Society of Actuaries, All Rights ReservedHuang and LalaniPage 7
conclusion is an important consideration for corporations contemplating changes totheir pension accounting. Similarly, Moody’s concluded that de-risking activities aretypically credit-rating neutral (Smyth, 2013).Even though corporate finance often has the most influence on strategic pensiondiscussions, plan sponsors are also mindful of their fiduciary responsibilities. Forexample, in General Motors’ announcement, it stated, “we have taken great care inensuring the security of their (retirees’) retirement benefits.” The separation of theplan sponsor’s settlor function and fiduciary function is crucial in pension buyouttransactions. For significant pension plan restructuring, an independent fiduciary maybe engaged to oversee the retiree’s interest. In the General Motors case, State Streethas served as the independent fiduciary who represents members of the pension plan(Burr, 2012).2. Pension liability should be assessed economically.The financial economists’ preferred pension liability measure is a market-consistentvaluation of the Accumulated Benefit Obligation (ABO). This measure reflectsmarket interest rates but does not assume an implied labor contract of continuedemployment. Financial economists view this as the true economic measure of thepension liability, and the use of this measure leads to less distortion in the benefit forwage trade-off in the labor market (Bodie, 1990; Bulow, 1982; Enderle et al., 2006;Exley et al., 1997).While the ABO measure of economic liability is not widely used in the accountingpresentation of balance sheet liabilities (Projected Benefit Obligation (PBO) is stillthe widely used measure and is required under FAS 158), there is recognition that aneconomic assessment of pension plans is the first step in understanding their real cost.Usually this involves adjusting accounting PBO to obtain an appropriate liabilitymeasure to be used in strategic pension analysis.Three types of adjustments are frequently made:a. Update mortality and mortality improvement assumptions if theaccounting mortality assumptions are inadequate. This is especiallyimportant if longevity risk is under consideration.b. Lower discount rate assumptions. In a plan termination analysis, thediscount rate should reflect annuity purchase rates.c. Reflection of the value of embedded options—specifically, optionsavailable to participants when interest rates change, such as adjustablecash balance crediting rate, or interest rate used for lump-sum options.d. Reflection of the value of contingent liabilities based on the funded statusof the pension plan—for example, additional PBGC premiums or taxes onpension surpluses. Society of Actuaries, All Rights ReservedHuang and LalaniPage 8
Corporations considering pension risk transfer or pension liability hedging will makethese adjustments to the PBO. As an example of such analysis, Mercer’s PensionBuyout Index gives an indication of the adjusted pension liability relative to the PBO(Mercer, 2014). Coughlan makes the same point in his analysis of longevity risk(Coughlan, 2013). These developments speak to the importance of an economicassessment of corporate pension plans in any strategy development.3. Pension accounting should be transparent to decision-makers.Closely related to an economic assessment of pensions is accounting transparency.Accounting obfuscation has been cited by financial economists as an impediment tosound decision-making. The criticisms are usually in the area of pension smoothingand the presentation of pension information in the footnote of corporations’ financialstatements rather than in the actual income statement (Blake, 2009; Coronado et al.,2008). The use of long-term expected return assumptions and the smoothing ofactuarial gains and losses create an artificial stability in corporate income statementsand hide the risks of corporate pension plans (Hueffmeier, 2010).The change in pension accounting rules such as FAS 158 and IAS 19 can be viewedas a response to such criticisms. Moreover, in recent years, several companies haveadopted mark-to-market accounting for pension costs (SEI Investment ManagementCorporation, 2013a). This, among other things, provides more transparency forpension obligations and pension costs. Meanwhile, credit rating agencies haveincorporated pension information into their rating systems (Smyth, 2013).More transparent accounting reveals volatility in pension investments and makes therisk of the mismatch between assets and liabilities more apparent (Peskin, 2012).Managing pension-related volatility has become a new paradigm for pension riskmanagement (Peskin & Hueffmeier, 2006, 2008).4. Pension deficits are corporate debts.It is now widely accepted that pension deficit is a form of corporate debt. The nextquestion is: What are the characteristics of pension debt,
regarding corporate DB pension plans, such as freezing of defined pension plans or transferring pension risks to insurers, have been made in a corporate finance framework at an enterprise level. Similarly, corporate pension funding policies and investment policies are being analyzed within a set of corporate finance metrics. Therefore, there is a
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