By Scott Sprinzen So how quickly must regulators act to shore up Corporate America's pension plans? Broadly, the favorable stock market performance of 2003 and 2004, coupled with special funding actions some companies undertook, has undone much of the deterioration caused by the bear market of 2000-02. In economic terms, this has helped improve aggregate pension-plan funding levels considerably from the low point of late 2002 -- adjusting for the effect of low interest rates, which will reverse if rates continue rising, as expected.
And yet, two factors lend some urgency to the Bush Administration's proposals to modify regulations for corporate defined-benefit pension plans. First, in the wake of the bankruptcies of some major steel companies and airlines in recent years, the government-owned entity that insures qualified benefits, the Pension Benefit Guaranty Corp. (PBGC), has reported that its deficit as of Sept. 30, 2004, exceeds $23 billion for single-employer plans. This is a record and represents a substantial decline from a $7.7 billion surplus only three years earlier.
LOWERING LOSS EXPOSURE. Since Sept. 30, that deficit has increased even further. On Feb. 2, the PBGC assumed responsibility for certain pension plans of US Airways (UAIRQ), which are underfunded by an estimated $2.3 billion. And on Mar. 11, the PBGC said it will assume $2.1 billion of liabilities from UAL Corp. (UALAQ).
Second, in early 2004 the government passed a stop-gap bill - the Pension Funding Equity Act of 2004 -- that created a revised means of determining the discount rate used for regulatory purposes to calculate the pension liability. However, this legislation covered only the 2004 and 2005 plan years.
The Administration's proposals are intended to bolster the PBGC's financial condition by increasing its premium revenue, while lessening its exposure to losses by having companies accelerate pension-plan contributions to eliminate unfunded liabilities. Obviously, such measures could increase pressures on the cash flow and liquidity of companies burdened by such liabilities.
What does the Bush team's reform plan involve? Here's a look:
Asset values: Plan assets would be measured at fair value. This would supplant the smoothing of asset values under current regulations, which obscures the effect of investment portfolio volatility.
Discounting: A spot (i.e., fixed in time)
yield curve of high-quality corporate bonds matched to the expected payment date of retiree benefits would be used for discounting purposes. Again, this would replace the current smoothing. Under the Pension Funding Equity Act, discount rates are tied to the weighted-average interest rates of long-term investment-grade corporate bonds over the previous four years. In addition, assuming a normal, upwardly sloping yield curve, the act would increase the size of pension obligations for companies with mature plans that have short benefit obligation durations.
Contributions: A company's required contributions would be based in part on its credit quality (see table below). If a company is investment-grade (defined as having senior unsecured debt rated investment-grade by at least one rating agency), its minimum annual contribution would be based on its "ongoing liability." This is the present value of all benefits expected to be paid in the future based on benefits earned to date, taking into consideration the probability that benefits would be paid in lump sums and using mortality tables and discount rates (as described under "Discounting" above) prescribed by the Treasury Dept.
Rating-Based Funding Targets
Investment-grade (Baa or better)
Target assumes it's an ongoing plan
Junk-bond credit status less than 5 years
Target in between ongoing and at-risk status
Junk-bond credit status 5 years or more
Target assumes it's an at-risk plan
Data: U.S. Labor Dept.
If a company's credit rating were below investment-grade, its annual contribution would be based on its "at-risk liability." This would be calculated in the same manner as its ongoing liability, except that it would assume the earliest possible retirement point for all employees, maximum benefits being distributed as lump-sum payments, and a "loading factor" ($700 per plan participant, plus 4% of the at-risk liability before the loading factor) intended to reflect the transaction costs of purchasing a group annuity if the plan were terminated.
A company losing its investment-grade rating (as defined above) would be given a five-year transition period, during which it would have to fund to a target between its ongoing and at-risk liabilities.
If a company were unrated, and its pension plans exceeded a certain size, its credit quality would be determined by "financial measures, such as whether the long-term debt-to-equity ratio of the controlled group is 1.5 or more, with debt to include the unfunded pension liability.
Makeup payments: Companies would generally be required to make up any shortfall in plan assets vs. the ongoing liability (in the case of investment-grade companies, as defined above) or vs. the at-risk liability (for speculative-grade companies) in equal annual payments over seven years. Currently, in many cases, companies have up to 30 years to fund deficits resulting from plan amendments.
Tax-deductible contributions: To encourage companies to maintain healthy funding surpluses in their pension plans, they would be given increased leeway to make tax-deductible contributions, even if their plans were already fully funded. However, the current "funding credit balance" would be abolished. This has allowed underfunded companies the discretion to forego making contributions for several years, in some cases, if earlier contributions had exceeded requirements.
Limits on enhancing existing benefits: A company's credit rating - plus the extent of any underfunding -- would also determine the extent to which it would be permitted to enhance existing benefits.
PBGC premiums: They would be increased significantly, and the company's payment would be tied to the extent of any underfunding and its credit quality. Currently, all companies with PBGC-insured plans pay a trivial annual flat-rate premium of $19 per employee and retiree -- the equivalent of $1.9 million per year for a company with 100,000 employees and retirees. Under the Bush Administration's proposal, this would be increased to $30 per year -- still a nominal expense.
Companies with funding deficits now pay an additional variable-rate premium (VRP) equal to $9 per year for each $1,000 of unfunded vested benefits (as defined). This, too, has not been a significant expense. For example, an outfit with a deficit of $1 billion pays only $9 million per year of additional VRPs.
However, under the Administration's proposal, the VRP would be increased substantially. It would still be a flat fee per amount of underfunding, but would be based on the company's relevant target funding level as determined for funding purposes (as described above).
Also, the VRP rate per dollar of underfunding would be revised periodically by the PBGC board. According to the proposal, "risk-based rate adjustments will be computed based on forecasts of the PBGC's expected claims and of its future financial condition." Premiums would be set at a level "...necessary to meet expected future claims and to retire PBGC's deficit over a reasonable time period." Thus, to the extent that the PBGC's annual claims paid plus its investment earnings on the assets of assumed plans exceeded flat-rate premium revenue, the difference would fall squarely on the companies picking up the tab for VRP premiums.
PBGC claim status in bankruptcy: Once a company has filed for bankruptcy, the automatic stay provision of the federal Bankruptcy Code currently prevents the PBGC from perfecting a lien (i.e., giving legal notice of its claim on the assets) against the company. The Administration's proposal would amend the code to create an exemption from the automatic stay to allow creation of liens, and perfection of those liens by the PBGC, against the company for required pension contributions that had been missed. However, other claims of the PBGC, which can far exceed those relating to missed payments, would remain on a general unsecured basis.
If the Administration's plan is implemented as proposed, the credit implications would be varied. Broadly, given the use of current asset values and spot interest rates, plus the elimination of much of the flexibility in the timing of payments that exists under the current framework, year-to-year required contributions would be much more volatile and less predictable than they are right now.
Clearly, businesses would have a greater incentive to avoid funding deficits. To the extent that a company devoted more cash to plan contributions than anticipated, Standard & Poor's Ratings Services would need to consider this in the context of the outfit's cash-flow adequacy and other potential calls on cash.
HIGHER FUNDING TARGETS. Again, given the greater incentive to prevent funding deficits, some companies might choose to adopt more conservative investment strategies for their pension portfolios, deemphasizing equities in favor of high-quality fixed-income investments, which we continue to view as a more prudent approach. Some market observers have noted that just the potential for regulatory changes along the lines proposed by the Administration has already sparked significantly increased demand for long-dated, high-quality bonds.
Given the increased downside risks of defined benefit pension plans, the new legislation might give renewed impetus to some companies' efforts to curtail benefits and/or switch to alternative defined-contribution schemes. We would need to assess such actions in the context of each company's labor relations and the competitive environment it faces.
Implementing the Administration's plan would represent an unmitigated adverse development for companies that currently have significant unfunded liabilities. Under the yield-curve approach, businesses with relatively mature plans -- those having substantial benefit-payment obligations over the next few years - would likely face a higher funding target than under current regulations.
MORE DISCLOSURE. These outfits would have less time to make up the deficit and much less flexibility in the year-to-year timing of contributions. Moreover, such companies could also face dramatically higher PBGC VRP payments - and little predictability in year-to-year changes in these. Ironically, substantially higher PBGC premiums could divert funds that would otherwise be available for pension contributions.
At this time, we don't foresee that implementation of the Administration's proposals, in and of itself, would lead directly to any rating actions, but we don't discount this possibility entirely. Also, matters relating to pension reform have typically been highly divisive in Congress, meaning that it's uncertain what legislation might ultimately be enacted. It's possible that in the course of congressional deliberations, special relief could be granted to certain industry sectors, possibly leaving them with no more burdensome near-term funding requirements than they currently face.
The Administration has also indicated it supports increasing the disclosure of information about pension plans to workers, investors, and regulators to ensure greater transparency and accountability. This would include much more rapid filings of Form 5500, which reveal a plan's funding status, and public disclosure of Section 4010(c) filings, which include information now disclosed only confidentially to the PBGC regarding unfunded pension liabilities, calculated on a termination or "shutdown" basis -- a move we would welcome.
At S&P, we'll continue to monitor developments closely concerning the planned legislative initiatives.
Editor's Note: Related video clips can be found under "Hot Topics" at standardandpoors.com Sprinzen is a senior credit analyst for Standard & Poor's Ratings Services