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1 April 2014 CFA Institute Journal Review

Managing Pension Risks: A Corporate Finance Perspective (Digest Summary)

  1. Yaw Mante

Defined benefit pension plans are more underfunded today than they were after the dot-com era in both the United States and Europe. The authors discuss the risk for corporations of such underfunding and present strategies to mitigate the pension deficit.

What’s Inside?

Underfunded defined benefit pension plans create significant risks for the valuation and credit rating of, as well as the tactical and strategic options available to, a corporation. Addressing such underfunding is critical when managing the risks of a corporation. The authors discuss strategies for managing underfunded defined benefit pension obligations.

How Is This Research Useful to Practitioners?

According to the authors, the current funding deficit is worse than in the period immediately following the dot-com era; 92% of S&P 500 Index companies with defined benefit plans faced a pension deficit in 2013 compared with 84% in 2003. Similarly, in Europe, the funded status of pension plans of STOXX 600 companies was at 77% in 2012.

Allocating pension assets to such higher-return asset classes as private equity, real estate, and hedge funds imposes higher risks on the performance of pension plan assets. The authors’ analysis reveals that companies in the S&P 500 that had more than 75% of their pension assets in fixed income had a funded status of more than 90% at the end of 2012.

The authors argue that large pension deficits have negative corporate finance implications. Companies with large pension deficits tend to receive lower valuations compared with those of peers with better pension funding positions. They show that S&P 500 companies with pension deficits relative to plan assets in the top quartile have a multiple of firm value to EBITDA (earnings before interest, taxes, depreciation, and amortization) that is 0.2× lower than industry peers in the bottom quartile.

In addition, pension deficits weaken balance sheets and may lead to lower credit ratings because the major credit rating agencies treat underfunded pensions as debt-equivalent liabilities. The authors report that for S&P 500 industrial companies, the unadjusted 2012 debt-to-EBITDA ratio was 2.2×; it increases to 2.7× when adjusted for pension liabilities.

The impact of large pension deficits on the cost of capital is significant. The authors explain that for the typical S&P 500 industrial company, funding a pension deficit through debt would reduce its weighted average cost of capital by about 13%.

Finally, the authors discuss the difference between debt and an unfunded pension liability. Debt on the balance sheet has a fixed face value, but a pension deficit is influenced by equity valuations and interest rates, which are outside of the corporation’s control. Therefore, pension deficits represent a source of additional volatility; indeed, they increase the relative volatility of the company stock price to above the industry median.

The authors suggest strategies for dealing with pension deficits. They note that voluntary contributions often have a positive effect on net present value and earnings per share. Funding a pension deficit with equity instead of debt can be more expensive. In a low interest rate environment, funding with low-cost, fixed, long-term debt is leverage-neutral and, in most cases, increases earnings per share because interest is deductible.

How Did the Authors Conduct This Research?

Taking an empirical approach, the authors analyze the impact of the underfunded status of defined benefit corporate pension plans across the United States (S&P 500 companies) and Europe (STOXX 600 companies). They use publicly available data on these companies from 2002 through 2012.

They also use regression analysis to assess the impact of the level of pension deficits on valuation multiples and other fundamental metrics.

Abstractor’s Viewpoint

Most corporate finance specialists are aware of the risks inherent in an underfunded defined benefit pension plan. But the authors, by providing detailed empirical evidence, make the case more strongly. Although they draw most of their analysis from companies in the S&P 500, their findings are relevant to any company that runs a defined benefit pension plan. The research is a welcome and contemporary addition to the existing body of work that analyzes the impact of underfunded defined benefit pension plans.

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