Those pension fund deficits: an opportunity to borrow?

Citation

Robinson, B. (2003), "Those pension fund deficits: an opportunity to borrow?", Balance Sheet, Vol. 11 No. 3. https://doi.org/10.1108/bs.2003.26511cab.001

Those pension fund deficits: an opportunity to borrow?

Dr Bill Robinsonis Head UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.

Some problems are also opportunities. This is especially true of the increase in pension fund deficits resulting from the new thinking on pensions accounting embodied in FRS17. If you have a large pension fund, and are coming under pressure to switch the assets into bonds, there is a new financial strategy open to you which will: (a) ensure that your move into bonds does not look foolish if the equity market subsequently rises, (b) give you some capital to finance expansion, and (c) create shareholder value by reducing your tax bill. Let me explain.

The scenario

Pension funds have been in the news lately, mainly because the 50 percent fall in share values since the market peak has created some large pension fund deficits. The market downturn has revealed the inherent risks that all companies run when they fund their pension schemes (as most of them do) predominantly with equities. These risks have not been apparent during a bull market that has lasted, with minor interruptions, for a quarter of a century. Accounting rules that permit smoothing of market fluctuations also helped to reduce the apparent risk of equity investment. Now the bull market is over, accounting rules are about to change, the risks of holding equities in pension funds have been revealed for all to see. Companies are coming under a lot of pressure to do something about them.

Equities have been the favored means of funding pensions liabilities because they offer a larger expected return than bonds. They do so because they are riskier than bonds but the risks are not reflected in the traditional accounting treatment. This is how it works. The current accounting rules reflect the higher expected returns from equities by allowing companies to discount their pension liabilities at a higher discount rate if they fund them with equities. So a company choosing to buy equities rather than bonds can put in less money. These rules have encouraged companies to invest in equities. Effectively they have been allowed to take credit for the additional return from equities (the equity risk premium). But the other key characteristic of equities, their risk, (which financial economists measure by the variance of equity returns) was not revealed under the old standards, which permitted infrequent reporting and smoothing.

A new way of calculating

Finance theory tells us that pension liabilities are what they are, irrespective of how they are funded. As liabilities that are completely certain, they should be discounted at a bond rate of interest. The new thinking, embodied in the FRS17 accounting standards, recognizes this and will require pension liabilities to be calculated using a corporate bond rate. They will also require pension fund assets to be measured at market prices on an annual basis. The new rules will thus reveal both the true size of the pensions obligations and the inherent risks of meeting them with equity funding. There will be a negative effect on value on both counts.

From now on it should become clear that any company that fully funds its pension liabilities with equities is effectively increasing its gearing, increasing its risk, reducing its credit rating, and thereby potentially reducing its value by pushing up its cost of capital. Table I illustrates the point with a simple example. We assume the company has a market capitalization of 100. The pension fund assets and liabilities are both 50, so there is no deficit. The stock market value of the company therefore exactly reflects the discounted present value of the cash flows in the company. We assume the company is of average risk, in other words it has a unit beta, and that the pension fund is invested in an average market portfolio.

Now consider what would happen if the stock market fell in value by 10 percent. Because the company has a beta of 1, the present value of its cash flows in the company will also fall by 10 percent to 90. The value of the pension fund assets will also fall in line with the market to 45. The liabilities do not change. As a result it can be seen that the market capitalization of company plus pension fund falls to 85, a 15 percent fall. So although the company has an equity beta of 1, the company plus pension fund has a beta of 1.5. Ownership of an all-equity pension fund of 50 increases the gearing of the company by exactly the same amount as taking on debt of 50.

The implications of this simple fact are profound. The effect of volatile markets, magnified by a switch to new accounting rules, reveals that companies with pension funds are more risky than previously thought. The ratings agencies are starting to recognize this and downgrade companies with large pension funds, thereby reducing their value. Obviously it is not every company that has a pension fund as large as that shown in the table. The size of the average pension fund is closer to 15 than 50 percent of the value of the company. But many older companies are in the predicament illustrated above.

So what to do about it?

One way of dealing with this problem is to switch the pension fund into bonds. But most companies are reluctant to do this because they risk looking silly if the equity market, after three years of decline, bounces back. A better solution is to adopt an idea first put forward by the economist Fischer Black (he of the Nobel Prize-winning Black-Scholes formula for options pricing). Black pointed out that a company which sells equities and buys bonds in its pension fund has a unique opportunity to carry out the opposite transaction in the company. It can issue bonds and use the proceeds to buy back its own shares, finance investment, or even (possibly less advantageously) buy a portfolio of equities. A transaction of that sort makes the company more risky – but the additional risk is offset by the reduction in risk in the pension fund. Properly presented, the double transaction (cognoscenti call it Black Magic) should make no difference to the firm's credit rating.

But the double transaction will, for many companies, deliver shareholder value in the form of a new tax shield. Every finance director knows that a debt financed share buyback creates such a tax shield. But the value can often be destroyed by the increase in risk, reflected in a worse credit rating, resulting from the transaction. The double transaction delivers the tax value, but has no impact on the risk of the combined entity.

Firing the magic bullet

Where does the tax value come from? The easiest way of looking at it is to imagine that the company is issuing bonds in order to buy bonds. The interest payments on bonds attract tax relief in the company. The interest receipts from bonds are not taxed in the pension fund. The deal is worth doing as long as the tax savings outweigh the difference between the company's borrowing costs and the return on lending. On the equity side, the company is selling equities (in the pension fund) in order to invest in physical capital, or buy back its own shares. There are no adverse tax implications of this switch.

The magic bullet described above does not work for every company. You need to be paying tax, or the tax shield has no immediate value. You need a good credit rating, or the spread on your borrowing could wipe out most of the tax gains. It helps if you are looking to make an investment, an acquisition or a share buyback, because this gives you a tax efficient way of deploying the share capital liberated from your pension fund. If you meet these criteria, then Black Magic could be for you.

If it is such a brilliant idea, why hasn't it been done before? The simple answer is that as long as the accounting rules made your pension fund liabilities look smaller if you funded them with equities, it was a brave company that did otherwise. But the new thinking, which brings the accountants' way of looking at pensions liabilities closer to the finance theorists' approach, removes the disincentive to hold bonds in the pension fund. So Black's idea, ignored for nearly a quarter of a century, is an idea whose time has come.

Dr Bill Robinson can be contacted at his e-mail address: dr.bill.robinson@uk.pwc.com and welcomes discussion of the issues he has raised.