Rescue Strategies for Defined Benefit Plans Presented by: Chip Hunt, AIF Tom Bowler, QPFC, AIF Principal Chief Investment Strategist (864) 627-4015 (864) 213-4015 chunt@primetrustadvisors.com tbowler@primetrustadvisors.com Challenges for Pension Plans • Pension plans are underfunded • Asset values are down • Liability values are up • PPA 2006 changes in plan funding rules • FAS changes in accounting rules • “At-Risk” Status • Traditional investment solutions may pose unexpected risks to the Plan Sponsor Opportunities for Advisors • The need is urgent! • The impact is significant! • CFOs need competent advisors • Separate yourself from the crowd • Manage the entire process • “Value-added” service equals “value-added” fees to your firm 1
Historical Perspective While investments recovered nicely in 2009, increases in pension liability values dampened the anticipated improvement in funded status for most plans. Data provided by Ryan Labs Contributions on the Rise Since the “tech bubble” pension contributions have increased and are on the rise again in the aftermath of the 2008 global economic crisis. Time to Re-evaluate Pension portfolios’ allocation to equities are reducing… accidentally or otherwise. 2
Risk Budgeting Sources Source of US Pension Funding Volatility Source: Mercer Human Resource Consulting Defining the Central Issues • Keeping it real • There are no silver bullets • Closing the funding gap… • Evaluating the trade-off between growth through increased contributions or investment returns • Negative leverage has to factor into the decision Impact of Negative Leverage 3
Defining the Central Issues The issues can not be defined in isolation! They must be defined in terms of the financial impact upon the plan sponsor • Cash flow impact • Financial statements – Balance Sheet – Income Statement – Shareholder equity • Existing debt covenants Corporate Finance Approach 1. Emergence of the CFA 2. Integrate ALM and LDI results into financial statements 3. Identify key pension metrics as they relate to financial statements 4. Size does matter 5. Separate yourself from the crowd 6. Manage the process Corporate Finance Approach Size Matters The impact of a drop on plan funded status on the sponsoring company’s balance sheet Company A Company B Today: Plan Future: Plan Today: Plan Future: Plan 100% Funded 75% Funded 100% Funded 75% Funded Current Liabilities $ 1,900 $ 1,900 $ 190 $ 190 Liabilities for pension benefits - 500 - 500 Deferred income taxes 800 600 80 -120 Other long-term liabilities 16,750 16,750 1675 1675 Total liabilities $ 19,450 $ 19,750 $ 1,945 $ 2,245 Common Stock $ 1,500 $ 1,500 $ 150 $ 150 Retained earnings 14,500 14,500 1450 1450 Accumulated Other Comprehensive Income 7,250 6,950 725 425 Total shareholders' equity $ 23,250 $ 22,950 $ 2,325 $ 2,025 Total liabilities and shareholders' equity $ 42,700 $ 42,700 $ 4,270 $ 4,270 -1.30% -13.00% Reduction in shareholder equity Financial Leverage Ratio 1.84% 1.86% 1.84% 2.11% Source: Vanguard Investment Counseling & Research 4
Corporate Finance Approach Key Metrics Metric Description Purpose Balance Sheet For any given investment policy and/or funding Probability of pension deficit Access the downside risk of Balance policy, the probability that the deficit will exceed a exceeding threshold Sheet vulnerability level acceptable to the Plan Sponsor An estimate of expected downside changes in the Expected downside impact to plan's funded status and how these affect Measure shareholder equity at risk Shareholder Equity company estimates of shareholder equity Income Statement Estimates of downside changes in pension Expected downside impact on earnings and how these affect company estimates Measure operating earnings at risk operating income of operating income Standard deviation of pension Varibility of pension expense, measured as Assess the potential impact on expense dispersion from the mean earnings volatility Mixed Ratios An estimate of change in pension expense or Assess potential impact on a Return on Assets (ROA) funding status and its influence on company ROA company's profitability ratio Other Estimates of expected and downside contribution Contributions & corporate requirements and the potential impact on company Measure risk to company cash flow cash flow cash flow Expected and downside Estimates of expected and downside contribution impact on planned capital requirements and the potential impact on plans for Assess impact on capital budgeting expenditures projects Source: Vanguard Investment Counseling & Research Corporate Finance Approach The Process 1. Identify Plan Goals & Objectives 2. Establish finance risk control parameters 3. Perform asset-liability modeling (ALM) 4. Model impact of alternative funding policies 5. Integrate the results into financial statements 6. Choose the scenario best meeting company’s risk tolerance Corporate Finance Approach The Process 7. Establish Investment Policy 8. Establish Funding Policy 9. Measure, evaluate and monitor results 10. Make tactical adjustments, as necessary 5
A Case Study The Goal Get the Plan fully funded! The company wants to terminate the plan and distribute benefits to the participants as soon as practical. A Case Study The Facts • US manufacturing company; subsidiary of European parent company • US pension deficit big concern for balance sheet impact • Frozen pension plan • Plan Assets as of 12-31-08: $47,539,000 • Plan Liabilities as of 12-31-08: $73,048,000 • Balance sheet funded status: - $25,509,000 • Target allocation as of 12-31-08: 65% LDI and 35% Equities • Duration of plan liabilities: approx. 11.7 • Min. Req. Cont. for 2008: $2,064,000 • Min. Req. Cont. for 2009: $4,000,000 A Case Study Risk Parameters • CFO is focused on pension funding deficit on the balance sheet (IAS 19) • Highly leveraged company very sensitive to impact of additional liabilities hitting the balance sheet • Focus of the ALM, Investments and funding policy on variability of pension deficit • Very little tolerance for downside pension deficit results • European CFO predisposed to 100% Government Bond portfolio 6
A Case Study ALM Study The ALM Study focused on the results expected from 4 Asset Allocation Models… - Sampled Investment Mixes - 1. 65% LDI and 35% equities 2. 75% LDI and 25% equities 3. 85% LDI and 15% equities 4. 100% LDI A Case Study ALM Study And the ALM Study focused on the results expected from 4 alternative funding policies as an overlay to the investment policies… - Sampled Funding Policies - 1. Minimum Required Contribution (approx $4 mil) 2. Minimum Required Contribution, plus $1 million 3. Minimum Required Contribution, plus $1 million, plus one-time addt’l $5 million in 2009 4. $ 6 million annually Funding: Minimum Contribution Balance Sheet Funded Status 30,000,000 Funded Status in not achieved 20,000,000 10,000,000 0 -10,000,000 IAS 19 Balance Sheet Liability is eliminated -20,000,000 -30,000,000 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 5th - 25th 25th - 50th 50th-75th 75th-95th Bars Left to Right Increase LDI Allocation: 65% (Leftmost), 75%, 85% and 100% (Rightmost) 21 7
Funding: Minimum + $1 Million Balance Sheet Funded Status 30,000,000 20,000,000 10,000,000 0 -10,000,000 IAS 19 Balance Sheet Liability is eliminated -20,000,000 -30,000,000 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 5th - 25th 25th - 50th 50th-75th 75th-95th Bars Left to Right Increase LDI Allocation: 65% (Leftmost), 75%, 85% and 100% (Rightmost) 22 Observations • Investment mixes with more than 35% equities violate the company’s balance sheet liability threshold • 100% LDI strategy never reaches fully funded status without increased contributions • Contributions above MRC in combination with a 25% - 35% equity portfolio appear most efficient within the company’s tolerance bands 23 Conclusions • The Board approved the 35% equity portfolio and is evaluating the level of additional contributions • The recommendation is MRC plus $1 mil 24 8
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