Locking in

J.C. Penney buys into LDI for closed plan

Strategy is revealed in unusual webcast: 'Pensionomics'

J.C. Penney Co. Inc. executives intend to move to a liability-driven investing strategy over the next five years for the company's $4.1 billion defined benefit plan.

The new approach will result in a 75% allocation to fixed income, up from 20%, and a reduction in equities from 70%, which includes 5% in private equity.

“We want ultimately to get to 100% bonds,” said Robert B. Cavanaugh, executive vice president and CFO of the Plano, Texas, company.

The strategy was revealed in a webcast Penney executives conducted June 18 for securities analysts and investors. Called “JCPenney Pensionomics Class,” it was devoted exclusively to pension plan investment and financing, and lasted almost three hours.

The webcast featured Mr. Cavanaugh; Michael D. Porter, Penney vice president and treasurer; Sal Saggese, Penney vice president and chief accountant; Michael Smith, consulting director at Russell Investments; and Richard E. Jones, principal and chief actuary at Hewitt Associates Inc. Russell and Hewitt are consultants to the Penney pension plan.

Penney designed the webcast to “show you we have a new game plan with significant risk reduction” to the pension plan and corporation and to reveal “what action steps we see over the next several years ... and finally where we see the ... game plan several years down the road,” Mr. Cavanaugh said.

Penney is moving to LDI as a result of closing its plan to new entrants as of Jan. 1, 2007. Because of concerns about underfunding and locking in losses, it did not adopt the strategy until now, Mr. Cavanaugh said.

The plan was 93% funded as of Jan. 31. Last month, the company contributed $340 million in Penney stock to the plan, hiring Evercore Trust Co. as independent fiduciary to manage the stock. The stock contribution raised the funding of the plan to between 104% and 110%, making the timing better for moving to LDI. The plan has $3.7 billion in pension liabilities.

During the webcast, Mr. Cavanaugh gave no time frame for the move to 100% bonds, noting “some logistical issues” Penney will have to overcome. “How do you unwind private partnerships” in private equity and real estate, he asked. To begin, Penney will make “no new allocations, no new commitments” to private equity and real estate “and take cash generated by those private partnerships and redeploy (it) into fixed income.”

Penney's current asset allocation is 45% domestic equity; 20% developed international and emerging markets equity; 5% private equity, including venture capital, buyouts and international; 10% real estate, both private market partnerships and public market real estate investment trusts; and 20% fixed income.

Mr. Porter said, “Our current investment strategy has a heavy weighting toward equity with its higher expected return. As we go forward, our liability growth slows and then becomes negative. ... We can now shift from equities to a more stable bond portfolio. As the economic characteristic (of the pension plan) changes, it becomes more bondlike: higher cash flows and more predictable. This allows us to transition to a fixed-income-weighted portfolio with its lower expected return but also with its lower risk and volatility ... yet still be matched to our liability characteristics going forward.”

Penney is the only major company that moved to LDI in the past year, primarily because the market meltdown left most other corporate plans underfunded, analysts said.

St. Joe Co., Jacksonville, Fla., announced June 25 it annuitized $93 million of its pension plan liabilities by transferring $101 million in assets to Massachusetts Mutual Life Insurance Co. The annuitization will reduce the company's risk and raise the plan's funding ratio to 260% from 145%, William S. McCalmont, St. Joe executive vice president and chief financial officer, said in the statement. Once the deal is completed, the plan is expected to have $73 million in assets and $28 million in liabilities.

LDI variation

Michael A. Moran, vice president at Goldman Sachs Group (GS) Inc., New York, said of the St. Joe strategy: “You can think of that as another variant of LDI. With that part of the plan they could have done LDI internally and put it in fixed income so they match those obligations, or alternative they could put them with a third party and have them do it for us. I think for some companies it tends to be more expensive to do it with a third party. But the concept is the same. ... If you were doing LDI, that obligation would still be the company's responsibility.”

The best time to move to LDI is when a plan is overfunded and closed to new entrants, Mr. Moran said, especially when the size of the plan is big enough for volatility to affect the company's financial position. Companies with underfunded and open plans would lock in obligations with little chance for investment growth, putting a further financial burden on sponsors to contribute more, Mr. Moran added.

“From an LDI perspective, a lot of companies that didn't do it (before the market collapse) feel they can't do it now because they would lock in liabilities,” Mr. Moran said.

Penney executives hosted the webcast “to provide clarity ... and to eliminate any investor uncertainty regarding our financial risk, cash flow, balance sheet, capital structure and EPS earnings volatility” Mr. Cavanaugh said. He called Pensionomics “the continuous financial optimization process for the management” of the pension plan promise. The webcast was accompanied by a 65-page slide presentation.

“We conducted the Pensionomics class and webcast because it's a great way to make our pension plan better understood by the financial community,” Penney spokesman Quinton Crenshaw said in a statement, noting “we've never had a dedicated call or webcast related to this topic.”

Mr. Moran said aside from General Motors Corp. and Ford Motor Co., he doesn't know of another company that has ever devoted such a lengthy presentation to its pension financing.

Mark Ruloff, director of asset allocation at Watson Wyatt Worldwide Inc., Arlington, Va., said Penney's public revelation of its strategy was highly unusual, especially since the company is just starting the radical restructuring. He couldn't point to a similar example.

“While companies want to inform shareholders ... to explain risk reduction to their plans and its reflection in market valuation, it's still rare to do it in a public fashion,” he said.

Lower returns

Once completed, Penney's move to LDI will decrease the expected return on assets to 7% from 8.4% and reduce volatility of investment returns to 6% from 13.2%. As a result, return on assets per unit of volatility will rise to 1.2% from 0.6%, according to the presentation.

In its transition to LDI, Penney also plans to move fixed income to a long-duration portfolio from a short-duration one.

Penney expects no contribution requirements to its plan at least through 2014 and potentially none again as the closed plan's liabilities ultimately fall through attrition.

“We have a new game plan with significant risk reduction ... and transition action (to LDI) and thirdly the key goal, as always, is you want to enhance shareholder value,” Mr. Cavanaugh said.

The strategy seeks to instill employee, customer and shareholder confidence, Mr. Cavanaugh said. “We have to win with all three.”

Penney's longtime use of mark-to-market pension accounting has been the driving force behind its historically well-funded plan, as well as its new LDI strategy, he said.

“The accounting liability has it all wrong,” Mr. Cavanaugh said. “The tax liability has it all wrong. Those are not the real liabilities. The economic liability — it's real simple — is the liability we always managed to. From that liability, we then try to match the investment strategy and the contribution strategy. That goes into all the annual impacts,” including financial, capital structure, earnings-per-share volatility and the plan's funded status.

“The interaction, the feedback loop for optimization is all those items impacting corporate financial flexibility.”

Last month, Penney devoted a 36-minute webcast to explaining the financial engineering of contributing its stock to the pension plan, noting that move raised the company's estimated earnings per share for 2009 by 2 cents, to 77 cents.

That stock contribution, fully tax deductible, “will eliminate all of our taxes due and payable in 2009,” totaling $131 million in federal, local and state taxes, Mr. Cavanaugh said in the webcast. The move thus increased the company's cash flow by $131 million, which it plans to use, coupled with $209 million in corporate cash, to buy back $340 million of debt in the open market. He called the transaction “a financial arbitrage opportunity ... and a tax-deductible equity-for-debt exchange, which helps us re-equitize our balance sheet and deleverage our capital structure.”

“It's all about management optimization ... and minimizing our long-term costs and risks,” Mr. Cavanaugh said in that webcast.

“We could have contributed cash” to the pension plan instead of stock, Mr. Cavanaugh said. “We do have an excellent (corporate) liquidity position ... but we wanted to ensure ... liquidity in the uncertain (economic) environment.”

Unlike Penney, most companies use amortization, or smoothing, accounting for their pension plans. “As a result, in the JCP model, when actual and expected returns vary substantially (as they did in 2008), the market-related value of plan assets can diverge substantially from the fair value of plan assets — taking a disproportionate toll on the income statement relative to companies adopting more aggressive accounting (smoothing) methods,” according to a June 16 report by J.P. Morgan Securities Inc., New York.