Pension surplus assets, discovered by shareholders in the 1980s as a big ripe hidden plum, are becoming of little or no value to large sectors of the economy. The reason stems from government's hopeful but misguided intervention to preserve pension surplus assets. The change will have immense implications for the way pension funds are invested, the attitude of companies on continuing defined benefit plans, and a key source of funds for the capital markets.
Like assets frozen in a foreign country, stockholders can realize the value of surplus assets only indirectly. That wasn't always so. More than a decade ago, the hidden corporate value in the form of pension surplus assets was put into play often in the sweep of merger and acquisition transactions. Since then, successive rounds of federal legislation intended to reduce the exposure of the Pension Benefit Guaranty Corp. placed layers of additional liability coverage and reversion tax between pension surplus assets and stockholder value.
Now, stockholders can tap pension surplus by two indirect routes. First, corporations can grant supplemental liabilities in the form of benefit increases. But if existing pension plan terms in a comprehensive compensation package are sufficient to attract and retain top flight employees, this tactic is of no value to stockholders. Second, corporations can run off pension surplus by not making further contributions. But since this takes time, there is a loss of present value. By this route, a dollar of surplus pension assets is worth less than a dollar - a sort of time-value-of-money tax.
This non-convertibility introduced a kink in the stockholder value of pension assets at the level of pension liabilities. Moreover, because of the reversion tax and special PBGC premiums involved, the marginal value of pension assets below the level of liabilities is high, or conversely, the cost of a dollar of unfunded liabilities is more than a dollar.
Optimal corporate financial policy becomes keeping pension assets equal to liabilities. In a world of capital markets' volatility and the marking-to-market of liabilities consistent with bond market prices, this corporate financial policy objective favors fixed-income over equity investment.
A corporation can take equity risk efficiently on its balance sheet directly with the benefit of dividend income exclusion. Whatever asset allocation policies are going forward, they have neglected pension liabilities and stockholder value maximization for too long.
Modern economics is modern because of its inclusion of the economics of risk bearing or finance. In this view, the de facto ownership of assets is risk-bearing - what senior federal tax officials call the "smile test" when applied to tax-oriented option strategies. If you smile when something's value goes up and frown when it goes down, you are a de facto owner.
Before recent rounds of federal regulation, for a reasonably funded ongoing pension plan, stockholders were the beneficial owners. This recognition is inherent in actuarial funding methods in their treatment of unfunded liabilities. Who else is slated to make the contributions?
Today, the stockholder value of pension assets is reduced by the increased value of Treasury and PBGC tax and premium options on the plan sponsor. By tying plan termination to bankruptcy, not insuring benefits above certain levels, and imposing additional insurance premiums on underfunded plans, the formerly important value of the "pension put" - walking away from underfunded pension liabilities, leaving them to the PBGC - is much reduced.
Private sector companies either contracting with the government or rate-regulated by a public body will come to recognize they no longer effectively own pension surplus assets, and consequently will get rid of them. Surplus assets are interpreted as overpayment for employment costs in either prior contracts or rate tariffs. The argument that the surplus pension assets are the product of investment acumen will not wash. The Department of Defense, or relevant rate commission, for example, will seek some form of redress in future contracts or services pricing. They also will conclude there is less reason to hold asset classes other than domestic fixed income; only some form of matching assets and liabilities will ensure neither unfunded nor overfunded conditions prevail.
There is a collateral issue to the diminution of the value of pension plan surplus to shareholders of all corporations generally. That issue is the impending takeover of pension surplus assets of government contractors and publicly regulated companies, such as defense or health care companies and utilities. The takeover mechanism is inherent in negotiations for contracting services or rate relief.
Companies with public-regulated customers whether directly (government contractors) or indirectly (public utility service providers) will sooner or later seek pension financial policies that eliminate surplus assets and more closely manage their pension asset/liability objectives. Large sectors of the economy will find pension surplus assets of little or no value. The diminution of value will nail two coffins - defined benefit plans and a major source of equity risk capital that would have fueled badly needed U.S. economic growth.
Douglas A. Love is managing director of Ryan Labs Inc., New York.
