Others expected to hitch ride on GM funding idea

A spate of corporations is expected to follow the lead of General Motors Corp. by issuing debt and using the proceeds to fund their pension plans.

"The general truth is that fewer companies that should be doing this actually have done it. But I do think it definitely will be the case going forward that more companies will look to do this … especially if we see a change in the regulatory environment," said Michael Peskin, global head of capital markets at Morgan Stanley & Co. Inc., New York.

According to an Aug. 8 research report from Merrill Lynch & Co., New York, corporations with underfunded pension plans should consider issuing bonds and use the proceeds to fund their pension plans to take advantage of a low interest-rate environment and stay ahead of pension reforms that are expected to be passed by Congress in the next year or two.

The strategy paid off in spades for Detroit-based GM, which issued $17.1 billion of multicurrency bonds and convertible securities in 2003, pumping about $14 billion of the proceeds into its pension plan. At the time, the plan was $19.3 billion underfunded. Morgan Stanley was one of the lead underwriters.

The proceeds were invested in several alternative investment portfolios that generated a 14% return last year, a GM spokesman said.

The Merrill Lynch paper by Gordon Latter, senior pension strategist, said corporations can create a tax arbitrage by issuing debt to fund the pension plan. That's because interest payments on bonds are tax deductible and pension assets are tax exempt. Companies also could avoid the variable rate premium (based on pension liabilities) that the Pension Benefit Guaranty Corp. charges, the paper noted.

If a company with a double-A debt rating issues $100 million worth of 30-year bonds, it could most likely notch a spread of 100 basis points over a comparable Treasury bond, so the coupon would be 5.2%, the report said. By issuing those bonds and using the proceeds for pension funding, a company could generate an estimated cash-flow saving of $4.7 million in the first year, provided interest rates do not change. The savings would be through tax savings and avoiding the PBGC charges.

The report also notes strong demand for long-duration bonds, which is what a corporation would issue to fund its pension plan.

The Merrill report uses Exelon Corp., a Chicago utility, as another example. Exelon issued $1.7 billion in senior notes in June to pay off the $1.4 billion remaining on a $2 billion term loan. Proceeds from the term loan were contributed to the company's $7 billion defined benefit plan. Merrill Lynch served as one of the lead underwriters on the deal. George Shicora, Exelon's director of investments, did not return calls.

In 2002, Boots Co. PLC, Nottingham, England, issued £300 million (valued at $456 million at the time) worth of bonds and used the proceeds to buy back an equal amount of its own stock, while at the same time immunizing its pension plan by investing exclusively in corporate bonds. The strategy Boots used is an offshoot of one outlined in 1980 by Massachusetts Institute of Technology finance professor Fischer Black, entitled "The Tax Consequences of Long-Run Pension Policy."

While Mr. Black's strategy isn't identical to the one outlined by Merrill Lynch, it essentially demonstrates how a company can create a tax arbitrage by investing its pension assets in fixed income while simultaneously issuing bonds to buy back its shares.

Said Morgan Stanley's Mr. Peskin: "The real benefit in this is the tax savings, which would be twofold. One, the interest-rate payments would be tax deductible and two, the proceeds would be applied to a pension plan, which is tax exempt. … It's very clear that strong companies should borrow and fund from a pure (tax) arbitrage standpoint. On the other hand, this strategy would not make sense for a very weak company or a company on the verge of bankruptcy. For companies in between those two statuses, it may or may not pay off. It depends on the rating, debt capacity and the coupon it could get on its bond issue."

Despite the benefits, some industry executives said an individual company's debt capacity and improving market conditions have caused companies to hold off on issuing debt to pay down their pension liabilities.

Other corporate executives have different reasons. "Debt-based funding makes all the sense in the world on paper, and it seemed to have worked out for GM. But the fact is, we'd probably rather use our debt capacity to fund projects that will grow our business — that's what our shareholders and analysts expect to see from us. I know GM did it, but their debt capacity is a lot bigger than ours," said the treasurer of a large corporation who requested anonymity.

Scott Sprinzen, an auto analyst at Standard & Poor's, New York, said an improving stock market has prompted most companies to believe they can fund their plans by meeting their expected rates of return.

"I think the sentiment right now is that the equity markets have improved over the past year, and that most corporate CFOs believe that they can fund their pension plans by meeting their expected rate of return and maybe through cash contributions," Mr. Sprinzen said.

"But what this issue really boils down to is debt capacity. Unless a company is facing very large cash contributions to their plans, most companies wouldn't want to use some of their debt capacity simply to fund their pension plans," he added.

Fred Dopfel, senior strategist at Barclays Global Investors, San Francisco, said a company's credit rating could be an issue.

"This strategy may make a lot of sense for a corporation that is considered ‘underleveraged' and where taking on the additional debt would not impact credit rating," he said. "As pointed out in the (Merrill Lynch) report, the ‘net debt' from a holistic point of view may be unchanged anyway by this strategy, and we hear that rating agencies are waking up to keep a closer eye on funded status.

"Everything would be heightened if there were regulatory changes and PBGC sensitivity," Mr. Dopfel said.

"The follow-up question to the corporation is, after raising the debt, what is the corporation's plan for investing those monies. There is definitely some good thinking behind it, but the market conditions described in the research have existed for a while, and there appears to be very little action."

Merrill's Mr. Latter said in an interview that more companies could implement this strategy if the Financial Accounting Standards Board, Norwalk, Conn., eliminates the practice of actuarial smoothing.

"There are very few drivers in the U.S. (at this time) that say you must undertake this strategy," he said. "For the most part, the analyst community has pretty much ignored or does not understand the extent of the smoothing game. The changes we have witnessed in the U.K. and the Netherlands (requiring mark-to-market accounting), for example, are forcing more explicit recognition of these off-balance sheet arrangements. Although accounting and regulatory reforms are slow to occur in the U.S., as a greater number of companies understand what could lie ahead, this will make this strategy more attractive, assuming it is still available."

Mr. Peskin said issuing debt to fund liabilities basically turns out to be a wash on a company's balance sheet in terms of its debt capacity. "If the unfunded pension liability is treated by the bond markets as debt, then funding it would serve to reduce debt. Consequently, borrowing to fund a pension plan is a wash with respect to debt capacity. If the bond market focuses more on near-term contributions, rather than the full unfunded liabilities, then fully funding the plan would not result in a commensurate reduction in debt," Mr. Peskin said.

"In this world, the funding rules are important, and the likely strengthening of the funding rules expected later this year would cause more of the unfunded liability to be treated as debt."