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."