Jonathan Nus: In 2006, the Pension Protection Act was passed. That significantly increased the amount of cash funding that was required of companies. It basically said that companies need to fund their pension plans over a seven year period. Around the same time, there was an accounting change which was just as meaningful from our perspective. The accounting change actually moved the pension deficits from the footnotes to the actual balance sheet. As we know from many other accounting issues which have been moved from the footnotes to the balance sheet, there was a change in corporate behavior.
Pension shortfalls are considered debt-like in our analysis. But what’s interesting is that as many companies over the last couple of years have de-levered, and their balance sheets have become smaller, the ratio of the pension obligation in proportion to the company’s overall balance sheet has grown. In fact, if you take a look at a typical corporate balance sheet, pension obligations are generally the largest financial obligation right after debt.
And just to give you some perspective, in many recent studies that we’ve done where we’ve looked a credits across our entire rating spectrum, across various industries which are pension heavy as well, we find that pension deficits add nearly 20, sometimes 30 percent to a company’s reported debt levels.
We look at defined benefit pension plans from both a business risk and a financial risk perspective. When we’re focused on business risk, we’re thinking about the competitiveness of that particular company in comparison to its peers in that industry and how pension plans relate to the company’s or issuer’s cost structure. All of our credit metrics are adjusted for pensions. We adjust debt, profitability, and cash flows to take into account the particular system that’s in place, no matter what region of the world that we’re discussing.
We have seen an increased amount of cash contributions being put into a pension plan. There are many corporate entities which have excess cash and they have funded their plan. Some companies are using a low interest rate environment to go out and borrow funds, and they’re using the proceeds to put into their pension plan. One thing that we’ve also observed from the fact that pension plans are now on the balance sheet is that the funding status is being more closely scrutinized in order to avoid excess volatility.
Many companies are managing both the liability and the asset side of the equation together in a much more holistic way. And those companies that are managing both the liability and asset side of the equation are minimizing much of the volatility and noise that ultimately affects their balance sheet and their capital structure.
It’s in the financial risk that we actually seek to adjust a company’s reported metrics. At S&P, our view is that pension underfunding is a debt-like obligation. In our minds, a pension plan is nothing more than a form of deferred compensation whereby the employees essentially become creditors to their own companies. These plans ultimately translate into a call on the cash flows of the entity. And so we adjust leverage, profitability, and cash flow metrics as a result.
Directed / Produced by
Jonathan Fowler & Elizabeth Rodd