How to Bankrupt a Plan Sponsor (Hint: Not with an Underfunded DB Plan)

A specific exposure common in DC plans—but almost unheard of for corporate pensions—most strongly predicts future financial distress, researchers have found.

The corporate bankruptcy narrative of ballooning pension costs driving firms to insolvency may be more myth than fact, according to a study published earlier this month.

What did increase the likelihood of future balance-sheet distress appeared on the defined contribution (DC) side, wrote finance researchers Ying Duan (University of Alberta), Edith Hotchkiss (Boston College), and Yawen Jiao (University of California Riverside).

Unlike DC plans, DB pensions rarely—if ever—double down on exposure to their plan sponsors by becoming long-term shareholders.

Plans with more than 10% of their assets in sponsor-company stock had a “significantly” higher probability of corporate defaults than those with smaller, but still existing, exposures. These firms were also more likely to seek bankruptcy protection rather than restructure debts out of court.

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Finally, compounding the problem, “DC plan sponsors and participants do not actively adjust these plans’ exposures to company stock prior to defaults, and such inertia imposes significant losses on plan participants because of the value loss of company stock.”

In contrast, defined benefit (DB) pensions—as a matter of law and practice—rarely if ever double down on exposure to their plan sponsors by becoming long-term shareholders.

While both the proportion of internal stock held by DC plans and DB unfunded liabilities tended to rise as sponsors neared insolvency, the authors found no causal link between DB funding ratios and defaulting or bankruptcy.

Nearly two-thirds of DB plans are “substantially underfunded” when their sponsoring firm hit the financial wall. However, according to Duan, Hotchkiss, and Jiao, those scant assets tend to be an effect of balance sheet distress rather than a cause of it. Unlike a DC plan sponsor, corporate treasuries enjoy greater leeway to fund—or not fund—their employee retirement pools.

Still, the study determined that only 20% of bankrupt DB plan sponsors terminated their schemes by transferring the assets and liabilities (which often end up cut down) to the Pension Benefit Guaranty Corporation. Based on their data set, “the probability of a bankruptcy filing shows no significant relationship between underfunding and the likelihood of bankruptcy.”

Thus, the researchers concluded, “our findings cast doubt on the argument that defaulting firms often opt for bankruptcies to terminate underfunded pensions—a practice not allowed in out of court restructurings.”

Authors Duan, Hotchkiss, and Jiao presented their study “Corporate Pensions and Financial Distress” earlier this month at the American Economic Association’s annual meeting in Boston.

Worrying about deflation as an action itself, rather than a symptom of something else, will tie investors—and markets generally—in knots, according to Professor John Kay.

The economist and former chair of several academic institutions said inflation—and its counterpoint—were “no more than a reflection of the experience of people alive today,” in a column for the Financial Times.

“We could have been experiencing deflation for years without realising it.” —Professor John Kay“In 1913, unlike now, a pound or a dollar would have bought the same goods as a century earlier,” said Kay. “The longest semi-official price series we have reports a 140 fold rise in prices in the UK since 1750—but even then all the increase up to 1938 is accounted for by inflation during the Napoleonic and first world wars.”

While the price level roughly doubled during both these episodes, according to Kay, it fell slightly over the rest of the period. While this point of reference may serve to allay fears for those whose currency buys more today than last year, Kay advised against panicking.

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“With a commodity such as petrol, you can tell whether the price at the pump is rising or falling because petrol is a homogeneous product that changes little over time,” said Kay. “But what has been happening with cars, or smartphones, or medical services? In the [UK inflation measurement] the consumer price index (CPI), the price component for cars comprises the sticker price adjusted for changes in quality. Such quality adjustment is subjective — and, it is generally conceded, too low. So we could have been experiencing deflation for years without realising it.”

“In 1913, unlike now, a pound or a dollar would have bought the same goods as a century earlier.”Essentially, the central point is that the significance of a fall in a price index depends on the causes of that fall, said Kay, citing the declining price level in the second half of the 19th century as the result of rising manufacturing productivity and the opening up of new lands, particularly in North America.

Digital advancement and the rise of China as a financial superpower since the 1980s contributed in a similar way to the technological developments of the 1800s and shifts in global trade, said Kay. These events have combined to lead to inflation.

“On the other hand the deflation, and the associated depression and social strife, that Britain experienced between the world wars was largely the result of a misguided attempt to restore the 1914 exchange rate against the dollar,” said Kay. “Prices in Britain fell steadily after 1920 until President Franklin Roosevelt finally wrecked the gold standard at the London Conference on exchange rate stabilisation in 1933.”

Therefore, investors—and the markets in which they play—should be aware of what is causing prices to rise or fall and act accordingly.

“Raised body temperature might be a sign of fever or the result of a relaxing hot bath: it is wise to determine which it is before you start to worry, far less prescribe remedies,” Kay concluded.