Not as Stubborn as They Look

Art by Marcos Shin

While both are far from dogmatic, Textron CIO Charles Van Vleet and Morgan Stanley’s Caitlin Long have strong views on the hibernation-versus-termination debate—as well as about the changing role of the CIO in corporate America.

Long: First off, it’s always, always, company specific.

Van Vleet: Yes. That needs to be said—not least because I don’t want anyone mad at me…

Long: There are companies for which the hibernation strategy makes sense and there are others for which termination—usually a partial termination of retirees only—makes sense. 

Van Vleet: Agreed. But the question I have is for a 90% funded plan: What are the pros and cons of hibernation versus transfer? And in answering it, I think of it this way: There are four main constituencies, the most important of which are participants. The fund is there to serve their retirement. And the bottom line is that the transfer could be seen as a takeaway—as a benefit taken away by having it transferred to an insurance company. Right or wrong, employees prefer a plan sponsor guarantee, backed up by the Pension Benefit Guaranty Corporation as opposed to an insurance company guarantee backed up by a state regulator. 

Long: In rebuttal, I’ll say that in all of the large corporate transactions, an independent fiduciary has been hired to look after the interest of the participants exclusively. And they do very thorough work. No question, pension transfer is a change and change is always uncomfortable—but the level of due diligence, preparation, and procedural care in these transactions is very high.

Van Vleet: So the second most important constituency, in my view, are bondholders. In a transfer, you’re crystallizing a soft debt into a hard debt, and bondholders don’t benefit. The sponsor will either draw upon liquidity or lines of credit to top up that plan and transfer those liabilities. Rating agencies, at least in the beginning, were very much neutral-to-negative on this idea. Caitlin tells me that there has been some more recent rethinking, but I thought it was always a very logical conclusion made by the rating agencies. 

Long: Charles is correct. The agencies have shifted their views in the past few years. As Standard & Poor’s wrote in February, following the Kimberly-Clark transaction, it saw the deal ‘as a modest credit positive since pension volatility will be reduced, notwithstanding the slight weakening in credit ratios.’ So essentially you have a rating agency saying, ‘look, this does deteriorate slightly the credit ratios, but it’s still viewed as a modest credit positive.’

Van Vleet: The third constituent is the shareholder—and the impact they have on the stock price of transfers is inconclusive at best.

Theoretically, I can put it this way—let’s even make it personal. When I give money to Apple, Google, or Textron, I want them to take that money and do something smart and clever with it. I want them to get a return on an investment that’s equal to, or better than, the market average. Instead, with a transfer, they are taking my cash and simply using it to remix the balance sheet. Show me all the numbers you want, but I know that personally I would not be happy. I gave that money to the people at Apple, Google, and Textron to do something clever with it, not just rejig the balance sheet. 

Long: If you look at how stock prices have reacted upon an announcement of a transfer, they have been, in virtually all cases, neutral-to-positive relative to the market. I’ve seen 12 transactions announced by public companies since 2012, of which only two had a slightly lower stock price relative to the S&P on the date of the announcement.

Van Vleet: The fourth constituent is the sponsor. To date, sponsors have been more likely to transfer only retirees. Therefore, the problem hasn’t gone away—it’s only been reduced.

The effect is this: If I were to transfer all my retirees, I would take my 13-year average duration and extend it out closer to a 16- to 20-year average duration. By transferring retirees, I would actually need to re-risk the portfolio to address a longer-duration portfolio. 

Long: Just like any corporate transaction, a question that a CFO will ask is whether it is net present value (NPV) positive or not. Termination transactions have been NPV positive and that’s because the cost savings exceed the costs companies pay to settle the obligation. 

Van Vleet: Next, I want to move through four categories of the hibernation-versus-transfer debate: the impact on cash flow, earnings, legal and accounting, and the final cost.

“Even though pension transactions feel like a threat to the status quo, the reality is the liability-driven investing wave has actually changed the pension CIO’s role even more.”
—Caitlin LongFirst, cash flows. In the case of a transfer of a 90% funded plan, I need to find that next 10% by draining liquidity somewhere or borrowing capital in the market to put up that capital today. Basic math says putting up the cash now is more expensive than putting it up slowly over time. So, in other words, you’re paying an insurer a premium to take on that risk. Why pay them when you could do it yourself and make those contributions slowly over time? 

Next, I want to talk about two different impacts on earnings. Simply put, when pension expenses go up, earnings per share go down—immediately, in the case of a transfer.

Another impact on earnings is that there is, realistically, a finite amount of access to capital. For example, companies like Textron are brimming with all kinds of tremendous ideas: M&A, R&D, and rolling out new products. Capital is dear to us. So to take that cash and use it to crystallize a soft debt doesn’t feel like the right thing to do by our shareholders.

I also want to touch on one issue under accounting and legal: Transfers can sometimes trigger a settlement charge and/or a labor contract renegotiation.

Lastly, cost. Insurance companies need to make a profit—they deserve to make a profit. But how will they hit the 12% to 15% return on capital they’re targeting? Insurance companies would not tell us they’re going to recoup it by having a more risky portfolio—that’s contrary to everything they tell us they’re doing. Instead they say they take a liability and match it exactly, or at least closely. That’s also what they tell their regulators because that’s how they report their capital reserve requirements. So, as a result, they need to buy the exact same stuff I could buy to hibernate the plan—only they need to buy it in some way that the economics gives them a profit…

Long: Here’s a very important observation: The insurance industry is a better owner of this liability than corporate America because it’s more efficient. Insurers have huge scale in their asset management businesses and administration platforms. As a result of the size advantage—even small insurers are bigger than the largest corporate pension funds—they’re able to spread their fixed costs over a much larger asset base. They can offset longevity risk against mortality risk in other business lines. We also think the cost advantage of the insurance industry to own this liability adds up to about 5%.

One more thing: Even though pension transactions feel like a threat to the status quo, the reality is the liability-driven investing wave has actually changed the pension CIO’s role even more. Because corporate America wants CIOs to button down pension volatility, you have many more companies investing in long-duration fixed income. That’s partly a function of what the rating agencies have said about the volatility of pensions.