On Corporate America's Pension Windfall
Inside Eastman Kodak Co., the once-iconic camera maker, a small pension investment team reaped such large gains in recent years that they windfalled themselves out of a job.
The group, managing a pool of retirement assets for more than 37,000 people, poured money into hedge funds and private equity and, in seven years, turned a $255 million deficit into a $1.1 billion surplus.
That represents a potential fortune for a company that spent the past decade stumbling to find a post-bankruptcy direction, lurching from crypto to Covid vaccines and back to a niche resurgence in film. Earlier this month, Kodak said it was moving management of the pension to an outside firm while it weighed how best to utilize the extra assets, which amount to almost triple the company’s market value.
The photography pioneer isn’t alone.
Across corporate America, buoyant markets and rising rates have turned a subset of employee pensions — defined-benefit plans — from a costly legacy of past promises into an unexpected nest egg.
The question now is how to tap it: a complex dilemma that’s shaping merger talks and corporate strategy, while attracting insurers and asset managers who see a lucrative opportunity in companies that want out of this volatile game altogether.
“This is the pension opportunity of a lifetime,” said Scott Jarboe, a partner at consulting firm Mercer. “Pension plans are better funded than ever.”
Companies with defined-benefit pensions in the S&P 1500 Composite Index — including household names such as Coca-Cola Co., Kraft Heinz Co. and Johnson & Johnson — were sitting on a combined $137 billion surplus as of Feb. 29, according to Mercer. In late 2016, they had a deficit of more than $500 billion.
The flush status of these frozen legacy plans starkly contrasts with the chronic shortfalls at public pensions that are meant to cover retirement costs for hundreds of thousands of teachers, firefighters and police officers, among other government employees. Corporate US workers now mostly save for retirement through 401(k) plans that remove retirement responsibility from employers. Those plans don’t have the fixed benefits for retirees that previous offerings did.
For most people, it has been “a shift from financial certainty to financial uncertainty,” BlackRock Inc. Chief Executive Officer Larry Fink said this week in his annual letter to investors. He warned of a retirement crisis facing the US. Even for the generous defined-benefit plans, it’s unlikely that the surplus riches will simply be handed over to retirees. Firms are more likely to use the extra cash for corporate purposes.
Using the surplus isn’t straightforward, but strategies for dealing with it could mean more business flowing to pension consultants and financial firms like Mercer, a unit of Marsh McLennan, and Goldman Sachs Group Inc. In the US, these pension plans represent a $2.5 trillion pool of assets that insurers and asset managers are eyeing as a fruitful source of revenue.
Simply taking the cash earmarked for retirees to use on other expenses comes at a high cost: a 50% federal tax that can balloon to as much as 90% when factoring in state and local levies.
“Could a corporate take the money out to pay for share buybacks?” said Michael Moran, a senior pensions strategist at Goldman Sachs. “You could, but you pay a huge tax, so it doesn’t make much sense.”
Companies can avoid taxes if they use part or all of the surplus to increase benefits for the retirees in the pension plan. They can also transfer the surplus into a new plan that includes beneficiaries from the old one. Both options don’t leave much for the employer to use.
A more strategic route is actively cultivating the surplus and leveraging it as an M&A tool. Several firms are considering using their surpluses to help mitigate costs in a potential acquisition for a target company with an underfunded plan. Firms are allowed to merge plans, which can unlock the trapped surplus in one to fund the other.
International Business Machines Corp. decided to combine a pension plan with a $3.6 billion surplus with another to use the surplus to offset the roughly $550 million it paid annually to that plan. That means IBM won’t have to make another cash contribution for five to 10 years, saving on its pension costs and freeing it to use the money for other corporate purposes.
“A lot of companies are dusting off their pension plans and looking at what can be done,” Goldman’s Moran said. “Especially what to do with the trapped surplus. This is something they haven’t had to do since before the global financial crisis.”
Surpluses also give companies the chance to use the extra cash to pay for an otherwise costly and complex transaction that offloads the pension from the balance sheet to an insurer, which takes over the assets and the responsibility of payments to the retirees. In industry parlance, this is called a pension risk transfer.
Often, the first step before a risk transfer is similar to Kodak’s: Engage a money manager to take over investment of the assets and determine the best way forward.
These third-party firms, dubbed outsourced chief investment offices, or OCIOs, are usually part of financial companies or pension consultants. Companies are spending hundreds of millions of dollars a year on managing plans, including costs for human resources, paying investment managers and covering skyrocketing mandatory fees to the Pension Benefit Guaranty Corp., the US agency that backstops private sector retirement funds.
“That lends itself to a rationale for the company deciding to go the OCIO route or to an insurer,” said Sean Brennan, head of the pension risk transfer business at Apollo Global Management Inc.’s Athene insurance arm.
It also means executives can focus solely on their core businesses rather than also devoting time and attention to running a mini-asset management firm from within.
The popularity of getting rid of the plans is seen in the increasing size of deals in recent years for external money-management mandates. The industry’s assets are expected to grow more than 10% annually over the next five years, according to consulting firm Cerulli Associates.
The biggest providers of outsourced management globally are Mercer, with approximately $420 billion of assets, BlackRock ($400 billion) and Russell Investments ($375 billion).
Goldman Sachs, which manages about $250 billion, won a blockbuster mandate of roughly £23 billion ($29 billion) from BAE Systems Plc’s pension plan in September. Goldman, Mercer and other firms specialize in helping companies continue to invest the portfolio assets and can help broker the types of risk transfer deals to insurers that Kodak is likely considering and that many others have done with increasing frequency.
Activity reached a 10-year high of $48.3 billion in risk transfer deals in 2022 and $29 billion by the third quarter of last year, according to Goldman’s annual corporate pension study. This year is off to a strong start with several multibillion-dollar transactions, including two for insurer Prudential Financial Inc.: Shell Plc’s $4.9 billion plan for its US retirees and Verizon Communications Inc.’s $5.9 billion plan covering 56,000 retirees.
A majority of US companies with surplus plans are expected to do pension risk transfers in the next year or two.
More than half of the 152 senior financial executives who responded to Mercer’s annual CFO survey conducted in 2022 said they were considering doing a pension risk transfer in 2023 or 2024.
“With a surplus, there’s less of a chance a company needs to pay cash to top up the cost of the deal,” Athene’s Brennan said. “Doing a pension risk transfer is the ultimate de-risking.”
This article caught my attention for a few reasons.
First, corporate plans are experiencing windfall pension gains as rates backed up and assets are at record levels.
Unlike US public pension plans which use rosy investment assumptions to discount their liabilities and are still experiencing pension deficits (although not as bad as in 2008), corporate DB plans use AA-rated bond yields to discount their liabilities and those rates have risen along with long bond Treasury yields in last two years (after reaching a record low).
So as the discount rate rises, liabilities decline and add to this record stock market gains as well as private equity gains and you see why the health of US corporate plans has drastically improved since 2020.
The driving force behind these surpluses and better funded statuses in general is the higher discount rate but increase in asset values also helps.
The death knell for all pensions is a deflationary crisis like in 2008 when rates declined precipitously as did asset values. Pension deficits soared to record levels, especially for corporate plans which have to use market rates to discount their liabilities (I never understood this discrepancy between corporate plans and public state plans in terms of the discount rate they are allowed to use, somewhere in the middle makes more sense).
Notice however how corporations are using their surpluses in strategic ways for M&A activity but most CFOs are just happy to de-risk their plans and pass on the risk to an insurance company which will annuitize these plans.
The windfall gains in corporate pension plans have been a boon for insurers, consultants and outsourced CIOs like Apollo (Athene insurance arm), BlackRock,Goldman, Mercer, Russell Investments, etc.
We are talking billions here which is why so many firms are peddling their services.
The same is going on in Canada where big insurance companies like Sun Life and Manulife are also offering their services to de-risk pension plans.
This is the dominant trend and there's a race to the finish line because CFOs want to avoid being caught in a financial crisis where their funded status will deteriorate significantly, making it impossible to de-risk these plans (need to be fully fund first).
That brings me to my final point, with corporate plans are flush with windfall pensions, we are closer to the top of the market so prepare for a downturn.
I've already expressed my fears of potential stagflation in second half of the year and that will mean higher rates which will further bolster corporate plans but their assets will get hit (still rates dominate in terms of impact on funded status).
Conversely, as I stated above, if we get another deflationary crisis similar to the 2008 GFC, that's a perfect storm for all pensions, especially corporate plans using market rates to discount liabilities.
Keep all this in mind as you wonder about the health of your corporate or public plan and what's going on in the background.
Remember pensions are all about managing assets and liabilities. That's it, that's all.
Below, BlackRock Chairman and CEO Larry Fink talks about ways to make sure Americans can retire with dignity. He says baby boomers need to step up and help the younger generations. He speaks to Bloomberg's David Westin.
Also, Dan Doonan, executive director of the National Institute on Retirement Security, joins 'The Exchange' to discuss the potential formation of unions at banks, the pension renaissance, and more.
I have very strong views that the best way to solve the ongoing retirement crisis is by offering private sector workers government backed defined-benefit plans like public sector workers have.
Just make sure you get the governance right and leave the politicians out of it, use the Canadian pension model and even improve on it to fix Social Security and bolster America's corporate plans.
But I will never get invited on Bloomberg to discuss my views, hopefully Larry Fink is paying attention.
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