Corporate America's Clean Little Secret
While much of the media focuses on how individuals are benefiting from stocks, a huge beneficiary of the bull market is going unnoticed--and trying hard to keep it that way. This investor--the old-fashioned company pension plan--reaped some $200 billion in capital gains in 1995. After years of investing billions in equities, corporate pension plans have more assets than they know what to do with. And the implications of that for Corporate America are enormous.
The long bull market has swollen many pension plan assets far beyond what the companies will have to shell out to their workers in the future. But few of the big-name corporations benefiting from this phenomenon will discuss what they plan to do with their surplus. "We deal with many companies who have surplus assets, but it's hush-hush--none of them wants to discuss it publicly," says Alan A. Nadel, a partner with Arthur Andersen LLP. "It's a major corporate asset, and companies don't want to talk about how they might utilize it."
STRATEGIC WEAPONS. But utilize it they will. Although companies are prohibited from tapping directly into much of the surplus in so-called defined-benefit plans, which provide a fixed level of benefits to retirees, there are significant ways to use a surplus to the company's advantage. For one thing, an overfunded plan means a company doesn't have to make cash contributions to the plan, leaving more cash for expansion or other corporate expenditures. Overfunded plans can tap into the surplus to cover hefty retiree medical costs. Surplus assets also give a big boost to earnings. And a pension surplus can be a strategic weapon, affording a company the flexibility to sweeten early retirement packages in downsizings.
Corporations have gotten a big bang for their bucks by putting assets into equities. On average, defined-benefit plans hold 43% of assets in stocks, according to the Employee Benefit Research Institute (EBRI). Not an overwhelming amount, considering how much stocks have appreciated in recent years. But the largest pension plans typically allocate at least 60% to stocks. Some companies take even larger equity stakes--Motorola Inc. has as much as 74% in stock (table). "Large corporations such as AT&T and GTE Corp. are very heavily equity-weighted," notes Dallas L. Salisbury, EBRI's president. "Their plans are so significantly overfunded that they can afford to take the volatility risk." AT&T's defined-benefit plans have a surplus of about $10 billion. And GTE's plan surplus is $6 billion--or more than $6 a share.
Many of the largest plans have done so well that they fund themselves. "Very few of us put any money into the pension funds, and there are huge amounts coming out to pay pensions and in downsizings," says Ronald Boller, vice-president of investments for Owens-Illinois Inc., which has a $2.5 billion plan that is 70% invested in stocks. "We haven't had to put a nickel in our fund for years." Since corporations don't get tax deductions for putting money into very overfunded plans, many have stopped contributing and are letting funding levels drift down.
Tapping surplus assets got a lot tougher after the raids on corporate pension plans in the 1980s. Then, some raiders recouped the purchase price of a company and more by terminating an overfunded plan, replacing benefits with annuity contracts, and pocketing what was left. To put an end to such maneuvers, Congress tacked on a 50% excise tax and a 35% income tax that makes terminating an overfunded plan, without substituting another one with similar benefits, a foolhardy venture.
Just about the only straightforward use of surplus assets is to pay retiree medical costs. If a plan's assets are consistently at a level of at least 125% above liabilities, then it can take money out of the pension plan to cover retiree medical costs. Owens-Illinois has done that for four of the past five years. "We have had big-time retiree medical to pay, and being able to pay it out of the pension fund has been wonderful," says Boller. AT&T and DuPont Co. have also tapped surplus funds to pay retiree medical costs over the years.
Surplus assets can also increase a company's earnings. That's because the expense of providing a defined-benefit pension fund decreases as the earnings on assets increase. Pension expense is offset by the expected return on pension assets. "When your assets get to be significantly large, that number gets big enough to cause total expense to be a negative number," notes James Baumstark, a principal at Chicago Consulting Actuaries Inc. That offset to expense is called a pension credit and it works its way into earnings. "In some cases, it can make up as much as 20% to 25% of reported earnings," says Baumstark. Ethan E. Kra, a managing director at consulting firm William M. Mercer Inc., scanned a database of 1994 earnings at 300 public companies and found 40 companies that reported pension income. The total amount: $2.3 billion. In the case of GTE, its 1995 reported earnings, before a one-time charge, were $2.5 billion--and $403 million, or 16%, of that is pension credit, according to the company. DuPont and General Electric Co. also have big pension credits.
Some companies are loath to talk about their surpluses because it might invite an unfriendly takeover. The overfunded plan at aviation and electronics-products manufacturer Teledyne Inc. was a motivation for a hostile takeover bid by WHX Corp., parent of Wheeling-Pittsburgh Steel Corp. Analysts say that Teledyne's surplus of $851.4 million is a big lure to WHX, which is facing labor negotiations that will likely result in higher pension obligations. But if it merges with Teledyne and adopts their plan, it could avoid making a big cash infusion. If WHX takes over Teledyne and needs to do any downsizing, Teledyne's pension surplus could be a big help.
To avoid becoming a takeover target, some companies make a concerted effort to use up some of their surplus. One corporate treasurer tells of how his company was worried about "becoming very visible with our big overfunding." The plan had no element of cost, and "we were recognizing income. The plan assets on our books were equal to our company's net worth."
FUNDING DOWNSIZING. To bring down the level of overfunding, the treasurer modified his company's defined-benefit plan. He added a feature that could be funded out of the old plan's surplus. That so-called "cash balance" feature guarantees employees a return, often tied to the 30-year Treasury bond, and allows employees to take pensions with them when they change jobs.
Surpluses can also help companies that are in dire economic straits. Take DeSoto Inc., a consumer goods company in South Holland, Ill. In January, DeSoto notified the Pension Benefit Guaranty Corp. that it plans to terminate its employee retirement plan in April if it gets government approval. The company's press release notes that its plan is "substantially overfunded" and that DeSoto, which is in a liquidity squeeze, "has been continually evaluating various methods of maximizing the economic benefit of their excess funds." If able to terminate the plan, it would use the money to pay off creditors and "stabilize continuing operations." DeSoto is also exploring a merger as an alternative to terminating its plan.
Overfunded pension plans also play a big role in downsizings. They allow companies to offer early retirement deals and add to a worker's pension as an incentive to leave. In the last few years, the regional Bell telephone companies have made good use of their overfunded plans. "One of the reasons they could achieve their downsizing is because of their overfunded plans, which allow them to extend pension enhancements or sweeteners to employees," says Guy Woodlief, an analyst at Dean Witter Reynolds. "Essentially, the downsizing becomes a non-cash event."
With the stock market continuing to set records, the returns on company pension plans should continue to mushroom. And that means that Corporate America's hidden treasure may become impossible to keep under wraps.