Far from a cause for worry, issuing debt to fund pensions is actually a smart move for public companies like Kroger.
It must have raised some eyebrows on Monday when supermarket chain Kroger launched a big $1.5 billion bond sale—with a primary goal of funding its pension plans. Contributing to retirement plans may seem to be a surprising priority for a leader in an industry that is now squarely in Amazon.com’s sights.
In fact, issuing debt to fund corporate pensions is a growing trend. A bunch of large companies have done the same thing as Kroger this year, including FedEx, Delta Air Lines, and DuPont.
To investors more accustomed to companies issuing debt to fund acquisitions and stock buybacks or issue dividends, this may sound like a troubling trend. But it is actually a very good idea. More companies with underfunded pension plans should do the same thing.
At midyear, the average corporate defined-benefit pension plan was only 83% funded, according to Goldman Sachs Asset Management. That’s up from 81% at the start of the year, but it’s still a big shortfall. General Electric, Lockheed Martin, andExxon Mobil all had plans funded at just around 70% of assets at the end of last year. The shortfalls are “despite very benign equity markets,” notes Kevin McLaughlin, who heads liability risk management in North America at Insight Investment. “The need to make contributions to close these deficits is real.”
There are several reasons borrowing to fund pension plans makes particular sense right now. First, current interest rates are very low, making issuing debt cheap, especially for investment-grade companies. What’s more, corporate contributions to pension plans are tax-deductible. If corporate tax reform is passed later this year or next—a major goal of Republicans—the tax benefit of making those contributions would shrink.
Most pressingly, the cost of having an underfunded pension is growing, as annual fees on shortfalls charged by the Pension Benefit Guaranty Corp., which guarantees benefits to retirees, rise. Those fees have grown from less than 1% in 2013 to 3.4% today and are scheduled to rise above 4% by the end of the decade. That increase has been a key catalyst for the new spate of bond deals, says Mike Moran, chief pension strategist at Goldman Sachs Asset Management.
There aren’t a lot of downsides to issuing debt for this purpose. Far from frowning on the activity, credit-rating agencies see it as neutral to positive. An underfunded pension already counts as a form of debt, so it doesn’t add to total liabilities. Moody’s, for example, said Delta’s contributions to its pensions are improving its credit profile in an April note.
From a bond investor’s perspective, it’s a lot better for companies to use debt to fund pensions than using it for dividends or stock buybacks, which only benefit equity holders, says Matt Brill, a bond fund manager at Invesco. “We don’t feel negative toward it at all,” he says. “At the end of the day, they owe the money anyway.”
Ideally, companies would fund pensions with cash from current operations or issue equity, but that’s not always realistic, Brill notes. Companies are also reducing the amount of equity risk in their pension portfolios, which Brill says he likes to see.
In this context, doing nothing to close a pension gap is the biggest risk. And issuing debt to fund a pension shortfall now, is the kind of smart fiscal management bond investors should look for.