Quirky tax break that will soon vanish seen jolting bonds
U.S. companies including FedEx and Motorola Solutions are seizing an opportunity to borrow money and top up their pensions, before a tax benefit shrinks.
Tax laws passed in December and a quirk in accounting rules are giving corporations an unusual incentive to take care of the massive pension obligations that have weighed on balance sheets for at least a decade. Companies that are selling bonds to fund the contributions and injecting the money into retirement plans now can save tens, or even hundreds, of millions of dollars on taxes.
“This is their last chance,” says Pierre Couture, who advises pension plans on their investment strategies at Voya Investment Management. “Companies are thinking they need to fund their plans sooner rather than later.”
If enough companies make contributions to their pensions, this year may mark a real turning point for retirement plans, which according to estimates from Willis Towers Watson Plc as of the end of 2017 have just 83% of the funds they’ll eventually need to meet future obligations. The impact on markets may be far-reaching. Company pensions control $1.95 trillion of assets in the U.S., and as the plans move closer to being fully funded, they usually sell stocks and buy longer-term corporate bonds and Treasuries. That shift is already showing some signs of taking place.
Motorola Solutions, a communications equipment manager, sold $500 million of notes last week to help fund its U.S. pension, which was about 69% funded as of Dec. 31. FedEx borrowed $1.5 billion last month to make new contributions.
Companies like AbbVie, 3M and Lockheed Martin have also recently said they were boosting their pension contributions without specifying a source of the money. General Electric said last year it would borrow $6 billion in 2018 to fund its pension shortfall, which stood at $31 billion as of the end of 2016, the largest among S&P 500 companies.
A majority of these will probably be funded with debt, says Hans Mikkelsen, head of U.S. high grade credit strategy at Bank of America.
“Most companies want to deal with this problem sooner rather than later,” Mikkelsen says. “The way you deal with it is a combination of issuance and tax savings, but first and foremost it’s going to be issuance.”
In December, lawmakers slashed corporate rates to 21% from 35% effective this year, reducing the value of any deductions that companies take. But under a decades-old law, corporations that make voluntary pension contributions now can deduct them on their 2017 tax return, any time until the due date of the return, including extensions. For most companies, that’s sometime before mid-September.
If a company acts now, a $1 billion contribution would only cost $650 million after taxes, based on 2017 rates. But once the corporation has passed the due date of its 2017 return, including extensions, the $1 billion contribution would cost $790 million after taxes.
On top of that, the cost of government insurance on unfunded pension obligations has jumped in recent years — the fees now are more than four times their level in 2013. That’s part of the reason employers increased their contributions about 19% to an estimated $51 billion last year, according to Willis Towers Watson’s Beth Ashmore.
“It’s starting to become more and more expensive to make the decision not to fund,” says Ashmore, who’s a senior consultant.
Other factors may also move companies’ pensions closer to being fully funded this year. The U.S. stock market has risen more than 385% since March 2009 after accounting for dividends, boosting investment returns for pensions that own equities. Longer-term Treasury yields have been rising this year, which can help reduce the accounting value of future obligations. And companies have been contributing more to their plans — last year’s estimated $51 billion was up from $43 billion the year before, according to Willis Towers Watson.
Once pensions are around 80% funded, they tend to sell stocks and buy bonds to lock in gains and better match the duration of their assets and liabilities, a strategy known as de-risking. Much of that demand will be for longer-term corporate bonds, which pay higher yields than Treasuries, says Bank of America’s Mikkelsen. The extra yield that investors demand for 30-year corporate bonds could shrink by another 0.20 percentage point this year compared with Treasuries, he said.
There’s as much as $1 trillion of potential demand for long bonds from pensions, and plan sponsors will look to take advantage of rising rates to cut risk in their equities holdings and lock in returns with fixed income securities, says Dave Wilson, head of the institutional solutions group at Nuveen Asset Management, which advises on pension plans.
A yield closer to 4% with an additional percentage point in credit spread premium will draw “some real action” from pension plans, he says.
Demand from pensions may already be evident in how longer-term corporate bonds have performed this year. Risk premiums for the securities have narrowed, to an average of around 1.33 percentage point as of Friday, compared with 1.37 percentage point at the end of last year, according to Bloomberg Barclays index data. The average spread for the broader corporate bond index went in the opposite direction, widening two hundredths of a percentage point to 0.95 percentage point over that time.
“You’re now at this inflection point, which is building because of tax reform,” says Jason Shoup, a money manager at Legal & General Investment Management America, which oversees more than $150 billion for clients including pension plans.