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Stock contributions to pension plans

Jun 16, 2009

The 2008 financial downturn has left many plan sponsors with underfunded pension plans and, in combination with PPA funding rules, sizeable contribution requirements. Sponsors may have different reasons to contribute, whether it is to satisfy minimum requirements or, avoid benefit restrictions, but in many cases the current economy has made it difficult to raise the required cash.

With such a setting, it is not hard to see why there has been recent renewed interest in using stock in lieu of cash as a contribution to pension plans. Over the past few months, several companies including Honeywell, Caterpillar, 3M, JCPenney and United Technologies have announced sizeable contributions made or to be made with their own common stock. This is not a new phenomenon. During the last recession in the early 2000’s, significant contributions using stock were made by companies including Northwest Airlines and GM. Northwest, for example, made a significant contribution with non-publicly traded stock of an affiliate.

Whatever the specifics of the situation, contributing stock in lieu of cash presents plan sponsors with several financial and legal issues. This article is intended as an overview and introduction to this topic, rather than an exhaustive review of the legal requirements and financial implications of a stock contribution.

Several perspectives

Our approach will be to consider implications of pension contribution of stock in lieu of cash from the following perspectives:

Company management

It is likely that company management would have a keen interest in the idea of contributing stock. Presumably, the move is a positive one from their perspective.

The typical scenario is a plan sponsor suffering strained cash flow with a simultaneous increased pension funding requirement due to pension investment losses. To satisfy the funding requirement with treasury stock relieves the current cash requirements and allows cash to be used for operations as the company copes with the financial and economic downturn.

However, companies that pursue this strategy expose themselves to added volatility if a significant proportion of plan assets are invested in company stock. Plan assets could take a significant hit at the worst possible time when business is not performing well. A contribution requirement may be triggered precisely at a time when the company is least able to make a cash outlay to the plan. On the other hand, management may see the stock as being undervalued thus a great opportunity to take advantage of a potential run up in value of the stock in the pension plan.

Of course, there are other issues to consider and other perspectives on these transactions, as will be described below. Also, management should be aware of ERISA restrictions on plan ownership of employer securities and rules on prohibited transactions. For example, ERISA sec. 407 provides a strict maximum limit of 10% of the value of employer security being held at the time of the transaction. However, if the nature and/or size of the transactions are not permitted within the boundaries set in ERISA code section 406 and 407, the sponsor may still seek Department of Labor (DOL) approval.

Plan participants

For healthy employers, plan participants should be indifferent to the investment decisions of the defined benefit (DB) plan trustee, since, in a DB plan, the plan sponsor is ultimately responsible for all risk the plan bears.

The reality is that participants do share in some of the risk. As we stated above, a company that has a portion of its assets invested in company stock exposes itself to a contribution requirement at a time where resources are limited, thus increasing the risk in bankruptcy. Participants want to avoid sponsor bankruptcy. If the plan obligations are assumed by the Pension Benefit Guaranty Corporation (PBGC) as part of a sponsor bankruptcy, only a portion of otherwise accrued plan benefit may be insured, especially for highly-paid employees or for plans with generous early retirement subsidies or (non-guaranteed) supplemental benefits.

In a post-Enron world, where many employees lost a large portion of their retirement savings, today’s employees may have a negative perception of their pensions being invested in company stock. Sponsors may be required to disclose this type of investment to the public in the employer’s financial statement and to participants in the annual participant funding notice (ERISA section 101(f)). The sample funding notice provided by the DOL, for example, requires sponsors to disclose the amount of employer securities held by the trust.

Also, the most recent amendment to FAS 132, effective for years ending after December 15, 2009, will require employers to disclose any concentration of risk that exists in the plan’s assets. The FASB did not provide any specific guidelines as to what constitutes a concentration of risk but, presumably, owning a significant amount of company stock in the trust might meet this definition.

From another perspective, employees and unions at a distressed company may favor a stock contribution in lieu of cash, if they perceive the move as allowing the company to avert bankruptcy and continue operations. At another level, the contribution could also prevent participants from having their benefits negatively affected by a benefit restriction (e.g., limiting lump sum payments or stopping benefit accruals) if the funded level falls below certain thresholds.

Plan fiduciary/CIO

Plan fiduciaries need to thoroughly evaluate the sponsor stock contribution to ensure they are in compliance with ERISA and fulfill their duties regarding management of the pension trust. Should a “worst-case scenario” come true, plan fiduciaries will certainly be called on to justify their decisions on any transactions that could be construed as favoring the employer to the detriment of plan participants.

There are several specific items that fiduciaries should review:

• Would the transaction violate ERISA or any related regulations or IRS Code?
• Do the plan or trust legal instruments or collective bargaining agreements prohibit such a transaction?
• Would the transaction run counter to the plan’s slated investment policy?
• Are institutional trustees for the plan willing to take on stock?
• Is it a “prudent” decision, and in the best interest of plan participants and beneficiaries?
• Is the transaction being done in a transparent, even-handed manner?
• What other actions might this precipitate (e.g., reallocation of other trust assets)?

These are some of the issues plan fiduciaries should resolve prior to execution of the transaction. Input from legal counsel is critical for any fiduciary contemplating this strategy. Fiduciaries should also document their careful, prudent steps in making the decision.

The addition of a sizeable company stock position should cause the CIO to revisit the risk position of the portfolio. In this instance, the contribution may considerably affect the current asset allocation of the plan. This will require compensating adjustments as needed to keep within appropriate risk boundaries provided in the investment policy. Assuming the stock is not seen as part of the long-term optimal strategic allocation, plans should be in place for efficient diversification back out of company stock over time. At the same time, a plan to divest should also be developed in the event of a negative outlook for the company.

PBGC and DOL

The PBGC and DOL share some of the same concerns participants have. If the pension plan’s ability to make benefit payments, and the plan sponsor’s ability to make required contributions is put at an increased risk due to a sizeable trust position in sponsor securities, much of that increased risk will fall on the PBGC.

For many transactions, no specific DOL approval is required. But if ERISA waivers or exemptions are necessary, DOL’s Employee Benefits Security Administration will get involved. The PBGC and DOL may be willing to accept increased plan risks if they perceive a real opportunity to avert sponsor bankruptcy. They may be less likely to allow a transaction seen only as postponing bankruptcy, particularly if it would leave the PBGC with an even larger bill to pay in the end.

Company shareholders

Company shareholders will want to consider all of the issues discussed, and add some of their own unique concerns. Along with management, they would like to see an efficient use of company cash and improved financial performance in what may be trying times. They are obviously also concerned about bankruptcy risks. Furthermore, shareholders want to ensure that company transactions are appropriate and fiduciary responsibilities and handled appropriately. Other optimal uses of company cash will provide shareholders little satisfaction if the market place punishes the company stock for what it perceives as a financial “shell game.”

Shareholders may see their interest in the company diluted by the higher share count. Management, as agents of shareholders, should consider potential ownership dilution in their analysis.

Companies facing sizeable pension plan funding requirements at a time when operating cash flow is scarce will naturally look for alternative approaches to meeting pension funding obligations. Some may see a stock contribution as an attractive alternative especially in this environment where issuing debt can be expensive or impossible. Such a transaction can be successful, but sponsors should thoughtfully consider the risks and rewards assumed by each plan constituency before making this decision.