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Cashless Contributions

Are noncash assets really a smart way to fund pension liabilities?
Joseph McCafferty, CFO Magazine
November 1, 2003

The sagging stock-market performance of the past three years hasn't been kind to pension plans. By one estimate, companies are carrying underfunded pension liabilities in the neighborhood of $400 billion. And the economic environment that has left pension plans with gaping deficits has left companies with little cash with which to fix them.

Now those liabilities are coming due. A recent Watson Wyatt Worldwide report estimates that Fortune 1,000 pension-plan sponsors with underfunded plans will contribute at least $83 billion to their plans this year. Even assuming annual returns of 8 percent, these employers will be on the hook for another $80 billion in 2004.

Three of the biggest industries affected are airlines, steel, and automakers. "They're not particularly performing well, so they're not in a position to contribute much cash," says Ari Jacobs, east regional actuarial leader at Hewitt Associates.

Instead, many of them are digging deep into their balance sheets for any other asset with which to prop up their plans. Some companies are depositing their own stock; others are putting in stock of subsidiaries or real estate. General Motors Corp., for example, put shares of its Hughes Electronics Corp. subsidiary into its pension plan. U.S. Steel Corp. is putting in timberland it has owned for nearly 100 years.

But cash alternatives aren't always applauded by pensioners. First, the assets in question can be tricky to value. If the bottom falls out on a stock the company has contributed, it's the pensioners who are left holding the bag. Second, the assets can have a big impact on the risk characteristics of the plan, especially if they are tied to the same troubled industry as the company that sponsors the plan.

Little wonder, then, that strict rules govern the use of noncash assets to fund pension plans. Companies that want to make contributions of assets other than their own stock typically need to get a prohibited-transaction exemption from the Employee Benefits Security Administration of the Department of Labor. These exemptions aren't easy to get, however. Steve Pavlick, a partner in the Washington, D.C., office of law firm McDermott, Will & Emery, estimates that the DoL issues only a few dozen each year for in-kind contributions. Still, he says, "if there just isn't any cash available, this is the only game in town."

Breaking the Covenant
More and more companies are choosing to play that game—and winning. "You can contribute anything you own," says Pavlick. The DoL just doesn't "like to see a lot of junk put in these plans," he adds.

In August, for example, the DoL granted Northwest Airlines Inc. permission to contribute as many as 11.4 million shares of Pinnacle Airlines Corp., an affiliated regional airline, to its three pension plans, which were a combined $3.9 billion in the red at the end of last year. (Pilots, contract employees, and management have separate plans.) What is unusual about the transaction is that the Pinnacle shares are not publicly traded. Critics questioned whether it made sense to strengthen a shaky pension plan with nontradable shares of a struggling airline. In fact, the DoL received a number of comment letters suggesting that the stock was risky because it was illiquid, and that the transaction involved a conflict of interest on Northwest's part.

Yet the agency ruled in favor of the transaction. "Based on...the adoption of additional protections, the department found that the transactions would be in the interest [of] and protective of the pension plans' workers and retirees," it explained in a statement.

The Pinnacle stock contributions included put options that would allow the pension funds to put the stock back to Northwest at a certain price, giving the pension funds a safety net if the value of the shares decreased dramatically. "You have to convince the DoL that the plan is not going to be taking a big risk with the assets you are putting in," says Carl Hess, global director of asset allocation at Watson Wyatt Investment Consulting in New York.

The Pinnacle stock contributions included put options that would allow the pension funds to put the stock back to Northwest at a certain price, giving the pension funds a safety net if the value of the shares decreased dramatically. "You have to convince the DoL that the plan is not going to be taking a big risk with the assets you are putting in," says Carl Hess, global director of asset allocation at Watson Wyatt Investment Consulting in New York.

The shares, which are valued at $340 million, will go a long way toward helping Northwest meet the minimal funding requirement of the plans. And although Northwest says it cannot comment on the transaction, because it has filed the preliminary paperwork for a Pinnacle initial public offering, president Doug Steenland defended the proposal earlier this year at a DoL hearing. "The contribution of Pinnacle stock allows Northwest to preserve over $330 million in cash to weather these challenging times," he argued.

Meanwhile, U.S. Steel hopes to convince the DoL to allow it to use 170,000 acres of timberland to finance its estimated $390 million in pension liabilities. John Armstrong, spokesman at the Pittsburgh-based company, explains that the timberland, located in Alabama, is currently worth about $100 million and will appreciate as the harvest approaches. "The timberlands are a nonstrategic asset that we are looking to monetize by contributing it to our pension fund. [Its] value is allowed to grow, tax-deferred, and we benefit indirectly from its appreciation," he says.


But valuing the land could be difficult, since the trees are years away from harvesting and anything could happen to them in the meantime. Hess argues that there is nothing unusual about a pension plan owning real estate, and that it could even be a cheap way of diversifying the plan's portfolio. "It's a way [for the plan] to avoid paying the cost of acquiring those assets," he says. U.S. Steel hopes to win DoL approval for the transaction by the end of the year.

The Easy Way
In both the Northwest and U.S. Steel cases, the companies hired independent fiduciaries to value the assets, a common practice for noncash contributions. Northwest hired investment advisory firm Fiduciary Counselors Inc., which in turn hired aviation consultancy Eclat Consulting to estimate Pinnacle's value. The fiduciary will also make decisions on holding or selling the assets for the plans, to remove any conflicts of interest.

Another step in the exemption process is convincing the DoL that the assets couldn't simply be liquidated. "The DoL is going to ask, 'Why didn't you sell the asset?'" says Pavlick. If a company has a good enough answer, he adds, regulators should welcome such noncash contributions. "The thinking is that something is better than nothing," he says.

The way around the exemption, of course, is for a company to contribute its own stock. Continental Airlines, for example, recently placed shares of its ExpressJet regional affiliate, which operates the Continental Express airline, into its plan. But unlike the Pinnacle stock, ExpressJet is publicly traded, which means the airline didn't need to file for an exemption.

But there were still hoops to jump through. First, to put a subsidiary's stock directly into the plan, 50 percent of the stock had to be owned by shareholders unaffiliated with the parent. Second, the pension plan could not own more than 25 percent of the entire issue after the transaction was complete. And third, no more than 10 percent of the total plan could be made up of employer stock, including subsidiaries.

In July, Continental owned 53 percent of ExpressJet shares, more than the allowable amount. But the stock wasn't important to Continental's strategy. "We never intended to own any ExpressJet stock over the long term," says CFO Jeffrey Misner. Instead, he says, Continental planned to contribute the cash proceeds from a planned IPO of 5 million shares of ExpressJet to the plan. But in July, when the share price fell below Continental's expected price of $15.50 a share, the parent canceled the offering. "If we could have sold it all, we would have, and just put the cash in," says Misner. "But we couldn't sell so much of it at a reasonable price."

So the company sold the shares back to ExpressJet, and contributed the $127 million in proceeds to the pension plan. That transaction took Continental's ownership to 44 percent, clearing the way for the legal placement of $100 million worth of ExpressJet shares into the pension plan. Continental also contributed $103 million in cash, bringing its total contributions to $372 million. "It brought our funding status on a current liability basis up to approximately 90 percent," says Misner. "It provides an extreme amount of flexibility for our cash-funding requirements for '04," he adds.

Cracking the Gates
Experts expect more companies to consider making noncash contributions to their pension plans. "Companies are looking for ways to solve their pension problems at a time when they have other demands on their cash," says Fiduciary Counselors president Nell Hennessy. She says companies will have to look at how noncash contributions stack up to their internal investment policies. And, she says, they will need to conduct a new review of their risk profile of the assets in the plan.

But don't expect the DoL to rubber-stamp exemptions. After Enron, regulators are keenly aware of the dangers when employees have too much of their retirement plans staked to the company itself. "When they go wrong, they go real wrong," says Watson Wyatt's Hess. "So the DoL is not going to throw the gates open."

Joseph McCafferty is news editor at CFO.




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