Human Capital & Careers

Moody’s Cites Effects of New Pension Law

Moody's contends that companies with poorly funded plans may start to redirect cash flows into pensions to avoid having plans deemed "at risk."
Stephen TaubAugust 18, 2006

Requirements of the new pension bill signed by President Bush on Thursday could have an impact on credit ratings, warns Moody’s Investors Service.

In a new report, the credit-rating agency explained that companies with underfunded pension plans will likely borrow to cover the increased contributions that the new Pension Protection Act of 2006 will require starting in 2008. Generally, the additional borrowing will not affect credit ratings because companies will be exchanging pension-related debt for contractual debt, Moody’s acknowledged.

However, “in certain circumstances, substitution of pension debt with contractual debt could reduce the cushion under existing covenants or require some firms to seek waivers to existing credit agreements,” said Moody’s managing director Gregory Jonas in a press statement. “Also, we expect that lower rated companies will likely see increased pressure on coverage ratios given the likelihood of borrowing at higher interest cost to fund increased pension contributions,” posited Jonas, who co-authored the report.

The report was careful not to sound the alarm bells. The credit agency pointed out that the new law’s 2008 effective date, and several transition provisions, should give companies enough time to adequately prepare for additional funding requirements. Moody’s also said that companies with well-funded plans will not see a meaningful change in their required contributions. In fact, those companies could benefit from their ability under the law to put additional funds into plans in a tax-efficient way, noted the report.

“The reform act will likely lead to a more direct relationship between the funding status of a company’s pension plan and its required pension contributions,” said Moody’s vice president and report co-author Rohit Mathur in a press release.

Still, Moody’s contends that the law may change corporate behavior in several ways. For example, companies with poorly funded plans may redirect cash flows into pensions to avoid having plans deemed “at risk.” Moody’s also expects that the law will cause more companies to freeze pension plans or exit the plans entirely. In addition, some companies may shift their funding away from equities and toward fixed-income instruments to better match the cash flow from their assets to benefit payments, thereby “immunizing their pension liabilities.”