Evaluating Corporate Pensions from a Rating Agency Perspective

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Evaluating Corporate Pensions from a Rating
Agency Perspective

• Waylon Iserhoff
• Vice President

CIA Pension SeminarColloque sur les régimes de
retraite April 16, 2007
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Corporate Pensions - A Rating Agency Perspective
Canadian Pension Obligations

• Overview
• Moodys views the underfunded status of defined
  benefit pension plans as a debt-like obligation.
• No revisions necessary to Moodys standard
  methodologies for Canadian based issuers.
• Plan Valuations
• Moodys will make inquiries about valuation dates
  as minimum triennial valuation requirement often
  exacerbates underfunding

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Corporate Pensions - A Rating Agency Perspective
Canadian Pension Obligations

• Ranking in Bankruptcy
• Senior Unsecured claim
• Funding Requirements
• Recent 2006 federal changes which extended the
  period for companies to fund solvency deficits,
  will benefit an entitys financial flexibility.
• Proposed Accounting Changes
• Minimal impact from a credit perspective

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Whats wrong with pension accounting?
Corporate Pensions - A Rating Agency Perspective
Smoothing inconsistent with economics
Excessive netting of components into pension
expense
Inappropriate classification in cash flow
statement
Sometimes aggressive, unrealistic assumptions
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Moodys pension adjustments
Corporate Pensions - A Rating Agency Perspective
Balance sheet Recognize pension under-funding (ABO FMV of plan assets) as debt like liability Removes all other pension assets and liabilities
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Pension adjustments (continued)
Corporate Pensions - A Rating Agency Perspective
Income Statement Eliminate smoothing by Reverse all pension costs in income Recognize service cost (best estimate of the operating cost of the plan) in Cost of Goods Sold and Selling, General and Administrative expenses Recognize interest cost on PBO in other income/expense Add or subtract actual losses or gains on pension assets in other income/expense1 Attribute interest expense to pension-related debt, which we reclassify from other income/expense to interest expense
1 We limit gains to amount of interest on PBO
to avoid net pension income
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Pension adjustments (continued)
Corporate Pensions - A Rating Agency Perspective
Cash Flow Statement Recognize only service cost as an outflow from cash from operations (CFO) Reclassify cash contributions to pension trust in excess of service cost from an operating cash outflow to a financing cash outflow 1
1 We do not adjust the cash flow statement if
pension contributions are less than the service
cost
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Scrutiny of assumptions
Corporate Pensions - A Rating Agency Perspective

• Comparability and reasonableness of assumptions
• Discount rate
• Expected return on plan assets
• Salary progression
• Nothing below public radar screen
• Changes
• Plan amendments
• Measurement date

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Asset Allocation
Corporate Pensions - A Rating Agency Perspective

• Evaluate reasonableness of asset allocation and
  investment guidelines
• Evidence of swinging for the fences
• Rarely see plans with unreasonable asset
  allocations or big investments in illiquid assets

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Assess volatility in future pension contributions
Corporate Pensions - A Rating Agency Perspective

• Through private discussions we seek to
  understand
• Expected payments for next few years
• Required minimum payments
• Factors that affect required payments (including
  impact of asset liability mismatch)
• Possible and worst case scenario

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Corporate Pensions - A Rating Agency Perspective
Other considerations

• Unfunded plans, defined benefit plan considered
  partially debt-like
• Adjustment reduces debt and increases equity
• Simulates a pre-funding of the obligation
• OPEBs not considered debt-like, unless
• Workforce significantly unionized
• Older workforce
• Discretionary adjustment considered by rating
  committee

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Typical metrics most affected
Corporate Pensions - A Rating Agency Perspective
Ratio of Industry Methodologies
Debt/EBITDA 50
FCF/Debt 55
EBIT(A) Margin 38
EBIT/Interest 45

• Pension adjustments affect leverage,
  profitability and coverage ratios, that are used
  as key metrics in industry methodologies used to
  assign ratings

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Change in Pension Accounting
Corporate Pensions - A Rating Agency Perspective

• Funded status of pension and OPEB plans fully
  recognized on the balance sheet
• Increases balance sheet volatility related to
  pensions
• Minimal impact from a credit perspective

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Corporate Pensions - A Rating Agency Perspective
Impact of Proposed Accounting Changes
Company (C 000s) Funded Status of Retirement Plans (Fiscal 2005) Funded Status of Retirement Plans (Fiscal 2005) Shareholder Equity Impact of ED
Company (C 000s) Pension OPEB Shareholder Equity Impact of ED
Nortel Networks (2,910,000) (972,000) -64
Bombardier (2,625,000) (490,000) -59
Abitibi-Consolidated (874,000) (256,000) -35
Fraser Papers (204,000) (75,000) -30
Canadian Pacific Railway (842,000) (487,000) -29
Tembec (274,000) (75,000) -23
Domtar (282,000) (125,000) -20
CHC Helicopter (74,000) - -19
BCE (2,431,000) (2,032,000) -18
Quebecor World (519,000) (81,000) -13
Catalyst Paper (114,000) (217,000) -9
Alcan (3,105,000) (1,252,000) -8
Cascades (86,000) (96,000) -8
Petro-Canada (378,000) (330,000) -4
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Corporate Pensions - A Rating Agency Perspective
Moodys Early Observations SFAS 158

• No significant changes to credit metrics
  subsequent to the adoption of SFAS 158
• Moodys adjustment to debt to be more precise due
  to enhanced disclosure requirements.

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Corporate Pensions - A Rating Agency Perspective
Moodys Early Observations SFAS 158