P STATEMENT OF JACK L. VANDERIIEI, PII.D. infl IMP uACT ence O on N sTHE tock re PBGC turns. Alderson and Chen 12argued that stock price responses to literature for evidence of the role of pension plans in the market for corporate control to that participants receive the furl accrued benefit to which they are legally entitled and (b) acquired. The average values were much lower for sponsors that maintained their EMPLOYEE BENEFIT RESEARCII INSTITUTE reversions could be used to test whether pension assets are distinct from the assets of the provide additional information on the likely impact of each of these cases. the conventional wisdom that the overfunding is already imputed in share price. overfunded plans then those that terminated. This result would be expected if sponsors TO firm that is sponsoring the defined benefit plan (separation hypothesis) or inseparable from The long run impact of corporate control changes on the PBGC will likely depend Before exploring the empirical evidence on this topic, it is important to note that of overfunded pension plans used reversions as a defensive tactic when they had been (or TIIE SUBCOMMI'ITEE ON OVERSIGIIT PENSION PLAN INVESTMENTS IN LBOS on such theassets relative (integration tradeoff between hypothesis). changes They in the predicted sponsor's thatexposure an excess (i.e., asset underfunding) reversion would and there may be other reasons for a post-takeover reversion such as a desire to switch from where perceived to be) targeted as a possible takeover. IIOUSE COMMI'ITEE ON WAYS AND MEANS T-69 affect the probability stock prices of anunder insured the event separation (i.e., bankruptcy hypothesis of if the plansponsor) termination for the could companies not be Three additional studies have used statistical analysis to measure the quantitative a defined benefit to a defined contribution pension plan or the added efficiency of CONCERNING TIIE ROLE OF PENSION PLANS accurately involved in predicted. these transac Under tions. theAsintmentioned egration hypothesis earlier, ,pension they predicted plan inves that tments stockholders in LBO Although estimates from the witnesses providing oral testimony for this hearing have standardizing pension plans for all employees of the employer after a takeover. relationship between the likelihood that a sponsor will terminate an overfunded plan and IN TIIE MARKET FOR CORPORATE CONTROL would not be affected by termination. Their estimates of large positive returns to rel varied, ated ac it tivity appears doessafe notto appear concludeto that be apension major plan problem investments due to in its all relaLBO tively related small characteristics Unfortunately of there the isplan not sufficiently sponsor and detailed the pension data available plan. In at particular, the current the timeregression to assess shareholders around the legal date of the termination for all reversions in excess of $1 magnitude activity (LBO for most funds portfolios. and "junk"However, bonds) represent many commentators less than 5 have percent suggested of total that pension LBO properly the significance of each factor. analysis conducted by Hamdallah and Ruland 17,Harrington and VanDerhei, TMand Stone 19 MAY 26, 1989 million between 1980 and 1984 were interpreted as providing support for the separation transactions, when accompanied by excess asset reversions, will necessarily increase the assets. There also appears to be a tendency, at least among the larger plans, for state and each showed a significantly positive relationship between reversions and financial leverage. hypothesis. In other words, when considered on an aggregate basis, shareholders of firms local plans INCIDENCE to invest OF larger CORPORATE absolute dollar OWNERSIIIP amounts in CHANGES this type ofAMONG investmentSPONSORS than their expected claims for the PBGC due to the removal of any buffer for adverse investment This finding is important because firms involved in hostile takeovers often undergo massive sponsoring TERMINATING overfunded pension OVERFUNDED plans could PENSION expect a PL short ANSterm profit for the termination experience private pension or future fund funding counterparts. waivers.Even Thisinignores a worst-case the possibility scenario that it is a unlikely LBO may that actually existing financial restructuring that results in highly leveraged positions. These results suggest that and levels recap of tLBO ure investments of excess assets. would impair However the , no benefits separate of participants, analysis was theprovided financial for solvency those decrease the likelihood that a sponsor will eventually be forced into bankruptcy and hence continuing LBO activity leading to increasing financial leverage could result in increased reverting Although due to much changeof in thecorpora recentte controversy ownership. from changes in the market for corporate present of the pension a claim plans to theorPBGC the long if the run pension profitability plan of is the not sponsor. sufficiently funded at the time. An SEC study by Mitchell and Mulherin finds no systematic evidence that takeovers reversion activity. However, it is important to note that each of these studies used a VanDerhei 13also estimated abnormal returns associated with reversions using the control has stemmed from leveraged buyouts (LBOs), it is important to realize that a LBO Still, some commentators have suggested an outright ban on the investment of Unfortunately there currently is not sufficient data available to assess whether LBO activity are a primary cause of pension terminations2 Out of a sample of 313 terminations from sample period that ended prior to the 10-percent excise tax on reversions added by the is Form only 5310 one of filing the date ways asin the which event control date. TM of The a firm results can indicated be transferred a significantly from a group positive of (with pension or without plan assets an accompanying in LBO related reversion) activity. will The result impact in the of entity imposing beingsuch ablerestrictions to better 1980-1987, 34 cases were found in which the termination occurred within a year following Tax Reform Act of 1986 (later increased to 15 percent by the Technical and Miscellaneous shareholders to another entity. This takeover transaction can be accomplished though a abnormal aggregate rate of return for publicly-traded firms involved in a reversion in meet woulditsdepend long-runto pension a large obligations. extent on the ability of pension plan investment managers to an actual change in corporate ownership of the plan sponsor. The authors compare this Revenue Act of 1988). To the extent that this increase in the penalty tax is not offset by number of activities? excess substitute of $1other million assets between with 1979 similar and risk 1983. andHowever return, characteristics this study went infurther their to portfolios. address rate of 10.9 percent to the 21.9 percent of a general sample of 1158 firms (not necessarily decreases in the effective corporate tax rate, 2°the increased cost of "borrowing" from the • the area acquisition of a change in ownership. When analyzed by self-reported reason for Although there is currently insufficient data on the risk and return characteristics of LBO sponsors of terminated pension plans) that were acquired during the same time period. 1° pension plan may decrease the importance of the leverage variable in explaining more termination o , the merger five firms or consolidation terminating due of two to ownership firms change did not produce significant related investments to perform a detailed analysis, it may be useful, given the obvious The sample involved pension plans of 32 target firms of which only five were acquired recent reversion activity. Moreover, the reduced full funding limitation imposed by the abnormal returns around the announcement day. Cross-sectional regression analysis of similarities, o to acquisit review ion the of analysis stock through performed tenderbyoffers Westerfield 5 for restrictions previously in hostile takeovers. The authors conclude that "this evidence suggests that pension plan Omnibus Budget Reconciliation Act of 1987 will tend to reduce the magnitude of abnormal returns were also conducted and the results suggest that shareholder's gains were o acquisition of assets suggested via social investing. terminations do not disproportionately follow corporate takeovers." On average, the overfunding in the future. • positively proxy relacontest ted to the firm's debt-equity ratio and the amount of excess assets and The analysis suggests that the capital asset pricing model 6 may be utilized to assess reversion for the takeover sample accounted for only 7.3 percent of the purchase value • negatively going related privateto the cash flow generated by the firm. the cost of social investing in the following procedure: of acquisition. PENSION PARACHUTES Preliminary findings from Alderson and VanDerheP 5 have extended this type of Going-private transactions are often defensive tactics when managers of a targeted firm 1. Choose a proxy for a market portfolio which includes the universe of It should be noted however that the 10.9 percent rate reported by the authors is investments deemed relevant for pension plans. attempt analysis to to resist includethemore takeover. recent This reversion arrangement activity.frequently This study takes confirms the form thatof in a leveraged aggregate not directly comparable to the GAO's finding that almost 40 percent of the 190 companies Conceptually similar to poison pill provisions that are designed to defend against 2. Exclude all assets that are considered socially undesirable. buyout the firms in undergoing which existing a reversion management receive shares abnormally the new high equityreturns. interest When with outsiders. the results The are taken over in LBOs between 1982 and 1987 terminated pension plans after the takeover. '1 acquisition attempts, a pension parachute is designed to provide either all or a portion of stratified by self reported termination reason, the returns for 52 firms reverting due to public shareholders 3. Identifyare the forced most efficient to accept portfolio cash for from their the shares remaining while assets. the business is The GAO analysis included terminated defined contribution plans as well as defined excess pension assets to current participants in the form of increased pension benefits. continued ownership 4. by change existing Compute areand not the new statistically correlation management. significant. of returns The cash of This the offer finding portfolio price is is financed in confirmed step 3with with in large cross the Mitchell and Mulherin identified the exact dates when investors became aware that benefit plans terminated prior to and more than one year after the LBO. A more amounts of debt. sectional regression analysis on the abnormal returns. Although variables measuring portfolio in step 1. appropriate comparison would be the percentage (5.9 percent) of defined benefit parachutes had been adopted for each of 10 firms. The average three-day rate of return financial The distress short term and relative financial reversion benefit of size takeover are both activity significantly for existing greater shareholders than zero of , the the 5. Compute the cost of social investing based on returns, standard deviation, terminations occurring within one year after the LBO (39) to the total number of defined for the shareholders (after controlling for market effects) around the adoption date is a and correlations.' targeted variable for firmownership has been enormous. change was W.T. insignificant. Grimm & Co. estimates that from 1981 to 1986 benefit plans (656) for the 190 LBO companies studied. statistically significant loss of 2.01 percent. Although this suggests a sizeable reduction the total These dollarfindings value suggest of the premiums that while paid the for average securitprice ies involved increase infor change-of-control shares of firms Westerfield applied this analysis to Pax World Fund, an open-end investment company that Expanding the analysis to consider unsuccessful takeover attempts as well, the SEC in share price, the results must be interpreted carefully due to the small sample size and transactions was $118.4 billion) Although financial economists have attributed the gains reverting their excess assets is positive, there is no evidence that a reversion accompanied avoids investing in the securities of firms that do business in liquor, gambling, weapons and authors found that 25 percent of the reversion sample had been involved in some type of the possibility of confounding events. For example, companies may have instituted other from with athese change transact in corporate ions to "productive ownership benefits entrepreneuri the alfirm's activity shareholders that improves in the the shortcontrol term. defense contracts. His analysis of the fund's results from 1975-1981 yielded a cost takeover attempt (either successful or unsuccessful). Again, this was actually a lower antitakeover provisions around the time the parachutes were adopted) 1 and attributable management to diversification of assets and constraints helps move of .34 assets percent to more and an productive overall cost uses, of''3.14 there percent. are incidence than that found among the general population by Mitchell and Lehn (40 PREDICTION STUDIES continuing worries that other parties (such as existing creditors) may be paying for these percent). A total of 64 (36) percent of the takeover attempts for the reversion sample PENSION PLAN TERMINATIONS IN LBOS AND RELATED TRANSACTIONS gains? was associated with hostile (friendly) takeover bids. The authors conclude that "even Concern over LBOs has been directed towards pension plans in three specific areas: Perhaps the most relevant results for this topic are contained in Mittelstat's 16 within this broader perspective, the large majority of pension terminations are not takeover prediction model of firms acquired between 1/1/81 and 12/31/83. Based on a the investment Corporations of pension have plan been assets knownin to LBOs, use recaptured the relationship plan between assets in takeover the financing activity of associated with corporate takeovers." _TAhmed El-Sayed Hamdallah And William Ruland, "The Decision to Terminate and seriestermination of financialofvariables overfunded , each pension sponsor plans of and an overfunded the impact of defined both of benefit these plan factors in on his corporate takeover and anti-takeover activities. Several firms have terminated overfunded Overfunded Pension Plans," Journal of Accounting: and Public Policy, 5 (Spring 1976): 77- the studyPension was assigned Benefit a Guaranty value -- the Corporation higher the (PBGC). value the greater This paper the probability reviews theof extant being STOCK PRICE STUDIES pension plans of newly acquired companies such as Mobil Corporation's $29 million 91. recapture from Superior Oil and St. Regis $88 million recovery from Champion International? Reversions have also been reported when a company is threatened by a Additional evidence on this question can be obtained from the event studies that _Scott E. Harrington, and Jack L. VanDerhei. "Internal vs. External Financing in 12Michael J. Alderson, and K. C. Chen. "Excess Asset Reversions and Shareholder hostile takeover and wants to prevent excess plan assets from being used as a possible Credit Markets with Asymmetric Information: The Case of Pension Plan Asset measure the effects of reversions on stock prices, after correcting for overall market _Stephen A. Ross and Randolph W. Westerfield, Corporate Finance (St. Louis: Times Wealth." source of Journal financing of Finance the takeover. 41 (March For 1986): many financial 225-241. economists the notion that post- Reversions." Pension Research Council Working Paper Series, Number 87-3, (December Mirror/Mosby College Publishing, 1988), p. 690. takeover reversions should be prohibited or constrained is somewhat puzzling given (a) 1987). 13Jack L. VanDerhei, "The Effect of Voluntary Terminations of Overfunded Pension Plans2Gregg on Shareholder A. Jarrell, James Wealth," A. Brickley Journal , of and Risk Jeffry andM.Insurance, Netter, "The 54 Market (1987), for 131-156. Corporate _gMary Stone, "A Financing Explanation for Overfunded Pension Plan Terminations," Control: The Empirical Evidence Since 1980," Journal of Economic Perspectives vol 2 Journal of Accounting Research Vol. 25, No. 2 (Autumn 1987):317-26. _4The administrator of a terminating plan must file a termination report with both the (Winter 1988), p. 49. 5Randolph Westerfield, "Capital Market Perspectives," in Social Investing Dan M. QMark L. Mitchell, and J. Harold Mulherin, "The Stock Price Response to Pension Department of Labor and the Pension Benefit Guaranty Corporation (PBGC). IRS Form Terminations McGilI, _Even ed., though (Homewood, and the the Tax Relation Illinois: Reform of Irwin Act Terminations of for1986 the reduced Pension with Cthe Research orporate maximum Council, Takeovers corporate ,1984):107-129. " Financial tax rate, 3Michael C. Jensen, "The Takeover Controversy: Analysis and Evidence," Midland 5310 commonly is used for this purpose. Management many firms receiving (forthcoming). reversions had tax loss carryforwards that effectively shielded the Corporate Finance Journal 1986, p. 6. 6William Sharpe, Capital Asset Prices: A Theory Of Market Equilibrium Under sponsor from the tax. See In-Mu Haw, William Ruland, and Ahmed Hamdallah, "Investor 15Michael J. Alderson and Jack L. VanDerhei, "Excess Asset Reversions and Securities Condition Of Risk, Journal of Finance (September 1974):425-442. Evaluation 1°Mark of L. Overfunded Mitchell and Pension Kenneth PlanLehn Terminations," , "Do Bad Journal Bidders ofBecome Financial Good Research, Targets Vol. ," 4Although there is recent anecdotal evidence to the contrary, the results from a Returns," (1989) Working Paper. mimeo. U.S. Securities and Exchange Commission (1988). XI, No. 1 (Spring 1988): 81-88. Carryforwards will not offset the penalty tax however. sample of 108 LBOs from 1980 to 1984 indicate no evidence that losses from preferred 'See Westerfield, p. 119 for the equation. shareholders or bondholders are used to create increased shareholder value. See Kenneth _6H. Fred Mittelstaedt, "An Empirical Analysis Of The Factors Underlying The nTestimony of Joseph F. Delfico, Director of Income Security Issues, Human _See for example Gregg A. Jarrell and Annette B. Poulsen, "Shark Repellents and Lehn and Annette B. Poulsen, "Sources of Value In Leveraged Buyouts," in Public Policy_ Decision To Make Extreme Reduction In Pension Plan Funding," Arizona State University 8Lynn Asinof, "Excess Pension Assets Lure Corporate Raiders." Wall Street Journal Resources Stock Prices: Division The ,Effects United ofStates Antitakeover General Amendments Accounting Office Since, 1980," before Journal the Subcommittee of Financial Towards (October Corporate 1988) Working Takeovers Paper.(New Brunswick, New Jersey: Transaction Publishers, 1987). (September 11, 1985): 6ft. on Oversight Committee on Ways and Means, House of Representatives, April 27, 1989. Economics 19 (1987): 127-168. 41 62 3 5