The End of Pensions

Roger Lowenstein is an interesting contributor the New York Times magazine. In Sunday's article, with the same title as this post, he investigates the status of the employer-provided pension system, from both private and state- and local-government employers. On balance, I suggest reading the whole thing, though I do disagree with several of the conclusions he draws along the way. I explained my views on pension insurance in April, and I still have those views. In fact, this passage is directly relevant, and the thrust of it is missing from Lowenstein's article:

Defined benefit (DB) pension plans pay out benefits to retirees (and often survivors and occasionally the disabled) based on formulas that may increase with age, years of service, and earnings. The obligations look like the payment stream from a bond. In fact, a pension sponsor with a steady aggregate earnings profile and employee hiring and turnover could fully fund the liabilities and insure against risk with a portfolio heavily weighted toward bonds.

There is therefore no need for formal pension insurance. The government already provides the means for any conscientious pension sponsor to (nearly) fully insure. Every defined benefit pension plan has the opportunity to invest in Treasuries, to avoid the rate-of-return risk inherent in every other investment opportunity. With Treasuries [maturities] of a long enough maturity, the pension sponsor can even choose Treasuries to match the duration of its fund to those of its obligations, so that even shifts in the riskless rate of return do not affect its pension plan's financial position.

If you wanted to figure out what the cost of funding a pension plan with a given formula is, you would need to calculate the required annual contribution under the assumption that the pension plan sponsor were following the duration-matched Treasury investment strategy. The federal government shares the cost of this investment by allowing the pension fund to accumulate at the pre-tax rather than the post-tax return. (It also defers the employee's tax liability on compensation taken through a pension plan.)

Any deviation from this funding strategy should be examined with suspicion. The biggest deviation is to invest some of the fund in equities. This allows pension plan sponsors to assume a higher average return on the plan's assets and thus reduce contributions required to support it. This strategy is okay, as long as the pension fund is small relative to the firm's assets, so that the firm can make up the shortfall if the fund's asset values drop. As the article points out, we are learning that this isn't necessarily the case with a lot of the airline, steel, and auto companies. Almost by definition, it is not the case when a company approaches bankruptcy.

The problem is nicely illustrated by this passage from Lowenstein's article:

G.M. and other industrial companies, along with their unions, have harshly attacked the Bush pension proposal, which would force many old-economy-type corporations to put more money into their pension funds just when their basic businesses are hurting.

Well, no kidding. The industrial companies and their unions that encouraged them have no one to blame but themselves for their current troubles. They used their pension funds as speculative investment vehicles, and the combination of low interest rates, sagging stock market values, and optimistic funding assumptions put them in this position. Who but their shareholders and workers should be asked to make those additional contributions?

The government has decided through ERISA that it will permit the investment of pension funds in equities and subject plan sponsors to a set of minimum funding rules and require them to purchase (vastly underpriced) PBGC insurance. This is a bad strategy, in my view, because of the numerous ways to game it, which Lowenstein's article discusses in good detail. It creates the appearance that someone else is responsible for these companies, and that may ultimately prove to be the reality, with the taxpayers being asked to step in to make up the shortfall.

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