A New Year, An Old Post on Pensions

One of my earliest research projects focused on the shift from defined benefit (DB) to defined contribution plans and its implications for retirement income. I started it in 1993, along with my colleague (then at the NBER, now at Dartmouth) Jonathan Skinner, and after a lot of updates and modifications in response to comments, it was eventually published in The American Economic Review in 2004.

The reason we wrote it, and the reason why I mention it today, is that many commentators on pensions, and the public policy toward pensions (the name of the conference at which we originally presented it), simply have no idea about the generosity of defined benefit pension plans as they existed before the shift to 401k plans began. What was noteworthy about our article is that it used data on defined benefit pension plans, collected through the Pension Provider Surveys of the Federal Reserve's Survey of Consumer Finances, (SCF) to simulate the distribution of future retirement benefits that would obtain under the vintage of defined benefit pension plans that existed as this trend emerged.

We had data on DB pension plans in 1983 and 1989, and we were able to compare the distribution of benefits under those plans to the analogous distributions of defined contribution or 401k plans as they emerged in 1989 through 2001, the latest year of data prior to our publication. So we had the true heterogeneity in the DB plan universe, and our simulation framework incorporated uncertainty in both future wages and asset market returns. Our universe of 401k plans, and the contribution and investment behavior of participants, was drawn from those SCF respondents who relied on the 401k as their sole pension plan, not those who had it as a supplemental plan.

The key point of the paper was that even for workers who remained with the same pension plan for an entire working career, the vintage of 401k plans that existed by 1995 was providing a comparable distribution of retirement income. Put simply, participants who relied on the 401k as their sole source of pension income were, along with their employers, contributing enough and holding enough in stocks (as opposed to bonds) to match what they would have received under the DB plans that were supplanted. In a nutshell, the DB plan formulas were not necessarily that generous in terms of their replacement rates, and their reliance in many cases on "final average pay" exposed participants to a lot of uncertainty.

The comparison is even worse when we consider workers who switch pension plans one or more times during their career. When the job changes happen before the worker reaches the DB plan's early retirement age, the worker is typically entitled only to "vested deferred" benefits, the value of which is eroded by inflation (if taken at the plan's normal retirement age) or full actuarial reductions. The balances in defined contribution plans like 401k plans are fully portable and do not suffer from this "backloading" of benefits under DB plans.

This study is what informs my view, which I expressed to Bloomberg View reporter Ramesh Ponnuru in his article that appeared today. I am quoted as saying:

Criticism of 401(k)s frequently idealizes the defined-benefit plans they have largely replaced. It’s true that 401(k) participants have more responsibility for their retirements than defined-benefit plans involved, and they are also exposed to market risk. Andrew Samwick, a professor of economics at Dartmouth College, pointed out in an interview that defined-benefit plans had their own risks. The company sponsoring those plans could skimp on pension contributions, or allocate its investments poorly, or go bankrupt and leave plan participants short.

And the shift to 401(k)s has coincided with a large increase in the number of people with retirement plans: Most workers didn’t have those defined-benefit pensions. “People have a very distorted notion of how good things were under defined-benefit plans or how good they would be today if that system of defined-benefit plans had continued,” Samwick said.

Our comparisons also did not consider the problem of DB plans that the security of the participants' retirement income depends on the solvency of, and funding decisions made by, the plan sponsor. It was not over 401k plans that Daniel Gross declared "the decade of cramdown."

Take Your Plan Administrator to Court

Carrie Johnson reports in today's Washington Post on the Supreme Court's latest pension ruling:

The Supreme Court handed workers a major victory yesterday by allowing them to sue over mismanagement of their 401(k) retirement accounts, in which more than 50 million employees have invested nearly $3 trillion.

The unanimous holding reverses a lower court decision that had barred individuals from suing over losses related to mistakes and misconduct, and thus had insulated employers from lawsuits even as more U.S. workers came to rely on the savings accounts to help fund their retirements.

[...]

Yesterday's decision will allow James LaRue to proceed with a case against his former employer, DeWolff, Boberg & Associates, over $150,000 in losses he claims he suffered after the Texas management consultancy failed to act on instructions to shift his retirement savings when the stock market hit turbulence more than six years ago.

In a telephone interview, LaRue, 47, criticized his former company for being "nonresponsive" when he asked to transfer his money from stocks into cash as the Internet bubble burst and the market plunged after the Sept. 11, 2001, terror attacks. LaRue, now a self-employed consultant to manufacturing and telecommunications companies, said his former colleagues at DeWolff Boberg were "hiding under the law."

Seems like a reasonable step forward--LaRue should get his day in court. The reaction from businesses are predictable:

Business advocates predicted the ruling would unleash a raft of lawsuits by employees, particularly as stock market volatility once again is causing havoc with investment accounts.

"Ultimately, employers aren't going to sponsor plans if they're going to be sued every time they make an innocent mistake," said Thomas Gies, a Washington lawyer who defended the consulting firm, which denies any wrongdoing.

Even innocent mistakes have consequences, and the entity that makes the mistake should pay to fix it. If an employer cannot sponsor a plan without making multiple innocent mistakes, then that employer should not sponsor a plan. The defense against lawsuits is to have clear procedures and to stick to them.

Scrambling Your Nest Egg

J.W. Elphinstone reports on a growing number of people taking loans and withdrawals from their retirement accounts to cover their expenses:

Trent Charlton knew the risks when he borrowed $10,000 from his 401(k) and cut his retirement savings in half.

But Charlton, a 40-year-old account executive at an Irvine, Calif., trucking company, said he had little choice because he and his wife could not keep up with monthly expenses after American Express reduced the limits on three credit cards.

As home prices fall and banks tighten lending standards, more people are doing the same thing: raiding their retirement savings just to get by and spending their nest eggs to gas up SUVs, pay mortgages or put food on the table.

But dipping into 401(k) accounts can carry risks because defaulted loans and hardship withdrawals are taxed as income and are subject to a 10 percent penalty if the worker is under 59 1/2 years old.

That means if the trend grows, many Americans will risk coming up short on retirement savings or may have to rely on an overburdened Social Security system.

"People who take out a loan or withdrawal are adding to a looming retirement crisis over the next 30 to 40 years," said Eric Levy, a partner at global consulting firm Mercer. "And what implications will that have (for) our economy?"

Some of the nation's largest retirement plan administrators, such as Great-West Retirement Services and Fidelity Investments, are seeing double-digit spikes in hardship withdrawals and increases in loan requests, a sharp departure from levels that traditionally varied little.

Administrators say consumers are using retirement savings to pay for unmanageable mortgages, maxed-out credit cards, and costly utilities and groceries.

Charlton and his wife used the retirement money and $7,000 from savings to pay down their credit card debt. They also cut monthly expenses by pawning a diamond ring and selling camera equipment he owed money on. And he's looking for someone to take over his $550 monthly payment on a gray BMW 335i he leased last April.

Charlton said his goal is to pay off the 401(k) loan in two years. He has not decided whether he will contribute to the plan during that time.

If I may be indelicate here, Trent's problem is that he thought a $550 monthly car lease payment and maxed out credit cards were appropriate expenditures for a 40-year old worker with only $20,000 in a 401(k), even before the credit crunch hit. If that's his attitude toward money, he is going to have a lifetime of financial worries.

Read the whole thing for more about the procedures for loans and withdrawals and more information on how this trend is evolving.

Citigroup, Yeah, Right

It's been quiet of late on the pension front, as the parade of stupid ideas for how to further erode workers' retirement security seemed to be over. Interrupting the silence are the events in this recent article by Jonathan Peterson of the Los Angeles Times with the inviting title, "Pensions May Be Outsourced." It begins as follows:

WASHINGTON -- Would you feel comfortable if your company sold off your pension plan to a big bank?

This month, Citigroup Inc. got the green light from the Federal Reserve for an unusual deal to take over the $400-million retirement plan of a British newspaper company.

In exchange for getting its hands on all that cash, Citigroup will run the pension plan -- investing the money, paying the benefits and taking on the liability previously borne by Thomson Regional Newspapers. And it's eyeing similar moves stateside.

Let's not mince words here. There is no upside for the workers and retirees. Federal regulators should put a stop to this immediately. If Citigroup (yes, this one) can convince the plan sponsor that it can provide financial management services in the most efficient manner, then the plan sponsor should be allowed to employ Citigroup for its investment management. However, the plan sponsor must still be the entity that guarantees the pension payments to the plan participants. The plan participants should always have recourse to the plan sponsor. That should not be outsourced.

Read the whole article. If you are like me, you will roll your eyes, possibly to the point of permanent damage, when you get to this part:

Ari Jacobs, head of the Retirement Benefits Advisory Group at Citigroup in New York, said American employers seemed "very interested in opportunities to reduce or eliminate the risks associated with their pension plans." He added: "We in the U.S. are looking at a similar model" as the British deal."

A lot of these companies -- including some that are our clients -- are asking, 'What are our alternatives now that we've frozen the pension plan?'" said Scott Macey, senior vice president and director of government affairs for Aon Consulting.

Until now, the alternatives have been to pay off workers with cash or to buy annuities from insurance companies, which then continue to pay the benefits.

But now, financial companies such as Citigroup say they could do the job more cheaply than insurance companies -- and with greater expertise at managing risk. Insurance companies, for example, face costly state-by-state regulation that pushes up the price of annuities.

"As a financial institution, we believe we're better at managing financial risk than anybody else," Citigroup's Jacobs said. "That's our core business."

(Yes, that Jacobs fellow seems to be talking about the risk management virtues of this Citigroup.) If the plan is frozen, then the plan sponsor can simply prefund the present value of expected payouts with purchases of government bonds and eliminate interest rate risk by duration matching the bonds to the expected payouts. That's all that needs to be done if what is being done is purely in the interests of the plan participants, and any number of financial services or insurance companies could be contracted to do it.

The reason plan sponsors perceive there to be risk is that they feel like they should be using the pension fund to invest in stocks, so that they can claim the risk premium in the present value calculations of their obligations and prefund them with less money today. That sleight of hand is what generates almost all of the problems in pension regulation.

And where there are investors looking to get something for nothing, there will be investment firms willing to give them nothing for something. Normally, I'd say they are a perfect match for each other, except that in this instance, they are playing with the pensions of workers and retirees.

Does the Senate Have Any Bite, or Is It All Bark?

As I posted a couple of weeks ago, Continental and American did an end run around compromises reached in the pension reform legislation last year. In his column yesterday, Jeffrey Birnbaum reports that the Senate Finance Committee is not happy about it:

The top brass at the Senate Finance Committee are incensed over a legislative end-around engineered by American and Continental airlines. The airlines used their contacts with the Democratic leadership in Congress to sneak into the Iraq war spending bill a provision that will reduce the payments they have to make to their workers' pension plans, a move that will save them millions.

The Finance Committee's senior members are not pleased. They have asked the airlines' chief executives to explain themselves and are warning that theirs may well have been a Pyrrhic victory.

"These two airlines flew around the Finance Committee to get this pension provision in the spending bill, but we will review, in the light of day, exactly what deal they got," Chairman Max Baucus (D-Mont.) said ominously.

"The committees of jurisdiction spent many months working on a pension bill that took each airline's status into account," added Sen. Charles E. Grassley of Iowa, the panel's ranking Republican. "These two airlines and their allies in Congress have undermined that work."

In other words, flyboys, you've made some powerful foes.

Really? I'll believe it when I see it. If the Senate Finance Committee is incensed, then there is nothing that prevents Baucus and Grassley from introducing new legislation to undo the end-around and building the support to pass it. There may yet be hope for the Senate if they do.

If You Ever Wanted a Reason for a Line Item Veto ...

... now you have it. From the Review and Outlook in today's WSJ:

Pension Crash Landing
May 29, 2007; Page A14

When Congress passed a broad pension reform last year prodding companies to get their retirement programs in order, it seemed too good to be true. Now we know it was.

That's the lesson of an amazing bit of corporate welfare the Senate tucked into the Iraq war supplemental last week. Last year's bill included a hard-fought political compromise: Carriers that agreed to a "hard freeze" of their pension plans would be allowed to use a higher interest rate in calculating their plans -- which would reduce their net liabilities. The idea was to discourage airlines from buying union peace by running up their pension tabs, which they might later dump on taxpayers. A few airlines, such as Northwest and Delta, took this medicine.

Their competitors, namely American and Continental, headed back to the Beltway and last week their lobbying blew apart last year's compromise. Under the Senate's backroom fix, the airlines can use a higher interest rate even if they promise higher pension benefits. The airlines claim this is about "leveling the playing field," which makes little sense because American and Continental could have accepted the same rules all along. This is about giving those two a competitive advantage over other airlines that have already agreed to play by the reform rules.

The taxpayer-backed Pension Benefit Guaranty Corp. is obliged to bail out any company that can't meet its pension obligations, so there is once again little reason for these airlines to practice any pension restraint. The PBGC conservatively estimates that this airline fixeroo will result in an additional $2 billion in underfunded pension obligations over the next 10 years.

No Senator is taking credit for this pension earmark, though we'd note that both Continental and American hail from the great state of Texas. Meanwhile, the architects of the provision were nothing if not clever; by including this in a war supplemental, they made it veto proof.

This is simply unbelievable. When even good legislation is undermined by backroom dealing, it shows a corrosive lack of seriousness on the part of the legislature itself. I think this bumper sticker sums it up pretty well.

Looming Trouble with State and Local Employee Pensions

Mary Williams Walsh brings us all up to date on the problem in today's New York Times:

Across the country, government workers’ pensions are protected by guarantees even stouter than those on pensions in the private sector. The legal promises, often backed up by union contracts, cover more than 15 million people.

Years of supporting court interpretations have enshrined the view that once a public employee has earned a pension, no one can take it away. Even during New York City’s fiscal crisis 30 years ago, no existing pension promises were reduced.

But now a number of state and local governments are quietly challenging those guarantees. Financially troubled San Diego is the highest-profile example, but a handful of states, cities and smaller government bodies have also found ways to scale back existing promises and even shrink some current payments.

While still only scattered cases, these examples may be an early warning sign of what could be coming elsewhere. As local officials take stock of unexpectedly large obligations to retired public workers, some are starting to question whether service cuts, sales of government property and politically acceptable tax increases can ever go far enough to bring things into balance.

And it's not just retirement income benefits:

Governments are also studying the guarantees on retiree health benefits because of a new accounting rule that is now requiring them to calculate, for the first time, the total value of the health benefits they have promised to retirees.

The numbers now being disclosed are daunting. Mercer Human Resource Consulting estimates that when all the calculations are done, the nation’s states and cities will find they have promised a total of about $1.4 trillion, said Derek Guyton, a senior consultant.

Little, if any, money has been set aside to fulfill these obligations.

We'll be hearing more about this issue in the coming years, as the bills come due in more places and other localities join San Diego in its financial woes. (For example, see Walsh's earlier article from August.)

If there were anything with which to take issue in the article, it would be the title, "Once Safe, Public Pensions Are Now Facing Cuts." Safety comes from direct ownership or a binding guarantee. Public sector employees are in a situation where they thought they had more of a guarantee than they do. If you were open to attack but weren't attacked, were you really "safe?"

As a matter of policy, when focused on replacing income in retirement beyond Social Security, I'd much prefer the transparency and ownership of a defined contribution or 401(k) plan to the vague promises of a defined benefit plan, acknowledging that running such a plan effectively requires thoughtfulness applied to plan design and participant education.

The Public Employee Pension Mess

Continuing her fine reporting on pension issues, Mary Williams Walsh turns her attention to state and local government pensions in "Public Pension Plans Face Billions in Shortages" in today's New York Times. In a nutshell, the accounting standards are even more lax with public plans than with corporate plans, and there actually seem to be laws that bar oversight entities from blowing the whistle on bad practices. The size of the problem is staggering:

It is hard to know the extent of the problems, because there is no central regulator to gather data on public plans. Nor is the accounting for government pension plans uniform, so comparing one with another can be unreliable.

But by one estimate, state and local governments owe their current and future retirees roughly $375 billion more than they have committed to their pension funds.

And that may well understate the gap: Barclays Global Investments has calculated that if America’s state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22 percent, to $2.5 trillion. Only $1.7 trillion has been set aside to pay those benefits.

So this may be an $800 billion problem, compared to the $450 billion problem in the corporate sector. Lovely. And how did we get this way? Here's one method, favored by those in the Garden State:

Still, officials in Trenton have been shortchanging New Jersey’s pension fund for years, much as San Diego did. From 1998 to 2005, the state overrode its actuary’s instructions to put a total of $652 million into the fund for state employees. Instead, it provided a little less than $1 million. Funds for judges, teachers, police officers and other workers got less, too.

To make up the missing money, New Jersey officials tried an approach similar to one used in San Diego. They said they would capture the “excess” gains they expected the pension funds’ investments to make and use them as contributions.

Clever. Too bad Enron isn't around to hire these officials. Another culprit has been (absurdly) long funding schedules, which serve to reduce the required contribution in each year:

Illinois officials say the state’s 50-year schedule is actually an improvement; before adopting it in 1995, the state had no funding schedule at all. In Colorado’s most recent legislative session, lawmakers enacted pension changes that they hope will make the plan solvent in 45 years.

And the National Association of State Retirement Administrators says it is unrealistic to expect all public plans to be fully funded, because they do not have to pay all the benefits they owe at once.

I'm guessing there's no financial literacy requirement to be a spokesperson for NASRA.

Wishing won't make this problem go away. At some point, state and local taxes go up or benefits to public employees or retirees get cut. There is no ERISA coverage for these plans, so I presume that attempts to cut benefits will wind up in court.

Pension Reform Gets up off the Canvas

When last we discussed pension reform, the prospects for any meaningful increase in pension funding requirements seemed bleak. But sometimes five months can make a difference, and the intrepid Mary Williams Walsh is back on the case:

Earlier this year, as Congress inched toward a broad overhaul of the nation’s troubled corporate pension system, experts said the bill was so fraught with escape clauses that it could become easier for companies to shortchange their pension funds than under the current, flawed law.

But under the version just approved by lawmakers, companies appear to get a break in putting money into their pension funds for only a couple of years before the rules start to tighten. Within a decade from now, according to a new analysis by the Congressional Budget Office, companies will be putting substantially more money behind their pension promises.

The CBO's cost estimates can be found here. The higher contributions take about five years to kick in. I don't see the rationale for waiting so long (and even making the contributions lower in the next couple of years), but I suppose I'll take what I can get. Ditto for the special extensions granted to the airlines (a lot to Northwest and Delta, somewhat less to American and Continental) and to GM and the UAW.

A big win in the legislation is that the variable rate premiums to the Pension Benefit Guaranty Corporation--the extra amounts proportional to plan underfunding--go up to the tune of roughly $5 billion over ten years.

Read more coverage of the legislation's provisions here.

Should I Stay or Should I Go?

On Wednesday, we learned of the agreement between General Motors and the United Auto Workers regarding a buyout plan:

G.M., staggering under the weight of $10.6 billion in losses last year, said it would offer buyouts and early-retirement packages ranging from $35,000 to $140,000 to every one of its 113,000 unionized workers in the United States who agreed to leave the company.

When firms are in financial distress, they need to get their creditors--typically private banks and public debtholders--to write down the value of their claims. If existing creditors are willing (or can be coerced) to do this, then the firm faces a better prospect of getting new creditors to help it finance value-enhancing projects. (I am still waiting to see what these might be for G.M.)

In a standard workout from financial distress, the firm enters an agreement with a bank and then makes an exchange offer to its public debtholders to give them new securities in exchange for their old ones, if a sufficient number of them accept. For an exchange offer to work, it typically has to shorten the maturity or raise the seniority of the new debt relative to the old. Those who opt for the exchange have to be able to "get in line" ahead of those who don't in the event that not all of the firm's creditors will be repaid in full. The more workers who take the buyout, the less money will be available in the near future for those who did not take it, in the event that G.M. doesn't recover.

In G.M.'s case, its labor contracts are so costly and so rigid that its unionized workforce resembles a major creditor, and what they have been offered resembles an exchange offer. So each of the 113,000 workers is making an individual assessment of whether they are likely to receive more money by taking the sure payment now or by seeing what uncertain payments they get when G.M. enters bankruptcy or recovers. As a Reuters story points out:

Several union officials said workers who have been thinking about a career change or those worried about the auto industry overall are the ones considering the offers.

The story also notes that employee reactions are mixed:

Reactions to GM's buyout offers, announced on Wednesday, varied among workers, with younger employees worrying about their future because the offers would not include health benefits, and some older ones getting ready to retire.

But some senior GM workers might just refuse to go.

Terry Brumley, 63, who works at the Corvette plant in Bowling Green, Kentucky, has been with GM more than 40 years.

"I'm not taking the money. I can raise a garden, go to dinner with my wife and go fishing, and still have a job. So why should I retire?'' he asks, adding that he sees himself working for at least another 10 years.

And, to show some of the problems with getting in the habit of offering buyouts, consider:

"Members of high seniority are very interested,'' Eldon Renaud, president of the United Auto Workers Local 2164 in Bowling Green, Kentucky, said. "There were a lot of people that were ... holding on to see if there was going to be a buyout offer.''

On this sort of dynamic inconsistency, more later.

Bradley Belt, We Hardly Knew You

Via my former partner in crime, Phill Swagel, I learn that Bradley Belt, executive director of the Pension Benefit Guaranty Corporation, has submitted his resignation. To find out why, you could read the letter and get to the phrase "the time has come to pursue other opportunities." Or you could read his remarks to the National Association of Business Economics from ten days ago. Everything up to the statement "But there is hope ..." constitutes one of the best expositions of why we face these troubles in the defined benefit universe. My tenure in DC overlapped very briefly with Belt's, and I wish him well.

The shorter version of Belt's remarks is that the entirety of pension regulation is set up to distort and minimize the impact of economic conditions on the firm's reported pension liabilities. He takes particular aim at smoothing of asset and liability values:

And thus we come to another figment of imagination in pension-land—smoothing. “Smoothing” is a seductive marketing word. It conveys the sense that we are sparing investors from the rude jolt they would receive if pension losses were reported at full value and saving companies from the terrible burden of repairing pension deficits as quickly as they were created.

In the accounting context, smoothing allows companies to show pension losses to investors in small slivers over time rather than all at once. This helps make a company’s reported earnings look smoother as well, which is to say, more divorced from economic reality. But if we have learned anything from recent economic history, it is that attempting to manage reported earnings leads to trouble. Going back a few years further, would we have avoided the need for an S&L bailout if we had allowed thrifts to smooth interest-rate spikes over a several year period? Would the economic reality of their asset and liability mismatch have been any different? In the pension context, it should be a wake-up call when the deputy chief accountant of the SEC derides smoothing for its potential to render financial statements “meaningless.”

But as problematic as smoothing may be in the pension accounting context, in some ways it is even worse in the pension funding context.

Under the pension funding rules contained in ERISA and the Internal Revenue Code, a company can skip needed contributions to its pension plan on the grounds that “smoothed” assets and liabilities make the plan look well-funded. When followed by a corporate bankruptcy, this policy of ignoring economic reality and failing to make needed contributions can lead to devastating losses of retirement income for long-serving employees.

On the asset side, the funding rules allow companies to use values smoothed over five years. The only constraint is that the market value of the assets cannot be more than twenty percent different than the so-called “actuarial” value of assets. In practice, this means a pension plan with $1.2 billion in liabilities and $1.2 billion in “actuarial” assets may not be fully funded but rather $200 million short of what’s needed to pay promised benefits. If I tried to pay my bills with the “actuarial” value of my bank account, I’d be bouncing checks left and right—which, unfortunately, is what some companies are doing with their pension plans.

If anything, the situation is even more perverse on the liability side. Companies are permitted to calculate the present value of their pension liability using the four-year average of a corporate bond index. It should go without saying that interest rates from four years ago have absolutely nothing to do with the value of the pension liability today (or tomorrow). This is akin to driving down the highway at a high rate of speed looking only in the rear-view mirror.

Still, I can understand why plan sponsors want the flexibility afforded by smoothing the discount rate. It is a fact of life that pension liabilities are extremely sensitive to movements in interest rates. If the discount rate drops by one hundred basis points, that can easily drive up liabilities by ten percent or more. Better to “smooth in” that rate drop slowly over time to avoid unpleasant hiccups in the plan’s funded status. Of course hiding the volatility doesn’t mean it isn’t there.

Without these (and other) smoothing mechanisms, the argument is made that companies won’t be able to “predict” their pension contributions and won’t be able to budget accordingly. This is a particularly fascinating line of reasoning. How can a CFO of an airline possibly function without being able to “predict” future oil prices? Or the CFO of an auto manufacturer with respect to steel prices? Or the CFO of a multinational enterprise that has to deal with currency fluctuations? Or, perhaps most similarly, a bank or insurance company CFO whose business is especially sensitive to changes in interest rates?

Ah, say the inhabitants of pension-land, but our obligations are “long term.” These benefits are going to be paid out over decades, so there’s no need to value the liability based on what interest rates are doing today.

Nonsense. I want to know the market value of my house today even if I have a thirty-year mortgage and plan to live in it for another thirty years—it affects my net worth and my ability to borrow. Moreover, there’s always the chance that I may have to sell my house earlier than I expected.

Similarly, workers and retirees need to know the funded status of the pension plan today even if the benefits are going to be paid out over thirty years. Not only should it affect their planning for retirement, but there’s always the possibility that their company may go bankrupt and turn its pension plan over to the PBGC. I can assure you: At that point a liability calculation based on interest rates from the year 2002 is utterly meaningless and misleading. Yes, most pension obligations are long term. But, there have been more than 160,000 standard terminations of fully funded plans over the past thirty years. There have been 3,600 terminations of underfunded pension plans. Ask the participants in these plans whether these are necessarily long-term obligations.

The argument that something other than the current market values of assets and liabilities should be reflected on corporate financial statements is bizarre. I suppose it comes from an idea that a corporation should not have to suffer the consequences of reporting the impact of return volatility in its pension funds because ... it is doing the world a favor by sponsoring the pension. Paraphrasing Belt, that's "nonsense." It is only doing the world a favor if it does bear the consequences of that volatility. Those consequences should drive it to fully fund its liabilities and duration match its assets and liabilities (e.g., in a heavily bond rather than equity portfolio). Only then would it really be doing the world a favor and merit the substantial tax advantage of the pension relative to other forms of compensation.

More on pensions tomorrow, focusing on the GM/UAW deal.

Pass the Spittoon, Pension Reform Edition

For the trouble of having to wade through all of the details of the pension reform bill now being gutted in House-Senate conference, Mary Williams Walsh gets a Voxy. I remember working on the early stages of this reform effort while at CEA. It started out simply enough:

With a strong directive from the Bush administration, Congress set out more than a year ago to fashion legislation that would protect America's private pension system, tightening the rules to make sure companies set aside enough money to make good on their promises to employees.

Enter the Congressional porkfest, and what do we now have?

Then the political horse-trading began, with lawmakers, companies and lobbyists, representing everything from big Wall Street firms to tiny rural electric cooperatives, weighing in on the particulars of the Bush administration's blueprint.

In the end, lawmakers modified many of the proposed rules, allowing companies more time to cover pension shortfalls, to make more forgiving estimates about how much they will owe workers in the future, and even sometimes to assume that their workers will die younger than the rest of the population.

On top of those changes, companies also persuaded lawmakers to add dozens of specific measures, including a multibillion-dollar escape clause for the nation's airlines and a special exemption for the makers of Smithfield Farms hams.

As a result, the bill now being completed in a House-Senate conference committee, rather than strengthening the pension system, would actually weaken it, according to a little-noticed analysis by the government's pension agency. The agency's report projects that the House and Senate bills would lower corporate contributions to the already underfinanced pension system by $140 billion to $160 billion in the next three years.

Two excerpts from the article say it best:

"It takes a better economist than me to understand how reducing contributions by that much is going to protect benefits and put the system on a sounder footing," said Jeremy I. Bulow, an economist at Stanford University.

That's actually funny, since there are no demonstrably better economists than Jeremy Bulow. And then we have the author's own attempt to make sense of this:

Someone must pay for this. Currently, the pension agency finances itself in part through the insurance premiums that companies are required to pay into the system. Raising the premiums to support pilots or help other victims of corporate bankruptcies, some companies in other industries are starting to say, would be unfair.

This is the contemptible legislative impulse to favor the special interest over the general interest. Read the whole thing and be amazed at how unprincipled the House and Senate are being.

The President has been losing credibility on several issues related to finances as of late. He could get some of it back if he would simply VETO this monster and send it back to the sty. If for no other reason, he should do it to show respect for the many people in his administration who worked diligently on a much better blueprint for reform.

For my own views on how to reform the defined benefit pension system, see these earlier posts.

Stitching a New Safety Net

So goes the title of the latest Econoblog, where Mark Thoma of Economist's View and I discuss the changing resources and expectations of social insurance. The teaser:

For many years, workers could manage their medical expenses with employer-provided health insurance and Medicare and look forward to underwriting their golden years with payments from a defined-benefit pension and Social Security.

But the landscape of social insurance is shifting. Many large corporations are moving their employees from traditional pensions to riskier 401(k)s and asking workers to pay more out of their own pockets for health insurance. At the same time, Social Security and Medicare, the two venerable entitlement programs, are facing growing demographic strains as the vast baby boom generation reaches retirement age.

The Wall Street Journal Online asked economist bloggers Mark Thoma and Andrew Samwick to explore how we how arrived at this point and discuss what workers and retirees might expect in the future, as the composition of the social safety net continues to shift.

Thanks to Mark for exchanging ideas. Enjoy!

Somebody Needs a 401(k) Plan

I confess that I am far removed from the NYC transit strike, and so I have not been following the details. But this item in the New York Times is just sad. The issue seems to be the pension plan. The key paragraph:

The strike began after talks between the union and the transportation authority were halted Monday night after the union rejected the authority's last offer. The authority had agreed to drop its previous demand to raise the retirement age for a full pension to 62 for new transit employees, up from 55 for current employees, but said it expected all future transit workers to pay 6 percent of their wages toward their pensions, up from the current 2 percent.

If this is right, the remaining issue is whether new employees (i.e., NOT the ones currently on strike) will have to pay 6 rather than 2 percent of their wages for the same pension benefits as those currently employed. For people they've never met, who might be willing to work under the new terms, they cost the city hundreds of millions a day? Not the way to score points.

In fairness to the employees-to-be-named later, I wouldn't want a 6 percent contributory pension to be managed by a public bureacracy. Give the new employees a 401(k) plan with an employer match on the first 6 percent of wages contributed and let that be the end of it.

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Another Pension Headline to Make You Cringe

Courtesy of the New York Times, we have, "Pension Officers Putting Billions into Hedge Funds." This is just a bad situation getting worse. Defined benefit pension plan sponsors are in a hole and continue to dig--someone should take away the shovel. Let's be clear from the onset:

1) I do not have any major issues with defined benefit pensions per se. If corporations want to sponsor them and workers will accept them in lieu of cash wages, then so be it. My own research contradicts the widespread perception that DB pensions offer the typical worker a better retirement outcome than DC pensions, given the way people contribute to them and invest them. They also make the firm's financial statements a bit more complicated.

2) I do not object to corporations making investments in hedge funds, if that's what the shareholders want to do. It is not my preference, because the impact of the investments on the firm's financial statements might make performance evaluation more difficult. But that's a small complaint.

3) I do not object in principle to PBGC insurance, but I do object to the way it is implemented. The insurance premium is too low on average, is inadequately related to the amount of underfunding, and is completely unrelated to the investment mix of the fund's assets. That premium structure, combined with lax funding standards, is what has put the PBGC in its current predicament, even without hedge fund investments.

The cocktail comprised of equal parts (1) - (3) is a vile brew. And the interaction with the political process will be a disaster. From the article:

While most pension plans have modest stakes in hedge funds, others have invested more than 20 percent of their assets. Weyerhaeuser, the paper company, has 39 percent of its pension fund's assets in hedge funds. In Congress, there has been a push for amendments that would make it easier for hedge funds to manage even more pension money, without having to comply with the federal law that governs company pensions.

Such a bad idea. So now the PBGC won't be able to figure out whether it is offering portfolio insurance to Long Term Capital Management? Continuing with the article:

Weyerhaeuser's big position has significant benefits for the company. Accounting rules let companies factor expected pension returns into their operating income; Weyerhaeuser's hedge-fund-laden portfolio allows it to claim expected annual returns of 9.5 percent. By comparison, the 100 largest companies that sponsor pension funds predicted last year that their average long-term returns would be 8.5 percent, according to Milliman Inc., an actuarial firm.

For Weyerhaeuser, each 0.5 percent increase in the expected rate of return is worth an additional $21 million to the company's pretax income this year, according to S.E.C. filings. Weyerhaeuser did not respond to phone inquiries about its hedge fund investments, but said in S.E.C. filings that its actual pension investment returns more than justify its assumption of 9.5 percent.

The article is missing the point here--the higher the rate of return the company can assume on its pension assets, the lower the contributions it needs to make today. Note that funding rules do not require any reserve to be accumulated to protect against the extra risk associated with the higher returns, nor do PBGC insurance premiums go up due to the added risk. So to the corporation, this looks like free money.

And finally, more bad news from Congress:

In Washington, despite concerns over the health of the nation's pension system, there has been little discussion of pension plans' growing use of nontraditional investments. Even as Congress has been working to shore up the pension system and strengthen the Pension Benefit Guaranty Corporation, a provision to relax the pension law for hedge funds has been proposed.

The provision would raise the limit on how much pension money a hedge fund can handle before it is deemed a fiduciary under the pension law, which would require it to be more prudent and careful than is required under securities law and would bar some trades entirely. The provision was added to a broad pension bill in the House shortly before the Committee on Education and the Workforce approved the legislation.

Currently a financial institution becomes a pension fiduciary when more than 25 percent of its assets consist of pension money; the bill would raise that to 50 percent.

That's just sad. We should be heading in the other direction: pushing corporate DB sponsors to use a term-structure of riskless Treasuries to value and fund their liabilities. At some point, somewhere, someone is going to have to pay the true economic cost of their activities.

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A Place Somewhere

In a post regarding "The End of Pensions," Brad DeLong notes:

I think Andrew misses an additional important aspect of the situation. When pension funds (and health benefit programs) become large relative to the size of the firm, the retired and the sick join the bondholders and the stockholders as claimants on the firm's cash flow, but the retired and the sick don't have any place in the firm's corporate governance structure, and claimants on a firm's cash flow should have a place somewhere.

I agree. Last April, I suggested that DB plan participants be moved ahead of all other unsecured claimants in bankruptcy, in the context of how to protect current and past workers if the PBGC were eliminated. I don't know if that's enough, but it is a start, and I would equally well recommend it for all deferred compensation claims of rank-and-file workers, including retiree health benefits.

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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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Pensions Lost in Translation

It has finally happened. The Pension Benefit Guaranty Corporation (PBGC) has assumed responsibility for the four defined benefit (DB) pension plans at United Airlines. The impact, as reported in The New York Times is as follows:

The federal government said yesterday that it had reached an agreement to take over all four of United Airlines' employee pension plans, with a shortfall of $9.8 billion, making it the biggest pension failure since the government began insuring pension benefits in 1974.

Because the PBGC caps the benefit amounts it insures, only $6.6 billion of this amount is guaranteed, but even that hit to its balance sheet will increase the PBGC's net deficit (reported as $23.3 billion last September) substantially. Plus, we can now expect all of the other legacy airlines to seek the same sort of treatment from the PBGC.

However, there has been a tendency in news reports to suggest that the American taxpayer is somehow on the hook for this money. That isn't true, unless the federal government passes new legislation to make it true. At present, it is the rest of the DB pension sponsors in the PBGC-insured universe who are on the hook. As the PBGC's press release explains:

By law, the PBGC is required to keep premiums as low as possible and has no call on the U.S. Treasury beyond a $100 million line of credit. ...

The PBGC is a federal corporation created under the Employee Retirement Income Security Act of 1974. It currently guarantees payment of basic pension benefits for about 44 million American workers and retirees participating in over 31,000 private-sector defined benefit pension plans.

Pension insurance--not the idea but its implementation, and certainly not the dedicated people who work at the PBGC--is a complete joke. There are three problem's with the PBGC's setup:

1) The premium amounts are too low. On average, companies do not pay enough to cover the risk to which they expose the PBGC.
2) The premium formula is inadequately linked to underfunding. Pension sponsors whose plans are underfunded do pay slightly more in premiums than pension sponsors whose plans are fully funded, but the amount of additional premiums does not adequately compensate the PBGC for the added risk of a claim.
3) The premium formula is unrelated to the PBGC's risk exposure--the portfolio allocation between stocks and bonds and the bankruptcy risk of the company.

There are some extremely smart people working on pension insurance, both at the PBGC and outside. The issue is not that we couldn't figure out how to charge the appropriate premiums. The issue is entirely that Congress will never allow the PBGC to charge actuarially fair premiums. That would put too large of a burden on key political constituencies. United would have been paying enormous premiums over the past few years. Airline, steel, autos--these are the industries that have been least responsible in funding their pension plans. So this is what we get--subsidized risk-taking at the expense of responsible plan sponsors.

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.

With PBGC insurance, the company has an incentive to invest in a portfolio heavily weighted toward stocks. If the stocks do well, the company can cut back on future contributions. If the stocks do poorly, then in some cases, the company can terminate the plan and leave the liability with the PBGC. Classic moral hazard. When the economy goes through a period of weak stock market returns (so the pension fund's assets fall in value) and low interest rates (so the present value of the future liabilities rise in value), we get tremendous underfunding. And the laws governing minimum pension contributions don't require pension sponsors to make up the difference quickly enough.

What to do? Impose a levy on each DB pension plan sponsor that is proportional to the current value of all past PBGC premiums paid for current participants. Impose the levy based on 2004 data, so there is no rush to the exit. The levy should be enough to put the PBGC at a zero balance position. Then retire the PBGC and allow companies to obtain pension insurance privately if they so desire. For current sponsors, pass a law that moves pension participants' claims in bankruptcy ahead of all unsecured creditors. If this means that fewer firms offer DB pensions, then so be it. Unhealthy companies--like United--ought not to be making promises to pay beneficiaries decades into the future.

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