Tuesday, November 01, 2005

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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5 comments:

Anonymous said...

i actually do not think the end of pensions will happen. we may be approaching a limit.

cash balance plans may be more the waive of the future, along with some notion of portability.

pensions have some advantages: stability, lower transaction fees, retention of key employees, professional money management, long-term investments that require professional money management, diversification of investor base, etc-

i do not think the life insurance or other can entirely replace these advantages (eg, elimination of all pensions implies less diversification of some sort...)

so i do not think that pensions should or will end entirely-

furthermore, in the near future you may see nice earnings surprise (positive) at big companies due to an increase in interest rates (present value of future liabilities for retirees looks smaller given higher discount rate). i am not for sure the market has considered this.

Anonymous said...

one more-

another thing that needs to be explores is modification of pension benefits without bankruptcy. too many companies have an incentive to pursue bankruptcy, and intentionally become bankrupty, because htis is perceived as the only way to re-negotiate pensions and benefits.

Anonymous said...

one last comment:

pensions are the punching bag for companies who have much bigger problems: uncompetitive products, neglecting to manage number of headcount, productivity problems, failure to adapt, etc-

united airlines will be an interesting test case on this.

Robert Schwartz said...

We are watching the last pension plans go out of business. And there is nothing we can do to stop it. The natural history of capitalism is that industries are born, grow, add lots of employees, become more efficient, reduce the numbers of employees, see foreign competition eat into their markets, grow sclerotic and die.

When companies are young, they will want to keep capital in their operations to finance their growth. When industries shrink so much that their number of retirees vastly exceeds their active workers, they will be sorely tempted to cut the pension plans loose. At no time will companies be tempted to put their pension contributions in T-bonds.

The steel industry was mentioned above. A few days ago I read that POSCO, the major Korean steel maker, which a generation ago destroyed US competitors with its efficient operations at a time when Korean workers were making $2/hr., is now worried about Chinese competition and is spending billions of dollars to build new plants in India.

The social cost of frustrating this Schumpeterian cycle far exceeds the benefit of keeping companies alive to pay pensions. The realistic policy will be to cut-off future insurance to DB plans and to publicly fund the obligations of the PBGC. In the future, Companies will provide DC plans and leave investment risk to the workers. The best way to socialize that risk would be to make endowment insurance policies and differed annuities major pension funding vehicles. Unfortunately, the insurance industry is for the most part a method by which the parasitic class of commission salesmen steals their clients' money and leaves their bloody corpses unburied.

Arun Khanna said...

Corporate pension plans should be managed by independent pension trustee firms which can buy put options each year on equity investments of pension fund to cover that year's anticipated retirees. This strategy will provide higher returns then duration matching T-bonds.