Thursday, March 23, 2006

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.


Robert Schwartz said...

Sure, make them mark to market. There will be no pension plans in public companies in 5 years and then we won't have to worry about it anymore.

Tom C said...

Here's the part that ticks me off. All these executives over the years making fortunes by showing "profits" that don't really exist, then leaving the company to go bankrupt while sitting on their money. I hope they choke on it (literally).

I personally don't understand why courts in this area don't act like bankruptcy courts and pull back assets given to those who cheated the pension funding...a simple law that allowed courts to "look back" say, 25 years, and take back the interest and principal for any bonuses (or option sales) achieved while a company was underfunding a pension would end the practice in minutes.

Would it end pensions? Only for the companies that want to cheat. The others will do it if they see value in long term employees. Don't confuse the 2 issues: the reduction in defined benefit plans has happened because fewer and fewer companies see the need for permanent employees.

Arun Khanna said...

One should step back and look at this issue through the lens of a ‘version’ of Fisherian separation. There is no need for firm decisions for asset allocation for employee pension plans, 401-K plans which allow employees to make their own individual investment decisions are far better.