Wednesday, August 25, 2004

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Headlines from the future

Bloomberg runs a story on an arcane policy entity called the Pension Benefit Guaranty Corporation that I fear will be making news in, oh, about five years:

The pension shortfall among U.S. companies may force the federal agency that insures retirement plans to seek a taxpayer bailout similar to the one during the savings and loan crisis, according to the Cato Institute, a policy research group.

The Pension Benefit Guaranty Corp. had a record deficit of $11.2 billion last year after taking over plans for 152 companies, including Bethlehem Steel Corp. and US Airways Group Inc.

Without changes to funding and premium rules, that deficit is likely to swell to $18 billion in the next 10 years and may reach more than $50 billion, said Richard A. Ippolito, who wrote the study for Cato, a policy research group, and is a former chief economist for the pension agency.

"If exposures create claims that reach catastrophic levels, taxpayers will be called upon to provide a bailout," Ippolito said.

Here's the link to Ippolito's study. From the abstract, this sounds like a classic moral hazard problem:

The Pension Benefit Guaranty Corporation, the federal agency that insures private-sector defined-benefit pension plans, had a surplus of $9.7 billion at the end of 2000 but a deficit of $11.2 billion at the end of 2003. Pension plan underfunding stands at more than $350 billion, which increases the likelihood that more pension plans will go under and taxpayers will eventually be called upon to provide a bailout.

The reasons for the PBGC's financial difficulties can be found in the structure of defined-benefit pension plans and in the way Congress set up the premium rules when it created the program in 1974. First, because the PBGC stands as the ultimate guarantor of companies' pension liabilities, plan sponsors have an incentive to invest their assets in equities rather than fixed-income securities of the same duration as the liabilities. Second, funding rules allow companies to make gradual contributions to their pension plans in the event of underfunding, which guarantees long-term exposure for the PBGC. Furthermore, when faced with higher contributions, companies have usually appealed to Congress to reduce the underfunding that they need to report, which reduces contribution requirements.

Unfortunately, Congress has failed to adequately address the problems of the PBGC. In temporary legislation passed in April 2004, Congress reduced the required contributions companies must make to their defined-benefit pension plans by an estimated $80 billion over two years by changing the formula used to calculate pension liabilities. Congress also provided additional relief of approximately $1.6 billion to steel and airline companies with heavily underfunded pension plans.

Rather than place the PBGC on sounder financial footing, those measures will likely worsen the agency's financial condition.

Read the whole thing.

posted by Dan on 08.25.04 at 11:27 AM


private-sector defined-benefit pension plans, had a surplus of $9.7 billion at the end of 2000 but a deficit of $11.2 billion at the end of 2003

Obviously these plans' portfolios' weighting toward equities means that their financial health will wax and wane with the stock market. Seems pretty arbitrary, therefore, to choose as comparative benchmarks of health the very peak and near bottom of the market in the past eight years.

Also missing from this snippet is any attention to demographics or to the skill at managing the portfolios themselves. Ford and GM's plans have recently moved into surplus.

The real picture isn't nearly so grim as it's being painted. It's not time to ignite talk about bailouts.

posted by: lex on 08.25.04 at 11:27 AM [permalink]

Moral hazard?

Naive question. Shouldn't the managers of the companies who require bailouts be punished in some significant way?

Meanwhile, profit rates are high, real wages stagnate and Bush cuts taxes for the super-rich in order to, er, get the job creation machine going. Qui bono from all this?

posted by: Peter K. on 08.25.04 at 11:27 AM [permalink]

While GM's pension plan has made significant strides in the past year, it is not due to an improvement in their investing style or management of assets. GM contributed approximately $18.5 billion in cash to their pension plan which was raised through the debt markets, making them one of the few companies to recognize this growing problem.

As for end of year 2003 numbers being the bottom of the market and deceptive, I wouldn't make that quick assumption either. The S&P 500 went from around 900 at the end of 2002 to just over 1100 by the end of 2003, around a 22% return (not including dividends) which is pretty damn good.

As for end of year 2000 numbers being the peak, that's not exactly true either. The S&P 500 was over 1400 at the end of 1999 and was around 1300 by the end of 2000. The real peak was around April 10, 1999, the Monday before the entire market tanked for an entire week.

As for how pension contribution legislation is formulated, I don't have much to say. What I will add though is a recent nugget from United Airlines, who is now threatening to dump their defined pension plan scheme in bankruptcy and saddle PBGC with even more problems.

posted by: Jay on 08.25.04 at 11:27 AM [permalink]

Private industry has reacted to every PBGC reform that increases defined benefit pension costs by terminating such pension plans, and moving to 401(k) plans. There is no reason to believe that the reform proposed in the paper wouldn't do the same thing. One thing corporate America is very good at is shifting costs imposed on it by government to others. In this case, it will be employees who will lose the benefit of a guaranteed monthly income, and have the benefit replaced by the uncertainty of a 401(k) plan in which, dollars to donuts, they will be left with responsibility of managing their own funds.

In other words, companies will outsource their pension investment management to their employees, who are frequently unsuited to the task. Of course, maybe they will read the paper, and know to invest in bonds that correspond to their own personal retirement horizen.

By the way, no article in this area is complete without noting that employers are frequently unable to contribute to their pension when times are good because the tax code views "overfunded" pension plans as a tax shelter.

posted by: Appalled Moderate on 08.25.04 at 11:27 AM [permalink]

Much of the blame should go to Congress and IRS for creating funding rules that not only allowed zero contributions, but often mandated them in order to limit tax deductions.

Some of the blame should go to the Financial Accounting Standards Board. Its rules make putting pension assets into anything but equities a huge competitive disadvantage.

Congress and the IRS are currently not in an easy spot. Without funding relief this year, many more companies would have to fund their pensions at the expense of new hires and investments. A healthy stock market will solve many more pension problems than new regulations ever will.

posted by: Ron Barlin on 08.25.04 at 11:27 AM [permalink]

One thing corporate America is very good at is shifting costs imposed on it by government to others.

Of course, all costs imposed on corporate America are shifted to others (and, eventually, individuals), in the grand scheme of things.

posted by: Chris Lawrence on 08.25.04 at 11:27 AM [permalink]

There should have been/should be a condition where if a pension fund takes on investments that exceed a certain level of risk, it will lose coverage. Or, better yet, regulations on pension funds requiring that they be mostly conservatively invested.

"United Airlines, which appears likely to default on its pension plans in the coming months, invested a larger-than-average share of its $6.6 billion pension portfolio in illiquid investments, while also investing liberally in junk bonds, technology and pharmaceutical start-ups, even a gold mining company in Ghana."

- NY Times August 13, 2004

posted by: Jon H on 08.25.04 at 11:27 AM [permalink]

Keep in mind two things. First, things really were worse before ERISA and the creation of the PBGC. Second, a significant part of the current underfunding came from companies removing "surpluses" from their pension plans (and reporting it as profits) when stock prices were at or near their peaks. That money, which was once a part of the resources devoted to pensions, has moved into the pockets of the rich.

posted by: Donald A. Coffin on 08.25.04 at 11:27 AM [permalink]

Mr Coffin:

Employers may not capture so-called "excess assets" in their pension plans, unless the plan is terminated and accrued to date benefits are fully funded by insurance contracts. These type of annuity funded benefits are not protected by the PBGC, and therefore don't contribute to the PBGC deficit.

I think you have in mind the infamous "termination/reestablishment" pension play of the mid-80s (which was taxed out of existence by the early 90s), and are confusing it with the fact pension surpluses can be included as part of a corporation's financials (thereby inflating net worth).

You are right, though, that things were far worse when there was no PBGC protection of pensions.

posted by: Appalled Moderate on 08.25.04 at 11:27 AM [permalink]

Defined benefit pensions simply seem to be too subject to the vagaries of investment fortune. We've already had major bailouts of pension systems--recall railroad pensions. Is there any way to sufficiently mitigate risk by spreading it across time and enough people? Consider Social Security as an example that even nearly the entire US population might not be enough to survive changing demographics, much less a long-term downturn in the fortunes of a single company.

posted by: Sam on 08.25.04 at 11:27 AM [permalink]

In the long run, if Social Security gets privatised, I expect the PBGC to be rescuing private pensions that go tits up. Or I suppose we could see more pensions crash and burn from enron stlye shenanigans.

posted by: Peter on 08.25.04 at 11:27 AM [permalink]

Interesting topic. Glad you provided the first link to the Cato Institute study as the 2nd one does not work. But are you saying there is no need for the government to back pension funds at all? Eliminating PBCG (as flawed as it may be now) will assure a perfect markets situation?

posted by: Harold McClure on 08.25.04 at 11:27 AM [permalink]

Dan, thanks for bringing up this subject. Over here in the United Kingdom, Tony Blair's government is planning to set up a Pension Protection Fund on broadly similar lines to the US model. Already, critics have warned that unless the new fund is paid for out of risk-adjusted fees similar to a proper insurance firm, the fund could easily create a moral hazard problem. Firms with well-funded pension plans could be forced to cross-subsidize retirement schemes with big shortfalls.

The pensions issue, both in the private and public sector, is in my view the No 1 domestic policy headache for western governments. In truth, I cannot see how it will be solved unless govts are honest enough to tell electorates that they have to work beyond current retirement ages or accept lower benefits.

(I have a nasty feeling I will be toiling until I am about 200 years old)

posted by: Johnathan Pearce on 08.25.04 at 11:27 AM [permalink]

Good comments.
Will add only that this is another boomerang of the yuppies and now their offspring (which includes all the paper professionals and attorney business monopoly, govt. employed, skimming govt. union leaders and other union leaders ) --- all desiring to live the life of princes and princesses (with little respect for productive work done in the country).

posted by: Alex on 08.25.04 at 11:27 AM [permalink]

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