While the airlines have been getting most of the news concerning the failure of pension funds, they are just the tip of a massive iceberg. As we’ll explain, both America’s private and public pensions are in jeopardy.
While the airline pensions are under-funded to the tune of $32 billion at the moment, the auto companies are down nearly twice that amount.
In fact, the lack of funding is growing at a galloping 27 percent per year, according to a recent article in BusinessWeek. Meanwhile, the Pension Benefit Guaranty Corporation, or PBGC, which recently bailed out Bethlehem Steel and United Airlines, among others, faces its own shortfall of $23 billion. The PBGC is the federal agency that insures private pensions.
One of the reasons for this mess is that the government’s own rules about how pensions are handled do not make any sense. For example, Bethlehem Steel was legally in compliance with the rules, even while it made no contributions to its pension plan for three years running prior to collapsing in 2002, when it was already $4.3 billion behind.
United made no contributions from 2000 to 2004, and it was $3 billion down when it started. On the basis of odd and useless accounting rules, United’s plan appeared to be fully funded. In reality, it was short by 41 percent. When United finally turned over its plan to the PBGC, it was nearly $10 billion in the hole, making it the largest corporate pension default in U.S. history.
As of now, there is no incentive for companies to avoid such abuses of the system. They can simply fail to pay and then wait for the government to step in and pick up the tab.
In addition, these failures often come as a complete surprise to the workers, because under the current rules, no one has to tell them when their pensions are under-funded until as much as 30 months after the fact, by which time it may be too late.
The latest series of reports filed with the PBGC on April 15, 2005 covered 15 million workers and 1,108 pension funds. They were under-funded to the tune of 69 percent, on average. But that series of reports covered only companies that were down $50 million or more.
The total shortfall in all insured pension plans exceeds $450 billion in the private sector, according to an InvestorsInsight article. That’s up $400 billion since 2000.
Worse yet, experts predict that corporate pension plans will find themselves $1.2 trillion in the red in coming years. As corporations are forced to make up the shortfall, their profits will be reduced, which in turn will adversely impact stock market returns, reducing the value of the assets those pension funds have in stocks. As a result of this vicious circle, Barclays Global Investors estimates that American corporations could be $2 trillion in thehole on pension funds in the next 10 years.
But that’s just part of the story. America’s public pension plans are no better off. In fact, they’re worse.
Wilshire Associates reports that 84 percent of state retirement plans are under-funded. These plans paid out $78.5 billion in the 12 months that ended in September of 2000. By 2004, the payments had climbed to $117.8 billion, a 50 percent jump. The hard fact is that the money just isn’t there. Short of raising taxes or issuing bonds, there’s little anyone can do.
Not counting federal employees, more than 14 million people in the public sector are owed $2.37 trillion by more than 2,000 different cities, states, and agencies, according to BusinessWeek. In 2003, cities and states spent $46.2 billion on retirement plans, up 19 percent over 2002.
These same pensions amounted to 2.15 percent of all state and local spending in 2002. The next year, that figure was up to 2.44 percent. The fact is that the public sector is in bigger trouble than private companies, with twice the shortfall found in S&P 500 firms. If the government calculated what it owes using the same math that companies use, it would not be down the published estimate of $278 billion; it would be more than $700 billion in arrears. And that doesn’t even count the tens of billions in health care that retirees are expected to get.
It’s stunning to see how quickly things can turn around. For example, five years ago in 2000, the larger state funds were actually over-funded, with about 109 percent of their liabilities covered. Last year, they were down to 83 percent, for a shortfall of 17 percent.
Of course, the downturn of investment markets in the period between 2000 and 2002 hurt these funds substantially. But another reason was that politicians, seeking reelection, made promises they couldn’t keep.
For example, the city of Houston lets employees retire, take their pension, and keep on working at their normal salary, essentially double dipping. The retirement money is held in an account earning interest.
BusinessWeek reported that, according to Joseph Esuchanko, an actuary hired to analyze the situation, a person who earns $92,000 could get $420,000 a year in retirement benefits. An employee could literally become a millionaire by working this plan right.
This scheme, dreamed up by some politician seeking reelection, put the city 40 percent in arrears in two years. The city’s contribution to pension plans jumped from 9.5 percent of payroll to an astounding 32 percent.
Employees in the public sector have always expected generous benefits as one of the perks for doing such work and possibly earning a lower salary than someone in the private sector. Some 90 percent of them have “defined-benefit pensions” and “guaranteed payouts,” while only 24 percent in the private sector have “defined-benefit pensions,” but instead have 401(k)s.
Today, even those companies with a long tradition of supporting their retirees, such as Motorola, IBM, and Delta Air Lines, are turning to 401(k) plans.
But government is predictably out of step with the times: State and local government employees earn 40 percent more than their private sector counterparts, and benefits for those employees costs 60 percent more. It hasn’t been easy to make changes to this system. When California’s governor tried to institute a 401(k) plan for state employees, he was defeated by a publicity campaign led by police and fire fighters.
Meanwhile, the city of San Diego is $1.4 billion behind in its pension fund, amid allegations of fraud and public corruption. Salinas may have to close its libraries as pensions eat away at that city’s budget. Orange County, Los Angeles County, and many other California counties are in the red, too. The state’s pension bill has tripled in the last three years.
One of the reasons is that in California, an employee can often earn more by retiring than by working, according to the article in BusinessWeek. California’s not alone in this business of politicians giving out gifts to lure voters. New York, Colorado, Illinois, New Jersey, and many other states have done the same. At the time, during a bull market, with investment returns fat, it seemed like a harmless perk. Then the stock market fell.
Most of the shortfalls we’ve seen have been the result of states that rely on investment gains while cutting real funding. Illinois, the fifth-wealthiest state, has played this game for 30 years. It hasn’t paid a full pension bill since 1970. Like other states, it plays an accounting game with retirement funds.
The state of Illinois estimates its return on investment at 8 percent and then figures that when it doesn’t put money in, it’s in essence borrowing at that rate of interest from the fund. With bonds paying 6 percent, it’s not even a very good game. In fact, it’ll end up costing hundreds of billions before the shortfall is made up, if it ever is. By the Illinois bureaucrats’ math, the Dow will have to reach 22,000 in 2015 to fund the future.
Many other cities, counties, and states are counting on the stock market to solve the problem. That isn’t going to happen, according to a pessimistic analysis by John Mauldin of InvestorsInsight.
Consider a typical pension portfolio with 60 percent invested in stocks and 40 percent in bonds. If the bonds yield a 5 percent annualized return over the next 10 years, the stocks would have to appreciate by 10 percent in order for the entire plan to return 8 percent.
Is that likely? Not according to Mauldin, who contends that stocks will likely return only 4 to 5 percent. That means that total portfolio returns will probably be about 5 percent, which is much less than the 8 to 9 percent returns that most fund managers are projecting.
If he’s right, the brutal reality of this situation is that taxes may have to rise. But if a state raises its taxes, what’s to stop companies and even citizens from simply moving to a state with a better offering? Some observers of this trend predict “an economic desert” will be the result.
But raising taxes may prove nearly impossible. It’s difficult enough to do under normal circumstances. But in essence, the same politicians who have been making promises they can’t keep will be in a position of asking ordinary citizens to pay for pensions they themselves couldn’t get.
One reason the public pensions are in so much trouble is that they aren’t governed the way corporate pensions are. They aren’t guaranteed by the government, either, as private pensions are. And when things go bad, they have no recourse. They can’t even cut benefits like corporations can, because they’re guaranteed by state constitutions in most cases.
In the face of this trend toward massive pension default, the Trends editors believe Congress needs to change the rules so that companies that have under-funded pension plans get charged higher premiums while those that keep funding up-to-date, get tax credits.
In short, it’s time for Congress to stop the insanity and bring some sense to the entire question of retirement, especially in light of the rapidly aging baby boomers and the retiree explosion on the horizon. Senator John McCain called the corporate pension fund situation an impending “train wreck,” according to the Fort-Worth Star-Telegram. Meanwhile, Congress has been making promises and sitting on its hands.
But some congressmen are trying to get the Pension Protection Act passed. It would represent major reforms in federal laws regulating corporate pensions. The bill was introduced on June 9 and represents the main thrust of the President’s recommendations on the subject.
It would require, for example, that corporate pensions be fully funded within seven years. Companies that had under-funded pensions would be unable to raise benefits until they funded the current ones. That would include giving more benefits to top executives or even deferred compensation.
The bill would also require the PBGC to clean its own house and become solvent so that it can pay the retirement checks it owes through its bailouts of companies such as United Airlines. One way the PBGC could do this is through the bill’s proposed hike in insurance premiums that corporations pay to the organization. The premiums would be indexed to future wage growth.
In addition, the bill would force corporations to use real market values for assets, rather than a pie-in-the-sky estimate, and to tie funding requirements to a company’s financial health, based on its credit rating.
And finally, the proposed reforms would require much more transparency and timeliness in the way companies fund and account for pension plans. Retirees, employees, and shareholders would have access to this current information under the plan.
The reforms are focused on defined-benefit plans, under which retired workers receive a monthly pension check of a set amount, based on salary and years of service.
Most importantly, the bill would change the law so that companies could no longer “pull a fast one” on employees and taxpayers, as United did by neglecting to contribute to its own pension fund and then turning to the bankruptcy courts and the PBGC to bail it out.
But corporations are already protesting that such reforms will cost too much. In fact, S&P 500 companies would have to pay $41 billion into their plans this year if the reforms were in place today. That’s about 28 percent above the $32 billion those same firms were expecting to cough up.
Of the 373 companies in the S&P 500 that have defined-benefit plans, 92 could see their pension costs more than double, including 14 that would pay more than $100 million each, such as General Motors, Delta Air Lines, and Xerox. No wonder companies are bailing out of fixed-benefit plans as fast as they can.
Many observers have likened the situation with pension funds today to the Savings & Loan debacle of the 1980s. During that time, more than 1,000 institutions failed, leaving taxpayers to pick up the $124 billion tab through the Federal Savings and Loan Insurance Corporation, which insures such banks. Of course, neither the FSLIC nor the PBGC was ever intended to perform miracles like that at taxpayer expense.
Some observers believe that the PBGC just encourages risky behavior on the part of corporations, according to an article in The Atlanta Journal-Constitution. They say the federal agency shouldn’t be in the position of bailing out companies that fail. They should just let them fail. Others say that companies such as United Airlines are simply too big and important to allow them to fail.
In light of this trend, we offer five forecasts for your consideration:
First, President Bush’s suggested reforms will become law prior to the 2006 elections, either through the legislation currently in the House or a similar bill. The topic has simply become too hot, and the failures of the system too prominent, to let it drag on any longer. Corporations will protest loudly, but eventually they’ll bite the bullet and fund the existing pension plans.
Second, as corporations feel the crunch of having to fund those pension plans, they will unburden themselves of them as efficiently as possible. That means that fewer and fewer companies will have fixed-benefit programs, while more and more will go to the 401(k) model. The era of traditional retirement plans will come to an end. Public sector pension funds will undergo a similar transformation in the long run. Initially, governments will raise taxes and issue bonds, depending on circumstances, in order to keep funding their own pension programs. But ultimately they, too, will have to divest themselves of the fixed-benefit model and start using the more sensible 401(k) or another defined-contribution program, which transfers the burden of investing to the employee. This will encourage managers and employees to pull in the same direction, and make pro-business policies the national consensus.
Third, the Trends editors expect a substantial rise in the stock market between now and 2010 to bring the pension funds more into balance. We agree with other Wall Street experts who foresee that the annualized nominal equity market return will be 7 to 8 percent for the next 20 years. This is a much better return than the 4 to 5 percent predicted by InvestorsInsight, but it will still barely solve the problem. What are really needed are the average historic returns of 9 to 11 percent. To get 9 to 11 percent average nominal stock market returns in a world of 2 to 3 percent inflation, we need to have 3 percent or higher average GDP growth over the next 20 years, not 2.4 percent or less. That’s why the pro-growth oriented trends we’ve discussed in previous issues of Trends ? such as retiring retirement, off-shoring, and selective immigration ? are so crucial. They offset the coming labor shortage. Also, much of the earnings growth will come from businesses that are just now emerging, like biotech, nanotech, and robotics. Low taxes will provide plenty of capital for entrepreneurs with better ideas.
Fourth, the PBGC will undergo a shake-up that will lead to stricter rules for bailing out a corporation in pension trouble. Combined with the reform legislation that forces corporations to fund and account for pension plans in a more realistic manner, this will make bailouts like the one at United Airlines a rarity. The PBGC’s resources will be conserved to deal with what might be called “honest failures” and generally ones on a much smaller scale.
Fifth, combined with Social Security reforms proposed by the President, these changes will ring in a new era of personal savings and investing that will put future retirees in a much more secure environment. They will know exactly what they have coming, and will be able to count on it being there at the end of their employment.
References List : 1. BusinessWeek, June 20, 2005, “The Pension Mess: How Washington Can Start Cleaning Up.” ⓒ Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.2. To access John Mauldins commentary, “Public Pensions, Public Disasters,” visit the InvestorsInsight website at: www.investorsinsight.com/thoughts_va.aspx?EditionID=1403. BusinessWeek, June 13, 2005, “Sinkhole! How Public Pension Promises Are Draining State and City Budgets,” by Nanette Byrnes, with Christopher Palmeri. ⓒ Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.4. ibid.5. To access John Mauldins commentary, “Public Pensions, Public Disasters,” visit the InvestorsInsight website at: www.investorsinsight.com/thoughts_va.aspx?EditionID=1406. Fort-Worth Star-Telegram, June 19, 2005, “Trying to Avoid a Train Wreck.” ⓒ Copyright 2005 by The Fort-Worth Star-Telegram. All rights reserved.7. The Atlanta Journal-Constitution, June 15, 2005, “Abolish Federal Pension Guarantee,” by Ivan G. Osorio. ⓒ Copyright 2005 by The Atlanta Journal-Constitution. All rights reserved.
