S&L redux

Buttonwood

Jun 21st 2005
From The Economist Global Agenda

Who should be responsible for honouring the promises that companies make to their workers?

BUTTONWOOD is not exactly counting the grey hairs yet. But in the unlikely event that her children ever finish their hugely expensive education, it would be nice to think that she could hang up her keyboard one day and devote herself to Sudokus. The way company pension funds are going—and The Economist’s is better than most—that day looks increasingly remote.

It’s not just the headline problem-kids—MG Rover, the British carmaker that went bust this year stranding 5,000 workers; America’s United Airlines, which tossed its 120,000 workers at the Pension Benefit Guaranty Corporation (PBGC) in May and ran, in the biggest pension default in history; or General Motors, borrowing to pay the pensions of workers as it fights for its life. The issue is broader.

Pension plans depend on company contributions and investment returns for their funding.
Actuaries’ assessments of mortality rates give a guide to future liabilities. Bond yields provide the discount rate that broadly determines what current assets the plans must hold in order to meet those liabilities. The situation has been dire all round. Returns on investment have been lower than expected. Bond yields have been too, thus swelling the amount of current assets plans must hold. Beneficiaries are living longer than anyone thought they would.

True, companies could have spent more of their recent record profits topping up their pension plans and less of them pleasing shareholders with dividend increases and share buybacks. But they have at least been paying more in. Employer contributions have shot up in Britain; last year, for example, firms contributed £25.6 billion ($47 billion), compared with £20.9 billion the previous year, and a steady level of around £7 billion in the 1990s (almost all of the money goes to defined-benefit schemes). The trouble is that liabilities have shot up faster.

In Britain, defined-benefit pension funds of FTSE 350 firms were around £70 billion short of where new international accounting standards say they should have been at the end of May, on figures from Watson Wyatt, a firm of actuaries. A broader definition of full funding puts the shortfall at £197 billion. Pension legislation enacted in 2003 and 2004 has broadly tightened funding, but these baked-in deficits are huge and so is the anxiety they generate. The only worry that is not yet on many lips is that taxpayers might have to underwrite the Pension Protection Fund if too many pension schemes go into default.

Not so in America, where people are speaking openly of a taxpayer bail-out to rival the rescue of America’s savings-and-loan (S&L) sector in the late 1980s. The pensions insured with the PBGC showed a shortfall of almost $354 billion at the end of the last fiscal year, compared with $279 billion a year earlier. If the deficits of less underfunded plans are rolled in, the total shortfall is more than $450 billion. The PBGC had a $23.3 billion deficit last year in its main programme.
Premiums do not keep pace with expected claims, still less reduce the accumulated shortfall. An independent think-tank, the Centre on Federal Financial Institutions (COFFI), said this week that the PBGC needs an infusion of $92 billion in today's dollars to meet its future obligations.

And the problem can only get worse. America’s defined-benefit schemes tend to be more concentrated than Britain’s in the unionised and industrial sectors that have been most buffeted by competition of one sort or another lately. Delta Airlines threatens to follow US Airways and United Airlines into bankruptcy and pension default. Ford, GM and DaimlerChrysler have among them hundreds of thousands of pensionable employees and retired workers. More generally, the number of those receiving benefits is increasing, while the number of active workers in defined-benefit schemes is falling. This adds to the pressure.

Companies and asset managers have tended to take a laid-back approach to pension underfunding, relying on the markets to right things as they often have before. What is worrying about the latest numbers is that we are seeing them towards the end of a period of strong economic growth and corporate profitability, neither of which is likely to continue. John Mauldin, an investment consultant, calculated in a recent column that total portfolio returns over the next ten years were likely to be around 5%, far less than the 8-9% projected by most funds. He reckoned that the total shortfall in America could be somewhere between $500 billion and $750 billion. And that is without counting companies’ promises to provide health care to employees and retired workers. Nicholas Colas at Rochdale Research, an independent firm, calls these obligations a bigger problem than pensions because they are neither funded nor insured.

There are a couple of weird circularities here. Most of the burden of filling these gaps will fall on the companies themselves, which will depress their profits. That, in turn, will depress share prices, which will make it harder to achieve adequate investment returns. And if asset managers turn en masse to bonds with long maturities to match their assets and liabilities more precisely, which is necessary especially for older plans, that will raise bond prices, depress bond yields and increase the present value of assets they must hold—again, widening the pensions gap. They could, of course, look to other asset classes that pay higher or “absolute” returns (hedge funds of funds, private equity, property) and many are doing so. But “alternative” assets do not typically account for more than one-tenth of the total portfolio, in part because they are labour-intensive to manage.

This is all looking dark, if not necessarily as bad as the S&L meltdown, which cost taxpayers $128 billion. It is especially bleak because it is forcing societies to establish difficult priorities. These “legacy costs” are, in a sense, the debt that the new economy owes the old one. But no one wants to pay it.

Should workers just be forced to accept the bad hand that fate dealt them? That looks rash as well as unfair: in America, the workers who would be thus left to their own devices fall disproportionately in swing electoral states such as Michigan, Ohio and Florida. Should a company’s current shareholders bear the brunt? If so, more firms than ever will close their defined-benefit schemes (in America, only about a fifth of all workers are covered by one now) and the investment risk inherent in saving for retirement will fall on the untrained individual. Or the taxpayer could foot the bill—but both America and Britain (indeed, most governments in most places) are printing money as it is. As COFFI’s Douglas Elliott says, “All the choices are ugly.”

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