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October 31, 2005

Roger Lowenstein on the Pension System

Roger Lowenstein writes about the messed-up U.S. pension system. Congress has succumbed to lobbying to keep the U.S.'s private-sector defined-benefit pensions underfunded. And Congress has not managed to reform ERISA in order to make 401(k)s a very good substitute.

I do think Roger is unfair to Mark Warshawsky, Assistant Secretary of the Treasury for Economic Policy, in writing that Mark "merely said that [ERISA reform] was under study. Anything that smacks of regulation (like rules to make sure employees get a particular menu of choices, whether for annuities or for their portfolios) gives the administration shivers." It's widely recognized among the administration's economists that the 401(k) system is broken and that more can be less where investment choices are concerned (see, for example, Alicia Munnell (2005), "Test Drive Suggests 'Ownership Society' May Be a Lemon," Economists Voice http://www.bepress.com/ev/vol2/iss1/art9/). And there has been considerable staffwork to support a bunch of small but very important and powerful reforms that only idiots think would count as 'overregulation'. If President Bush and Senator Grassley could agree on making pension reform a high priority, we could have it quickly. It's a failure of political will, not of analysis or of ideological blinders.

The End of Pensions By ROGER LOWENSTEIN: When I caught up with Robert S. Miller, the chief executive of Delphi Corporation, last summer, he was still pitching the fantasy that his company, a huge auto-parts maker, would be able to cut a deal with its workers and avoid filing for bankruptcy protection. But he acknowledged that Delphi faced one perhaps insuperable hurdle - not the current conditions in the auto business so much as the legacy of the pension promises that Delphi committed to many decades ago, when it was part of General Motors. This was the same fear that had obsessed Alfred P. Sloan Jr., the storied president of G.M., who warned way back in the 1940's that pensions and like benefits would be "extravagant beyond reason." But under pressure from the United Auto Workers union, he granted them. And as future auto executives would discover, pension obligations are - outside of bankruptcy, anyway - virtually impossible to unload. Unlike wages or health benefits, pension benefits cannot be cut. Unlike other contracts, which might be renegotiated as business conditions change, pension commitments are forever. And given the exigencies of the labor market, they tend to be steadily improved upon, at least when times are good.

For the U.A.W., Miller noted forlornly, "30 and Out" - 30 years to retirement - became a rallying cry. Eventually, the union got what it wanted, and workers who started on the assembly line after high school found they could retire by their early 50's.... Earlier this month, Miller and Delphi gave in to the pressure and sought protection under the bankruptcy code.... It followed by a few weeks the Chapter 11 filings of Delta Air Lines and Northwest Airlines, whose pension promises to workers exceeded the assets in their pension funds by an estimated $16 billion. The three filings have blown the lid off America's latest, if long-simmering, financial debacle....

The amount of underfunding in corporate pension plans totals a staggering $450 billion. Part of that liability is attributable to otherwise healthy corporations that will most likely, in time, make good on their obligations. But the plans of the companies that fail will become the responsibility of the government's pension insurer, the Pension Benefit Guaranty Corporation.... Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators have found it easier to pay off unions with benefits tomorrow rather than with wages today. Since the benefits were insured, union leaders did not much care if the obligations proved excessive.... The P.B.G.C. is now $23 billion in the red - a deficit that is expected to grow, significantly, as more companies go under. The balance sheet for the end of September will very likely show a deficit of more than $30 billion. If nothing is done to fix the system, the Congressional Budget Office forecasts, the deficit will mushroom to more than $100 billion within two decades....

[T]he problem of state and local government pensions is even worse. Public pensions, which are paid by taxpayers and thus enjoy an implicit form of insurance, are underfunded by a total of at least $300 billion.... In San Diego... the city has been forced to allocate $160 million, or 8 percent of the municipal budget, to the San Diego City Employees Retirement System this year, with similar allocations expected for years to come. San Diego has tabled plans for a downtown library, cut back the hours on swimming pools, gutted the parks and recreation budget, canceled needed water and sewer projects and fallen behind on potholes....

Bradley Belt, executive director of the P.B.G.C.... points out, the number of workers covered by pensions is shrinking without government help. In 1980, about 40 percent of the jobs in the private sector offered pensions; now only 20 percent do....

To understand why pensions are still important, you have to understand the awkward beast that benefits professionals refer to as the U.S. retirement system. It is not really one "system" but three, which complement each other in the crudest of fashions. The lowest tier is Social Security, which provides most Americans with a bare-bones living (the average payment is about $12,000 a year). The highest tier, available to the rich, is private savings. In between, for people who do not have a hedge-fund account and yet want to retire on more than mere subsistence, there are pensions and 401(k)'s.... During most of the 90's the decline in pension coverage was barely lamented. It was not that big companies were folding up their plans... but that newer, smaller companies weren't offering them....

From the beneficiary's standpoint, pensions mean unique security. The worker gets a guaranteed income, determined by the number of years of service and by his or her salary at retirement. And pensions don't run dry; workers (or their spouses) get them as long as they live.... A 401(k), on the other hand, promises nothing. It's merely a license to defer taxes - an individual savings plan. The employer might contribute some money, which is why 401(k)'s are known as "defined contribution" plans. Or it might not....

Various people have studied how investors perform in their 401(k)'s. According to Alicia Munnell, a pension expert at Boston College and previously a White House economist, pension funds over the long haul earn slightly more than the average 401(k) holder. Among the latter, those who do worse than average, of course, have no protection. Moreover, pensions typically annuitize - that is, they convert a worker's retirement assets into an annual stipend.... This might seem a trivial service.... [But as] Jeffrey Brown, an associate finance professor at the University of Illinois at Urbana-Champaign and a staff member of the president's Social Security commission, notes that as baby boomers who have nest eggs in place of pensions begin to retire, they will be faced with a daunting question: "How do I make this last a lifetime?"...

[I]n the first half of the 20th century... government policies turned pensions into a tool of social policy. First came the tax deduction. This feature was abused, as companies used pensions to shelter payments to their executives. The rules were gradually tightened... forcing plans to include the rank and file. World War II gave more incentives to create pensions: punitive tax rates made the pension shelter enormously attractive.... The effect of these policies was to encourage unions to bargain for pensions and to pressure employers to grant them....

The Studebaker failure was a watershed. Thousands of employees, including some who had worked 40 years on the line, lost the bulk of their pensions. Stunned by the loss, which totaled $15 million, the U.A.W. changed its tactics and began to lobby in earnest for federal pension insurance.... [I]n 1974, Congress finally passed the Employee Retirement Income Security Act, or Erisa, which, among other protections, established the P.B.G.C. to insure private pensions.... Erisa, which would be amended several times, was supposed to ensure that corporate sponsors kept their plans funded. The act includes a Byzantine set of regulations that seemingly require companies to make timely contributions. As recently as 2000, most corporate plans were adequately funded, or at least appeared to be.... Corporations have been gaming the system by using the highest rates allowable, which shrinks their reported liabilities, and thus their funding requirements. The P.B.G.C., when calculating the system's deficit, uses what is in effect a market rate.... Depending on whom you talk to, General Motors' mammoth pension fund is either fully funded or, as the P.B.G.C. maintains, it is $31 billion in the hole.

What is not in dispute is that... falling stock prices, plunging interest rates and a recession in the beginning of this decade was the pension world's equivalent of the perfect storm.... As the P.B.G.C. assumed responsibility for more and more pensioners, it became clear that the premium it charged was way too cheap. Mispriced insurance, like mispriced anything, sends the market a distorted signal.... United Airlines did not make contributions to any of its four employee plans between 2000 and 2002, when it was heading into Chapter 11, and made minimal contributions in 2003.... Bethlehem Steel similarly enjoyed a three-year funding holiday as it was going through hard times, letting its liabilities swell in advance of turning them over to the government.... Neither Bethlehem nor United broke any laws.... As Belt testified to the Senate Committee on Finance in June, "United, US Airways, Bethlehem Steel, LTV and National Steel would not have presented claims in excess of $1 billion each - and with funded ratios of less than 50 percent - if the rules worked."... [C]orporations - airlines in particular - have been lobbying for greater permissiveness for several years. And they have gotten it. Congress has twice relaxed the rules, permitting pension sponsors to use a higher rate to calculate their liabilities.

Enter the Bush administration... [which] wants the funding rules tightened.... 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.... The Senate is still divided, however, on how to treat corporations with junk credit ratings - the ones most likely to wind up in the P.B.G.C.'s lap. Hard-liners like Senator Chuck Grassley insist they should be forced to strengthen their pension plans in a hurry; Senators Mike DeWine and Barbara Mikulski (both from states with blue-collar constituencies) want to give such companies lenience....

Even in states where budget restraint is gospel, public-service employees have found it relatively easy to get benefit hikes for the simple reason that no one else pays much attention to them.... The average voter doesn't take notice when the legislature debates the benefits levels of firemen, teachers and the like. On the other hand, public-employee unions exhibit a very keen interest, and legislators know it. So benefits keep rising.... Because public pension benefits are legally inviolable, default is not an option. Sooner or later, taxpayers will be required to put up the money.... [T]he West Virginia Teachers Retirement System has, embarrassingly, only 22 percent of the assets needed to meet its expected liabilities.... According to Barclay's Global Investors, if you use realistic assumptions, the total underfunding in all public plans is on the order of $460 billion....

Earlier this year, Schwarzenegger tried to move California to a 401(k)-style defined contribution plan (for new employees), but the Legislature refused to go along.... De Maio, the San Diego watchdog, is lobbying for a federal law that would impose Erisa-type rules on public plans....

Elaine Chao, the secretary of labor... made no bones about the fact that, in the administration's view, traditional pensions are losing their relevance.... It's hard to argue with her.... Although 44 million people are covered by private-sector plans, half are people who have already retired and are collecting benefits or whose plans have been frozen or terminated.... [T]he private-sector pension community will mostly die off in a generation.... [I]t would make sense to try to incorporate their best features into 401(k)'s. The drawback to 401(k)'s... [T]he government could... require that a portion of 401(k) accounts be set aside in a lifelong annuity... [make] a high contribution rate the "default option" for employees.... Promoting an annuity culture is probably the single best way to make up for the demise of pensions. Yet most companies that provide 401(k)'s don't even give the option of purchasing an annuity when people cash in their accounts. As Brown, the Illinois professor, notes, "There is no box to check that says 'annuities."' That is a minor scandal. "I wish someone in Washington were thinking bigger thoughts about what the optimal retirement package should look like," says Watson Wyatt's Coronado.... Mark Warshawsky, the Treasury's top economist, has written about the need for annuities, and in an interview he allowed that as 401(k)'s become the primary, or the only, source of retirement income for more people, "I think it is a concern that annuities are not being offered in those plans." When I asked what the Treasury was doing about encouraging annuities, Warshawsky merely said that it was under study. Anything that smacks of regulation (like rules to make sure employees get a particular menu of choices, whether for annuities or for their portfolios) gives the administration shivers....

When it passed Erisa, Congress agreed that corporations that invested tax-sheltered retirement funds - pensions - should have to live by certain rules. But in the defined contribution world - the world of 401(k)'s - there are no rules. Employers can contribute or not. Employees can diversify or blow it all on the company stock (even if it is Enron). If nothing else, the century-long experiment with pensions has proved that in the absence of the right rules, the money will not always be there. The purpose of pension reform should be not merely to avoid a fiscal disaster but to find a fiscally sound way to preserve the likelihood of secure retirements...

Posted by DeLong at October 31, 2005 09:41 AM