To the Depression-era generation entering the workforce after World War II, one of the secrets of the good life was to catch on with “a big company with a pension.” Although fewer than half of private sector workers ever had a defined benefit pension, it was one of the trademark features of the American dream—a defined benefit pension, promising a set monthly payment for the rest of your life, and usually your spouse’s life, so long as you put in the service time.
The first realization that pension promises were not ironclad may have come when the Studebaker Co. folded in 1963 and defaulted on its pension obligations. Congress eventually responded with the Employee Retirement Income Security Act (ERISA) of 1974. ERISA established financing and accounting standards for defined benefit pensions and created the federal Pension Benefit Guarantee Corporation (PBGC) to insure private defined benefit pension commitments.
The modern portfolio management industry is, to a great extent, a creature of ERISA’s requirement that companies set aside assets to fund their future pension liabilities. If the actuarially determined present value of pension liabilities exceeds that of pension fund assets, the shortfall is subtracted from the company’s net worth as if it were a debt. As of mid-2005, private companies have amassed $1.8 trillion in assets to support their defined benefit pension obligations, against future liabilities valued at about $2.2 trillion. Pension funds initially concentrated their investments in high-grade bond portfolios, but as the stock market recovered through the 1980s, funds gradually shifted to higher-yielding stocks, in the hope that higher returns would allow reductions in annual contributions. During the 1990s market boom, stock returns were so high that many plans became overfunded, and pension funds actually became an important driver of company earnings. When the markets reversed after 2000, pension fund underperformance hammered profits, at the same time as falling operating earnings reduced companies’ ability to increase plan contributions. Just as important, although not widely understood, the steady fall in interest rates after 2001 greatly ratcheted up the book value of future pension liabilities.
The negative swing in corporate pension fund positions has been roughly $750 billion since 1999—from a $300 billion surplus to an estimated $450 billion deficit as of mid-2005. Analysts at CreditSuisse/First Boston (CSFB) recently published a list of twenty major companies with pension liabilities that equal or exceed the company’s market value; the list includes Delta Airlines (which has since declared bankruptcy), with pension obligations 13 times higher than its market value; General Motors, 4.7 times higher; Ford, 2.7 times higher; Lucent, 1.9 times higher; and U.S. Steel, 1.4 times higher. Mounting deficits at the PBGC are creating the potential for a federal bailout on the scale of the 1980s Savings and Loan crisis. (Technically, the PBGC, which is supposed to be self-financing through fees and insurance premiums, has no legal call on the federal purse, but political pressure for a federal response could be overwhelming.)
A number of proposals are being floated to shore up defined benefit pension funding and accounting, but most would require companies to report higher levels of debt and lower profits. More likely, companies will accelerate the process of extracting themselves from their pension obligations. One path is the strategic bankruptcy. Shedding pension obligations has become practically a standardized financial engineering tool in the hands of private equity buyout managers—in steel companies, auto parts companies, and more recently, a string of airline bankruptcies. Collectively, it appears that United, Delta, and Northwestern airlines, and the auto parts maker Delphi will be relieved of some $32 billion in pension liabilities through the bankruptcy process. (The last four companies on that list have not yet officially requested a PBGC takeover, but that seems inevitable.) Less dramatic alternatives include terminating a plan, or closing it to new employees, or converting it to a “cash balance” plan. Even financially healthy companies, like IBM, have been taking the cash balance route; at least a third of employees in nominally “defined benefit” pension plans have been converted to the cash balance format.
In short, the days when defined benefit pensions were a major support of American retirement systems are over. Currently, only about 20 percent of private sector workers participate in defined benefit pensions, and that number will drop to the vanishing point over the next ten years or so. Overall, defined benefit coverage is higher because almost all federal employees and up to 90 percent of state and local government employees are members of defined benefit plans. Analysts have estimated, however, that the unfunded liabilities of state and local defined benefit plans are even higher than in the private sector. Pension fund payments have become the fastest-growing items in many jurisdictions, squeezing out education and other essential spending. State issues of tens of billions of “pension obligation bonds” to take advantage of rising markets in the late 1990s have only worsened the problem. The phasing in of private-sector-like accounting rules for state and local governments starting in the late 1990s is forcing accurate disclosure, although their initial effects have been masked by superb market returns—indeed, many jurisdictions fattened benefits. “Smoothing” provisions have also blunted the stated impact of market underperformance and falling discount rates, but the scale of the liability overhang cannot be suppressed much longer.