March 13, 2006
Remarks before the National Association for Business
Economics
by Bradley D. BeltExecutive
Director, Pension Benefit Guaranty Corporation
Good afternoon, and thank you for the opportunity to address this
distinguished audience, which I am confident will appreciate the importance of
the issues we are discussing today.
With more than $2 trillion in obligations, defined benefit pension plans
represent one of the largest off-balance-sheet liabilities underwritten by
corporate America. One out of every five private-sector employees still
earns a pension benefit, and more than two-thirds of the companies in the
S&P 500 still sponsor a defined benefit plan. In many cases, pension
plans have grown so large that they dwarf the companies that sponsor
them. Consider: With the pension assets of one of the domestic
automakers, you could buy all three companies.
And yet, despite their massive size and economic importance, defined benefit
pension plans have been largely hidden from view behind a nearly impenetrable
thicket of often incomprehensible accounting standards, funding rules, and
actuarial conventions. Indeed, when we gaze upon the pension landscape, we are
struck with the peculiar sensation that much of what we were taught?about
economics, about corporate finance, about accounting?no longer applies. With
apologies to Lewis Carroll, we feel as though we have followed Alice down the
White Rabbitfs hole into a looking-glass world that is disconnected from
economic reality?one where you can add risk without adding cost, where a dollar
of stocks is worth more than a dollar of bonds, and where the value of assets
five years ago affects your pension contributions today.
Let us begin with one of pension-landfs more remarkable propositions?that
employee compensation, which one generally considers to be a cost center for
corporations, can be a rich source of profits. As you know, private-sector plan
sponsors are required by law to set aside a certain level of assets to meet
their pension obligations. But under the pension accounting rules?FAS
87?companies can book to income not the actual return on those pension
assets but the expected return. Holding everything else constant, a
company with $50 billion in pension assets and a ten percent assumed rate of
return can claim a gpension profith of $5 billion, even if in reality the assets
decline by ten percent that year. For some companies in recent
years, the pension plan has been a primary source of profits?phantom
profits in the view of many, but with the power to boost share prices and
executive compensation just the same.
In a series of well-researched reports, David Zion of Credit Suisse has
called this the gmagich of pension accounting. Perhaps that is too generous a
spin?pension accounting is beyond magic. It is alchemy. Todayfs financial
engineers have swapped the medieval alchemistfs mortar and pestle for the modern
tools of smoothing and expected returns, but the end result is the same?lead
miraculously transformed into gold. With pension accounting, we move beyond
managed earnings to manufactured earnings, to a world where
two minus two can equal five.
Imagine if this approach applied to other areas of corporate finance. That
ten percent drop in sales you experienced becomes a ten percent gain, because
thatfs what you gassumedh would happen based on past experience. That fifty
percent increase in the price of raw materials never happened, because it wasnft
in your projections.
You probably wouldnft buy shares in any company that kept its books this way,
and I suspect that the SEC would have an issue as well. But, when it comes
to pensions, we look the other way. You can be a large, insolvent annuity
provider attached to a small widget maker and report profits based on phantom
income from the pension plan. Caveat emptor.
I would like to make one other observation about the practice of booking
assumed returns?there is no free lunch. The risk-free rate of return is
currently hovering just south of five percent. Yet companies routinely book
income based on the assumption that their pension assets will earn 8, 8.5 or
even 9 percent.
Of course, these higher expected returns are only possible by taking on extra
risk, yet that risk apparently carries no immediate cost. The extra three
hundred basis points above the risk-free rate just materializes with no
acknowledgement that the only way to guarantee such returns is to buy
portfolio insurance whose cost, when subtracted from the assumed return, would
lower your effective return to the risk-free rate.
When pension-land was dominated by actuaries and benefits professionals, it
was relatively easy to get away with loose thinking about how to value pension
assets and liabilities. Consider two promises to pay: one collateralized with
stocks and the other collateralized with bonds. The actuarial view says the
gcheaperh promise is the one backed by stocks, because stocks have higher
expected returns. The financial economics view, which has been making steady
inroads in the pension space, considers that approach nonsensical?a dollar of
stocks is worth exactly the same as a dollar of bonds. The economic cost of a
benefit promise is the same whether it is backed up by stocks, bonds, or no
assets at all.
The actuarial view, which also informs FAS 87, encourages companies to meet
their obligations by borrowing from employees, investing in riskier assets, and
hoping the assets beat the borrowing rate. And it holds a surface appeal:
If you borrow at a six percent corporate bond rate and earn eight percent on a
basket of riskier assets, your cash contributions to the pension plan can be
reduced accordingly. Of course, what pension plans experienced in the early
part of this decade was the opposite. Companies borrowed at six percent, earned
negative eight percent, and reacted with shock when the margin call of
higher required contributions came due.
So why do so many companies operate their pension plans the same
way? Clearly, much of it is driven by the pension accounting rules. The
ability to book nine percent on $10 billion of assets makes it powerfully
tempting to invest in assets risky enough to gjustifyh nine percent. But I
also think a herd mentality predominates in pension-land. Everyone else is
doing it exactly the same way and, besides, your performance as a pension
manager is judged not by how well you defease the planfs liabilities, but by
whether you beat your peers on the asset side.
That explains why the asset allocations of pension plans are remarkably
similar despite vast differences in the liability profile. For example,
some people think that a gyoungh pension plan with five active workers for every
retiree can afford to invest along the traditional lines of sixty percent
equity, thirty-five percent fixed income, and five percent cash. But what
we observe in pension-land is that gmatureh plans with five retirees for every
active employee invest exactly the same way. The cash flows and inflation
sensitivity of these two pension plans could not be more different. What is
the same is the desire to chase returns in heretofore almost blissful ignorance
of the liabilities.
Let me be clear: the pension alchemy we see practiced every day is permitted,
even encouraged, by financial accounting standards, ERISA funding rules, and
actuarial conventions. But it is disconnected from the economic reality in
which you must operate, and it obfuscates what every worker, retiree, investor,
and creditor has a right to see.
Those who take a different view will argue that we need not worry about these
stakeholders of the pension system. In this rose-colored view of the world,
pension plans are seen only as long-term obligations, with pension gains
and losses amortized over time. Corporate income statements will catch up
with economic reality eventually. Yes, that may happen. At some point
pension reporting and economic reality might even agree with each other, but
only by coincidence, and never for long.
And thus we come to another figment of imagination in pension-land?smoothing.
gSmoothingh is a seductive marketing word. It conveys the sense that we are
sparing investors from the rude jolt they would receive if pension losses were
reported at full value and saving companies from the terrible burden of
repairing pension deficits as quickly as they were created.
In the accounting context, smoothing allows companies to show pension losses
to investors in small slivers over time rather than all at once. This helps make
a companyfs reported earnings look smoother as well, which is to say, more
divorced from economic reality. But if we have learned anything from recent
economic history, it is that attempting to manage reported earnings leads to
trouble. Going back a few years further, would we have avoided the need for
an S&L bailout if we had allowed thrifts to smooth interest-rate spikes over
a several year period? Would the economic reality of their asset and
liability mismatch have been any different? In the pension context, it
should be a wake-up call when the deputy chief accountant of the SEC derides
smoothing for its potential to render financial statements gmeaningless.h
But as problematic as smoothing may be in the pension accounting context, in
some ways it is even worse in the pension funding context.
Under the pension funding rules contained in ERISA and the Internal Revenue
Code, a company can skip needed contributions to its pension plan on the grounds
that gsmoothedh assets and liabilities make the plan look well-funded. When
followed by a corporate bankruptcy, this policy of ignoring economic reality and
failing to make needed contributions can lead to devastating losses of
retirement income for long-serving employees.
On the asset side, the funding rules allow companies to use values smoothed
over five years. The only constraint is that the market value of the assets
cannot be more than twenty percent different than the so-called gactuarialh
value of assets. In practice, this means a pension plan with $1.2 billion
in liabilities and $1.2 billion in gactuarialh assets may not be fully funded
but rather $200 million short of whatfs needed to pay promised benefits. If
I tried to pay my bills with the gactuarialh value of my bank account, Ifd be
bouncing checks left and right?which, unfortunately, is what some companies are
doing with their pension plans.
If anything, the situation is even more perverse on the liability
side. Companies are permitted to calculate the present value of their
pension liability using the four-year average of a corporate bond index. It
should go without saying that interest rates from four years ago have absolutely
nothing to do with the value of the pension liability today (or
tomorrow). This is akin to driving down the highway at a high rate of speed
looking only in the rear-view mirror.
Still, I can understand why plan sponsors want the flexibility afforded by
smoothing the discount rate. It is a fact of life that pension liabilities
are extremely sensitive to movements in interest rates. If the discount
rate drops by one hundred basis points, that can easily drive up liabilities by
ten percent or more. Better to gsmooth inh that rate drop slowly over time
to avoid unpleasant hiccups in the planfs funded status. Of course hiding
the volatility doesnft mean it isnft there.
Without these (and other) smoothing mechanisms, the argument is made that
companies wonft be able to gpredicth their pension contributions and wonft be
able to budget accordingly. This is a particularly fascinating line of
reasoning. How can a CFO of an airline possibly function without being able
to gpredicth future oil prices? Or the CFO of an auto manufacturer with
respect to steel prices? Or the CFO of a multinational enterprise that has
to deal with currency fluctuations? Or, perhaps most similarly, a bank or
insurance company CFO whose business is especially sensitive to changes in
interest rates?
Ah, say the inhabitants of pension-land, but our obligations are glong
term.h These benefits are going to be paid out over decades, so therefs no
need to value the liability based on what interest rates are doing today.
Nonsense. I want to know the market value of my house today even if I
have a thirty-year mortgage and plan to live in it for another thirty years?it
affects my net worth and my ability to borrow. Moreover, therefs always the
chance that I may have to sell my house earlier than I expected.
Similarly, workers and retirees need to know the funded status of the pension
plan today even if the benefits are going to be paid out over thirty
years. Not only should it affect their planning for retirement, but therefs
always the possibility that their company may go bankrupt and turn its pension
plan over to the PBGC. I can assure you: At that point a liability
calculation based on interest rates from the year 2002 is utterly meaningless
and misleading. Yes, most pension obligations are long term. But,
there have been more than 160,000 standard terminations of fully funded plans
over the past thirty years. There have been 3,600 terminations of
underfunded pension plans. Ask the participants in these plans whether
these are necessarily long-term obligations.
This is but a glimpse of the often fantastical world of pension funding and
accounting. If it were simply the product of an imaginative storyteller, we
might be suitably amused. If the effects were benign, we might not
care. But neither is true?the interaction of pension finance, pension
policy, and the decisions made by pension managers and the PBGC affects real
people in the real world. It affects workers and retirees of American
corporations, who can lose billions of dollars in promised benefits when plans
terminate because of legal limits on the PBGC guarantee.
It affects corporations saddled with massive unfunded legacy burdens from an
earlier era. To provide just one example: When it went bankrupt, the
once-mighty Bethlehem Steel had about $1 billion in business debt and $7 billion
in unfunded pension and retiree medical obligations.
It affects healthy companies with well-funded pension plans, which are
growing weary of paying the pension bills of bankrupt steel and airline
companies through ever-higher PBGC premiums.
It affects investors who cannot penetrate the pension veil to perceive a
companyfs true value and end up paying more than they should.
It affects taxpayers who may one day be called upon to bail out the PBGC when
corporate America says enough is enough.
It affects the capital markets, which may not be operating as efficiently as
they should due to the distortions of pension accounting and the subsidies
created by the PBGC guarantee.
But there is reason for hope. Whereas the broad implications of the
pension system were heretofore not well understood, I believe we are poised to
see improvements both on the funding front and the accounting front.
As you know, both the Senate and House have passed their respective versions
of pension reform. Just last week the conference committee was formed to
iron out differences between the two versions, and the chairman of the
committee, Senator Mike Enzi of Wyoming, said he hopes a final bill will pass by
April 7.
The congressional bills share some important common elements with the
proposal the Bush Administration unveiled in January of last year. They
increase funding targets for plan sponsors to one hundred percent of accrued
liabilities, limit the period over which funding shortfalls can be amortized to
no more than seven years, and require the use of a modified yield curve to more
accurately measure pension liabilities.
That said, the Congressional bills need to be strengthened and improved to
better protect the benefits earned by workers and retirees. The Bush
Administration set the standard for the debate when it called for the
elimination of smoothing, a funding target equal to one hundred percent of
accrued liabilities that are accurately measured, full disclosure of the funded
status of pension plans to participants and the public, and a more rational
premium structure that raises enough revenue to bring the system back into
balance.
We look forward to working with the conferees to produce a bill that
strengthens the funding rules, increases transparency, and puts the insurance
program on a sustainable solvency path. Wefre not there yet. If the
end product of the conference committee is a bill that fails to improve on
current law, the Presidentfs senior advisers have said they will recommend a
veto.
Meanwhile, there are encouraging signs that pension accounting may also be in
line for much-needed overhaul. The Financial Accounting Standards Board has
announced a project to take a fresh look at accounting for all postretirement
benefits, including pensions. FASB Chairman Robert Herz has been forceful
in calling for a new regime that will account for pensions accurately and
honestly.
While we need to carefully balance often competing interests, we also must
recognize that the status quo results in the misallocation of capital, does a
poor job of protecting the benefits earned by employees, does a poor job of
protecting responsible companies from shouldering the costs of companies that
terminate underfunded pension plans, and exposes taxpayers to the risk of having
to bail out the federal pension insurance program. And the status quo is
not going to save the defined benefit system. Changes are needed
now?otherwise the costs will be higher and the decisions that much harder down
the road. The promise to provide deferred compensation to workers is a
straightforward proposition that should be accounted for and funded in a clear
and financially sound manner. It is time to pierce the veil and allow the
stakeholders of the pension system to understand these liabilities using the
same rules that govern other corporate obligations. Even Alice didnft
remain in Wonderland forever. Eventually she woke up.
Thank you again for inviting me to speak, and I would be happy to take your
questions.