Can employers be trusted to provide for our old age?
POLICYMAKERS in America and Britain used to be rather smug about their pension systems. They had shifted much of the burden of providing for people's retirement off the state and on to the private sector, they crowed, while in most countries in continental Europe private pensions were still embryonic. The future burden on the exchequers of these countries from increasing longevity and shrinking birth rates made for headlines about a “pensions time bomb” ticking away while powerful unions blocked attempts at reform.
Nowadays there is less complacency. Over the past year or so, in both Britain and America, there has been growing alarm about the state of companies' pension funds. The private sector's back was not as broad as policymakers thought. Many of the schemes are now deeply in deficit, to the consternation of prospective pensioners, investors and politicians.
Further dismay has greeted revelations of the extent to which top corporate executives have been able to shelter their own pensions from the effects of this fall in value. Not untypical were the special pension arrangements of the top executives at American Airlines—including Donald Carty, its erstwhile boss. While the airline's bosses secretly protected their own pensions against the risk of bankruptcy (with a multi-million-dollar dollop of extra funding), employees were being asked to accept hefty cuts in pay and benefits in order to save the firm from going bust. Likewise in Britain, it was recently revealed that Sir Geoff Mulcahy, who resigned last year from the top job at Kingfisher, a poorly performing retailer, left with a nest egg of £15.2m ($24.5m), which will pay him an annual pension of £790,000.
In America, many companies now run large corporate-pension deficits (the amount by which the value of the schemes' assets falls short of the current value of the pensions they are pledged to pay in the future). These deficits arise entirely from defined-benefit pension plans, which guarantee employees a pension related to their final salaries. Defined-contribution schemes—the other main type of pension—make no promises about ultimate benefits, merely contracting to pay a certain amount regularly into a fund.
According to estimates by the Pension Benefit Guaranty Corporation (PBGC), a quasi-governmental agency that insures the basic benefits of 44m Americans with pensions provided by about 32,500 private defined-benefit plans, corporate-pension deficits have swollen to some $300 billion. A recent study by Greenwich Associates, an investment-research firm, claims that the assets of corporate pension schemes have lost $500 billion in value in the past two years.
In Britain, corporate pension schemes are also in trouble. Morgan Stanley, an investment bank, estimates that the aggregate deficit of the defined-benefit pension schemes of FTSE 100 companies grew from £200m at the end of 2001 to £65 billion at the end of 2002. UBS Warburg, another investment bank, says that only four of the 100 companies retain a net surplus on their pension funds; 22 firms have pre-tax deficits in excess of £1 billion. The pre-tax deficits of seven firms—including blue-bloods such as Rolls Royce and British Airways—amount to more than half of their market capitalisation.
Not all those with underfunded schemes are American or British. Last June, Siemens, a German technology firm whose employees are almost all on defined-benefit schemes (a rarity in Germany), had to admit that it had a pensions deficit of more than euro5 billion ($4.8 billion) under American accounting rules—which the company follows because it is quoted on the New York Stock Exchange.
If equity markets do not recover quickly and substantially, the deficits will widen even further this year. Of course, if the markets bounce back, the problem will disappear, at least for now. Most of the funds' liabilities lie some way in the future.
The main reason for the recent shift from surplus to deficit is the prolonged bear market that began in March 2000. The pension funds of American and British companies all invest heavily in equities. American funds have, on average, 60% of their assets in shares. In Britain, the figure is even higher, with as much as 80% of funds' assets in equities, about two-thirds of that invested in the British market.
In the bull market of the late 1990s, this worked in the funds' favour, and many of them accumulated huge surpluses. The tax system forced many companies—British Airways, for one—to take holidays from contributing to their fund; and some—such as Shell, Unilever and Philips—even took money out of them.
America's accounting-standards body, the Financial Accounting Standards Board (FASB), said earlier this year that it wants to improve accounting for employee pension plans. It aims to publish a standard on the subject next year.
In Britain, a new accounting standard, FRS17, has already made the deficits in companies' pension funds glaringly obvious. The standard, which compels companies to value their pension assets at current market prices, is not yet fully implemented. But since June 2001 British companies have had to disclose their FRS17 numbers in notes to their accounts. Before that, says Alan Rubenstein, head of the pensions group at Morgan Stanley, “with negligible transparency, pension funds were assumed to be in surplus.”
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Highly unpopular with most companies (which prefer the opacity of the old system), FRS17 demands that a pension fund's short-term deficits be deducted immediately from profits, or added back if the fund is in surplus.
Under America's Employee Retirement Income Security Act (ERISA) of 1974, a fund is considered to be underfunded if the market value of a plan's assets is less than 90% of the plan's current liabilities. Deficits have to be made good, typically over a five-year period. General Motors, for example, has announced that contributions to its underfunded pension scheme will reduce its earnings by 26% this year.
Britain has a statutory annual test that evaluates the adequacy of a scheme's assets to meet its obligations. The test stipulates that a “seriously” underfunded scheme rectify its shortfall within three years. Schemes that are underfunded, but not seriously so, have to be brought in line within ten years. The British government is currently considering legislation that would modify or even abolish the test, but it is still uncertain when new rules would come into force.
Over the past couple of years in America, pension liabilities have become a key element in corporate insolvencies and resurrection from Chapter 11 bankruptcy. US Airways, for instance, America's seventh largest airline, was able to emerge from bankruptcy protection a few weeks ago only after shedding its pension obligations. The pension plan for its pilots is, the company says, underfunded to the tune of $2.5 billion. After much coming and going, the PBGC took over as trustee of the airline's pension plan on April 1st.
To appease its angry pilots, the company will set up a secondary plan that will cover some of the shortfall between what the pilots receive now and what they will get under the PBGC's basic regime. It is unlikely to assuage their anger with Stephen Wolf, who ran US Airways until a few months before it went into Chapter 11 in August last year. He was able to walk away with a one-off pension payment of $15m after a mere six years in the job.
US Airways may not be the last of the big American airlines to have trouble with its pension promises. Fitch, a credit-rating agency, estimates that the deficit in the funds of America's eight biggest airlines is more than $18 billion. As recently as 1999, they had a surplus of $1 billion.
The shortfall in America's corporate pension schemes has been such that even the PBGC is broke. This was hard to imagine 16 months ago when the agency sat on a comfortable surplus of $7.7 billion. But it is now in deficit to the tune of $5.4 billion. As it is financed by insurance premiums from corporations, it will probably have to raise prices across the board in order to refill its coffers. This will meet stiff resistance from corporate America, but the alternative (federal funding) will be resisted too. “Why should taxpayers foot the bill for something that was supposed to be self-financing?” asks Zvi Bodie, an expert in pension finance at Boston University.
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The new spotlight on the deficits in companies' pension funds is having an effect on their share price. Credit-rating agencies and investment analysts are giving them the thumbs-down, and investors are starting to vote with their feet. At the end of last year, Morgan Stanley put together a list of British companies that are most at risk from underfunded pensions. Some prestigious names were on it. Sainsbury's, a supermarket chain, for instance, is estimated to have pension-fund assets worth only 65% of its pension liabilities.
UBS Warburg is advising investors to part with shares in companies that carry too much pension risk. On April 3rd, it lowered (to “sell”) its recommendation on six media and technology companies because of worries over their pension liabilities. British Telecommunications (BT) is singled out by the investment bank because of its post-tax pensions deficit. Standing at £1.3 billion at the end of March 2002, UBS estimates that it had increased to £6.5 billion by the beginning of 2003.
Though they claim that pension liabilities have always been considered when they make a judgment about a company's financial strength, Standard & Poor's (S&P), Moody's, Fitch and other ratings agencies have started to look at them much more closely. S&P issued a report in March that attempted to clarify its approach, pointedly stating that nowadays the agency treats unfunded pension liabilities like debt. (In the past, it did not take pension liabilities into account in its calculation of a company's net debt.)
Moody's and Fitch recently came out with similar statements about their methodology. “It absolutely is debt,” insists Boston University's Mr Bodie. Sabine Mahnert, a pensions expert with Morgan Stanley, thinks pension liabilities are slightly softer than other forms of debt, but she agrees that debt they undoubtedly are.
Companies with pension plans that are unfunded, as many are in continental Europe, find such views hard to take. Their plans, they say, are financed on a “pay-as-you-go” basis, and do not need funding. Earlier this year, ThyssenKrupp, a German steelmaker, clashed with S&P over this debate. On February 21st, the rating agency cut ThyssenKrupp's rating by two notches (to junk status) because of its unfunded liabilities. At the end of September 2002, these amounted to euro7.1 billion. At the time, Thyssen was one of 12 European companies under review by S&P because of the burden of their pensions.
The company's executives denounced the downgrade as “incomprehensible”, and government officials took their side, arguing for the establishment of a new European ratings agency. Joachim Poss, spokesman for the Social Democrats, Germany's ruling party, claimed that S&P and Moody's, both of them American, do not understand German business culture.
For the most part, companies in Germany (and France and Italy) face a rather different sort of pensions crisis. Governments there have promised for years to privatise part of the state system, but little has happened to date. Public-pension spending is gobbling up between 12% and 14% of French, German and Italian GDP. In Germany, the goal is for the state to provide 70% of the final net salary of an employee who has worked for 45 years. (This is being reduced to 67% over the next decade.) Corporate pensions from companies such as Siemens and ThyssenKrupp supplement this system. Unlike America and Britain, Germany has few regulatory or tax incentives to encourage companies to fund their pension schemes. So most German companies opt for pay-as-you-go (PAYG).
The Netherlands is the only continental European country with a pensions system along American or British lines. The state provides a basic pension, equivalent to half the minimum wage, through an unfunded PAYG system. To supplement this, most Dutch companies provide their employees with pensions. The law requires that these be funded, and their investment strategies have to be approved by the country's pensions and insurance regulator. As the funds typically park half of their assets in equities and the rest in bonds denominated in euros, they are facing funding gaps not hugely different from those of companies in America and Britain.
While individual European Union governments are prevaricating over pensions reform, Brussels bureaucrats keep trying to unify the EU pensions market. But little has been achieved to date. For as long as the differences between countries' rules remain so pronounced, multinationals have to tailor their pension schemes to each country. When they move employees from one to another, they have to adapt their schemes to individual cases. For instance, any employee who, say, used to be part of the generous public pension system in France has to be compensated for being posted to England, where state pensions are far more frugal.
Some companies simply park their employees' pension money offshore—in the Channel Islands, for example. “Without tax changes and social-security reform, companies won't be able to offer one pension scheme,” says Morgan Stanley's Mr Rubenstein. He is pessimistic about the efforts in Brussels to unify the EU's pensions market.
With or without a properly functioning single market, continental countries will have to find a way to reduce the share of retirement income financed from taxes. Private pension funds and insurance policies are the only alternative. But do the investment strategies of those in charge of private pensions need rethinking? In particular, are equities a fit investment vehicle for providing for old age?
Mr Bodie says that, contrary to conventional wisdom, equities are not a prudent investment over the long run. He argues that, instead of focusing on the probability of equity returns outperforming bond yields, pension-fund trustees ought to consider a worst-case scenario. In the long run, the probability of positive equity returns increases, but the danger of continuous losses also rises. With investments in fixed-income assets, on the other hand, a known obligation is matched with assets of a predictable value at the maturity of that obligation.
Mr Bodie is thus a big fan of the decision by Boots, a British health-and-beauty retailer, to shift all its pension assets into a mix of inflation-linked bonds, credit swaps and bonds that are not protected against inflation. John Ralfe, the architect of Boots's move into bonds, is one of corporate Britain's few supporters of FRS17. The defined-benefit scheme at Boots is fully funded.
Mr Ralfe has left the company since he engineered Boots's withdrawal from the equity market, but on April 14th the company defended its decision to put all its pension fund's assets (of £2.5 billion) into bonds. However, rumours suggest that Boots is toying with the idea of reversing some of its pioneering policy.
There are other examples of funds putting almost all their pension eggs into a fixed-income basket. For example, nearly 90% of the assets of Siefores, Mexico's private pension funds, are invested in government bonds, and the Texas Municipal Retirement System has invested all its assets in fixed-income instruments since 1987 when it sold its last shares (in IBM). The scheme now manages about $10 billion for 783 Texan cities. Its trustees are not restricted to debt; they can buy equities at any time. For the moment, however, they are sticking to their debt-only policy, a policy that leaves them exposed to the risk of inflation. There are simply not enough inflation-linked, fixed-income instruments around to remove that.
One way for companies to resolve their dilemma is for them to get out of the pensions business altogether. Many of them have made the first move in this direction by closing their defined-benefit schemes to new members and offering defined-contribution (or “money purchase”) plans instead. Employees are not, in general, happy about the switch. Many of them prefer the paternalism of the old regime, and are afraid of the investment risk that they are being expected to carry for themselves. Yet in a modern economy, where people change jobs frequently (not to mention countries), money-purchase plans make more sense. According to a study by the Pensions Institute at the University of London, someone in Britain who changes his or her job six times loses more than a quarter of the benefits from a defined-benefit scheme.
Should companies continue to be responsible for the welfare of their employees in their old age? It is the role of government to provide a basic safety net for citizens. And it makes little sense for companies to be running the pension funds of their increasingly transient employees. In future, they would be wise to encourage their staff to look after their retirement funds properly. But why do it for them? It's not their business.