Retirement Rip-Off

Corporate Research E-Letter No. 38, August 2003


by Philip Mattera

Last month, House Ways and Means Committee Chairman Bill Thomas made headlines when he tried to have the Capitol Police arrest Democratic members who had left a bill mark-up session to review last-minute revisions submitted by Thomas. What got less attention, outside the business press, was the actual piece of legislation under consideration. It was a measure that will affect the retirement security of a large portion of the U.S. workforce by allowing employers to erase billions of dollars in pension liabilities.

Normally, questions about the techniques of calculating pension costs remain in the rarefied circles of actuaries and corporate financial officers. This year is not normal. In the wake of a long period of slumping stock prices and declining interest rates, the country’s traditional pension plans are experiencing unprecedented funding shortfalls -- totaling several hundred billion dollars. General Motors announced plans to borrow $10 billion to shore up its plans, which were underfunded by nearly $20 billion at the end of 2002. Federal court judges invalidated a new type of pension plan offered by companies such as IBM and Xerox, raising the possibility that they and many other companies will have to pay out billions of dollars in additional benefits.

Bankruptcies of major companies in industries such as steel and airlines have resulted in the termination of large pension plans, forcing the Pension Benefit Guaranty Corporation to take on enormous additional obligations. The PBGC, a federal agency that insures traditional pension plans, has gone from an $8 billion surplus to a $5 billion deficit in the course of a year, and it has been designated by the General Accounting Office as a “high risk” operation.

Concerned about the danger of additional plan terminations, many large labor unions have joined forces with employers in asking Congress for relief. Although Democrats on the Ways and Means Committee rebelled against the chairman’s imperious procedural style, the pension bill being considered had bipartisan support. The Bush Administration complicated matters by issuing a proposal that, surprisingly, would tighten pension funding requirements after a two-year breather, prompting howls of protest from its usual corporate allies.


To make sense of the current  Topsy-turviness, it is necessary to look back at the evolution of retirement benefits in the United States. Through the end of the 19th Century, pensions were largely non-existent. People worked until they died or became disabled. In the early 20th Century, some large employers, beginning with railroads and utilities, began to provide retirement benefits. Yet, by 1930 only about 10 percent of the workforce was covered, and this level declined during the Depression years. The creation of the federal government’s Social Security program in 1935 helped fill the coverage gap, though at a modest level.

Employer-provided pensions returned in a big way after the Second World War, thanks to pressure from unions and a desire by large companies to promote employee loyalty. By 1960, roughly half of the workforce could look forward to retirement financed by a combination of a company pension and Social Security benefits. Two decades later, more than 80 percent of employees in medium and large private establishments were covered by traditional pension plans.

Unless one worked for a small company, it was assumed that all employers, union or non-union, would provide pension benefits. In fact, the amount of money accumulating in employer pension plans -- which surpassed $1 trillion in 1983 for private and public employers combined --  came to represent one of the largest pools of capital in the country, much of which was invested in the securities of large corporations. This prompted management guru Peter Drucker to write of the arrival of “pension fund socialism.”

During this time, however, a counter-revolution was starting to take place in corporate headquarters around the country. Companies no longer looked at pension funds as employee nest eggs that they were charged with protecting. Now they were seen as sources of “excess assets” that could be put to very different uses -- if the plans were shut down. During the 1980s, hundreds of companies took the audacious step of terminating pension plans and using the captured assets for purposes such as financing leveraged buyouts by Top managers. Corporate raiders also got into the act. For example, when Ronald Perelman took over cosmetics maker Revlon in the mid-1980s, he gained control of $100 million in pension fund assets. Overall, more than $20 billion in pension assets were captured before Congress put an end to the practice by imposing a heavy tax on pension piracy


Most of the employers who terminated their pension plans realized they could not dispense with retirement plans entirely, so they turned to a new kind of benefit that began to spread quietly in the late 1970s.

Up to this point, when people spoke of retirement plans they were referring to what were technically known as defined-benefit pension plans. These provided retired workers with a specific amount of money each month, based mostly on their length of service. Employers financed these benefits by putting aside a portion of company funds each year and investing them. Retirees were guaranteed their benefit amount regardless of the ups and downs of company profits and the returns on the invested pension plan assets. This was truly a form of retirement security.

The new benefit that employers began to embrace was called a defined-contribution plan. Strictly speaking, this kind of plan was not a pension at all. Instead, it involved the creation of individual retirement savings accounts into which the company promised only to contribute a certain amount of money each year. The value of the funds in the account --and ultimately, the amount that a worker would have available at retirement -- vacillated according to the value of the assets in which the account was invested. Rather than providing security, defined-contribution plans forced workers to put their financial future at the mercy of the market.

In putting forth defined-contribution plans -- especially the kind called 401(k) -- employers were essentially engaging in a shell game. Plans of the 401(k) variety were originally devised as a way for workers to save some of their own money (sometimes with contributions from employers) to supplement traditional pension benefits. Increasingly, companies began to present 401(k)’s as their only retirement plan. The result was that workers ended up paying most of the cost of their retirement benefits, and employers were relieved of huge costs and financial risks. Between 1985 and 1998, the number of 401(k) plans -- as well as the number of participants -- tripled, while the assets in the plans reached $1.5 trillion.

In retrospect, it is surprising how little outcry there was over the large-scale elimination of defined-benefit plans. The reason why employees were willing to go along with the change was, of course, the mystique of the bull market. People were convinced that their 401(k)’s would make them rich--something that was not possible with traditional pensions. It took the arrival of the bear market, along with the corporate chicanery of companies like Enron, to disabuse employee-investors of that notion. 


Defined-benefit plans did not disappear entirely. In 1997 about half of the workforce in medium and large companies, especially ones that were unionized, still had that kind of retirement plan. Yet, by this time, the wizards of employee benefit departments had concocted a new strategy for reducing corporate pension fund costs. The innovation was something that was given the seemingly benign designation of cash-balance plans.

These plans are a hybrid of the defined-benefit and defined-contribution  approaches. Employers create an account for each employee to which a certain percentage of salary is credited each year. Unlike 401(k)’s, however, the employer manages the funds and guarantees a certain rate of return. The advantage for the employer is that it can keep any earnings beyond that rate, thus allowing for automatic capture of  “excess assets.” The advantage for employees is that they can take their account balance with them if they leave the company before retirement age, assuming they have met vesting requirements.

Yet what was most controversial was the way in which the contribution percentages were calculated. In traditional pensions, workers earn a disproportionate amount of their ultimate benefit during their latter years with the company--which is a way of rewarding tenure. Cash-balance plans, by contrast, typically contribute the same percentage to all employee accounts, irrespective of age or length of service. Consequently, following a conversion to cash-balance, older workers lose out big time.

After IBM announced plans to convert to a cash-balance plan in 1999, many of its older employees realized that they stood to lose up to 50 percent of their pensions, while the company was expected to reduce its pension costs by hundreds of millions of dollars. This created an uproar that shook the traditionally paternalistic company. IBMers flocked to public protest meetings and burned up the internet with angry postings about corporate greed. Bowing to the pressure, IBM gave older workers the option of remaining in a traditional plan, but it did not abandon the cash-balance approach entirely. A class action lawsuit against the company proceeded, and on July 31 of this year, a federal judge ruled that the plan discriminated against older workers. IBM is appealing.


Even before the recent court ruling, most employers with defined-benefit plans were hesitant to switch to the cash-balance approach -- largely because the Internal Revenue Service delayed giving its blessing to those plans. While waiting for the regulatory climate to be clarified, companies with traditional defined-benefit plans found other ways to lessen their liabilities, especially when the sagging stock market drastically reduced the value of their pension investments.

One popular ploy has been to assume an unrealistically high rate of return on pension assets. A study released earlier this year by the Milliman USA actuarial firm found that many large companies were assuming rates of return as high as 9 percent -- at a time when they were typically losing money on their investments.

Employer groups have been lobbying Congress, often with the support of unions, to allow them to achieve the same end -- reducing pension costs -- by changing the way in which companies calculate their funding obligations. The current method (called the discount rate) is based on the interest rates on a 30-year Treasury bond. Business interests argue that this approach is outdated (such bonds are no longer issued) and should be replaced by a benchmark, such as a corporate bond index, with a higher yield. This change would reduce pension fund obligations by tens of billions of dollars a year.

Changing the discount rate is a provision of a pension bill introduced earlier this year by Reps. Rob Portman (R-Ohio) and Ben Cardin (D-Maryland). The measure, which also raised the limits on 401(k) contributions, would switch the discount rate to a corporate bond index for three years, during which time Congress and the Treasury Department would devise a permanent solution. It is unclear whether that solution would incorporate the Bush Administration’s recent controversial suggestion that employers ultimately be required to calculate pension liabilities based on the age profile of their workforce.

The widespread consensus on easing corporate pension funding is perplexing. It is generated by a crisis atmosphere that is not entirely the result of declining stock prices. Many large plans are underfunded because companies have been using accounting gimmicks to reduce contributions while arranging special retirement benefits for Top executives. Some companies have been siphoning off assets to pay for the costs of downsizing. Lucent Technologies, for instance, removed $800 million to pay for severance benefits linked to downsizing and for retiree healthcare costs.


It is understandable that unions want to protect the remaining defined-benefit plans, but one has to wonder whether this deal with the devil will ultimately provide added protection for workers. The switch in the discount rate may simply mask a continuing problem of underfunding and do little to address the financial crisis of the PBGC. It is difficult to believe that Corporate America will abandon its longstanding efforts to evade pension obligations by using accounting tricks or by terminating traditional plans.

The combination of defined-benefit underfunding and growing use of defined-contribution and cash-balance plans over the past two decades represents one of the most massive transfers of wealth in U.S. history. Unfortunately, there is little indication that the big retirement rip-off will end anytime soon.