Business groups are asking Congress to delay required payments to pension funds, and a bi-partisan group of Senators seem willing to oblige by proposing the Pension Protection Technical Correction Act of 2008. The problem arises from the Pension Protection Act of 2006, which requires companies to fully fund pensions, paired with the recent securities markets declines that have greatly reduced the assets of existing pension plans. The result is that many companies will be forced to inject significant capital to pension funds to make up for the pension funds' losses.
This is indeed a hardship on companies. With capital constrained and profit margins declining, companies will have a difficult time procuring that capital. Even those companies with sufficient cash flow may find themselves deferring jobs-creating projects, as the capital for those projects is instead diverted to top-up pension assets. But many companies continue to reward shareholders while asking the government and labor for subsidies. Since shareholders are residual claimants, the government should seek to limit such actions.
The list of petitioning companies includes many - IBM, Rockwell Collins, ITT Corp, Northrop Grumman, to name a few - that are currently paying a dividend. In case their boards forgot, dividends are a way to return excess capital to shareholders. Eliminating these dividends would be an excellent source of cash to divert to pension funds.
While searching for more sources of capital, it would not be unreasonable to examine executive compensation. Executives who generate substantial profits are often paid substantial compensation, and it is unlikely you will find this space arguing for a restraint of the executive compensation market. However, pension accounting can distort earnings. In the current case, if the company needs to inject additional capital to pension funds now, it could mean previous earnings were overstated (see note on pension accounting below). If executives were paid in accordance with the profits generated in the past, and it turns out profits were actually overstated, it follows that executives were over-compensated. Clawing back compensation would free up cash to fund pensions.
But even for responsible companies, deferring payments to pension plans creates a subsidy, born by the Pension Benefit Guaranty Corporation and labor. The PBGC is an insurance scheme that insures pensions. If a company defers payments to underfunded pensions, and then goes bankrupt - and with Ford and Chrysler amongst the companies petitioning for this change, this is a real risk - someone must bear that loss. Retirees could see pensions reduced to the PBGC ceiling, and the PBGC would be obligated to fund any shortfalls to payout the guaranteed PBGC rate. If too many companies default, the PBGC could require taxpayer money to remain in operation, shifting the cost of these deffered payments directly to taxpayers.
So how should policymakers balance companies' legitimate need to defer contributions while minimizing the risk to labor and the PBGC?
First, ensure companies truly are in need of deferral by only allowing companies that ban dividends and share buybacks to participate. This eliminates a company's ability to divert capital to shareholders at the expense of labor or the government.
Second, charge participants a penalty rate to be insured by the PBGC. Currently, companies pay $9 per year for each $1,000 of unfunded, vested benefit. Given that participating companies will be cashflow constrained, they are at much higher risk of bankruptcy and should be made to pay a significantly higher rate - the exact rate to be determined by government actuaries, but in excess of expected losses. The premiums collected from this program could help offset any eventual costs to the PBGC, limiting the exposure to taxpayers, while still significantly relieving the cashflow burden. Instead of being required to fund the full amount of under-funding, companies would simply pay the higher insurance rate of, say, 4% of the under-funded amount.
With these two mechanisms in place, it will be up to the company's board to decide how to best proceed. Since the program is costly, companies should only participate if they have no better option. This will force boards to consider other ways to generate cash - and as noted above, a good place to look may be executive compensation. For those boards that determine funding the plan would be impossible or too costly, they can choose to participate at the costly rate. The board would have to exercise their fiduciary responsibility to choose the course of action that is best for the corporation. Hopefully, the much maligned hedge fund industry can help keep boards honest in making these decisions.
Note on pension accounting
Pension accounting is extraordinarily complex, and far too involved to explain in detail here. But, considering a stylized example should provide a similar benefit. Pensions are a substitute for wages. In short, a pension is part of the cost of paying workers, and therefore is similar to labor cost. The cost of this benefit is simple: the amount of cash the company must deposit today to pay pension benefits to the worker in the future. This cash will be invested, and the proceeds of that investment will be used to pay workers in the future. This amount - the amount of cash contributed today - is an expense, which runs through the income statement and lowers net income.
Now, if a company has to inject more cash today to make up for pension benefits incurred in previous years, that implies the company did not pay enough cash into the fund in the past. If the company did not pay enough earlier, that means its total EXPENSES were UNDERSTATED, and therefore its NET INCOME was OVERSTATED. In short, the company did not really make as much money as everyone thought. This is a particularly challenging issue, mostly due to the fact that the inverse is also true: if a pension is overfunded today, that implies that the company could have injected less cash and shown higher net income in the past. Measuring these changes every year creates significant volatility, and complicates this issue. It is not clear whether the pension fund will show gains or losses in subsequent years or not, creating confusion as to what exactly the appropriate assumptions are for determining "fully funded" pension plans, the expense associated with those plans, and the resulting financial statements.
This is indeed a hardship on companies. With capital constrained and profit margins declining, companies will have a difficult time procuring that capital. Even those companies with sufficient cash flow may find themselves deferring jobs-creating projects, as the capital for those projects is instead diverted to top-up pension assets. But many companies continue to reward shareholders while asking the government and labor for subsidies. Since shareholders are residual claimants, the government should seek to limit such actions.
The list of petitioning companies includes many - IBM, Rockwell Collins, ITT Corp, Northrop Grumman, to name a few - that are currently paying a dividend. In case their boards forgot, dividends are a way to return excess capital to shareholders. Eliminating these dividends would be an excellent source of cash to divert to pension funds.
While searching for more sources of capital, it would not be unreasonable to examine executive compensation. Executives who generate substantial profits are often paid substantial compensation, and it is unlikely you will find this space arguing for a restraint of the executive compensation market. However, pension accounting can distort earnings. In the current case, if the company needs to inject additional capital to pension funds now, it could mean previous earnings were overstated (see note on pension accounting below). If executives were paid in accordance with the profits generated in the past, and it turns out profits were actually overstated, it follows that executives were over-compensated. Clawing back compensation would free up cash to fund pensions.
But even for responsible companies, deferring payments to pension plans creates a subsidy, born by the Pension Benefit Guaranty Corporation and labor. The PBGC is an insurance scheme that insures pensions. If a company defers payments to underfunded pensions, and then goes bankrupt - and with Ford and Chrysler amongst the companies petitioning for this change, this is a real risk - someone must bear that loss. Retirees could see pensions reduced to the PBGC ceiling, and the PBGC would be obligated to fund any shortfalls to payout the guaranteed PBGC rate. If too many companies default, the PBGC could require taxpayer money to remain in operation, shifting the cost of these deffered payments directly to taxpayers.
So how should policymakers balance companies' legitimate need to defer contributions while minimizing the risk to labor and the PBGC?
First, ensure companies truly are in need of deferral by only allowing companies that ban dividends and share buybacks to participate. This eliminates a company's ability to divert capital to shareholders at the expense of labor or the government.
Second, charge participants a penalty rate to be insured by the PBGC. Currently, companies pay $9 per year for each $1,000 of unfunded, vested benefit. Given that participating companies will be cashflow constrained, they are at much higher risk of bankruptcy and should be made to pay a significantly higher rate - the exact rate to be determined by government actuaries, but in excess of expected losses. The premiums collected from this program could help offset any eventual costs to the PBGC, limiting the exposure to taxpayers, while still significantly relieving the cashflow burden. Instead of being required to fund the full amount of under-funding, companies would simply pay the higher insurance rate of, say, 4% of the under-funded amount.
With these two mechanisms in place, it will be up to the company's board to decide how to best proceed. Since the program is costly, companies should only participate if they have no better option. This will force boards to consider other ways to generate cash - and as noted above, a good place to look may be executive compensation. For those boards that determine funding the plan would be impossible or too costly, they can choose to participate at the costly rate. The board would have to exercise their fiduciary responsibility to choose the course of action that is best for the corporation. Hopefully, the much maligned hedge fund industry can help keep boards honest in making these decisions.
Note on pension accounting
Pension accounting is extraordinarily complex, and far too involved to explain in detail here. But, considering a stylized example should provide a similar benefit. Pensions are a substitute for wages. In short, a pension is part of the cost of paying workers, and therefore is similar to labor cost. The cost of this benefit is simple: the amount of cash the company must deposit today to pay pension benefits to the worker in the future. This cash will be invested, and the proceeds of that investment will be used to pay workers in the future. This amount - the amount of cash contributed today - is an expense, which runs through the income statement and lowers net income.
Now, if a company has to inject more cash today to make up for pension benefits incurred in previous years, that implies the company did not pay enough cash into the fund in the past. If the company did not pay enough earlier, that means its total EXPENSES were UNDERSTATED, and therefore its NET INCOME was OVERSTATED. In short, the company did not really make as much money as everyone thought. This is a particularly challenging issue, mostly due to the fact that the inverse is also true: if a pension is overfunded today, that implies that the company could have injected less cash and shown higher net income in the past. Measuring these changes every year creates significant volatility, and complicates this issue. It is not clear whether the pension fund will show gains or losses in subsequent years or not, creating confusion as to what exactly the appropriate assumptions are for determining "fully funded" pension plans, the expense associated with those plans, and the resulting financial statements.
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