free market economist Paul Poirot wrote a little book, The
Pension Idea. For 31 years, 1956—1987, he edited The
Freeman, a monthly magazine that promotes free market ideas.
Through him, I got my first national audience, beginning in February,
1967. I helped support myself in grad school by writing for The
In his book,
he warned against trusting in anyone else to support you in your
old age, especially the government. He also warned against expecting
investments in private assets — stocks or bonds — to
support you. Hope is fine, if backed up by wisdom. Confidence
because the government can tax bonds through inflation. Second,
because stocks are threatened by the existence of pension guarantees
for employees. There is no way to guarantee the future decisions
of consumers, but they are the people who will determine the profitability
of a company. To the extent that the government will enforce the
claims of a company’s retired workers at the expense of shareholders,
the shareholders’ claims are at risk. On page 48, Poirot offered
investment in the stock of business corporations afford some
security against the hazards of inflation? Ordinarily, one might
think so. But today, it is pure speculation. It is speculation
in the face of multiple taxation of corporate earnings. It is
speculation as to how far the corporate management, willingly
or under compulsion of government, may sacrifice the equity
of stockholders in acquiescence to the demands of the leaders
of organized labor. It is speculation as to how the courts will
rule concerning priority of claims against company surplus.
If the courts rule that employee pensions, for which contracts
are already signed, shall have prior claim over the stockholders’
equity, then the stock of many corporations today is worth less
than its current market price. Ownership of stock is an illusion
in a company whose management has pledged to employees that
future buyers of that company’s product will pay enough more
for the product to provide pensions for those who have ceased
producing. An all-powerful government, with the power to tax,
is the only management which can claim that kind of control
over the "buying" notions of its customers. When a
private corporation undertakes to guarantee the future behavior
of its customers, who are stockholders in the government, then
that corporation is a sitting duck for governmental control.
still alive. I call him every couple of years, just to see how
he is doing. He lives on a pension. His employer, the Foundation
for Economic Education, offered no pension plan. He made good
decisions with his own investments. Most people don’t. Most people
ERA OF PENSIONS
during the era that inaugurated the pension. In 1936, the Roosevelt
Administration began Social Security. Under that Administration
and under Truman’s, the idea spread to organized labor. The country
was under wartime price controls, 1942—45. Truman kept them
on until the fall of 1946. Under the rules governing wages, pension
contributions were not counted as a wage. So, businesses worked
out a mutually beneficial arrangement with trade union leaders.
The leaders could announce to their members that the leaders had
played hardball and forced management to hand over the money.
The money came in the form of pension funding.
a good deal for workers, who under wartime controls were limited
in what they could receive as wages. This was also a good deal
for management, who would not have to fund these pensions 100%,
even though the agreement was a legal document. It looked as though
management was giving up a great deal, but management in those
early years, like the Social Security Administration, did not
feel the pain. The pain would come later, long after that generation’s
retirement and internment.
was great: guaranteed income apart from children’s obligations
to support aged parents. Government pensions — minimal —
had come under Bismarck in the 1880s. It bought him time. It bought
him votes. It kept conservatives in power. Country by country,
the idea spread.
it was the productivity of capitalism that made this promise believable.
Ever since the late 18th century, output in the West,
even with its wars, has increased above 2% per annum. That seemingly
slow rate of growth has been sufficient to pay off the dreams
of retirees. A small percentage of the population has been able
to retire in comfort because of government extractions, corporate
growth, and their own wise decisions regarding investments.
But the pension
idea has spread. It has spread to hundreds of millions of European
and American workers, who have believed the promises of government,
union leaders, and corporate management. They assume that those
making the promises know what they are doing. And they really
do know what they are doing: making self-interested promises today
at the expense of managers who will come later.
no longer grows sufficiently to make possible the pension dreams
of the vast majority of these workers, especially with government-funded
medical care siphoning off most of the money that would have gone
to pensions. There are too many expectant beneficiaries, who think
that they can get more, now, at the expense of others, later.
The day of
reckoning will arrive within my lifetime, actuarially speaking,
and surely yours. Most people will run out of pension before they
run out of time.
writes a weekly free email letter. You can subscribe
He is the
author of a new book on investing, Bulls
Eye Investing, which is high on the New York Times’
best-seller list. It is a very good book. It points out why it
is unlikely that the stock market will perform well over the next
two decades, given its above-average performance, 1982—2000.
This book would not have been published in 2000. There is nothing
like running into the brick wall of reality to create new markets.
In his weekly
letter for August 13, he discussed the pension liability problems
facing major corporations. Because John writes well, and because
he is a numbers guy (he used to be my company’s manager), I will
quote extensively from his letter. That’s because I can’t make
the numbers any clearer. I assure you, no one in Congress is warning
his constituents this campaign year about the numbers and the
limits that they impose. They tell voters, "Vote for us,
and you will get what you deserve."
indeed. Mauldin writes:
I want to look at defined benefit pension plans. These are pension
plans which in theory guarantee a worker a specific set of benefits
for his retirement years.
a simplified analysis. Let’s say the pension of Company ABC
has $1 billion dollars. The actuaries work to figure out what
the fund will need in future years. The managers of the fund
make assumptions about how much the fund portfolio will grow
in the future from a combination of investments and more contributions
by the company. Let’s assume Company ABC is going to need its
investment portfolio to grow by 9% per year in order to stay
fully funded. The more you assume the portfolio will grow, the
less ABC will need to dig into its pockets to fully fund the
a typical 60% stocks/40% bonds mix, what type of returns does
the company need from its stock portfolio? Let’s be generous
and project a 5% return from its bond portfolio over the next
decade. That means it will need over 11% from the equity portion
of its portfolio!
not be so negative. Let’s assume bonds will return more and
increase our stock investments. Assuming an asset allocation
mix of 70% equities and 30% bonds (yielding 6%), stocks would
still have to earn 10.7% to attain a 9% composite return.
attainable? My answer is, "Not really." Quoting from
a private paper by Robert Arnott:
returns have only four constituent parts:
current dividend yield * +2.5% consensus for future inflation
* +0.0% P/E expansion (dare we assume more??)
* + ??
real growth in dividends and earnings
arithmetic suggests that, to get to a 7 percent return estimate,
we need a mere 3 percent real growth in dividends and earnings.
We can do far better than that, no?
Historical real growth in dividends and earnings has been
1 percent to 2 percent. To get to the 3 percent real growth
in the economy, we have turned to entrepreneurial capitalism,
the creation of new companies. Shareholders in today’s companies
don’t participate in this part of GDP growth. So, even a 7
percent return for equities may be too aggressive. To get
10.7 percent from stocks, we need nearly 7 percent real growth
in earnings, far faster than any economist would dare project
for the economy at large, let alone for the economy net of
Here we have
the problem: management wants to minimize the deductions made
from the pension system for its workers. Management, rewarded
with stock options, prefers high returns on shares, which come
from earnings after expenses. Expenses include the pension system.
To get a
high rate of earnings (profits), management tells the actuaries
to make the highest possible assumptions for the rate of return
on portfolio investments. Because of the stock market boom, 1982
to 2000, high rates of projected return became commonplace. Actuaries
were told to push the envelope by making the highest projections
they could get away with. The Pension Benefit Guarantee Corporation,
a government agency under the ERISA law, which stands as a final
guarantor of corporate pensions, allowed these high expected rates
has come since 2000. The stock market has showed a loss since
then. Until 2004, dividends have been low — under 2%. This
is beginning to change, slowly. A recession killed earnings until
2003. Everywhere management looked, there was a sea of red ink.
Yet the corporate pension obligations for defined benefit programs
kept growing at the pre-2000 rates of return, which the envelope-pushing
actuaries had projected.
METER KEEPS TICKING
do not go away because the economy hits one of Greenspan’s "soft
patches." It ticks away, night and day, day in and day out.
Today’s management is trapped by the decisions of yesterday’s
management, stretching back to World War II. The game went on,
decade after decade: pushing the day of reckoning into the future.
"Buy now, pay later" became the strategy. Buy trade
union cooperation, buy workers’ loyalty, buy a higher rate of
quarterly earnings by means of decades-long promises.
We live in
a society in which this strategy has become business as usual
in every area of life. We buy now and promise to pay later. When
the bills ad up, we change the accounting rules. This is what
Lyndon Johnson did with Social Security. He took it off-budget,
then raided the income produced by Social Security taxes to reduce
the official budget deficit. This scam is still in force.
is nave. Nobody reads the fine print. The promise-makers are
not the same people as the promise-keepers. There will be no promise-keepers.
The government, with cheering from overburdened corporations,
will get the Federal Reserve System to inflate the money supply,
making more fiat money available to pay off the obligations.
that will kill the bond market.
pensions start getting less return in their bond portfolios?
It is tough to get 5 percent today without taking some real
risk. To get to a 9 percent assumption in a 5 percent bond environment,
and if you have 70 percent in stocks/30 percent in bonds, that
9 percent overall return assumes you are getting almost 12 percent
returns on your stock portfolio. But what if the Dow drops to
6,000 as it might during the next recession and the NASDAQ goes
to 600? What if your returns are negative for the next few years?
are you underfunded then, as your portfolio drops another 20
percent? The number becomes mind-boggling. If each of the S&P
500 companies lowered its expected rate of return from the current
average of 9.2 percent to 6.5 percent, the total cost to earnings
would be $30 billion, according to a report by CSFB. But if
the Dow drops to 6,000 the number goes off the chart. Remember,
the average drop in the markets is 43% during recessions.
Is it realistic
to suggest we will not see a recession within a few years? I
think not. As I demonstrated in my book and have written here
many times, there has never been a period in history where the
stock market has out-performed money market funds over the next
ten years when valuations are at current levels (The core P/E
for the S&P is around 21).
wants to beat the market. Hardly anyone can. If you wanted a secure
retirement, you would have bought 100 shares of Berkshire Hathaway
for $1,500 in 1965, when you heard that Warren Buffett had purchased
control. You would now be sitting on a nest egg of $8.5 million.
That’s a return of 24.82% on your money, give or take a decimal
point. But you didn’t. Neither did I.
this got to do with where we are today? A lot.
is ticking loudly, but hardly anyone pays attention. We have all
grown bored with bad news. We have all grown used to the idea
that the day of reckoning can be avoided. This mentality governed
France in the 1780s. It hit the brick wall in 1789: the French
Revolution, which began as a fiscal reform. Red ink went to blood
red. Eventually the piper demands payment.
must therefore be stiffed. Mauldin continues:
If we were
starting from a point of strength, it might be less troublesome.
But the Pension Benefit Guaranty Corporation notes that defined
benefit pension plans are under-funded to the tune of $450 billion
(the combination of single and multi-employer plans). But that
is likely an understatement. How you figure full funding is
actually quite flexible. It is an arcane art rife with assumptions
and wiggle room. And employees are in the dark about how well
their pensions are funded. As an aside, the Bush administration
has proposals to require disclosure to employees, but strangely
Congress has yet to act on this obviously common sense and long
overdue proposal. Let’s make sure hedge funds are regulated
(we gotta protect the rich), but let corporations hide their
pension fund liabilities. I mean, you have to establish priorities.
in its last filing prior to termination of its plan, Bethlehem
Steel reported that it was 84% funded on a current liability
basis. At termination, however, the plan was only 45% funded
on a termination basis — with total underfunding of $4.3
billion. PBGC had to assume that liability. In Congressional
testimony, PBGC notes:
in its last filing prior to termination, the US Airways pilots’
plan reported that it was 94 percent funded on a current liability
basis. At termination, however, it was only 35 percent funded
on a termination basis — with total underfunding of $2.2
billion. It is no wonder that the US Airways pilots were shocked
to learn just how much of their promised benefits would be lost.
In practice, a terminated plan’s underfunded status can influence
the actual benefit levels."
You may have
read that US Airways now faces bankruptcy if it cannot get reductions
in wages from the pilots’ union. The pilots are playing hardball
with a company on the ropes. If the company goes under, the pilots
will have to live on their pensions. Unfortunately, the company’s
weakness is not limited to current income.
foot the bill? You and I, of course.
insures pension benefits worth $1.5 trillion and is responsible
for paying current and future benefits to nearly 1 million people
in over 3,200 terminated defined benefit plans. Benefit payments
totaled $2.5 billion dollars in 2003. Benefit payments are expected
to grow to nearly $3 billion in 2004.
is also underfunded to the tune of $11.2 billion, up from a
mere $3.6 billion last year. But buried in footnote 7 is a more
ominous number. The PBGC makes an estimate as to what its liability
in the future might be for companies which will go belly-up.
The "reasonably possible" exposure as of September
2003 ranged from $83—$85 billion, up from $35 billion in
set up by the government as an insurance program. Pension plans
pay an insurance premium (currently only $19 per covered employee
per year) to have their funds participate in the program. As
recently as a few years ago, the fund was well in the black.
But with the problems in the steel and airline industries, costs
have simply gone off the charts.
been many promises made. There has been insufficient funding to
redeem these promises at full market value. This lack of funding
has been across the boards — and boardrooms.
insures $1.5 trillion in plans. That is $1.5 trillion that pension
funds are assuming will grow by 7-9% over the next decade, depending
upon how conservative they are. They are currently underfunded
by $450 billion.
If I am
right about stock market returns being well below 4% for the
rest of the decade as we get further into a secular bear market,
and given the clear ability of pension funds to overstate their
funding positions, it means that companies are going to have
to come up with a huge amount of money over the decade to fund
their pension plans.
If a pension fund assumes an 8% growth, your principal doubles
in about 9 years. But 9 years at 5% is only a 55% growth. On
the amount the PGBC insures, that would be a shortfall of about
$650 billion, give or take a few hundred billion. That would
be on top of the current $450 billion underfunding.
out over 9—10 years, corporate America is easily making
enough to fund that amount. But such a number would significantly
eat into profits. Total US corporate profits (with the odd adjustments)
are running north of $900 billion from all companies. How much
of that is from companies with defined benefit pension plans?
I can find no data to answer that question.
can guess where the bulk of the problem lies. It is in the 360
companies in the S&P 500 that have defined benefit pension
plans. Credit Suisse First Boston (CSFB) estimates unfunded
pension liability as of 2002 for this group was $243 billion.
Morgan Stanley estimated $300 billion. The upshot is that companies
with defined benefit programs are going to see their earnings
under pressure as they will have to divert more and more of
their profits into their pension funds.
don’t invest in companies that have offered their workers defined
benefit pension programs. The problem is, that list comprises
72% of the S&P 500.
We are now
facing the reality that Paul Poirot wrote about in 1950: the companies
are legally owned by shareholders, but in fact are owned by the
retirees, who have legal claims against the companies.
these companies are essentially owned by their retirees, who
are going to get more and more of the profits. This is not going
to be good for shareholders in the company, or for S&P 500
index mutual funds. During the next recession, these companies
are going to be required to make up the underfunding in their
plans at a time when their earnings will be down. The projected
growth in their investment portfolios will be hurt because they
will have so much money invested in large cap companies just
like themselves who are facing underfunded pension problems.
facing every company with a defined benefit program is that current
pension obligations must be factored into retail prices. Consider
the auto industry.
In a study
by the FDIC, we note that: "The U.S. automobile industry
shows the effects of higher pension costs on the bottom line.
The results of a Prudential Financial study state that pension
and retiree benefits represent $631 of the cost of every Chrysler
vehicle, $734 of the cost of every Ford vehicle, and $1,360
of the cost of every GM car or truck. In contrast, an article
in the Detroit Free Press reported that pension and retiree
benefit costs per vehicle at the U.S. plants of Honda and Toyota
are estimated to be $107 and $180, respectively."
casually note, "GM recently has used about $13 billion
of a $17.6 billion debt offering — the largest ever made
by a U.S. company — to help close its pension gap. On average,
GM will pay a 7.54 percent yield on the debt, and hopes to earn
9 percent on the proceeds contributed to its pension fund. While
cash flow requirements have been eased for now, if this long
term expectation regarding returns proves problematic over time,
GM will need to find other sources to pay their obligation."
do not determine prices. Supply and demand determines prices.
If a new supplier comes along who is not burdened by past pension
fund obligations, this supplier can undersell the firm that made
such promises. For American and European firms, the four-letter
word that confronts them is "Asia."
excepted (an American satrapy, 1945—55), came to capitalism
late. Their governments, not being democratic, did not pay off
trade union members with special legislation, unlike Western governments,
beginning with Bismarck. The least democratic nation of all, The
Peoples Republic of China, has no pension obligations, only state-owned
factory obligations, which the government is shedding. As state-run
factories go the way of all flesh, China will compete without
one arm tied behind its back: the arm of past promises.
the fine print of your pension program.
Assume that your future is not guaranteed.
Your past employer regards you as a liability.
It is easier to create money than to create wealth.
The government is not your friend.