The Pension Catastrophe

In 1950, 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 Freeman.

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 is foolish.

Why? First, 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 this warning:

Does not 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.

Poirot is 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 won’t.


He worked 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.

This was 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.

The promise 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.

Of course, 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.

The economy 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.


John Mauldin writes a weekly free email letter. You can subscribe here.

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.”

They will, indeed. Mauldin writes:

Specifically, 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.

Let’s do 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 pension plan.

Assuming 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!

But let’s 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.

Is that attainable? My answer is, “Not really.” Quoting from a private paper by Robert Arnott:

“Stock returns have only four constituent parts:

1.5% current dividend yield * +2.5% consensus for future inflation * +0.0% P/E expansion (dare we assume more??)

* + ?? real growth in dividends and earnings

“This 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?

“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 entrepreneurial capitalism.”

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 of return.

The problem 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.


The obligations 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.

The public is naïve. 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.

Problem: that will kill the bond market.

Mauldin continues:

What if 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?

How much 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).

Everyone 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.


What has this got to do with where we are today? A lot.

The meter 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.

The piper 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.

For example, 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.

Who will foot the bill? You and I, of course.

The PBGC 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.

The PBGC 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 fiscal 2002.

PBGC was 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.


There have 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.

The PBGC 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.

How much? 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.

Now, spread 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.

But we 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.

His conclusion: 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.

Many of 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.

The problem 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.”

They later 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.”

But costs 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.”

Asians, Japan 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 lessons are simple:

Read 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.

August 18, 2004

Gary North [send him mail] is the author of Mises on Money. Visit For a free subscription to Gary North’s newsletter on gold, click here.

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