Asymmetrical Information

It seems a little transparency would accomplish a lot here. GAAP could be modified to oblige a company to show two sets of earnings: one with pension fund growth assumptions of its choice, and one with a standard baseline (say, 6%). If the difference between the two numbers was sizable, the company would have to justify its number (not a problem if 6% has "fallen afoul of reality" at some future time) or take the market pounding that would result.

Are there any other areas, besides pension liabilities, that let companies dial their profits by choosing arbitrary numbers?

I'm not saying that 10% was appropriate; in hindsight, it clearly wasn't. But prospectively, was tehre a way to make a clear regulatory determination that 10% was wrong? A lot of very smart people thought that the rules had change . . . still do, to judge by the professional money managers.

The problem isn't really with the SEC, as far as I can make out; the pension assumptions it allows are rather conservative. The problem is with ERISA and the PBGC, which allowed companies to make ridiculous guesses. I'd rather see a change of leadership, and more freedom given the PBGC to set rates and funding levels, than some statutory number which will just run into trouble on the high side or the low side down the road.

My impression, too, is that the problem at the end of the 1990s was less that of future projections than paper gains which allowed many companies to stop funding their pensions for several years. I don't know of any good way to make GAAP or the PBGC force companies to assume that the value of their current portfolio will plummet.

Doesn't it seem hypocritical for politicians to criticize companies for underfunding pension plans, when social security is basically unfunded?

I'm not saying that we shouldn't fix corporate plans, only that we should also at least partially fund the main plan that's supposed to cover practically everyone.

I read Kevin's site far less frequently these days. His output is more and more like a mirror image of Free Republic; any who disagree with him are not just wrong, but amoral fiends who are actively seeking to destroy civilization. Not much to learn from that, and pretty boring as well.

I think the real problem lies with the defined-benefit plan. And, like Social Security, with the oldsters who like them. I work with a few older guys who wish they had defined-benefit plans, and I just don't understand why any sane person would want one. It puts not only your current income in the hands of your employer, but also makes your future retirement income dependent upon the success of one company. I'll take my defined-contribution plans (a Roth IRA and a 401k) thanks. If you want your retirement dependent upon one company, just put all of your 401k contributions into employer stock, but don't come crying to me if you lose it all; by that point you'll deserve to be poor as punishment for your idiocy.

I would suggest that there is no way to reasonably determine appropriate funding levels for pension plans. Pension plans grew up during a particular era when the assumptions worked for a long time. That was luck. All systems of retirement will have to migrate over time to some kind of contribution based system rather than defined benefit system because the relevant return assumptions are too variable. This goes for individuals purchasing annuities who will have to diversify because individual comapanies may not make the returns to support them.

I love equities and investments, but the return assumptions even the "experts" assume on average (as opposed to those such as myself who think we can do better, here's hoping!) are based on a slew of faulty, questionable or highly speculative factors. Our pension system will really go to hell if we have another ten years of mediocre, flat or negative returns. Think 1966 to 1982.

Corporate pensions are not even the biggest story. States and municipalities have even bigger issues. Defined contribution plans have issues, but at least the amount there is the amount there. We as individuals can plan based on what is actually in an account rather than on what is supposed to be. If we need to work longer we work longer, if not, then we can hit the beach (or mountains in my case.)Relying on markets to cooperate to achieve a particular outcome is to put recent decades against longer term experience.

"We saw similar practices and events at Enron, but unfortunately, this time it's perfectly legal,"

I think defined benefit pensions were next to non-existent at Enron. Enron's problems have nothing to do with United's.

Patrick: You're right, Enron had an employer-sponsored 401(k) plan, not defined-benefit [in fact, the defined-benefit plans of PGE employees were converted]. The major problem at Enron was a combination of incompetence on the part of Lay and sheer, unbridled greed on the part of Skilling and Fastow. See also a Skilling associate unethically announcing at a company meeting in Houston that employees should "absolutely" put all of their 401(k) contributions into Enron stock. Then again, the employees who were dumb enough to listen, IMHO, deserve to be poor.

The problem, to the extent there is one, is that companies use several different methods to account for and report on the same thing. For example, companies often compute depreciation for books and tax differently. To the uninitiated, this may seem nefarious. Normally, it's not. It's not that companies WANT to hire scads of accountants to report the exact same item in many different manners, it's that the information is used for different reasons and that different accounting methods are mandated by the users of the information.

In the case of pension accounting, the GAAP rules are designed with one purpose in mind (fairly representing the financial health of the company over time) while the PBGC has an entirely different purpose (determining how much the current contribution to the fund needs to be). GAAP tries to smooth recurring expenses, such as pension contributions, from one period to the next. (This is because such expenses relate to several periods, not just the current quarter. If the market takes a pronounced downturn, pension expenses will likely go up in the long term. Lumping these additional expenses into one quarter would distort the overall results for the company and make it difficult to compare how the company is doing over time.) Since the pension numbers for GAAP and the PBGC are computed for different purposes, we should not expect them to be the same. The problem is that we, the public, do expect them to be the same. This allows people to demagogue the issue.

"United's pension fund was underfunded through gross company malfeasance..."

You'd better include the government in that.

For any year that a qualified defined benefit pension plan goes underfunded, the plan sponsor has to request in writing a waiver from the IRS and Department of Labor granting it permission to not fund up to minimum funding standards -- and the waiver must be granted, of course. See section 411 of the Internal Revenue Code.

So the federal regulators knew exactly what was going on -- and approved.

The thing is, there's a lot of politics in granting these waivers -- there's often a nasty choice involved.

In theory the waivers are supposed to be granted only *if* the business is fundamentally sound, suffering only a temporary hardship, and will be able to make up the funding shortfall later.

In reality, when both the business and the investments in its retirement plan have gone south at the same time, then the additional hit to cash flow of making a big make-up pension contribution could itself push the business under -- or at least force it to make big cuts in its current payroll, taking from the current workforce what it gives to retirees.

That's an option that employers and unions, and (thus) politicians, don't like at all -- so for big, troubled employers the waviers are routinely granted no matter how bad the shape the business is in. (See the old steel companies.)

It's only small businesses that have the waivers denied.

something which no one has mentioned is the impact of the massive increase in liquidity on pension obligations.

pension benefits have to use a discount rate to give us a present value to which the fund needs to be filled. with the significant drop in interest rates, this discount rate has dropped precipitously, drastically increasing the present value of future benefits. the fall in interest rates coincided with the drop in stock market valuations, so the funds took hits from both sides: their assets were less while their requirements were higher.

this is just one more example of how long term liabilities are very dangerous, given the accepted practices of finance and accounting. we just don't handle long term obligations very well, as they can fluctuate so wildly and unpredictably. while our risk models deal well with things in the short to medium term, dealing with long term risks of supposedly unlikely events is not the strongest suit of financial markets and professionals. This problem is exacerbated by the fact that we are really the first people to deal with such broad long term obligations. all of our market experience is based on life expectancy in the realm of 40-60 years, so that long term risks were decreased substantially by the severe deficit of long term beneficiaries.

Planning for a 40 year storm looks silly and wasteful to people in a decent market, especially when you're in a 20 year bull market. Noone remembers the pain of the 70s except for maybe the chairman of firms, and they have no interaction with the actual workers. If United, or Enron, or anyone, had funded their pension assuming that interest rates would drop to 2-4%, major blue chip companies (AT&T, Lucent, etc) would see 90% stock drops (look at the canadian market, where nortel madeup 35% of the market cap at one time and went down by 99%), and their own businesses would decline precipitously, they'd be LBO'd in a second for carrying way too much momney in their pension plan. Hell they'd likely have been over-funded by 2, 3 or more times.

I don't know how you could reasonably plan for this, given the massive variation in stock returns and interest rates over the past 10 years. It does make the case that a defined contribution plan is morally imperative for firms as they are otherwise forcing vastly too much risk onto the individuals that they emply.

I love seeing unionists and leftists declaim the fact that defined contribution plans offload risk from firms to employees. What would you rather have, a "guarantee" that's only good while your company is healthy, or money you control that you might screw up. I'd much rather have a 10-20% loss than the massive losses that people at united are seeing, and that those at so many other PBGC bailout firms have experienced. But then I have a much lower appetite for risk than labor leaders!

Well, hey, when one's primary objective is to define one's opponents as EVIL! EVIL! EVIL!, one shouldn't allow rational analysis to intrude.

First, allow us to recall that a majority of United's stock was owned by its unions and employees.

Second, every method of calculating actuarial amounts is plauged by uncertanties related to its choice of assumptions as well as the usual uncertainties arising out of asset valuation problems.

Third, every number cited in the article came about because of a calculation required by a regulatory agency for its own purposes.

The IRS, for its part, wants to minimize contributions, which are deductible, in order to maximize revenue. PBGC, wants to maximize contributions in order to protect its precarious financial position. GAAP exists to protect accountants from stockholder lawsuits.

Fourth, the sad truth is that like trolly cars, dial telephones, and industrial unions, the defined benefit pension plan has seen its day and is departing from the scene. Every change in the pension laws has made it more expensive to maintain a DB plan. If Grassley gets his way, there will be another turn of the screw.

The way I see it, the auto companies are next to go. An era is coming to an end.

I'm trustee for both a defined benefit and defined contribution plan. The DC plan is infinitely easier to administer, and costs the company less. Why not drop the DB plan? Because, if the investments have a good year (i.e. exceeds the projected increase) then the employer's cash contribution will be lower (or even zero) for that year, and the employer can pocket the cash he would have laid out. With a
DC plan, however, the employee pockets the bigger gain but may suffer the loss than is protected under a DB plan. Which is best? Depends on whom you are, and how the market performs.
In any case, if PBGC was privatized, you'd have individual, profit-seeking insurers making rules that could more appropriately apply to the circumstances of each client's plan and risks.

"I'm not saying that 10% was appropriate; in hindsight, it clearly wasn't. But prospectively, was tehre a way to make a clear regulatory determination that 10% was wrong?"

Jane, why would there ever be any expectation that the real (non-inflated) value of investments will grow at a sustained rate 6 or 7 % above the growth of the economy?

Jane Galt, I don't understand why you keep defending the current pension regulatory scheme. As I understand it, it is undisputed that
1.) Current regulations do not require companies to set aside enough money in pension funds to reasonably assure that the pension promises they make will be fulfilled.
2.) Many companies don't set aside enough money.
3.) The government has guaranteed (subject to certain limitations) private pension promises.
4.) This is going to cost the government a lot of money.
Why do you think this is a good thing?

As for your final paragraph if allowing effectively insolvent companies to continue to operate (and even pay dividends in some cases) while running up massive additional government guaranteed obligations is not a regulatory conspiracy, what is it?

Having been on the accounting for it side of much smaller plans, the government regulation merely serves to create addd work and paper. It guarantees nothing.

How do you predict your funding needs? An actuary looks at your employee pool and makes predictions about retirement ages and life expectancy. You then look at pension calcs based on those numbers and current and future payrolls. You estimate the rate of inflation in payrolls. You then look at your pension funds, and estimate the growth rate.

Every single one of these numbers has a jiggle factor. You have at least five factors with a min/max range. Most of your jiggle goes toward improving the look of your balance sheet, since the government insists that you put pension obligations up as a liability. Jiggle wrong, and your ability to obtain financing becomes more difficult because your ratios all go bad. Make yourself look too good, and it'll catch up to you in a bad investing year.

I'm not a stats person, but I would suspect that the calc itself is meaningless since there is so much jiggle for each of the numbers.

The current situation does not rise to the level of conspiracy or gross criminal conduct?

Hogwash.

The pension funds are wholely owned by the corporations, not their employees. That change was quietly slipped by most of the public a couple of years back.

The pension funds are no longer managed by the employer, they are solely the responsibility of the employee.

A nice double whammy - if you will - designed to foster malfeasance at the corporate level and a whole new layer of 'investment advisor' on Wall Street. ERISA is corporate fraud given the color of law.

Just take a look at the difference of DB and DC pension plans, as noted in Robert Kiyosakis' book 'Rich Dad's Prophecy'.

Under DB, the pension plan 'was a retirement plan that defined the benefit or the dollar amount a retired person would receive. For example, if an employee worked for forty years for a company and retired at sixty-five, a defined benefit might pay that employee, let's say, $1000 a month for as long as he or she lived. If that employee lived to sixty-five, the company actually did well because the company only had to pay the defined benefit for a year. If the ex-employee lived to 105, the company paid $1000 a month for forty years. In this case the employee was much better off, but at the expense of the company. Social Security is a government DB plan.

Subsequent changes to ERISA may allow companies to switch to DC, or defined contribution, plans. The difference...is found in the difference between definitions of the words 'benefit' and 'contibution'. A DB plan defines the 'benefit' whereas a DC plan is defined by the 'contribution'. In other words, a worker's retirement is only as good as the contribution ...if there is a contribution.'

So, the underfunding of a corporations share of a retirement account (401K, etc.) is criminal both in the long and the short run.

Another issue to consider is what happens to the markets these DC pension plans are tied to (via Mutual Funds, etc) when the percentage of outflows becomes greater than inflows? More sellers than buyers?? Not a great boon to Wall Street. And as market values tumble, so do the payments to retirees.

All this tends to explain several initiatives toward semi-privitization of Social Security (a defacto DB/DC shift), the 30% devaluation of the dollar through mass printing, and the derivatives and housing bubbles.

Like ERISA, they are tactics of theft, deception, and delay of the inevitable. It would behoove us to all start thinking critically and holistically, rather than treating issues as seperate and unconnected from logic/fundamental causality.

10% implies a pure stock portfolio with no expenses - and starting at a lower valuation than existed in the mid - 1990's.

Past U.S.
arithmetic return 12%
fluctuating return -1
survivor bias -1
past nominal 10% (tax deferred)
inflation -3
investing costs -2 (transaction,fund costs)
net real 5%
international -2 (u.s. was a past winner)
net real 3%
2% world growth

the problem is that, in the short term, valuation changes can overwhelm the lower long term expected return.

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