In my recent post on greed, I wrote about how for the last generation corporations have been trying to get out of as many of their expensive obligations to workers as they can reasonably get away with.  The list of obligations includes but is not limited to pensions, health care and job security.

One can debate whether they are being pulled into this unwillingly by competition from overseas or being pulled by the lure of large bonuses from cost cuts which boost shareholder returns. Either way, evidence that ordinary Americans are increasingly worried that corporations are looking to slough off their commitments onto workers comes from a case in Houston.

The Guardian reports:

Was it a sudden spate of marital disharmony? Or were there mercenary motives at play? A US judge has thrown out a case brought by Continental Airlines against nine pilots accused of getting "sham" divorces in order to collect large payouts from an employee pension fund.

The Houston-based international carrier smelt a rat when a spate of its cockpit crew members dissolved their marriages between 2005 and 2007, only to remarry shortly after their spouses had obtained up to $900,000 under a loophole permitting lump sum pension payouts to divorced partners of staff members.

Continental fired the pilots and sued, claiming it had been duped into distributing between $10m and $11m under false pretences. But at a federal court in Texas, a judge has sided with the pilots, ruling that, irrespective of its employees’ motives, Continental cannot hold itself up as an arbiter of marital authenticity.

Are these pilots greedy or are they worried that Continental will dispose of its pension obligations in bankruptcy court much as other American airlines did post 9/11?

• Basics of the Pension Benefit Guaranty Corporation (pdf)
• PBGC Assumes Pensions of Aloha Airlines
• Effect of United Airlines pension termination on PBGC deficit (pdf)

Continental plans to appeal.

Related posts:

• Lehman pension shortfall is a foreshadowing
• Pensions: $400 billion hole to reduce U.S. corporate earnings
• Another writedown risk: Chapter 7 Bankruptcy
• Muncipalities can tear up contracts
• Judge stops BofA deal with the SEC

Yesterday, I argued that the United States faced a policy dilemma in avoiding debt deflationary forces while maintaining fiscal prudence.  The reality is that President Obama faces political constraints in Washington right now in regards to budget deficits.  He is not likely to get another stimulus package through the Congress unless he can credibly demonstrate a longer-term deficit reduction outlook.  In my view, this necessarily means changes to Social Security and/or Medicare.

Last June and July, I presented five charts from Ross Perot’s website perotcharts.com which demonstrate the future budgetary problem:

• Chart of the day: US Federal government spending
• Chart of the day: US federal spending and receipts
• Chart of the day: projected US government deficit
• Chart of the day: US national debt
• Chart of the day: US Federal Deficit

Fiscal Year 2007: before the bubble burst

What becomes apparent if you look at these charts is that the United States faces a very large fiscal problem under present tax and spend scenarios given likely future growth outcomes.  In plain English: there is a gigantic hole in the U.S. Government’s balance sheet under normal GAAP accounting.  Let’s look at the balance sheet for 2007 because John Williams at ShadowStats.com has already done the analysis and this was a budget that was created before the housing bust was apparent.

On December 17th, The U.S. Treasury released the annual Financial Statements of the United States Government for fiscal year 2007 (year-ended September 30th), prepared using generally accepted accounting principles (GAAP), audited by the General Accountability Office (GAO) and signed off on by Treasury Secretary Paulson.

The statements still show that the federal government’s fiscal woes continue to careen wildly out of control. Based on my estimate of the 2007 GAAP-based deficit exceeding $4.0 trillion (see discussion below), the term "out of control" is not used loosely. If the government were to raise taxes so as to seize 100% of all wages, salaries and corporate profits, it still would be showing an annual deficit using GAAP accounting on a consistent basis.

The number $4 trillion is the number you would see if the U.S. Government reported its accounts as businesses do on an accrual basis using Generally Accepted Accounting Principles (GAAP). GAAP accounting means that all promises i.e. future pension and healthcare spending must be accounted for on today’s financial statement.  If we did not do accounts on an accrual basis, then many companies would go bankrupt when the unaccounted for future liabilities not addressed on their balance sheet came due.  In the case of General Motors, future liabilities for pensions and healthcare are a large part of their financial problem.

The U.S. government reports its accounts on a cash basis.  That means it matches the cash that comes in the door against bills it must pay in that current year.  This is how small businesses run their accounts.  Under this methodology, the accounting looks very different.  Here is how George W. Bush summed up his 2007 budget deficit (Fiscal Year 2007 Overview).

For 2007, the Budget forecasts a decline in the deficit to 2.6 percent of GDP, or $354 billion. By 2009, the deficit is projected to be cut by more than half from its projected peak to just 1.4 percent of GDP, which is well below the 40-year historical average deficit.

As last year’s dramatic increase in receipts demonstrates, the most important factor in reducing the deficit is a strong economy.

His last words are well-placed because we know that the course of events was quite a bit different than was predicted in this budget.  In sum, there is a large hole in the government’s accounts that an order of magnitude larger when you use GAAP.  This was true even before the housing bubble and makes plain that the U.S. government’s budgetary problems are structural. (Also see Wikipedia’s entry on the 2007 Budget. It gives a good overview)

Honing in on the problem: Medicare and Social Security

The problem, of course, is Medicare and Social Security.  Looking again at 2007 and the composition of spending (Chart of the day: US federal spending and receipts), one can see that 40 percent of the budget went to spending on Medicare/Medicaid and Social Security.  This percentage will rise inexorably as the Baby Boom generation retires starting in 2011.  If you look at the government’s own accounts (PDF), they tell the story.  Notice the over $40 trillion in unfunded liabilities associated with Medicare/Medicaid and Social Security

How this fits in to today’s debate

These unfunded liabilities fit into today’s policy debate in that reducing Social Security and Medicare benefits would not only eliminate structural budgetary problems, it would also allow Obama to demonstrate fiscal prudence – even while the present deficit balloons.  I guarantee you that Summers, Geithner, Orszag and Romer are on to this and that this is a debate of huge importance inside the Administration.  I anticipate we will see a Social Security/Medicare change under Obama.  The question is how would this change be achieved.  There are four possible ways:

1. Raise Taxes.  To satisfy liberals, who have become more and more worried about Obama, one could see the Administration allowing Congress to eliminate the payroll tax exemption on some of the income earned above $100,000.  If you listened to Joe Biden on Meet the Press on Sunday, it was clear that the President is going to make pragmatic decisions on budget issues and will not veto bills unless their totality is  “wrong for America.”  Translation: he would not necessarily add in a payroll tax increase himself, but he would sign a bill that has one if he could tout this as a tax increase for the rich and stress the fact that the middle class would see no rise in the income tax.
2. Reduce Benefits. Another way to reduce entitlement liabilities is to reduce the net benefits. Obviously raising tax on benefits for those earning a specific threshold outside income would be the taxation way of achieving net benefit reduction.  Again, this would be touted as a tax on the rich.  Cutting benefits outright is a non-starter and political suicide. On Meet the Press, Biden was unwilling to dismiss the potential that the President would sign a Universal Health Care bill that taxed health care benefits.  I think this is a crucial statement regarding  both UHC and entitlement programs.
3. Reduce Coverage. Because medical care has advanced hugely over the last decades, we are now able to keep patients alive (and often healthy) who would have died years ago.  As a result, medical costs have skyrocketed.  The simple fact is that using all available medical science to treat patients costs a lot of money.  This makes attractive the potential cut of Medicare coverage i.e. reducing which procedures and care will be paid for.  I expect, this is another option that is going to be explored.
4. Delay Benefits.  This is my preferred option. The average lifespan of Americans has increased tremendously particularly since Social Security was enacted.  As a result, retirees today receive many more benefits than they did in the 1940s. (“The 2000 U.S. census revealed that the number of Americans over 65 years old has more than doubled since 1950 and increased from 31.1 million to 34.91 million from 1990 to 2000, largely because of continuing advances in medical science and nutrition.” – MSN Encarta Encyclopedia).  These demographics are killing the U.S. and they are going to get worse.  Given relatively low fecundity rates among young American women, they will get worse still. Therefore, the U.S. government is going to have to raise the age at which Americans are eligible for Social Security.

In sum, while I prefer a delay of benefits, all of these ways of reducing entitlement benefits are going to be researched and suggested.  The Obama Administration does seem willing to address these issues, potentially as a quid pro quo for another round of stimulus.

An alternative view

I would be remiss if I didn’t present you with links to the other side of this argument.  This is handled capably by Dean Baker of the Center for Economic and Policy Research, one of the few economists to have spotted the housing bubble early (see his 2002 article here).  In April, he penned a piece at Andrew Cockburn’s site counterpunch.org called “Hands off Social Security.”  I suggest you read this for an alternative view.  In addition, I would also recommend his book with CEPR colleague Mark Weisbrot “Social Security: The Phony Crisis.” 

One reason Baker is so vehement in his arguments is that he knows ideologues are orchestrating a battle against social security in order to deprive you of your retirement benefits.  Remember the 2004 Bush plan to privatize Social Security?  What lies underneath this is a desire to give the financial services industry even greater power by allowing it to control the funds for Social Security. So, be forewarned.

In the end, while I have great respect for Baker – and agree with many of his arguments, I disagree with his conclusions (summarized here in his opposition to the film I.O.U.S.A.).  Social Security and Medicare must be changed.

Conclusion

In the end, if you are looking for ways to increase stimulus to prevent a double dip or debt deflation while remaining fiscally prudent, a cut to entitlement programs is going to be necessary.  As I see it, you can’t have your cake and eat it too.

Related posts:

• Don’t underestimate the power of printing money, part 2
• Kuwait: A harbinger of Mideast deficits to come
• The $1 trillion deficit: has Bill Gross gone crazy?
• Fiscal policy limited in the UK and the US
• The inflation-deflation debate

We are in a secular bear market. What this means for many pensioners or for many about to become pensioners is great uncertainty about the quality of their retirement. I expect this uncertainty to translate into anger regarding the move from defined benefit pensions to defined contribution pensions. Whether a policy response results depends on how stocks do over the next few years. Nevertheless, in my estimation, we are about to understand that human psychology and defined contribution plans are at loggerheads.

My thinking on this subject is influenced by my familiarity with the theory called Maslow’s hierarchy of needs. If you recall, the Great Depression left many feeling insecure and it illuminated the lack of a social safety net in the United States in particular. A basic “safety need” was going unmet. I see the present period of economic uncertainty ending in the same kind of angst as the realization that many have not provided adequately for retirement sinks in.

The following Wikipedia explanation of this hierarchy fills in the salient points (I have bolded the most important sections:

Maslow’s hierarchy of needs is predetermined in order of importance. It is often depicted as a pyramid consisting of five levels: the first lower level is being associated with Physiological needs, while the top levels are termed growth needs associated with psychological needs. Deficiency needs must be met first. Once these are met, seeking to satisfy growth needs drives personal growth. The higher needs in this hierarchy only come into focus when the lower needs in the pyramid are met. Once an individual has moved upwards to the next level, needs in the lower level will no longer be prioritized. If a lower set of needs is no longer being met, the individual will temporarily re-prioritize those needs by focusing attention on the unfulfilled needs, but will not permanently regress to the lower level. For instance, a businessman at the esteem level who is diagnosed with cancer will spend a great deal of time concentrating on his health (physiological needs), but will continue to value his work performance (esteem needs) and will likely return to work during periods of remission.

The crux of Maslow’s theory is that human beings become nearly incapable of focusing on higher level needs when basic needs like financial security are wanting. A bear market and severe recession, as we are now experiencing today, create huge levels of financial insecurity that did not previously exist. And that is going to mean a sea change in the way people behave.

We are seeing house prices decimated and stock prices have fallen by half for many. These events will put finances into focus for baby boomers, the first of whom will retire in two years. In my view, the switch from defined benefit to defined contribution will be seen as a major reason for the lack of security. The following snippet from an MSN Money article brings this point home.

After watching her account drop 44% last year, Kristine Gardner, a 35-year-old information-technology project manager in Longview, Wash., feels no sense of security.

“There’s just no guarantee that when you’re ready to retire you’re going to have the money,” she says. “You either put it in a money market which pays 1%, which isn’t enough to retire, or you expose yourself to huge market risk and you can lose half your retirement in one year.”

Many retirement experts have come to a similar conclusion: The 401(k) system, which has turned countless amateurs like Gardner into their own pension-fund managers, has serious shortcomings.

“This is the biggest test that the 401(k) plan has seen to date, and it has failed,” says Robyn Credico, the head of defined-contribution consulting at Watson Wyatt Worldwide, noting that many baby boomers are ready to retire. “We’ve put people close to retirement in a very challenging position.”

The most obvious pitfall is that 401(k) plans shift all retirement-planning risks — not saving enough, making poor investment choices, outliving savings — to untrained individuals, who often don’t have the time, inclination or know-how to manage them.

These are issues that 35 year-olds have time to deal with. But, if you are 58, things look a lot different. Now, during the past bull market, employers in the G-7 often switched from defined benefit to defined contribution pension plans, effectively giving individuals both the responsibility and risk of investing for their future. The timing could not have been worse for those 58 year-olds; they came of age in a time when markets rose and an illusion of adequate retirement savings was created by a bull market. What should be clear is that bull markets and defined contribution don’t mix. Basic human psychology (the recency effect) will see a never-ending bull market, leaving individuals short of savings. And, that’s where Maslow’s hierarchy steps in.

Not saving enough has always been a big problem for 401(k) participants. The tough economic times are exacerbating that tendency. In 2007, the median account balance for 55- to 64-year-olds in defined-contribution plans such as 401(k)s administered by Vanguard was just $60,740, and only 10% of all participants saved the maximum dollar amount in the plans.

Over the past year, about one in five workers age 45 or older has stopped contributing to a 401(k), IRA or other retirement account, according to a recent survey commissioned by the AARP, an advocacy group for older people.

Peg Kelley, a 58-year-old small-business consultant in Watertown, Mass., didn’t contribute anything to her 401(k) last year. Instead, she’s focused on paying down credit-card debt and building an emergency fund in case the bad economic times turn worse. She’s also still paying off an $8,000 loan she took from her 401(k) plan four years ago to buy a new car.

Afraid of reliving the dot-com market meltdown, which knocked $100,000 off her retirement savings, she moved her entire 401(k) from diversified stock and bond holdings into cashlike investments early last year.

“I’m not going to get rich on my 401(k),” she says, “but also don’t want to get poor because of it.” She had hoped to retire early, but now she figures she won’t quit work before age 65.

As I see this downturn lasting a very long time, even this kind of thinking will not go far enough in dealing with the economic insecurity to which we have all been exposed. Going forward, I see the whole idea of defined contribution coming under attack as people realize that huge financial burdens have been transferred from corporations to individuals. This conversation will take on a populist tone because I think many will notice that the owners of capital have become much richer over the preceding generation, while ordinary workers have not. With the illusion of wealth now gone as paper wealth declines, many will come to realize that we have just seen a massive transfer of risk.

Will this result in increased forced savings? Perhaps. After all, It is now evident to all that defined contribution pension plans work in good times but are woefully inadequate in bad times. I see this as the basis for some fundamental change. With that in mind, I say that if we are to follow the New Deal in any regard, it should be to increase the economic security of average citizens in a time of crisis. When politicians talk about change, this is where change must begin.

Sources
Maslow’s hierarchy of needs – Wikipedia
Do 401(k) plans still make sense? – MSN Money

Related posts:

• Kass: Bearish on equities
• Chrysler: bulls make money, bears make money, pigs get slaughtered
• The market is moving. You should be too.
• Pro-cyclical and pro-secular
• Partial recovery will mean new lows for stocks

An issue that has received scant acknowledgment in the media is the likely hole in pension funds books resulting from the recent rout in shares. Pension funds must invest the money they receive today in order to provide pensioners funds tomorrow. The problem is that pension funds have been overestimating the likely returns for years and now that we have hit a rough patch in the economy this poor actuarial accounting is about to catch up with them.

Volatile markets have saddled U.S. companies with a $409 billion deficit on pension plans, reversing a $60 billion surplus a year earlier, and will cut into earnings in 2009, consulting firm Mercer said.

As of December 31, pension plans among members of the Standard & Poor’s 1500 had $1.21 trillion of assets and $1.62 trillion of liabilities, Mercer said in a report released on Wednesday. At the end of 2007, pension plan assets totaled $1.66 trillion and liabilities totaled about $1.6 trillion, Mercer said.

The S&P 1500 is a broad portfolio representing large-cap, mid-cap and small-cap segments of the U.S. equity markets.

The shortfall suggests that more companies will have to pump cash into their pension plans to ensure they can meet their commitments to retirees.

Mercer estimated pension expenses will increase to about $70 billion this year from $10 billion in 2008, reducing overall profitability by about 8 percent.

“The decline in funded status will be capitalized and reflected in corporate balance sheets for many companies,” Adrian Hartshorn, a member of Mercer’s financial strategy group, said in a statement.

He said this will reduce balance sheet strength and could affect companies’ ability to make capital expenses, meet loan covenants and preserve their credit ratings.

Edward here. The fact is that pension funds have systematically used excessive projected returns in order to avoid paying into the fund. In fact, pension funds have been a large source of earnings for most companies.

How does this work? Say, you are an international company called American-British Consolidated. Each year, your workers contribute $100 million to their pension plan. In return, they are guaranteed a certain payout for life. This is called a defined benefit plan — something companies now loathe because they are on the hook for payouts. So they increasingly switch to defined benefit plans, or so called 401K’s.

Now, under Generally Accepted Accounting Principles (GAAP), one must calculate an estimated payout schedule and its net present value after subtracting the employees’ $100 million contributions All of this is complicated and requires assumptions on average life expectancy as well as average pension fund return.

Here’s the thing: if you run the numbers and they come too far short, you MUST cough up more money right now, today, to make the fund whole. What to do? Make optimistic assumptions, silly. If the fund returns 10%, that makes a future payout much less onerous than if the fund returns 7.5%. Everyone knows that.

Only during bear markets do these tactics come to light. Witness the following proposal from 2001 during the last bear market, still accessible on General Electric’s site (I have bolded the most important bits):

The Communications Workers of America Pension Fund, 501 Third Street, N.W., Washington, D.C. 20001-2797 has notified GE that it intends to submit the following proposal at this year’s meeting:

“Resolved that the stockholders request that the Board of Directors take the steps necessary to adopt a policy that future executive compensation will be determined without regard to any pension fund income, so that the compensation of senior executives will be more closely linked to their performance in managing the business.

“Supporting Statement: Accounting rules require the Company to include gains on the assets in its pension fund in calculations of income, even though no money is transferred to the Company. This distorts the principle of pay for performance because the Company relies on net earnings and earnings growth in determining the compensation of executives.

“GE reported $1.7 billion in pension income in 2000. According to a recent study by Credit Suisse First Boston (CSFB), this is the second largest amount reported of all companies in the S&P 500. This pension income amounted to 9.4% of GE’s reported pre-tax income for the year.

“While the impact of earnings calculations may vary, GE’s top five executives were given cash bonus awards of $23.7 million in 2000. They were given restricted stock units worth $89 million. They were given long-term incentive awards contingent on financial performance over a three year period, and were paid $58 million pursuant to the contingent awards that were made in 1997. In addition, they were given options with a potentially realizable value of $422 million if future earnings permit GE stock to appreciate at an annual rate of 10 percent over the option term.

“Executive compensation ought to be based on performance. It should not be distorted by ‘pension income,’ because that item of income does not represent money the Company has actually received, and does not reflect the operational performance of either the Company or its executives.

“As Business Week reported on August 13, 2001, when companies ‘are inflating earnings with income from pension plan assets, … their [reported] results look better than what’s really happening with their business.’ For this reason, a Morgan Stanley Dean Witter report declares that ‘net gains from pension assets do not deserve the same valuation … as true operating income.’

“A related concern, according to The Wall Street Journal (June 25, 2001), is the possibility ‘that companies can use pension accounting to manage their earnings by changing assumptions to boost the amount of pension income that can be factored into operating income.’ According to Business Week, ‘Companies can not only play around with the expected rate of return on assets but also with the value of the assets themselves.’ They can also boost pension income at the expense of employees and retirees by reducing anticipated benefits or withholding improved benefits.

“CSFB identifies several companies that ‘increased their expected rates of return on plan assets in 2000 even though their actual returns on plan assets declined.’ While such increases may well be an appropriate exercise of discretion, the proposed policy would reduce any temptation that senior executives may have to ‘use pension accounting to manage earnings’ for the purpose of increasing their own compensation.”

Your Board of Directors recommends a vote AGAINST this proposal.
This proposal requests the Board to make future executive compensation determinations without regard to reported pension fund income, purportedly to link more closely executive compensation to business performance. As discussed in the Compensation Committee Report at pages 16-19 (Compensation Committee Report), executive compensation is already closely linked to the performance of internal business units and to the appreciation of GE stock – which in turn is linked to GE’s overall business performance. Because your Board believes that senior executive compensation is already closely linked to business performance, and therefore to the long-term interests of the share owners, your Board believes this proposal is unnecessary and recommends a vote against the proposal.

Now, here’s the great thing about pension accounting. If your numbers are good enough, not only do you avoid a shortfall, you actually receive a windfall profit. Just as shortfalls must be topped up, windfalls must also be recorded and fall proportionately to the bottom line of the company. You will notice, however, these are phantom profits because they are non-cash items.

At issue with GE in 2001 was the fact that General Electric received nearly 10% of its earnings from fictitious, non-cash based net contributions from its pension fund. These profits boosted the bottom line and helped executives make a lot of money as their pay was directly and indirectly linked to the company’s profit. Some shareholders did not like this, so they issued the proposal quoted above. Of course, as you saw, the Board of Directors recommended shareholders vote against the proposal. So, the proposal failed.

Now that we have seen another massive drop in market returns, proposals like this are likely to resurface — especially given the $400 billion shortfall that Mercer foresees. We shall see if these new proposals have any more success than the ones in 2001 and 2002.

Source
U.S. companies face $409 billion pension deficit: study – Reuters
Share Owner Proposal No. 6 – GE Annual Report 2001

Related posts:

• Lehman pension shortfall is a foreshadowing
• JPMorgan’s $29 Billion windfall
• What Home-Loan Banks reveal about the effects of mark-to-market
• Chart of the day: social security and medicare
• FASB: Mark all financial assets at fair value

Apparently Lehman not only failed, it left a gaping hole its accounts. The UK pension scheme is missing £100 million. UK regulators certainly need o investigate whether the shortfalls are the result of criminal activity.

However, pensions are certainly something lurking in the background that I have failed to discuss. As the stock market falls and credit writedowns increase, pension and mutual fund investment portfolios will suffer.

This is yet another hidden cost of the credit crisis which has yet to make an impression. Expect to hear more about this after the initial shock of the crisis recedes.

Lehman Brothers in Britain collapsed with a mammoth £100 million black hole in its staff pension fund, it emerged last night. The deficit means that many former staff in Britain may not have their retirement promises met in full. Trustees of the fund wrote to the Pension Protection Fund (PPF), the industry lifeboat, last week seeking assistance, as The Times revealed on Saturday.

The size of the shortfall surprised experts. The £100 million deficit, confirmed last night by Pricewaterhouse-Coopers, the administrator, compares with one unconfirmed figure for total assets in the fund of only £180 million.

There could be only 50p or less in the pot for every £1 of pension promised.

The PPF is financed by all 7,800 final-salary pension schemes in Britain. The failure of Lehman to keep the pension scheme topped up means 12.5 million Britons may have to pay a higher PPF levy in future.

Under the PPF, pensions up to £28,000 are paid in full. John Ralfe, a pensions consultant, said: “One way or another, the members of Lehman’s UK pension scheme will lose out.”

Members of the scheme include 1,500 Lehman employees in London until last week, as well as 2,400 “deferred members”, former employees, who left the bank but continued to entrust the scheme with their benefits.

Source
Lehman Brothers reveal £100m pensions hole – Times Online

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• Dick Fuld feels horrible about Lehman collapse
• Lehman Brothers to post $3 bln loss; sets $6 bln stock sale
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