Are the Big Three's Pensions in Jeopardy?

Charles Millard, Director of the U.S. Pension Benefit Guaranty Corp (PBGC) raised his concerns in an interview with the Wall Street Journal:

The government agency that protects pensions for Americans is raising fresh concerns about the repercussions if one or more of the U.S. auto makers were to collapse, saying 1.3 million workers and retirees could see their pensions slashed if that were to happen.

The head of the U.S. Pension Benefit Guaranty Corp. acknowledged in an interview that General Motors Corp., Ford Motor Co., and Chrysler LLC have well funded pensions according to the standard accounting rules applied by the Securities and Exchange Commission.

But by the PBGC's measures, the pension funds of Detroit's Big Three would be underfunded by as much as $41 billion if one or more of the auto makers went under and killed their pension plans, PBGC Director Charles E. F. Millard said.

"An awful lot of people seem to think these plans are well funded or overfunded," Mr. Millard said in an interview. "Each of these plans is significantly underfunded [and] in three years I don't want people coming back and saying, 'How come the PBGC never told us that?'"

This concern adds fodder to an ongoing debate over what the government's role should be in helping the struggling auto makers from collapsing as the trio face a difficult road in 2009. Some people argue a bailout for Detroit would be a good use of taxpayer money, and that holding back financial aid would result in a collapse, and force the government to spend billions shoring up the companies pension plans.

Mr. Millard estimates that the three auto makers only have enough money in their pension funds to cover only 76% of the pension obligations they have made, if they terminate the pension plans. GM's plan is estimated to be $20 billion, or about 20% underfunded, while Chrysler's plan is 34% underfunded, leading to a $9 billion-plus shortfall, the agency said. Ford's funded ratio is not publicly available, but the company's pension plans are likely running at a $12 billion deficit.

About $13 billion of the estimated $41 billion shortfall would be covered by the PBGC, Jeffrey Speicher, an agency spokesman, said. The remainder represents benefits that PBGC could not pay because of limits set by Congress, and those benefits would be lost by employees and retirees.

If all three companies were to terminate their plans, the PBGC's current deficit would double, as would the number of people receive pensions from the agency.

GM spokeswoman Julie Gibson said the auto maker is in compliance with pension accounting, its pension are adequately funded and it doesn't have any near-term funding obligations. The company could make more contributions to its pension plans in coming years, but it also holds various credits with the Internal Revenue Service that could help fund the pension plans . The auto maker will report an update on its pension status when it releases annual report filing in coming months.

When GM last gave a year-end update on its pension funds, the funds covered more than 400,000 retirees and were overfunded by $18.8 billion. But in November, GM said its plan for hourly workers was underfunded by $500 million because of restructuring expenses. Its plan for salaried employees remains overfunded by at least $500 million. GM, like its rivals, have relied on the pension funds to help cushion its restructuring costs, and that has contributed to a quick deterioration in the health of the funds.

"In regards to our pension plans, we take our obligations very seriously, managing our plans with integrity and prudence even during difficult times," Ford spokesman Bill Collins said. The auto maker's most-recent numbers suggest its U.S. plans 103% funded, or carrying a $1.3 billion surplus with $45.8 billion in plan.

Mr. Collins said Ford will update its funding status when it releases its annual report.

A Chrysler spokeswoman did not return phone calls.

The PBGC steps in to take over failed pension plans, and protects the retirement savings of almost 44 million Americans. Because it is charged with insuring pensions in the event that a business or organization terminates pension plans, the PBGC monitors not only the SEC's accounting requirements, but also attempts to estimate how well-funded the plans would be if they were terminated in a liquidation or some other restructuring.

In recent months, as the cash reserves of GM, Ford and Chrysler have been drained due to slow auto sales and heavy restructuring obligations, concerns over the viability of these auto makers has skyrocketed.

The White House last month issued a $17.4 billion loan package to GM and Chrysler, but that money is only expected to last until the end of March. At that point, if the two car companies can prove they are on the path to sustainability, they may be able to successfully argue for more funding or be able to tell the government that they have stabilized to the point where they don't need government funding.

In early November, I wrote a comment, What's Good for GM's Pension Fund?, questioning GM's pension fund investments in alternative asset classes like real estate, private equity and hedge funds. I ended that comment with this warning:

I also wonder about the state of GM's pension fund. In particular, as I recall that arrogant and pompous statement uttered over 50 years ago, I wonder if what's good for GM's pension fund is good for American pension funds?

Unfortunately, I get this eerie feeling that GM's pension fund is not as solid as some make it out to be and that it too may be running on fumes.

Clearly there is a lot at stake here and workers at the Big Three have enough on their mind without worrying about whether they'll lose their pension benefits.

The car makers, however, are not the only ones struggling with soaring pension deficits. Corporations that had been expecting to receive some pension relief by lowering their plans' costs ended up with a year-end lump of coal last month when a key factor used to calculate their liabilities turned sharply against them:

The discount rate that is used to determine the present value of a company's pension liabilities took a steep fall south in the final weeks of 2008, compounding the problems facing companies that were already dealing with declining asset values in their retirees' plans. The change in the rate was so swift and so large that several Wall Street veterans said they couldn't recall a similar episode during their careers.

"What we observed in the last two months of 2008 was probably the most precipitous drop in the discount rate in such a short time. It exceeded what you might see in a year," said Ethan Kra, chief retirement actuary at consulting firm Mercer. "It's unprecedented in my experience, and I've been in this business 30-plus years."

The Citigroup Pension Liability Index, a widely used discount rate benchmark, dropped 125 basis points in December alone, finishing the year at 5.87%, a slide that followed on the heels of an 89-basis-point drop in November. Because the index made most of its gains in the early fall, it ended the year down only 61 basis points from December 2007. But that decline will still result in an average pension plan liability increase of about 9% to 10%, estimates Kra.

Companies must use whatever the discount rate is at the end of their fiscal year to calculate their current pension liabilities, or costs, and those liabilities climb as the rate falls. Because so many companies end their fiscal year with the calendar year, the year-end rate will affect a large proportion of U.S. corporations' pension expenses.

The discount rate drop comes at a particularly tough time for corporate pension plans, because the assets they own have been beaten down by poor market performance in 2008, leaving many companies with underfunded plans. Now rising liability costs will compound that further.

It's also an unpleasant turnaround because earlier in the fall -- at a time when companies are usually forming financial plans for the coming year -- the discount rate was up for the year. That led some corporations, ranging from mechanical power transmission manufacturer Altra Holdings inc. (AIMC) to Xerox Corp. (XRX), to predict that their liabilities would be eased by the discount rate.

"The interesting question is whether what happened in December will have an impact on 2009 guidance companies gave as recently as a few weeks ago," says Caitlin Long, head of the pensions solutions group at Morgan Stanley.

Altra Vice President of Finance Todd Patriacca says executives know that the discount rate has worsened since it last gave guidance to investors in November, but the company hasn't finished analyzing the impact it will have on its pension obligations. Xerox declined to comment, citing its quiet period until earnings are announced in two weeks.

The discount rate is based on the yields of corporate bonds rated AA or better. The reason it fell so rapidly in December, say analysts, is that rating agencies downgraded some higher-yielding AA corporate bonds from the financial services sector, including those of Citigroup Inc. (C) and Goldman Sachs Inc. ( GS).

The effects of rising liabilities and declining assets in any given year are absorbed by U.S. corporations the following year, so the hurricane that ripped through pension plans in 2008 will start showing up in 2009. That's when underfunded pensions begin to weigh on balance sheets and compensation expenses, triggering debt covenant changes, higher borrowing costs and lower earnings.

There is no doubt in my mind that underfunded pensions will weigh down the balance sheets of many U.S., Canadian and global corporations in 2009 and beyond.

As far the Big Three bailouts, my hunch is that if you factor in their underfunded pensions, the total bailout package will soar by several billions. And if you look at the state of Corporate America's pension plans, even more bailouts will be required to shore up underfunded pension plans in the near future.

My advice to President-elect Obama is to quickly create a Secretary of Pensions (apart from the Secretary of Labor) that will oversee a task force examining the health of private and public pension plans.This task force should recommend a sound course of action to make sure that hard working people can rest assured their pensions are safe and sound.

If President Obama ignores the pension problem, the crisis will get worse, jeopardizing the pensions of millions of Americans.

*** Update****

One professor of economics wrote me the following:

Hi Leo, the US Secretary of Labor is legally the Secretary of Pensions, because the Pension Guarantee body is part of his department. In case of the Big Three, many will lose their employment permanently, even if the corporations survive. Those will have to settle their pension accounts when their jobs cease, thus the part of the actuarial calculations based on experience with historical quit rates will have to be re-done. What that does, depends on the effective accrual rates during the later years of employment. All this is a very long way of saying that I do not know. What I do know, is that the appointment of new officials does not create new resources, if that should be required.

Fair enough, we might not need a new appointment focusing just on pensions, but I hope President Obama's Secretary of Labor, Hilda Solis, will place pension reforms on the top of her priority list.

Speaking of pension reforms, Bill Tufts of WB Benefit Solutions creator of the blog Fair Pensions for All, brought to my attention an opinion letter written by New York City mayor Michael Bloomberg published in the New York Post:

IF there is any silver lining to the in creasingly dark storm clouds hovering over our economy, it's that it creates an opportunity for action on problems that have been ignored for decades.

In Washington, there is growing talk of investing in the infrastructure our nation needs to remain competitive in the global economy. And in Albany, Gov. Paterson has proposed legislation to rein in pension costs - which have ballooned in recent years and are now driving potential tax hikes and layoffs.

Especially in these tough times, taxpayers deserve to know that government is operating as efficiently as possible. But right now, New York City is spending so much money on pensions - $6.3 billion, a 10-fold increase from the $695 million we spent in 2000 - that we have far less to spend on core services, such as public safety, education, parks and senior centers. That defies common sense, and it's hurting our city.

For instance, the city now has to spend more money on pensions and fringe benefits for firefighters than we pay in salaries for firefighters. That's one reason we've had to delay the hiring of a new class of firefighters.

All in all, letting pension costs continue to balloon harms taxpayers and makes recessions like the one we are in now even more difficult to climb out of.

Passing pension reform won't be easy, but this year may be our best hope. The governor's proposal, which our administration helped develop and strongly supports, would create immediate savings that would reach $540 million annually after 20 years. The proposal has two crucial parts.

The first part would eliminate for future employees two pension sweeteners that the state enacted during the boom years of the last decade. One sweetener allows employees to stop contributing to their pensions after 10 years of service; the other expands pension eligibility by reducing the required number of years of city service from 10 to five. Together, they have cost the city and state $1.8 billion since 2000.

Current employees will continue to enjoy these benefits, but as the state and city grapple with huge deficits, common sense says that all future hires should do their part once again. That means contributing to their pensions throughout their careers - as is standard practice in the private sector - and serving 10 years before becoming eligible for pension benefits, rather than five.

The second part of the governor's plan would modernize a pension system that hasn't been updated in 25 years and no longer makes sense, given longer life expectancies. Right now, uniformed city workers can retire after only 20 years of service. That means government is paying full pension benefits to many people whose retirements begin in their early 40s (although most continue working full-time in other jobs) and stretch for more than 40 years.

I believe that - again, only for future hires - we should raise the number of years required for a full pension for uniformed workers from 20 to 25, and provide retirement benefits to these future employees only after they reach 50.

New York City can't continue to offer the next generation of workers gold-plated pension benefits that even the most successful companies can't afford today.

The Big Three automakers offer some of the best pension plans in the private sector, yet even they cannot match the generosity of New York state government. And Detroit's expensive pension plans are part of the reason why the automakers are teetering on bankruptcy and pleading for a bailout in Washington.

New York went down that road in the 1970s, and we can't afford to go back.

Back then, thankfully, city and state leaders came together to deal with the structural causes of the fiscal crisis, adopting long-term measures to address them, including pension reforms. In fact, elected officials have adopted pension reforms at various points over the past four decades, just not in the last 25 years. The time has come again.

We can't wait for the specter of bankruptcy to threaten us once more. By proposing pension reforms, Gov. Paterson is demonstrating a quality all too rare in politics - courageous leadership. I look forward to working with him to pass his plan in the Legislature.

Pension reforms are happening all around the world and they will undoubtedly be a source of tension between politicians looking to cut pension costs and unions looking to maintain their pension benefits.

All the more reason for the new President and his new Secretary of Labor to start taking the pension crisis more seriously by implementing comprehensive reforms for both public and private pension plans that will introduce more transparency and more accountability into the pension system.