Is Pension Smoothing the New Normal?

Vipal Monga of the Wall Street Journal reports, Welcome to the World of 'Pension Smoothing':

A government accounting maneuver to pay for road repairs, subways and buses will allow many U.S. businesses to delay billions of dollars in pension contributions for retirees.

President Barack Obama on Friday signed a $10.8 billion transportation bill that extends a "pension-smoothing" provision for another 10 months. In short: companies can delay making mandatory pension contributions, but because those payments are tax-deductible some businesses will pay slightly higher tax bills, which will help pay for the legislation.

Companies with 100 of the country's largest pensions were expected to contribute $44 billion to their plans this year, but that could be slashed by 30% next year, estimated John Ehrhardt, an actuary at consulting firm Milliman.

International Paper Co., for example, had planned to set aside $1 billion by 2016 to fund its $12.5 billion U.S. defined benefit plan. The paper company says it now expects to funnel that money into other projects, including share buybacks or investments in new plants.

"It means more cash for us," says Chief Financial Officer Carol Roberts.

But the accounting tactic is controversial. The government's moves could undermine its own efforts to shore up the pension system. Some worry about the strain it could put on the government agency tasked with protecting the retirement of 44 million workers.

"To use the federal pension insurance program to pay for wholly unrelated spending initiatives is just bad public policy," said Brad Belt, former executive director of the Pension Benefit Guaranty Corporation, the government's pension insurer. "It has adverse implications for the funding of corporate pension plans."

Companies have struggled to keep up with mounting pension bills since 2008.

The present-day value of those promises increases when interest rates decline. Currently, the largest pensions have a $252 billion funding deficit, which has increased by $66 billion since the beginning of the year, according to Milliman.

The accounting maneuver was introduced in Congress's last highway bill in 2012, and was backed by large business groups, such as the Business Roundtable. The new bill, which expires in May, will extend the method.

The bill essentially allows companies to base their pension liability calculations on the average interest rate over the past 25 years, instead of the past two. The 25-year average is larger, because interest rates were much higher before the financial crisis.

The accounting technique doesn't actually reduce companies' obligations to retirees. Instead, it artificially lowers the present-day value of future liabilities by boosting the interest rate companies use to make that calculation.

The risk is that pension smoothing will ultimately increase corporate pension deficits by encouraging executives to delay payments, says the Congressional Budget Office. For instance, more companies could default on their obligations to retirees.

PBGC executives and labor unions aren't worried about the impact of the new transportation bill. "Even with this smoothing provision, we'll be in a vastly better position," says Marc Hopkins, an agency spokesman.

The financial health of the government's PBGC is improving. The agency has mapped out different scenarios of economic growth and estimated its fund to cover defaults will have an average deficit of $7.6 billion in 2023, down from $27.4 billion late last year.

Pension smoothing measures will only add $2.3 billion to its estimated deficit, the agency says.

The AFL-CIO, the nation's biggest labor union federation, says it supports pension smoothing because it reduces volatility to balance sheets, which makes the prospect of offering pensions less daunting.

"We've been supportive of greater smoothing in pension funding generally," said Shaun O'Brien, assistant policy director for health and retirement at the AFL-CIO. "While we would prefer a longer-term permanent change in the rules, we're supportive of the approach Congress has taken."

Under a 2006 law, companies need to make their plans whole over time. Pension smoothing provisions both artificially and temporarily make funding levels look healthier, so companies can lower their contributions.

Exelis Inc., a defense contractor, now expects to cut its pension contributions by as much as $350 million by 2017. Chief Executive David Melcher told investors earlier this month that Exelis would use the money to fund dividend payments, buybacks and to invest in the company.

Some companies will continue to finance their pension plans. Boeing Co. says it won't change its strategy and still expects to make a discretionary $750 million payment to its $68.6 billion in pension obligations.

"All you're really doing is deferring payments," said Jonathan Waite, chief actuary at SEI Investments Co., an asset manager. "It has to be put in someday."

I've already covered the tricky gimmick funding U.S. highways. I personally think it's nuts and terrible public policy but the boneheads in Washington are just as clueless as the boneheads in Ottawa when it comes to pension policy.

Why is it nuts? Think about it. The bill allows companies to base their pension liability calculations on the average interest rate over the past 25 years, instead of the past two. The 25-year average is larger, because interest rates were much higher before the financial crisis.

This allows companies to base their pension liabilities on a higher (smoothed) discount rate, artificially lowering the present value of future liabilities, and giving them the option of not funding their pension plan based on current interest rates. If for any reason rates stay low or go lower, the risk of defaulting on those pension obligations increases markedly, leaving the PBGC (ie. the taxpayer) on the hook to clean up the mess.

And what are U.S. companies going to do with the money they're not contributing to pensions? What else? They're buying back their shares to artificially boost the bloated compensation of their CEOs. You gotta love modern day American capitalism, screw labor any way you can to boost shares prices making CEOs and shareholders (capital) even richer. More food for thought on the 1% and Piketty.

But wait a minute, labor unions are all for it. In fact, as the article states, the AFL-CIO approves of pension smoothing. Do you want to know why? Because it allows them to keep the contribution rates of workers low. They too are smoking hopium when it comes to pension deficits. Both labor unions and managers of America's largest corporations are embracing the pension rate-of-return fantasy, ignoring the very real possibility that their 8% (or 7% or 6%) projection might turn out to be 0%.

Folks, we live in a world of fantasy. Nobody wants to face reality, especially on hot button public policy issues. But America's public pension problem won't disappear and neither will the private pension problem. Sure, companies can scrap defined-benefit pensions altogether or transfer risk to insurance companies but that will only exacerbate pension poverty which is already gripping millions.

And if you work for a company with a pension plan, don’t be surprised if you get an offer soon for a lump sum buyout—a deal where you accept a pile of cash in exchange for the promise of lifetime income when you retire. But be very weary of such pension buyout offers, there are plenty of reasons to hold off on such offers.

Finally, I corrected some figures in my last comment on the dark side of private equity on the prevalence of depression:

My father and brother are psychiatrists and tell me that 10% of the population suffers from depression at one point in their life (life prevalence) and 3% of the population at any given time (point prevalence). And these are people from all socioeconomic backgrounds all over the world. The disease doesn't discriminate between rich and poor but it does strike more women than men.

Luckily most people suffering from depression are easily treated but they have to recognize the signs early and do something about it, especially if it's severe. Employers also need to be informed and provide their employees with resources to battle this and other mental illnesses. Don't ask, don't tell simply doesn't cut it anymore.

The point is depression is a disease that is highly prevalent and individuals and companies need to be aware and deal with it. Just like pension deficits, smoothing over the problem doesn't make it go away.

Below, Assembly Speaker Sheldon Silver gives his view on New York Governor Cuomo's pension smoothing plan, saying ultimately it is up to the state comptroller to decide if it's a good idea.

They can study it all they want but pension smoothing will create more problems than it purportedly solves, risking the retirement security of millions of Americans that are already staring at pension poverty.

Feedback: John Cheeks, a CPA, sent me this comment on LinkedIn:

"I prefer to think that smoothing mitigates the damage done by the artificially low interest rates imposed by PPA'06 and compounded by the Fed's efforts at stimulating the economy." 

I don't buy that the Fed's quantitative easing is keeping rates "artificially low." I happen to think the bond market is worried that deflation is the ultimate endgame, which is why rates keep falling even though the Fed is tapering. Even if policymakers avert deflation, pension smoothing using an average rate of the last 25 years is just wishful thinking, not sound pension policy.