No quick fix for US pensions

The demise of Delphi, Northwest and Delta has intensified concerns over underfunded US pensions. Nadia Damouni reports on whether new laws can shore up the system

The bankruptcy of troubled auto supplier Delphi, hot on the heels of filings from Delta and Northwest Airlines, has brought the fragile condition of the US pensions system squarely back onto the corporate and political agenda. The fear is that these companies could be the next to default on their large underfunded pension plans and dump their liabilities on the already struggling government pension insurance agency, the Pension Benefit Guaranty Corporation (PBGC).

But as America's baby boomer generation approaches retirement age, a yawning asset-liability mismatch in America's pension system has become a major concern for corporates, politicians, unions and regulators alike. The US government reports that corporate pension plans are underfunded by around $450 billion at a time when demands on the system will only increase and contributions decline. The problem is widespread: in a recent report, corporate credit strategists at Bear Stearns showed that out of the 369 companies within the S&P 500 that have pension funds, 311 are underfunded.

By 2030, the US economy will have to support twice the current number of retirees, who in turn will have longer life expectancies, but there will be only 18% more workers. Laurence Kotlikoff, professor of economics at Boston University, argues that the sheer scale of the demographic challenge alone means that in its current form, the US pensions system is "functionally bankrupt".

Holding the baby

Part of the problem is that historically companies have granted generous pension benefits to labour groups in exchange for trade-offs in plant closures, wages and work rules. When those firms file for bankruptcy, the PBGC is then left holding the baby. "The point of bankruptcy is to try and restructure the terms of your debt, try to get your cashflow up, come out of bankruptcy and pay your debtors," says Matthew Scanlan, head of Americas International Business at Barclays Global Investors (BGI) in San Francisco. "Walking away from pension obligations should not be an alternative."

Previous airline bankruptcies have virtually exhausted the PBGC. In the 12 months through September, the agency reported that it remained a massive $22.8 billion underfunded after running a surplus four years earlier. This was in no small part due to the $10 billion pension bill it received from the bankruptcy of United Airlines. The last five years have brought unprecedented losses to the PBGC: total claims from failed pension plans in 2000-2004 came to $14.3 billion, which represents 70% of the total $20.6 billion in claims since Congress set up the insurance programme in 1974.

"This data highlights the unprecedented challenges facing the defined benefit system and the pension insurance programme," says PBGC executive director Bradley Belt. "While most companies should be able to honour their promises to workers and retirees, far too many are reneging on those promises and shifting costs to the pension insurance programme. Congress needs to act on the Administration's proposal to strengthen the defined benefit system and put the pension insurance programme on a sound financial footing."

However Douglas Elliott, president of the Center on Federal Financial Institutions (COFFI) says there is near certainty that the recently bankrupt companies will also terminate their pension plans. In the case of Delta, this would leave the PBGC with a claim likely to approach at least $6 billion, to which Northwest Airlines would likely add upwards of another $4 billion.

"I assume that a distress termination is nearly inevitable because the $6 billion is so large in comparison with total liabilities at Delta," says Elliott. "It is easier to shed pension liabilities in bankruptcy than almost any other obligation."

Delphi's pension plan is underfunded by $10.8 billion, although the PBGC says it will not insure more than $4.1 billion of that amount. But one analyst warns that if Delphi hands its multibillion dollar pension plan to the PBGC, it could set a pattern for other auto suppliers and potentially the Big Three automakers.

John Hendrickson, head of employee benefits and European labour department at law firm McDermott Will & Emery, says the Internal Revenue Code is partly to blame for the current quagmire that has impacted corporate plans, particularly steel, airline and now the automotive industry. Federal tax law caps the amount of contributions that can be made to a defined benefit pension plan, in which employees receive retirement benefits based on their final salary and length of service. "Above the cap and you are hit with an excise tax," he says.

As a result, companies have been discouraged in the past from contributing more than the minimum into their pension funds. "In its wisdom Congress said 'We don't want companies putting too much into a plan because it is a tax haven for them'," says Hendrickson. BGI's Scanlan also points to "stingy contribution policies", in which plan sponsors would look for aggressive investing to help pay for the plan so that they could sponsor it on the cheap or even make a profit off the pension plan with its income.

Pension revival

Some efforts have already been made to revive corporate pension plans, but thus far to little effect. The Pension Funding Equity Act, passed in April 2004, provided some temporary pension funding relief and reduced the minimum contribution requirements for 2004-2005 by allowing the discount rate, the rate used for determining the present value of future cashflows, to be based on three investment-grade bond indices. When this rule expires in 2006, discount rates will revert to the 30-year Treasury rate. The contribution savings are estimated at over $80 billion for the two years of the act, but it is likely that lacklustre markets did not provide the necessary returns to cover the funding shortfall.

Defined benefit pension plans have suffered the largest strain with growing funding shortfalls as a result of the decline in equity prices and the trend of sharply lower interest rates since 2000. Used by more than 40 million American workers, defined benefit schemes are increasingly regarded as a dying feature of old-economy companies: most plans are now closed to new members and many may soon become closed to existing members. Some traditional defined benefit plans are being converted to cash balances.

The most popular alternative is the defined contribution structure. Here, the annual contribution to the plan is fixed, but the final benefit is not; this is dependent on the performance of the assets in the fund. However, Barton Waring, head of the client advisory group at BGI, calls defined contribution plans "tremendously inefficient generators of investment returns". In a defined contribution plan the employee bears the entire investment risk rather than having it spread out over a pool of investors and assets. By contrast, Waring describes defined benefit plans as highly effective vehicles for delivering retirement income based on lower management fees, professionally managed investment strategies and built-in annuitisation.

Yet, others encourage the transition to defined contribution. Jonathan Rosenthal, a partner at California-based investment bank Saybrook and a lead banker in several high-profile corporate restructurings, says defined contribution plans allow the employee to select what level of risk volatility they are willing to accept. He says: "Defined benefit puts the government in the position of insuring market risk. If you want to mitigate risk, the private sector offers every flavour, from triple-A down. Why shouldn't employees be able to select the flavour they want based on the kinds of risk and returns they are willing to shoot for?"

Hendrickson and COFFI's Elliott disagree with both views. They recommend a combination of the two types of plan as the most efficient approach. "The defined benefit can provide a base level of benefit that isn't variable and then you supplement that with the defined contribution," says Hendrickson.

However, Hendrickson adds that from an actuarial standpoint, a well-structured defined benefit pension plan is the most efficient way for a corporation to provide retirement benefits to its employees. One reason is that the employer will have situations where not everybody will live their life expectancy and so they will recapture monies to be used for other people in the plan.

In recent years, defined benefit pension plans have also broadened their strategies to redress the mismatch between assets and liabilities. Alistair Lowe, head of global asset allocation at State Street Global Advisors in Boston, says pension funds are learning to manage assets so that the returns are greater. "Many pension funds in the US are underfunded. To fill that gap, you have to try and earn a positive return faster than the discount rate," he says.

Although most plans still remain heavily invested in equities, Ron Papanek, market strategist at consultancy RiskMetrics Group in New York, says that pension plans are much more comfortable using more complex structures in a bid to diversify the asset portfolio and better manage the long-term shortfall risk. These investments range from hedge funds to emerging markets, real-estate assets to private equity.

"What is important is not understanding just the riskiness or the risk characteristics of these investments on their own, but actually what the risks of these investments are in the context of their existing portfolio," Papanek says. "So there are some investments that are highly volatile on their own but taken into the context of their existing portfolio, given perhaps a negative correlation with their existing portfolio, they can reduce their overall risk."

Gavin Watson, businesses manager for asset managers at RiskMetrics Group, explains further. As part of a natural response to liability-driven investments, Watson says that hedge funds will move to become more focused on accounting for inflation adjustment. "This would be a win-win for pension funds," he says. "To get these uncorrelated returns and be able to use them with an eye towards inflation protection and being liability driven, I think you are going to see more and more managers out there offering these options."

State Street's Lowe argues that the way to solve the current funding problems is to be smarter about active management, measuring and managing the risk at the asset allocation level and making further cash contributions to defined benefit pension plans.

Neil Brown, global head of sales, product and client services at Citigroup Alternative Investments in New York, says that the crisis will force US pension funds to pay closer attention to both sides of the balance sheet and pursue liability-driven investments. "The Europeans have perhaps been a little more aggressive in that, although there are people in the US who are pursuing these options as well. There's certainly more of a double-sided balance sheet view than there was in the past."

Overhaul

As corporate America works to get its own pensions house in order, the crisis has also prompted debate over a series of legislative proposals to reform the pensions system. Some of the measures for defined benefit plans under the proposals include increasing the premiums plan sponsors pay to the PBGC; greater disclosure from plan sponsors; and benefit restrictions on underfunded plans.

The House Education and Workforce panel suggests the creation of risk-based premium differentials between those plans that are healthy and those that are not: unhealthy plans would owe more in insurance premiums to the PBGC.

And in November, the House Ways and Means Committee passed a $70 billion package intended to overhaul the US pensions system. The legislation forces companies to fully fund their pensions over seven years and increases the premiums paid by companies to the PBGC. "By strengthening pension funding rules in this bill before the committee, we are taking some of the first important steps to prevent companies from experiencing pension funding shortfalls and therefore the need to dump their plans in the first place," said Ways and Means Committee chairman Bill Thomas.

However, business and labour groups and some lawmakers argue that if financially rocky companies are forced to pay more into underfunded plans, this could increase the likelihood that they may go bankrupt and could therefore drop their pension programmes altogether.

Ron Gebhardtsbauer, the senior pension fellow of the American Academy of Actuaries, concurs with this sentiment. He says that under the new rules, unions for companies like General Motors, which was downgraded to junk status last May, realise that by forcing lower-rated companies to pay more, employees could lose out on better benefits. "The big question is when should you force employers to do it? Do you force them to pay more when they are strong? That's the other alternative."

The Senate has just recently approved its own pensions bill, but for weeks had been stalled by disputes over whether funding requirements should be tied to a company's credit rating and over forcing companies that are less than 93% funded to fully fund their plans within a year. Additionally, there was opposition to how plan liabilities should be calculated. Legislators have expressed their intention to tie up final pension reform efforts by the end of the year, but at this late stage, few analysts hold out much hope for a legislative resolution in time for the new year.