Your Government at Work
Yesterday, I wrote about Bill Gross’ piece on expected returns. He made the argument that returns have been unusually high as the result of the providers of capital capturing more of the gains while labor and government have captured less. Today, I want to extend this to a discussion about corporate pension funds.
There was a really interesting article in The New York Times about ten days ago. It was titled, “Private Pension Plans, Even at Big Companies, May Be Underfunded.” It was written by Floyd Norris. Let me start with some of the interesting statistics that he included. Then, I’ll talk about your Congress at work…as you can imagine, I will have my usual praise for our lawmakers.
The pension plans of S&P 500 companies were underfunded by $355 billion. They have assets of $1.32 trillion and obligations of $1.68 trillion.
Of the 500 companies, 338 have defined benefit plans. Eighteen are fully funded.
Seven companies are underfunded by more than $10 billion.
Much of the problem is that the S&P 500 rose at annual rate of less than 5% over the past 15 years. The Barclays Capital U.S. Aggregate Bond Index (all investment grade bonds) returned 6.3%.
Seven years ago, stocks made up 65% of pension fund assets and bonds were 29%. Last year, it was 48% and 41%.
Quick primer for those of you who haven’t studied finance…imagine that a pension fund has to pay $1 billion in 20 years. We have to calculate what that is worth today. If we discount that $1 billion at 8%, the present value (today’s value) is $214.55 million. If we discount the $1 billion at 6%, the present value is $311.8 million.
Lets imagine that we use 8%. So, the present value is $214.55 million. If we have that amount right now and we earn 8% over the next twenty years, it will turn into $1 billion. We would say that we’re fully funded right now. If we have less than $214.55 million today, we’d say we’re underfunded. If we have $0 today, we’d say we’re unfunded.
We can argue about what the proper discount rate should be. One school of thought is to say that we should discount the cash flows by using expected returns. So, if we expect to earn 8%, then we need to have $214.55 million today to be fully funded. Another school of thought is to discount the cash flows based on a rate that reflects the riskiness of those cash flows. For most companies, that would probably be similar to the amount they pay on their debt (bonds) – because you can think of the pension fund as a debt.
Your Congress at Work
Congress recently passed a transportation bill that is funded by an accounting gimmick. (There’s a shock.) The way they paid for this bill is that they changed the discount rate for corporate pension plans. Instead of using relatively current interest rates to discount the pension liability, companies now can use the average yield from the past 25 years! (I’d like to invest and receive yields that were available over the past 25 years.) Of course, rates were higher in the past than they are today.
In other words, by using these higher rates, the present value of the companies’ obligations appears to be lower. As a result, companies can contribute less. This smaller contribution means that companies will have a smaller deduction (from earnings) and that they will pay higher taxes.
Of course, this also means that these pension funds are more risky. These pension funds are insured by the PBGC (Pension Benefit Guaranty Corp). The PBGC is fancy speak for “the federal government.” The federal government is fancy speak for “you and me.”
While it’s true that rates are very low right now (making the liabilities appear to be very high), it’s also true that you can’t invest at rates that were offered a long time ago. It’s unlikely that these pension funds will earn 7% (even when they invest some of their funds in stocks). As a result, we’ve found another way to kick the can down the road and create more risk for the future. In addition, while this bill also increased the companies’ insurance payments to the PBGC, the PBGC reported a $26 billion deficit as of last year and the increased premiums will only bring in an extra $10 billion over the next decade.
Have a great week.
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