Now for the Reckoning

Retirement benefits promised to employees are becoming a crippling burden for a growing number of firms, especially in America.

CSFB estimates that two-thirds of S&P 500 companies have some OPEB obligations, and that these are underfunded by well over $300 billion, more than 80 percent of the total promised benefits. (Some firms have put money into “voluntary employees’ beneficiary associations;” for example, GM’s contains several billion dollars.) Again, the burden is heavily concentrated in older, unionized firms. (Union-unfriendly Wal-Mart’s health plan covers less than half of its American workers and does not extend into retirement.)

Worse, estimates of OPEB liabilities rely even more on guesswork than defined-benefit pensions, points out Olivia Mitchell of the Wharton School. Companies have simply promised to pay for whatever health care is required, regardless of the cost. At least a defined-benefit pension has a pre-agreed relation to final salary. In forecasting future healthcare costs, actuaries “tend to assume 10-11 percent growth next year, trending down to, say, 5 percent in year five,” says Mitchell, “but there is no actual evidence of healthcare inflation ever trending down.”

So what went wrong? In pensions, three trends came together, says Dambisa Moyo, an economist at Goldman Sachs. First, companies were caught out by the decline in equity prices and lower interest rates after 2000 that reduced the value of pension fund assets and, by lowering the discount rate, increased the present value of future liabilities. Second, firms failed to match the risk profile of their assets (which often consisted mainly of equities) with that of their liabilities, which are equivalent to a long-term bond. As a result, “lower interest rates have had a bigger impact on pension liabilities than on assets,” she says. Third, companies underestimated the life expectancy of their employees and thus the size of their liabilities. In America, until recently, many firms have used mortality tables from 1983, since when life expectancy has risen sharply.

Retiree healthcare promises first started to grow in the 1970s as a way to circumvent President Nixon’s wage controls. Managers subsequently came to see them as a relatively painless way of giving something to the unions during negotiations without having any impact on current costs. Considerable blame falls on how America has accounted for pensions and OPEBs. This has made it hard for anyone to understand the sort and magnitude of risks being taken, while at the same time creating incentives for managers to behave imprudently. For instance, firms are allowed to “smooth” out movements in asset prices, so that their profits are not excessively volatile. This is done by simply assuming in any given year that the assets earn a particular rate of return, and equities a higher return than bonds.

Fooled by Arbitrage

These rules create a “fallacious arbitrage opportunity,” says Zvi Bodie, an economist at Boston University, by encouraging firms to issue bonds and buy equities for their pension fund. This is what GM did a few years ago when it borrowed $18.5 billion for its pension fund and promptly reported a big improvement in the fund’s health by assuming that the equities it bought earned a higher return than the interest it was paying on the bonds.


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