Hedgeye’s Industrials Sector Head Jay Van Sciver hosted an expert call yesterday with David R. Godofsky, head of the employee benefits practice at the law firm of Alston & Bird. A Fellow of the Society of Actuaries, Mr. Godofsky has decades of experience in all areas of corporate benefits and compensation. His talk yesterday was titled “Pension Funding and Accounting: The Pension Pendulum.”
Mr. Godofsky’s analysis demonstrates how the nation’s pension plans have been yanked back and forth as Congress repeatedly tries to fix what is wrong with pension funding requirements – then rushes to fix what they got wrong the last time. Companies struggle to keep their balance while adjusting their pension funding practices to conform to the latest changes.
The Employee Retirement Income Security Act (ERISA) took effect in 1976, creating federal funding requirements and government insurance for private sector pensions. This first swing of the pendulum set funding requirements, giving companies 30 years to meet unfunded liabilities and setting rates for contributions.
ERISA was put under IRS jurisdiction, and the agency pressed companies not to fund their plans quickly, in order to maintain tax revenues. The convergence of a long time horizon, unrealistically low funding requirements, and IRS pressure to keep contributions low, led to low balances backing very large pension liabilities.
This was compounded by moral hazard with the introduction of federal pension insurance. Even today there is very little restriction on what companies can promise in terms of pension benefits – and federal insurance is on the hook. Godofsky says the vast majority of insurance claims come from collectively bargained plans, where both management and the union know the government will backstop whatever they agree to.
After ERISA was in place, Congress introduced funding caps and a 50% excise tax on withdrawals from overfunded plans, and Congress has kept the pendulum swinging ever since. Successive new rules keep trying to strike a balance between beefing up contributions to protect employees, and avoiding excessive corporate tax deductions.
One change, adopted in 1987, was to use actual bond rates as the investment return assumption. Companies realized they could issue their own bonds at rates below the assumed rate of return. They used the proceeds to buy stock in the pension plans, and booked the difference in interest rate payments as a profit. Through the “magic” of this paradigm, companies could consider their pensions fully funded when there was actually a significant asset shortfall.
So Congress changed the assumptions again, requiring contributions to be calculated on the assumption that all investment assets are equivalent. Except, as Godofsky points out, they are only equivalent today. Their values will diverge in 30 years. Or in ten years. Or by tomorrow. Companies could no longer create assets using borrowed cash.
Even though funding assumptions were now based on bond rates, between 40%-60% of all pension money is invested in stocks, which did what they were supposed to do: outperform bonds. This created a large number of overfunded plans. The companies can’t just withdraw the excess, because of the 50% tax hit. But they can get creative.
Some companies deal with excess pension assets by offering extra pension payments in lieu of current compensation. Or a company with an overfunded pension can sell a division to a company with an underfunded plan. The buyer also takes on a piece of the seller’s excess funding, paying for it in an inflated purchase price for the operating unit. There are also legal ways to give special pension bonuses to a select group of senior management employees without having to grant equal treatment to others.
The bottom line, says Godofsky, is that the 50% excise tax is never actually paid, and these measures also reduce payroll and other tax revenues. And all this still doesn’t prevent companies going out of business and defaulting on plans, increasing the burden on an already distressed pension insurance program.
Congress whipped the pendulum back the other way with the 2006 Pension Protection Act which exacerbates economic cycles by requiring companies to maintain funding levels. Companies are forced to pump cash into plans in down markets, taking away resources they could use for business expansion or job creation.
What’s The Next Swing?
Godofsky believes funding assumptions will continue to be a source of tension. Accountants believe pensions should invest in fixed income, because pension liabilities look like fixed income. Meanwhile, pension managers will continue to be about 50% in equities, because portfolio theory says stocks outperform bonds over the long term. This tension is not likely to be resolved.
Godofsky sees crises brewing in multi-employer plans, and in public sector plans, especially at the municipal level.
One thing that appears certain is that Congress will continue to meddle. It’s what they’re good at. As Godofsky’s Rule states: the pendulum never stops in the middle.