Financial Markets and Institutions (2-downloads)

Power to the Pensions

One ramification of the growth of pension plans and

other institutional investors is that the managers of

these funds have the ability to exercise substantial

control over corporate management. Clearly, when a

pension fund manager, who controls many thousands

of shares, calls a corporate officer, the officer is

going to listen. Evidence suggests that fund managers

actively apply the power they have to influence cor-

porate management. For example, pension funds

recently defeated management-sponsored anti-

takeover proxy proposals at Honeywell. And Texaco

agreed to name a director from candidates submitted

by the huge California Public Employees Retirement

System. In addition, the stated mission of the Council

of Institutional Investors is to “encourage trustees to

take an active role in assuring that corporate actions

are not taken at the expense of shareholders.” It is

possible that these actions will work to benefit share-

holders, who do not individually wield enough clout

to exert control. However, the clout shareholders

wield when their shares are placed into a fund man-

ager’s hands may be sufficient to improve corporate

management significantly.

Find detailed information

on your Social Security

benefits at 

www.ssa.gov/

.

G O   O N L I N E

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Chapter 21 Insurance Companies and Pension Funds

535

of workers supporting each one of those retirees will fall from 3.3 to 2 by 2041. The

government predicts that the Social Security trust fund, built up over the years with

excess payroll taxes, will be depleted by that date (see Figure 21.7). After that, taxes

would cover only 75% of benefits. Some experts argue that the crisis will arrive much

earlier, as soon as 2020. This is because in 2020 the program will have to start redeem-

ing the trust fund’s special Treasury bonds that represent the Social Security surplus.

The trouble is that money to redeem these bonds is being spent to run the federal

government. By 2030, Social Security will have to redeem $750 billion worth of bonds.

“Whether that’s a crisis for Social Security, it certainly is a crisis for whoever is around

trying to come up with $750 billion,” says Michael Tanner, director of the Cato

Institute’s Project on Social Security Privatization.

A number of proposals are being considered to help keep Social Security viable

for the future. The idea that AARP polling finds as the least objectionable is to raise

the cap on the maximum amount that workers have to pay into the fund in any given

year. The maximum wage that was taxed in 2010 was $106,800, which represents only

85% of all income. This is down from a tax on 90% of income in 1983. It is likely

that this will be one area for change.

Another possible change concerns the minimum age when one can start receiv-

ing benefits. This was changed in 1984 to gradually rise so that those born after

1960 cannot start receiving full benefits until they are age 67. The original retirement

Access

www.ssab.gov

for

the Social Security

advisory board. This site

will report the most current

estimates for when the

trust fund will be depleted.

G O   O N L I N E

Fund Assets

($ trillions)

0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1957 1960

1965

1970

1975

1980

1985

1990

1995

2000

2009

2005

1.8

2.0

2.2

F I G U R E   2 1 . 6

Social Security Fund Assets, 1957–2009

Source:

http://www.ssa.gov/OACT/TR/TR06/IV_SRest.html#wp227295

.

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536

Part 6 The Financial Institutions Industry

age of 65 dates back to 1874, when a railroad company established a pension plan.

The basis of this decision was that 65 was considered to be the maximum age at which

one could safely operate a train. This rule was later incorporated into the Federal

Railroad Retirement Act of 1934, which was used to support that retirement age when

the Social Security Act was written. Since few Americans are required to operate

trains any more, there is some justification for reevaluating the retirement age. The

good news is that relatively small changes to the retirement age have a large impact

on the Social Security fund balance.

In 2004, Alan Greenspan, then chairman of the Federal Reserve, suggested alter-

ing the way that cost-of-living adjustments to Social Security payments were calcu-

lated. Currently the benefit payments are adjusted annually based on the consumer

price index (CPI). Greenspan argued that this overstated true inflation because it

ignored consumers’ switching to less expensive alternatives. While admitting some

validity to this, critics argue that the CPI underestimates the increase in medical

costs, which make up a large portion of retirees’ budgets.

Still another suggestion is to recognize that beneficiaries are living longer than

in the past and to adjust benefit payments to stretch them over a longer period of time.

Prior to the stock market falling in 2000, many investors were calling for the

privatization of Social Security. The biggest obstacle to privatization is that funds

$ trillions

0

1

4

3

2

5

6

7

8

2005

2010

Assets

Outgo

Income

2015

2020

2025

2030

2035

2040

F I G U R E   2 1 . 7

Projected Social Security Trust Fund Assets

Source:

http://www.ssab.gov/documents/whyactionshouldbetakensoon.pdf

.

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Chapter 21 Insurance Companies and Pension Funds

537

diverted into private accounts would not be available to pay current retirees’ bene-

fits. This exacerbates the looming problem rather than solving it. Analysts estimate

that the cost of transitioning to a fully funded privatized plan would be enormous—

about $100 billion. Over time, analysts argue, privatization would gradually transform

Social Security from an unfunded, pay-as-you-go system to a fully funded pension

with real assets. However, falling stock prices in 2000–2002 and again in 2007–2008

have reduced support for all privatization options.

In the short term, Social Security reform is more likely to take the form of an

increase in tax, a reduction in benefits, a delay in receiving benefits, or all three.

For example, the age at which benefits begin is already scheduled to increase from

65 to 67. Some plans suggest delaying benefits until age 70.

If no funding reforms take place and the current estimates regarding the deple-

tion of the Social Security fund are accurate, some estimate that the payroll tax

rate would have to be increased from 12.4% to around 18%.

We must remember that these estimates are based on current facts as they are

known. Many factors can change to cause the estimates to change. For example,

research on cures for cancer has received a great deal of publicity recently. If a cure

for any major cause of death is found, the fund will be in greater trouble than cur-

rently thought.

It is extremely difficult to make accurate estimates on the health of the Social

Security system. In 1995, for example, the Social Security Administration estimated

that the fund would be depleted by 2029, instead of the 2041 currently projected.

Many factors affect the fund balance including life expectancies, birth rates, and

even the rate of legal and illegal immigration. While it would be political disaster for

the government to allow the program to fail, current workers should realize that they

should not rely on it to provide the majority of their retirement cash flow. In the future,

the proportion of preretirement income it replaces may well continue to decrease.

Regulation of Pension Plans

For many years, pension plans were relatively free of government regulation. Many

companies provided pension benefits as rewards for long years of good service and

used the benefits as an incentive. Frequently, pension benefits were paid out of cur-

rent income. When the firm failed or was acquired by another firm, the benefits

ended. During the Great Depression, widespread pension plan failures led to

increased regulation and to the establishment of the Social Security system.

A major U.S. Supreme Court decision in 1949 established that pension benefits

were a legitimate part of collective bargaining, the negotiation of contracts by unions.

This decision led to a great increase in the number of plans in existence as unions

pressured employers to establish such plans for union members.

Employee Retirement Income Security Act

The most important and most comprehensive legislation affecting pension funds is

the Employee Retirement Income Security Act (ERISA), passed in 1974.

ERISA set certain standards that must be followed by all pension plans. Failure to fol-

low the provisions of the act may cause a plan to lose its advantageous tax status. The

motivation for the act was that many workers who had contributed to plans for years

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Part 6 The Financial Institutions Industry

were losing their benefits when plans failed. The principal features of the act are

the following:

• ERISA established guidelines for funding.

•  It provided that employees switching jobs may transfer their credits from

one employer plan to the next.

•  Plans must have minimum vesting requirements. Vesting refers to how

long an employee must work for the company to be eligible for pension

benefits. The maximum permissible vesting period is seven years, though

most plans allow for vesting in less time. Employee contributions are

always immediately vested.

•  It increased the disclosure requirements for pension plans, providing

employees with more ample information about the health and investments

of their pension plans.

•  It assigned the responsibility of regulatory oversight to the Department 

of Labor.

ERISA also established the Pension Benefit Guarantee Corporation (PBGC

or simply called Penny Benny), a government agency that performs a role similar to

that of the FDIC. It insures pension benefits up to a limit (currently just over $49,500

per year per person) if a company with an underfunded pension plan goes bank-

rupt or is unable to meet its pension obligations for other reasons. Penny Benny

charges pension plans a premium to pay for this insurance, but it can also borrow

funds up to $100 million from the U.S. Treasury. Penny Benny currently pays bene-

fits to about 750,000 retirees whose pension plans failed.

Over 66% of defined-benefit pension plan assets are invested in stocks. When the

market prices were high, most defined-benefit pension plans were adequately funded.

However, the market fall in 2009 along with low interest rates and a weak economy

have put many pension plans in jeopardy. As a result, in 2009 PBGC was in the red

by $21.9 billion.

The accounting for pension plans makes it very difficult to accurately assess

whether a fund is over- or underfunded. The assumptions behind such calculations

are subject to constant revision and argument. Cash-strapped firms have tremendous

incentive to underfund their pension plans, and Congress is reluctant to enforce

higher payments that could put a firm at greater risk of failure.

The Pension Benefit Guaranty Corporation is rapidly facing a funding crisis that

could have far-reaching effects. Many defined-benefit pension funds are in severe trou-

ble due to the increasing life spans of their pensioners, increased medical costs, and

weak corporate income that has made it difficult to keep up with funding obligations.

Currently, the airline and steel industries are responsible for the bulk of PBGC’s claims.

For example, United Airlines terminated its defined benefit program in 2005. Since

then, PBGC has paid over $7.6 billion in claims to 122,000 vested United partici-

pants. Figure 21.8 shows annual payments made since 1980 to failed plan participants.

In PBGC’s 2008 data book, they say the plan has never been under greater stress.

Many firms with defined-benefit plans find it hard to compete against firms with

much lower cost defined-contribution plans. This competitive disadvantage increases

the likelihood that the firms may not survive to pay down their deficits. For exam-

ple, General Motors’ profit margin per car is about 0.5%. Without the burden of pen-

sion and retiree health care costs, the margin would be about 5.5%. Morgan Stanley

estimates that the benefits cost is $1,784 per car for GM, while it is only $200 per

car for Toyota.

Access

www.pbgc.gov

for

additional information

about the Pension Benefit

Guarantee Corporation.

G O   O N L I N E

Access

www.pbgc/gov/

docs/2005databook.pdf

for details on extensive

statistics on the health 

of PBGC.

G O   O N L I N E

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Chapter 21 Insurance Companies and Pension Funds

539

Firms often fail when they face a cost disadvantage. Due to higher costs, includ-

ing pension obligations, Bethlehem Steel, LTV, and National Steel all filed for bank-

ruptcy in 2002 and terminated their pension plans. PBGC is now paying over 200,000

former steel workers’ benefits. International Steel Group Inc. (ISG) has acquired

the mills of these old steel companies and is now the largest steel producer in the

country. Its defined-contribution cost for employees is about $45 million. Prior to

its bankruptcy, Bethlehem Steel alone was paying out $500 million a year in pen-

sion benefits.

If firms with defined benefit plans continue to fail, PBGC will be forced to assume

their pension funds’ liabilities. These obligations could quickly surpass the financial

resources available to PBGC if the economy remains weak. In that event, taxpayers

may be called upon to make up the difference.

The government is not strictly responsible for backing up PBGC; however, most

observers feel it could not politically allow pensioners to lose their benefits. The tem-

porary fix is to allow firms to use a higher interest rate in their pension calculations

so that their pension liability is reduced. The hope is that the economy will con-

tinue to revive, stocks will rise, and interest rates increase. This same technique

(called regulatory forbearance) was used to prolong the savings and loan crisis in the

1970s. We can only hope it works better this time.

The Pension Protection Act of 2006 was passed to address the growing problem

with underfunded and failing pension plans. This legislation provides for stronger pen-

sion funding rules, greater transparency, and a stronger pension insurance system.

Individual Retirement Plans

The Pension Reform Act of 1978 updated the Self-Employed Individuals Tax

Retirement Act of 1962 to authorize individual retirement accounts (IRAs). IRAs

permitted people (such as those who are self-employed) who are not covered by

other pension plans to contribute into a tax-deferred savings account. Legislation

Millions ($)

80 81 82 83 84 85 86 87 88 89 90 91 92

Fiscal Year

93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08

4,500

4,000

3,500

3,000

2,500

2,000

1,500

1,000

500

0

F I G U R E   2 1 . 8

Total PBGC Benefit Payments

Source:

http://www.pbgc.gov/docs/2008databook.pdf

.

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Part 6 The Financial Institutions Industry

in 1981 and 1982 expanded the eligibility of these accounts to make them available

to almost everyone. IRAs proved extremely popular, to the extent that their use

resulted in significant losses of tax revenues to the government. That led Congress

to include provisions in the Tax Reform Act of 1986 sharply curtailing eligibility.