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Old-line
companies have pledged a trillion dollars to retirees. Now they're struggling to compete
with new rivals, and many can't pay the bill
June 28 was
the day hope ran out for United Airlines' 35,000 retirees. That
was the day the government announced it would not guarantee the bankrupt
airline's loans -- virtually assuring that if UAL Corp., the airline's
parent, is to remain in business it will have to chop away at expensive
pension and retiree medical benefits. The numbers
are daunting. UAL owes $598 million in pension
payments between now and Oct. 15, and a total of $4.1 billion by the end of
2008, plus an additional $1 billion for retiree health-care benefits,
obligations the ailing airline can't begin to meet. And
if United finds a way to get out of its promises, competitors American
Airlines, Delta Air Lines, and Northwest Airlines are sure to try to as well.
UAL workers
are about to find out what other airline employees already know: The cost of
broken retirement promises can be steep. Captain Tim
Baker, a 19-year veteran of US Airways Inc., was one of several union
representatives sorting through that airline's complicated bankruptcy
negotiations in March, 2003. Of the airline's many
crises, the biggest was the pilots' pension plan, a sinkhole of unfunded
liabilities. Baker reluctantly agreed to back US
Airways' proposal to dump the pension plan on the Pension Benefit Guaranty
Corp. (PBGC), the government agency that is the
insurer of last resort for hopelessly broken plans. It's
a move that practically guarantees that retirees will receive less than they
were promised, in some cases less than 50 cents on the dollar. But of a raft of bad options, it seemed the only one
that could keep the company afloat. "It was the
pension underfunding and its future requirements
that were going to put in jeopardy the airline's ability to get out of
bankruptcy," says Baker. "At some point
you have to look around and say that is all there is."
Baker has
paid dearly for that decision. He was voted out of
his union position by angry fellow pilots and instead of the six-figure
annual pension he was promised, when he retires in 15 years he'll get just
$28,585 a year from the PBGC, plus whatever he can
save in his 401(k).
Stories
like Baker's are becoming dreadfully common as employers faced with mounting
retiree costs look to get out from under. It's not
just troubled industries like airlines that are abandoning their role as
retirement sponsors to America's workers, either. The
escalating cost of retirement plans is a critical issue at a range of
long-established companies from Boeing to Ford Motor to IBM, many of which
compete against younger companies with little or nothing in retiree costs.
Why are
retirees being left out in the cold? An unsavory
brew of factors have come together to put stress on the retirement system
like never before. First, there's the simple fact
that Americans are living longer in retirement, and that costs more. Next come internal corporate issues, including soaring
health-care costs and long-term underfunding of
pension promises. Perhaps most important, in the
global economy, long-established U.S. companies are competing against younger
rivals here and abroad that pay little or nothing toward their workers'
retirement, giving the older companies a huge incentive to dump their plans. "The house isn't burning now, but we will have a
crisis soon if some of these issues aren't fixed," says Steven A. Kandarian, who ended a two-year stint as the executive
director of the PBGC in February.
Kandarian is not optimistic about how that
crisis might play out, either. "By that time it
will be too late to save the system. Then you just
play triage."
As industry
after industry and company after company strive to limit -- or eliminate --
their so-called legacy costs, a historic shift is taking place. No one voted on it and Congress never debated the issue,
but with little fanfare we have entered into a vast reorganization of our
retirement system, from employer funded to employee and government funded, a
sort of stealth nationalization of retirement. As
the burden moves from companies to individuals -- who have traditionally been
notoriously poor planners -- it becomes near certain that in the end, a
bigger portion will fall on the shoulders of taxpayers. "Where
the vacuum develops, the government is forced to step in," says
Sylvester J. Schieber, a vice-president at
benefit-consulting firm Watson Wyatt Worldwide. "If
we think we can walk away from these obligations scot-free, that's just a
dream."
EVIDENCE
OF THE SHIFT is everywhere. Traditional
pensions -- so-called "defined-benefit" plans -- and retiree health
insurance were once all but universal at large companies. Today
experts can think of no major company that has instituted guaranteed pensions
in the past decade. None of the companies that have
become household names in recent times have them: not Microsoft, not Wal-Mart
Stores, not Southwest Airlines. In 1999, IBM, which
has old-style benefits and contributed almost $4 billion to shore up its
pension plans in 2002, did a study of its competitors and found 75% did not
offer a pension plan and fewer still paid for retiree health care.
Instead,
companies are much more likely to offer defined-contribution plans, such as
401(k)s, to which they contribute a set amount. In
1977, there were 14.6 million people with defined-contribution benefits;
today there are an estimated 62.5 million. Part of
their appeal has been that a more mobile workforce can take their benefits
with them as they hop from job to job. But just as
important, they cost less for employers. Donald E. Fuerst, a retirement actuary at Mercer Human Resource
Consulting LLC, notes that while even a well-matched 401(k) often costs no
more than 3% of payroll, a typical defined-benefit plan can cost 5% to 6% of
payroll.
Despite the
stampede to defined-contribution plans, there are still 44 million Americans
covered by old-fashioned pensions that promise a set payout at retirement. All told, they're owed more than $1 trillion by 30,000
different companies. Many of those employers have
also promised tens of billions of dollars more in health-care coverage for
retirees. Even transferring a small part of the
burden to individuals or the government can have a profound impact on the
corporate bottom line. The decision by Congress to
have Medicare cover the cost of prescription drugs, for example, will lighten
corporate retiree health-care obligations by billions of dollars. Equipment maker Deere & Co. estimates that the move
will shave $300 million to $400 million off its future health-care
liabilities starting this year.
The U.S.
Treasury, on the other hand, pays and pays dearly. That
drug benefit, which takes effect in 2006, is expected to cost the government
the equivalent of 1% of gross domestic product by 2010, and other potentially
big taxpayer costs are looming, too. In mid-April,
over the objections of the PBGC, Congress granted a
two-year reprieve from catch-up pension contributions for two of the most
troubled industries: airlines and steel. Congress
also lowered the interest rate all companies use to calculate long-term
obligations, lowering pension liabilities. While
these moves lighten the corporate burden, they increase the chances taxpayers
will have to step in. "The less funding required, the more risk that's
shifting to the government," says Peter R. Orszag,
a pension expert and senior fellow in economic studies at the Brookings
Institution. "The question is: How comfortable
are we with the risk of failure?"
Company-sponsored
health care, which generally covers retirees not yet eligible for Medicare
and supplements what Medicare will pay, is likely to disappear even faster
than company pensions. Subject to fewer federal
regulations, those benefits are easier to rescind and companies are fast
doing so. It's much harder to renege on pension
promises. So instead, many profitable companies are
simply freezing plans and denying the benefits to new employees. Last fall, Aon Consulting
found that 150 of the 1,000 companies they surveyed had frozen their pension
plans in the previous two years, a dramatic increase from earlier years. Another 60 companies said they were actively considering
following suit.
The cost of
honoring PBGC's commitments could be higher than
anyone is expecting. The government bailout fund has
relied on having enough healthy companies to pony up premiums to cover plans
that fail. But in a scenario of rising plan
terminations, healthy companies with strong plans still in the PBGC system would be asked to pay more.
For corporations already fretting that pensions have become a
competitive liability and a turnoff to investors, this could be the tipping
point. Faced with higher insurance costs, they could
opt out, rapidly accelerating the system's decline as the remaining healthy
participants become overwhelmed by the needy. In the
end, the problem would land with Congress, which could be forced to undertake
a savings-and-loan-type bailout. It's almost too
painful to think about, and so no one does. But when
the bill comes due, it will almost certainly be addressed to taxpayers.
Most
worrisome is the record number of pension plans in danger of going under. According to the PBGC, as of
September, 2003, there was at least $86 billion in pension obligations
promised by companies deemed financially weak. That's
up from $35 billion the year before. And it's on top
of a record number of companies that managed to dump their troubled pension
plans on the PBGC last year: 152.
In 2003, a record 206,000 people became PBGC
pensioners, including 95,000 from its biggest takeover ever, Bethlehem Steel
Corp.
Even for
healthy companies, pensions have become a serious drag. The
companies of the Standard & Poor's 500-stock index, for example, continue
to run an aggregate pension deficit of $149 billion, according to David Bianco, an accounting analyst at UBS. That's despite a strong stock market in 2003, which
pushed up pension plan assets, and despite the billions companies
contributed, including $18.5 billion from General Motors Corp. alone. If conditions don't change, Bianco
figures the S&P 500 companies will end the year
$192 billion in the hole.
WHAT
TODAY MIGHT be seen as an isolated problem for a limited number of
companies promises to bloom into big trouble for us all. By
conventional math, the PBGC is already insolvent:
As of September, 2003, it had $46.5 billion of liabilities and only $35
billion of assets, a deficit of $11.5 billion that had close to tripled in
one year. The agency paid 2003 benefits of $2.5
billion, but only took in $1 billion of premium income from companies with
defined-benefit plans. (The PBGC
says the deficit had dropped to $9.7 billion as of March, but can't give further
details.) The PBGC is not directly funded by the taxpayer, but it is backed
by the U.S. government, which would likely bail it
out in a crisis.
The
fragility of that system only increases the stress on other sources of
retirement income and insurance: Social Security, Medicare, and personal
savings. Social Security has its own $11.9 trillion
deficit. And the still-recent history of personal
savings vehicles like 401(k)s shows that people generally save too little,
pay too much in fees, and fail to adequately diversify their risk. Olivia S. Mitchell, executive director of the
Wharton School's Pension Research Council, is among the
many who think one result is that we will all have to work longer than we
thought. "It used to be thought Social Security
was the safe leg of the retirement stool, but that's not safe either,"
says Mitchell.
Demographic
trends will only make matters worse. As recently as
1985 there were three U.S. workers for every retired person. Now it's close to even. And
we're still six years away from 2010, when the first of the baby boomers will
hit 65. Not only are more people retiring, but
they're living longer once they get there. Today 17%
of the U.S. population is age 60 or older. According to Census Dept. data, that figure will rise to
26% by 2050, when college graduates entering the workforce today can finally
begin to think about retiring. It's the complete
reversal of the years after World War II, when companies first began offering
pension plans in great numbers. In those days the
workforce was young and retirees were only a sliver of the population. It was easy to make promises.
The world
has changed dramatically since then. In the '40s and
'50s, if a company offered retirement benefits, its competitors probably did
too. Pattern bargaining by unions held entire
industries to the same standard. But companies that
once could rely on geographic boundaries and market dominance to minimize the
threat of upstarts and outsiders are now struggling to keep up in a global
marketplace full of new competitors. Companies like
IBM, Verizon Communications, and even General
Motors today must contend with rivals who don't bear the cost of old-style
benefits. For every lumbering US Airways there's an
agile Southwest or Jet Blue Airways Corp., newer rivals with cheaper benefits. For every GM, there's a Toyota Motor Corp., with a
leaner and younger U.S. workforce.
Nowhere are
pension obligations a greater competitive millstone than in Detroit. The U.S. carmakers today have some of the biggest
pension obligations and pool of retirees anywhere. By
contrast, their Japanese competition only started U.S. manufacturing in the late 1980s, and
have far lower costs. General Motors has 514,120
participants in its hourly-rate employee pension plan, all but 142,617 of
whom are retired. Pension and health-care costs for
those retirees added up to about $6.2 billion in 2003, or roughly $1,784 per
vehicle according to Morgan Stanley. Compare that to
Toyota's U.S. plan, which had only 9,557 participants,
just two of whom were retired as of Toyota's latest Internal Revenue Service filing
covering 2001. Toyota's pension cost is
estimated at something less than $200 per vehicle.
The impact
on profits is dramatic. Excluding gains from its
finance arm, GM earned $144 per vehicle in the U.S. in 2003. GM's
margins are now 0.5%, among the worst in the industry. But
without the burden of pension and retiree health-care costs, the auto makers'
global margins would be 5.5%, according to Morgan Stanley. That's
not great, but a lot closer to Asian carmakers like Honda Motor Corp., which
earns 7.5% on its global sales.
Retiree health-care
coverage, which is easier to eliminate than pensions, is disappearing even
faster. Unlike pensions, which are accrued and
funded over time, retiree health care is paid for out of current cash
accounts, so any cuts immediately bolster the bottom line. Estimates
are that as many as half of the companies offering retiree health care 10
years ago have now dropped the benefit entirely. Many
of those that have not yet slammed the door are requiring their former
workers to bear more of the cost. Some 22% of the
retirees who still get such benefits are now required to pay the insurance
premiums themselves, according to a study by Hewitt Associates Inc. Some 20% of employers told Hewitt that they might make
retirees pay within the next three years. This hits
hardest those who retire before 65 and are not yet eligible for Medicare. But even older retirees suffer when they lose
supplemental health benefits like prescription coverage.
IT'S
NOT JUST struggling companies, either. IBM,
which is already fighting with retirees in court over changes made to its
pension plan in the 1990s, is now getting an earful from angry retirees about
health-care costs. In 1999, IBM capped how much
retiree health care it would pay per year at $7,500 of each employee's annual
medical-insurance costs. Although IBM is certainly
in no financial distress -- the company earned $7.6 billion on $89 billion in
sales last year -- Big Blue says its medical costs have been rising faster
than revenue. Last year the company says it spent
$335 million on retiree health care.
This year,
for the first time, many IBM retirees are beginning to hit the $7,500 limit. Sandy Anderson, who worked as a manager at IBM's
semiconductor business for 32 years, and today is the acting president of a
group of 2,000 retirees called Benefits Restoration Inc., saw his own
insurance bill triple this year. He suspects that
the company is trying to make the perk so expensive that retirees drop it, a
cumulative savings calculated by the group at $100,000 per dropout.
But more
than that, Anderson is angry that as a manager, IBM
encouraged him to talk to his staff about retirement benefits as part of
their overall compensation. The job market was
tight, and IBM's message was our salaries aren't the highest, but we will
take care of you when you stop working, he says. Now
he feels the company is reneging. "I feel I've
misled a lot of people, that I've lied to people," says Anderson. "It does
not sit well with me at all." IBM says its
opt-out levels are low and that it often sees retirees return to the plan
after opting out for a period of time. The company
also argues that it has not changed its approach to retiree medical benefits
for more than a decade and that the rising cost of health care is the real
issue.
Even with
the reductions, Anderson and his generation of retirees are better off than
many. In 2003 the giant
computer maker said it would pay nothing toward health insurance for future
hires when they retire.
One reason
companies have hit the accelerator on dumping their benefits is because of
sharp price increases. Retirement plans have become
radically more expensive in the past two years alone. Due
to smoothing mechanisms built into pension accounting, their investments are
still suffering from the equity market declines of 2000, 2001, and 2002. That has put a big dent in the value of their stock
holdings, generally 60% or more of their total assets. At
the same time, interest rates, which are used to calculate the size of a
company's liability, have remained stubbornly low, implying a bigger pension
liability. Although the recent legislation eases the
problem somewhat, it doesn't nearly close the gap between what these funds
owe and what they have in assets.
Combined
with the rise in retirees, those market conditions have led to two years of
record underfunding in company-sponsored plans. A recent study by analysts at CreditSights
Ltd. found that 85% of the defined-benefit plans in the S&P
500 don't have enough assets to cover their pension obligations. Together the underfunding
equals 15% of their 2003 cash flow. As a result,
companies will have to put billions of dollars of cash into these plans this
year to help close the gap.
It's a
drastic turnaround from the late 1990s when these plans had more than enough
money. In 1999, the average S&P
500 pension was overfunded by $726 million,
according to CreditSights. Four
years later, at the end of 2003, it was $463 million underfunded,
a swing of almost $1.2 billion. A steady rise in
interest rates and a strong stock market could help to solve that underfunding, but experts worry that the whipsaw effect
of the past few years and the billions companies have been forced to
contribute has heightened executive discomfort with the volatility of
pensions. According to Credit Suisse First Boston
analyst David Zion, the companies in the S&P
500 have contributed $88 billion to their pension plans over the past two
years. They're likely to have to add another $31
billion over the next two years. Despite an $18.5
billion infusion into its pension plan in 2003, it will take years before
General Motors, for example, has fully funded plans. "These
things have a fairly long tail," says GM Chairman and CEO G. Richard
Wagoner Jr.
Companies
didn't make it any easier on themselves by contributing as little as possible
to their pensions in the booming 1990s. As recently
as 2001, half of the large pensions monitored by actuaries at Milliman USA were generating pension income, contributing
an aggregate $12.5 billion boost to their parent companies' reported earnings. Companies with overfunded
pension plans were often able to fund retiree health care with pension
overage. Many companies contributed little or
nothing to their pension plans as the bull market drove up assets more than
enough. Former PBGC chief Kandarian notes that adjusting for inflation, in the
early 1980s plan sponsors were putting $63 billion per year into their plans. By the last half of the 1990s that had dropped to $26
billion, and companies had become used to getting expensive benefits on the
cheap.
WHEN
THEY DID contribute, it was often not with cash but with stock, real
estate, and other less liquid "alternative" investments. With pension promises basically free, companies were
also offering pension increases in lieu of salary raises, increasing their
obligations. From 1980 to 2000, the size of the
promises made grew 2.3 times, Kandarian says.
Among
those making the most extravagant retirement pledges were the steel mills,
and it was in their plans that the industry's weakness was most dramatically
realized. In a massive wave of bankruptcies, the
steelmakers have shifted $7.5 billion of their obligations to the PBGC in the past 3 years.
But in
that disaster some have found an opportunity to arbitrage the difference
between the old retirement model and the new. International
Steel Group Inc. has in the past two years grown into the largest steelmaker
in the country by acquiring the mills of old steel companies, including
Bethlehem Steel, LTV, and Acme Metals out of bankruptcy, once they've been
freed of pension and health-care promises. These
companies had been pummeled by cheaper international competition as well as
lower-cost U.S. mini-mills, and as they shrank to cut
costs, their retiree bases mushroomed to many times the size of the active
workforce. Faced with the possibility that they
would lose all the remaining jobs left at these companies, the United
Steelworkers union was eventually willing to compromise.
Free of
those pension promises, ISG chairman Wilbur L. Ross
Jr. enjoyed the big run-up in steel prices on a much cheaper cost base than
many of his competitors. ISG's
predecessor companies shed $12 billion of legacy health-care costs and
another $9 billion of pension obligations. The
company today claims to be competitive with both international steelmakers
and efficient U.S.-based mini-mills. ISG's defined-contribution cost for employees was $45
million in 2003. Its very modest retiree health-care
benefits cost $4.3 million. By contrast, Bethlehem
Steel alone was paying out $500 million a year in pension benefits. Today, U.S. Steel Corp. has moved to an ISG-style defined-contribution pension plan, but only for
future retirees. It still owes $8 billion to
existing pensioners.
It's a bit
of retiree-cost arbitrage that won't last forever. But
before it's over, Ross predicts other industries will follow this harsh path
to competitiveness. Those most at risk: textile
makers, airlines, tire and rubber companies, auto-parts suppliers and,
potentially, he says, the auto makers. "There
is a huge unfunded liability that's building up because of the
defined-benefit system," says Ross. "If
nothing changes, the stone they [PBGC] have to roll
up the hill will just get heavier."
Workers bear
the brunt of it. Bill Luoma,
head of the Mahoning Valley Steelworkers Retirees Council, which counts
bankrupt LTV retirees among its members, says that with their health
insurance gone, many have stopped visiting doctors other than for emergencies. For companies struggling to compete in the global
economy, carrying those burdens themselves is like strapping on a 200-pound
weight to run a 40-yard dash. But to shed them is to
leave decades of workers devastated. In the end,
someone will have to pay. The only question is who.
Why U.S.
companies are rapidly backing away from traditional pensions and health-care
benefits for retirees:
Retirees
are living longer and costing more. The companies of
the S&P 500 will have to contribute $14 billion
to shore up their pension plans this year, UBS
analysts estimate. Combined with annual retiree
health-care costs in the tens of billions and rising at double-digit rates,
many are concluding it has become too expensive to be generous with retirees.
Newer and
foreign competitors often don't bear the same retiree costs older companies
do. Airlines like Southwest, JetBlue,
and AirTran do not offer traditional pensions,
while older airlines like Northwest and UAL have pension deficits per
employee of close to $100,000, according to analyst Vaughn Cordle.
Corporate
pensions are backed by premiums paid to the Pension Benefit Guaranty Corp. With record plan failures and a multibillion-dollar PBGC deficit, there's pressure to up those contributions. The healthy are already subsidizing the weak: Steel
companies pay less than 3% of PBGC premiums but
account for 56% of claims.
Accounting
rulemakers are considering requiring companies mark
their pension plans to market values to bring U.S. standards in line with international
rules, a move that would greatly increase the plans' apparent volatility. When Britain made this shift, 26% of its companies
closed their plans to new entrants.
Three
years ago, pensions were generally self-funding and in the black, but some
industries, including auto makers, were still weighted down by the sheer
number of retirees. Then low interest rates and a
down stock market plunged pensions from a $200 billion overage in 2000 to a
$211 billion deficit in 2002.
COMPANY 2003 DEFICIT AS A PENSION PERCENT OF DEFICIT THE COMPANY'S IN BILLIONS MARKET CAP Delta Airlines $5.7 379.1% AES 1.3 79.2 Delphi 4.0 69.5 Ford Motor 11.7 69.1 Visteon 0.9 64.8 Allegheny Technologies 0.3 51.1 Hercules 0.4 38.3 Navistar International 1.0 35.7 Cummins 0.7 33.9 General Motors 8.6 28.8
COMPANY 2004 ESTIMATED DEFICIT REDUCTION CONTRIBUTION IN BILLIONS Exxon Mobil $1.8 Delta Airlines 1.1 Delphi 0.7 ConocoPhillips 0.5 Raytheon 0.4 Procter & Gamble < |