A Discussion on Pension Costs

It’s nearly 4 in the morning and I’m up reading political blogs; happened to come across http://cognidissidence.blogspot.com/ and enjoyed reading it. This particular entry is way off base from a financial perspective and since the author seems to be working to expose problems in government, I thought I’d take the time to explain why if any of you are interested. If not, that’s okay, too. Also, given the time, I apologize if there are errors or it is not entirely coherent.

[mainbodyad]Let’s imagine that you own a small widget manufacturing shop, providing high quality widgets from your own facility in Milwaukee County. You hire an employee for salary or wages that work out to roughly $36,000 per year. On top of that, you’re going to have payroll expenses of at least $2,700 plus a host of other costs that will probably add up to somewhere between $700 and $2,000 depending upon your state, the workers compensation laws, etc. Let’s say $1,300 in additional expenses so that we can say “extra” costs of $4,000 for all of the government regulations, et cetera which are good and necessary. So, as an employer, your total compensation now amounts to $40,000.

You decide to also offer a pension. Say this new employee is 35 years old and he will retire at 65, providing you with 30 years of hard work and dedication. You’d like to provide him a pension of at least $36,000 per year (even though that will be worth a lot less due to inflation in the future), so you set up a plan with a trust company, lawyers, etc. We’ll ignore the cost of establishing the plan, the tax filings, trade confirmations, bond spreads, etc. They exist and they are substantial, but in this scenario, we’re going to pretend like the tooth fairy pays for all of our plan maintenance costs.

How much money is your company going to have to set aside in the pension plan to fully fund the promise you’ve made to your employee to provide him with that $36,000 pension? Putting aside huge life expectancy probability tables for the sake of simplicity, a good rule of thumb if you have a diversified work force and stable employment is a 6% capitalization rate. That simply means that to provide $36,000 in annual payouts to this one employee, you are going to have to set aside $600,000 in assets specifically for him in the pension fund. Put another way, if this employee wanted to save enough for his own life to provide $36,000 in annual income through a 401(k), he’d have to have roughly $600,000 in assets when he retired. The difference between a 401(k) and a pension is, with the latter, it’s the company making 100% of the contribution.

The company has to work with its accountants to figure out how much money to put aside each year to make sure that when this employee retires, there is $600,000 in the pension. To do this, they use a special formula known as solving for payment in a present value of an annuity. It’s one of the key discounted cash flow calculations and the formula is:

PMT = FV(OA) / [((1 + i)n – 1) / i ]
where: FV(OA), or Future Value of Ordinary Annuity: the value of the annuity at time
t=0 PMT: Payment amount (value) of the individual payments in each period
i: periodic interest rate that gets compounded for each period of time (periodic rate may be determined by dividing an annual rate by the number of periods in a year)
n: number of periods (same as the number of payments)

I’ll skip the long math calculation and give you the answer: $5,296.46 per year. Let’s round it up and say $5,300. That’s the amount the company needs to put into the pension for the employee each Christmas assuming it can earn an 8% return on its blended asset base of stocks, bonds, real estate investment trusts, and other securities. Frankly, 8% is aggressive. A far safer bet would be 6%, which would require just shy of $7,600 each year deposited into the pension fund. To be safe, let’s split the difference and say that your widget factory needs to make a Christmas deposit of $6,450 into this pension fund around Christmas.

To fund the $600,000 pension, over 30 years your business will need to come up with $193,500 to deposit into the pension plan. The remaining $406,500 comes from capital gains, dividends, and interest, virtually all of which comes from the firms in the S&P 500 such as Exxon-Mobil, Wal-Mart, General Electric, and Johnson & Johnson. These are the only types of companies large enough to have securities that can be bought and sold on such a widespread scale.

Now, what how much does the employee cost? He would say $36,000 because that’s what he’s paid. He’s even more likely to give you the after-tax figure he takes home after the government has taken the FICA payment, income tax withholding, etc. To you, your immediate cash outlays are $40,000 per year plus the $6,450 pension funding, so $46,450. Put frankly, the employee is costing you 29.03% more on a pre-tax than he thinks he’s getting paid, which is an enormous amount.

Up until the pension rule overhaul (one of the very, very, *very* few things Bush and Congress got right), companies and state / local governments could simply ignore the $6,450 pension funding requirements and say they’d make up for them in the future. These liabilities, meantime, began growing in the background, the gap between what was promised and what was funded expanding at an accelerating rate. There is a very convincing case that this is the reason the manufacturing industry was decimated in the United States.

I had this same discussion with a reader on my site some time ago. She was convinced that debt and the economy caused GM’s failure. But a look at the 10K filings show the real problem was the underfunding pension and health care liabilities. The numbers speak for themselves: According to the report: “’Consider that from 1993 through 2007, GM has spent at a total of $103 billion in the U.S. to fund legacy pensions and retiree healthcare – an average of about $7 billion a year – a dramatic competitive and cash-flow disadvantage.’” “Blaming the debt would be like telling someone who went bankrupt because of their credit card balances that the problem was the credit card company. No, the reason they are under the crushing debt is because they spent more than they made. If you always spend less than you make, it doesn’t matter that your income fluctuates with the economy. There is no way GM could compete with Japan when they have a $103,000,000,000.00 hurdle to overcome. That number is staggering.”

The key is that management is just as responsible as the unions for destroying the companies and our government. When you make the promise for a small pension, it takes $600,000 to fund it given the inputs we assumed. That means for a tiny widget factory with 10 employees, the moment the union negotiated that pension requirement, the employees won a $6,000,000 payday. If you were to tell them that, it’s likely they’d think you were lying because our education system has done a horrible job preparing students for basic life skills such as finance and accounting.

In fact, the average worker is likely to argue that the real cost, if anything, was only $193,500 in cash that needed to be funded into the plan.  That’s inaccurate because of something economists call opportunity cost.  The average American business earns 12% on book value.  Had you, as the owner of this widget factory, invested the money back into growth, you would have been able to put an extra $6,450 to work in bigger machines and equipment, earning 12% on the investment and still getting the tax write-off from depreciation.  Over 30 years, you would be giving up $6,437,482+ in book value as the result of compounding.  If, 30 years from now, you are still earning the average return of 12% on book value, your company is giving up $772,500 in annual profit! If your firm is valued at 15x earnings, the wealth that you, as an owner, gave up for providing this one pension for one employee is $11,587,500.  In other words: You can either give them a $36,000 annual pension or you, as the owner, can make your shares worth $11,587,500 more than they would have been.  Don’t people understand why business owners aren’t providing pensions anymore???

One pension of $36,000
Cash Cost to Business Owner: $193,500 plus pension plan fees
Opportunity Cost to Business Owner: $11,587,500

The question becomes for you, as a man who has risked everything he has to start a business to provide for your family: Would you rather give that check to your workers or provide for your own kids?  Is a $36,000 pension worth you giving up just shy of $11.6 million in wealth?  For most people, the answer is no.

[mainbodyad]The reason this is shocking to 99% of the American population is because, as I’ve already said, our education system has failed.  The average high school student has no idea that if you make $1,000,000 as a basketball player, that’s it.  If you build a widget factory that is growing, successful, earns goods returns on equity and makes the same $1,000,000, you could probably sell your stock for between $10,000,000 and $15,000,000!  Same income = vastly different wealth.

The reality is that the United States is either going to have to reneg on pension promises, print money to fund them causing substantial inflation (and a transfer of wealth to those with large tangible asset holdings such as real estate and gold), or drastically raise taxes. Unfortunately, the last option isn’t really viable because the shortfall is so large, you would have a revolution if you taxed the younger generation upwards of 50% to 70% on their income. When the older generation of legacy employees makes up a smaller and smaller part of the voting population, you’re going to see the majority simply shrug their shoulders and say “too bad”.  Another option is some form of pension freeze where no more benefits accrue to the pension and when old employee positions are filled, they do not qualify to participate in the pension.  This was done a lot in the 1980’s and 1990’s in corporate America and the government sector is just now catching up.  It’s a potential way to make sure the older generation of retirees isn’t completely and totally screwed out of their pension benefits.

Personally, I don’t have a solution for the problem other than to say that it must start with good accounting. Not counting as a cost what is a cost is the reason we’re in this mess in the first place. Companies, governments, and organizations should be required by law to fully fund pension costs on an on-going basis. Bush at least got us 80% the way there by forcing the same recognition in government that had become standard in corporate America. Again, definitely NOT a fan of the man, but this is one of the extraordinarily few things he managed to get right.

Going forward as a nation, the unpleasant truth is that the United States, and the rest of the world, is going to split into “knowledge workers” and “working class”.  Peter Drucker predicted this decades ago and it’s terrifying how accurate he was when you go back and read his theory on the direction of manufacturing and union based jobs.  A nurse doesn’t think of herself as needing to join a union because the value of her services consists of the knowledge in her head.  If she is the best nurse in the world, she can get paid more.  Her skills are portable, she doesn’t need to work for the same hospital, and she can have them bid against each other for her services, especially if she has rare licenses, skills, or job experiences that make her more in demand.  She is her own company.  Psychologically, it’s unlikely that she will see herself as a member of a collective bargaining unit because it simply isn’t necessary.  If you worked for GM and left, you don’t have a lot of other choices.  If you are a nurse and leave your job, there are thousands of hospitals that can hire you.

The world has changed.  If I had to sum it up, here it is: In the future, a man will not be able to make a living by going to high school and working with his hands unless he’s some sort of artisan or there is a supply/demand mismatch.  All of the decent paying jobs will consist of those that require specialized knowledge in academic or trade fields such as engineering, accounting, graphic design, finance, mechanics, plumbers, and supply chain management.  The only option will be for people to make a living off an intellect / skill base that they can carry with them anywhere, not their physical labor.  Technology is making the latter unnecessary.  As more and more of the population fits this mold, they are going to be unlikely to accept the pensions that have been promised to government employees.  Whether this is morally acceptable or not isn’t for me to say; as an investor, my job is to attempt to figure out what will happen and why based on human behavior.

You can find our discussion here:
http://beginnersinvest.about.com/b/2009/06/01/general-motors-is-expected-to-declare-bankruptcy-within-hours.htm

And here are a few, more detailed pieces I had written about in the past:

Adjusting Pension Assumptions to Manipulate Earnings
http://beginnersinvest.about.com/od/gaap/a/aa090704.htm

In the above article, I pointed out several large companies that were reporting profits inflated by 35% or more due to the manipulation in pension accounting.  This is common place in the United States and completely unacceptable.  Without substantial pension reform, or the end of the pension altogether (which is looking increasingly likely), it will continue.

The States are Running a Ponzi-Scheme
http://beginnersinvest.about.com/b/2009/05/25/the-state-governments-are-running-ponzi-schemes.htm