The failing pension system in the U.S. private sector: have we seen the worst yet?

Introduction

During 2000, U.S. employers spent about 15.3 percent of their company's total worker compensation package on benefits. Pensions are now the single largest benefit expenditure that employers pay. Retirement benefits fell from about 60.0 percent of a worker's benefit portfolio in 1960 to 48.0 percent in 2000 (Okunade & Wunnava, 2002). According to a recent survey of workers 18 years old and older conducted by the National Association for Variable Annuities (NAVA) published in USA Today (2006), 49.0 percent of employees believe that their current or future employers will offer or continue to offer a guaranteed pension plan. This compares with 47.0 percent responding negatively. Therefore, statistically speaking, workers are evenly split on whether their employers will default on promised pension payments. On August 17, 2006, President George W. Bush signed into law the pension reform bill. The enforcement of the core provisions of the Pension Protection Act of 2006 could reinstate worker confidence in the pension system.

The nonprofit Employee Benefit Research Institute (EBRI), using retirement survey data developed during the past two years (Barr, 2006), reported that federal employees are guaranteed inflation-adjusted pensions (only 21.0 percent in the private sector are eligible for a defined benefit pension), can take their health insurance plans into retirement (compared with only 33.0 percent of large private-sector employees), and 53.0 percent plan to retire before age 62 (compared with 12.0 percent of all Americans who plan to retire at 65 years or older). Surprisingly, the EBRI also found that more federal workers are better prepared for retirement than are private-sector employees whose retirement proceeds are less assured, despite factual evidence that corporations are increasingly defaulting on retiree pension promises, while also changing the design structure of the portfolio of worker benefit plans to reduce corporate outlays.

The share of U.S. workers in defined-benefit pensions declined from 80.0 percent in 1985 to 36.0 percent in 2000, and this trend is likely to continue as workers become more uncertain of their future pension proceeds (Dominitz & Manski, 2006). Private pensions decline when companies file for bankruptcy protection and transfer their retirement obligations to the federal government's Pension Benefit Guaranty Corporation (funded by premiums, the nearly 30,000 defined-benefit plans managed by private-sector employers pay for coverage). This federal insurer, in turn, pays out about one-third of the amount due private-sector retirees. (The federal insurer of private-sector pensions itself operated with a $23.3 billion deficit in mid-2005.) as a result, affected retirees are returning to active workforce status. President Bush recently signed a new public policy initiative targeted at slowing pension default rates. The goal of this article is to discuss the recent trend in pension defaults and its implications, with special focus on the U.S. private sector, including the airline, energy, and automotive industries. Current survey data and literature on the reported gaps between pre-retirement plans and postretirement reality on expenses are used to caution baby-boomers currently in their 50s who are planning to retire.

The U.S. Department of Labor recently announced that wages and benefits rose at a robust 6.6 percent annual rate during the second quarter of 2006. After adjustments for inflation, primarily driven by energy price shocks, the gain was about 1.6 percent annually (Anderson, 2006). This short-term rise in compensation masks an increasingly important development in the market for employee benefits, notably pensions. Private-sector retiree pension benefit defaults increasingly occur at a time when senior executive compensation packages are ballooning (Brush, 2006). Because executive stock options are performance-based, the strategy since 1993 has been to tilt senior executive compensation toward stock options to save taxes on I annual executive incomes exceeding $1.0 million (Forelle & Scannell, 2006).

Pension Defaults Across Major Industries

According to Standard & Poor's ranking of the top S&P 1,500 companies with the worst pension funding problems (Ford, Exxon Mobil, IBM, Delta, Lockheed Martin, Delphi, Boeing, Raytheon, DuPont, United Technologies, Goodyear, Pfizer, Dow Chemical, Excelon, Procter & Gamble, ConocoPhillips, Hewlett-Packard, Altria, and Alcoa), the top five offenders are in the automotive, energy, and airline industries (Brush, 2006). In the U.S. automotive industry, Ford and GM experienced deep deficits in pension contributions, whereas United and Continental did so in the airline industry.

Since the September 11, 2001, attacks, 10 U.S. airlines have filed for bankruptcy, with industry losses totaling over $40.0 billion, in addition to the loss of about 150,000 fulltime jobs. This gloomy scenario is compounded by high jet fuel prices, reduced passenger miles flown, aviation security costs, rising labor unrests (pilots, flight attendants, mechanics) (Foss, 2006), and more expensive contract renegotiations. More specifically, "salary reductions ... are the centerpiece of the aggressive cost-cutting regimens embraced by the largest airlines" (Winship, 2006). In other words, compared with the 2001 level, 30.0 percent fewer employees now do more work and receive less compensation and fewer benefits.

Shortfalls in periodic pension contributions arose gradually over time in part because legal corporate accounting reporting practices had not required that pension contributions be explicitly reported. Therefore, U.S. corporations were able to hide their falling pension contributions in the face of dwindling profits, rising prescription drug bills of retirees that employers pay (CNN.com, 2005), and growth of executive compensation including stock options. The typical U.S. corporate executive's pay of $11.3 million in 2005 is 262 times the average worker's pay and represented a 27.0 percent increase from the 2004 level (Brush, 2006). Corporate earnings generated in the U.S. represented 10.7 percent of the economy's gross domestic income, the highest share since the 1960s (Petruno, 2006). Despite the accompanying phenomenal growth in worker productivity since the mid 1990s, labor's share of income remained fiat in the face of falling worker benefits and uncontrolled outsourcing of jobs to foreign countries. In the two years preceding United Airlines' (UAL) 2002 bankruptcy filing, for example, UAL pensioners were projected to lose in excess of $3.0 billion in promised pension payments at the same time that UAL's chief executives received over $13.0 billion. At Ford, the pension loss estimate was over $12.0 billion, and at GM the shortfall was roughly $8.0 billion. Similar to the situation at United, at GM the CEO received roughly $41.0 million. During 2004, the chief executive at Continental took a lump sum payment of $22.0 million from his retirement at the time that the company under-funded its pension funds by $1.58 billion.

Northwest Airlines (NWA), like United, has been operating under federal bankruptcy Chapter 11 protection since 2005. This means that its under-funded pension plan obligations have been transferred to the federal insurer with a significantly reduced payout to retirees. In June 2006, a U.S. bankruptcy judge extended Northwest Airline's deadline to file a reorganization plan until January 15, 2007 (Memphis, Business Journal, 2006). As recently as September 2006, NWA has continued to seek additional wage concessions from its flight attendants to trim operating losses. A federal bankruptcy judge ruled earlier in favor of NWA to cancel its contracts on delivery of large-capacity airplanes. The NWA fleet is now reduced and operates more regionally, with the goal of competing more efficiently with low-cost carriers. Thus far, the Association of Flight Attendants has not succeeded in ordering a work stoppage or random disruption of work. The airline is seeking a 21.0 percent wage cut and significantly reduced benefits for flight attendants, to the tune of about 40.0 percent in concessions that include reduced health benefits.

Summary, Implications, and Conclusion

Many important individual private decisions in the U.S., ranging from job relocation to retirement timing, marriage and divorce, and childbearing, are implicit in the structure of defined-benefit pension plans such as Social Security and a number of private-sector pensions. A rising trend in the U.S. is the gradual decline in the proportion of private-sector companies that fully fund employee pensions. Private pension funds are currently under-funded to the tune of about $450.0 billion, and slightly less than a quarter of this amount is with employers having serious funding deficits, which is potentially problematic as an unprecedented 77 million baby-boomers are expected to retire in the next 25 years (Knowledge @ Wharton, 2006). These retirees are most likely to face the twin challenges of managing their medical care bills and dealing with the problem of the "lump-sum illusion"--the tendency to view retirement savings as a lump sum rather than a prospective income stream.

Currently, the failure of private companies to fully pay out pensions as promised has major implications, including the likelihood that retirees will return to full-time employment after retirement. The ability of the federal insurer of defaulted pensions to bail out retirees is increasingly more likely to weaken as more companies default through bankruptcy protection. The lack of employee confidence in an employer's ability to fulfill its pension benefit promise could reduce worker incentives and shift employee preferences to jobs paying higher wages and anemic retirement benefits. This would add to the pool of roughly 50.0 percent of private-sector employees lacking pension benefits. Particularly, the older workers in this scenario would prefer current consumption (from higher disposable incomes) and higher current income tax brackets to future consumption opportunities (from pensions). In turn, reduced private savings for retirement would worsen retiree lifestyles and raise the need for public support of private-sector retirees.

Unanticipated cuts in retiree pension benefits typically coincide with rising costs of health care and corporate cutbacks in employer-sponsored retiree health benefits. Only 24.0 percent of Medicare-age retirees from employer -subsidized prescription drug coverage, Medicare Part D plans cover 53.0 percent of retirees, 13.0 percent are covered in other plans, and 10.0 percent lack coverage (Wessel, 2006). Thus, excluding the cost of long-term care (insurance coverage suggested for retiring couples whose net worth is less than $3 million), a 65-year-old couple retiring in 2006 without employer-provided retiree health benefits will need almost $300,000 for out-of-pocket health-care expenses if they survive to the average life expectancy (Knight, 2006). Uncertainties in private-sector employee pension and retirement health insurance benefits are making retirement preparedness less realistic. Data recently collected by McKinsey & Co. (Ruffenach, 2006) show that 36.0 percent of pre-retirees expected to take on work after retirement (10.0 percent actually do), 32.0 percent planned significant cuts in discretionary spending (10.0 percent actually do), and 31.0 percent planned to downsize home or relocate (7.0 percent do in reality). Consequently, one in four U.S. baby-boomers in their 50s plan to delay retirement at least two years because they lack the resources needed to retire at a similar age workers retired in the past (Associated Press, 2006). This percentage is expected to rise in the future, however.

Therefore, unless there is a radical legal change in how retirement fund obligations are reported in corporate financial statements, workers and regulators are highly unlikely to have information on whether pension funds are in deficit. Moreover, increased federal oversight of employee retirement funding is necessary. The recent signing into law of the pension reform bill by President Bush on August 17, 2006, could be a first small step in the right direction. Dubbed the most sweeping reform since the 1974 ERISA (Employee Retirement Income Security Act), the law requires undefended pension plans to reach full funding within seven years, while "at risk" companies are required to accelerate their contribution rate. The effort recognizes the decline of traditional defined-benefit pensions and the plan to embrace the defined-contribution savings plan. NWA and Delta Airlines, currently under bankruptcy, have frozen their defined-benefit pension plans in favor of the pension reform plan. The bankrupt airlines have 17 (not 7) years to fully fund their deficit pension plans. Portability is important, and risk-preferring younger workers are expected to benefit (Means, Jr., Okunade, & Stafford, 1993) from job mobility without the loss of pension benefits. Finally, the law mandates that companies should more accurately measure their pension fund obligations. Obviously, the worst is yet to come.

References

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Associated Press. 2006. "Boomers May Need Later Retirements." The Wall Street Journal, December 13: D3.

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Brush, Michael. 2006. "4 Ways You Can Fight Corporate Greed." (http://articles.moneycentralmsn.com/investing/CompanyFocus4waysyoucan fightcorporategreed.aspx), December 13.

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Dominitz, Jeff, and C. Manski. 2006. "Measuring Pension-Benefit Expectations Probabilistically." Labour 20(2): 201-236

Forelle, Charles, and Kara Scannell. 2006. "Revisiting Executive Pay Law. Congress May Reduce, Reverse Deduction That Fed Stock-Option Explosion." The Wall Street Journal, September 6: C1-C4.

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Means, Jr., Dwight, Albert Okunade, and Pamela Stafford. 1993. "What Influences Employees to Choose Optimal Benefits?" Journal of Compensation and Benefits, November/December: 37-41.

Memphis Business Journal. 2006. "Judge Extends Deadline for Northwest Reorganization." (http://memphis.bizjournals.com), June 29.

Okunade, Albert, and Phanindra Wunnava. 2002. "Availability of Health Insurance and Gender Differences in 'Job Lock' Behavior: Evidence from NLSY." Journal of Forensic Economics 15(2): 195-204.

Petruno, Tom. 2006. "Wages Crawl as Profits Soar." The Commercial Appeal, December 19, C5.

Ruffenach, Glenn. 2006. "The Retirement Lies We Tell Ourselves." The Wall Street Journal, December 11; R1 -R14.

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Wessel, David. 2006. "Once Unloved, Medicare's Prescription-Drug Program Defies Critics--But Issues Remain." The Wall Street Journal, CCXLVIII (134), December 7; A2

Winship, Tim. 2006. "How Many Airline Employees Does It Take To Screw In a Light Bulb?" (http://www.smarttravel.com).

Albert A. Okunade, Ph.D., Professor of Economics at the University of Memphis, conducts research in the economics of labor, health, and the non-profit sector, including higher education and health care financing. He has published over 80 research papers and presented research at numerous national and international conferences in the UK, Finland, Italy, Canada, Spain, Portugal, and others. His intellectual contributions in labor economics have appeared in leading journals including Economics Letters (multiple, Harvard University), Journal of Labor Research, The American Statistician, Education Economics, Journal of Applied Econometrics, Health Economics, Journal of Productivity Analysis, and others. Since year 2000, he has received several professional honors including the University of Memphis Distinguished Research Award in Social Sciences & Business, the (annual) Palmer Professorship Award for Research (The Fogelman College of Business & Economics), The University Honors Program Faculty Fellowship Award, Student Advising Award for Outstanding Dedication to Students (African & African American Studies Program in the College of Arts & Sciences), and many others. He has competed as finalist for the University's Distinguished Teaching Award (multiple times) and the Eminent Faculty Award (multiple years). Recently named a Sam M. Walton Free Enterprise Fellow, he has also served a faculty sabbatical at Harvard University, is on the Scientific Advisory Committee of the International Health Economics Association (iHEA), and sits on the founding Board of Trustees of the American Society of Health Economists (ASHE).