Retirement Heist

by Ellen E. Schultz

  One flaw in this construct is that employers have always been free to provide lump sums from traditional pensions; lump sums aren’t intrinsic to cash-balance plans. And in any case, most employers automatically distribute pensions in lump sums when the pensions are worth $5,000 or less, to spare themselves the trouble of keeping track of them over many years.

  Watson Wyatt, ever the innovator, offered employers the Single Payment Optimizer Tool (SPOT), a software program that enabled employers “to compare the cost of lump-sum cash outs to the costs of keeping employees on the retirement rolls.” “Often, lump sums are the most cost-effective form of pension payout because of lower administrative costs over time,” the accompanying marketing material says. It went on to note that sometimes employers are better off not offering lump sums if they can earn a higher rate of return on the assets than they will have to pay out to employees, adding that “SPOT can tell an employer when it is more cost effective to pay a lump sum and when an annuity is best…. With organizations scrutinizing every expense for bottom-line impact, every bit of savings helps.” So much for the concern about providing lump sums to help more-mobile workers build retirement benefits.

  Another fallacy is that workers are more mobile. Younger workers are, indeed, more mobile—Bureau of Labor Statistics data show that they tend to change jobs seven times before they’re thirty-two. But pensions, including cash-balance plans, require five years on the job before one vests, so few younger, more-mobile workers remain in place long enough to collect a pension at all.

  Older workers, by contrast, aren’t mobile at all (at least not voluntarily). As IBM and other employers were painfully aware, older workers tend to stay on the job until they lock in a bigger pension. That was the portion of the workforce IBM and other companies wanted to dislodge. Lump sums offered a twofold solution. For one thing, they were an enormous carrot to get people out the door. Companies knew that employees found lump sums irresistible. “Choosey Employees Choose Lump Sums!” was the title of one of Watson Wyatt’s surveys.

  The carrot was especially effective when presented along with a stick: As part of their retirement “windows,” numerous companies told employees that if they agreed to leave now, they could take a pension as a lump sum. If not, they could take their chances and get laid off next year and have only the option of a monthly check in retirement. Another benefit of lump sums—from employers’ perspective—is that they shift longevity risk to retirees. Employers have been acutely aware that life spans are increasing, which explains why companies with a large percentage of women and white-collar professionals have been eager to provide lump sums.[6] If the pension is based on a life expectancy of seventy-eight, then an engineer who lives to age ninety will have drawn a pension for roughly twelve years longer than the amount the lump sum would have been based on.

  By contrast, coal miners and factory workers tend to have shorter life spans than the national average, so it’s no surprise that they are less likely to have a lump-sum option. General Motors, for instance, doesn’t allow most of its factory workers to take a lump-sum payout. But it does allow its white-collar workers to take a lump sum if they leave before retirement age.[7]

  Government data show a strong correlation between longevity and payout options: Bureau of Labor statistics show that about one-third of blue-collar workers have a lump-sum option in their pension plans, while 60 percent of white-collar workers do.

  This concept is understood by noncorporate pension managers as well: The Marine Engineers’ Beneficial Association, which covers ship engineers and deck officers, requires workers to take a medical exam before being eligible for a lump sum. Retirees in good health can take a lump sum, but those in poor health may not be allowed to.

  Thus, despite all the talk about the burden of longer life spans, employers that pay out pensions in lump sums actually face none at all: The longevity risk has been passed on to the retirees.

  TAKING THEIR LUMPS

  Lumps sums provided employers with yet another benefit. Companies used them to secretly cut pensions even as people walked out the door. The mechanism was simple: If someone’s pension, converted to a lump sum, was worth $400,000, the employer could offer a lump sum worth, say, $350,000. How can this be legal, given anti-cutback rules?

  Simple: Companies didn’t tell employees that the lump sum was worth less, and employees couldn’t tell. But as long as the employee chooses the lump sum—unknowingly cutting his own pension—the anti-cutback law hasn’t been violated. (A key reason the lump sums are smaller is that they might not include the value of any early-retirement subsidy, which can be worth 20 percent or more of the total value.)

  Few employees would knowingly give up tens of thousands of dollars’ worth of pension, but unless employers provided apples-to-apples comparisons of the actual values of the monthly pension and the lump sum, there was no way to compare. In 1999, Mary Fletcher, a marketing services trainer and fourteen-year veteran of IBM, had to decide between taking a lump sum and a monthly pension when IBM sold a unit with three thousand U.S. employees to AT&T. She hired an adviser who calculated that while the monthly pension would be worth $101,000 if cashed out, the lump sum IBM offered Fletcher was worth only $71,500. Still, she took the lump sum. Almost all employees do, figuring they can invest the money and eventually end up with more. She was forty-seven and figured she was better off having nothing more to do with the IBM pension plan.

  Employee advocates, including the Pension Rights Center and AARP, demanded better disclosure rules, but employers fought back. Lobbyists for the American Society of Pension Actuaries, the ERISA Industry Committee, and the U.S. Chamber of Commerce told Senate staffers that employees would only become confused if they were presented with too much complex information, and that providing more disclosure would be a “daunting task.” Lawmakers didn’t completely buy this, so in 2004 the IRS began requiring employers to tell people more clearly if the value of the lump sum wasn’t equal to the monthly pension.

  In 2006, the Pension Protection Act banned wear-away prospectively, meaning that if an employer set up a cash-balance plan after the 2006 law went into effect, it couldn’t include a wear-away period.

  But the issue of pension deception is still playing out in the courts. Cigna employees, who hadn’t been told their pensions were essentially frozen when the company changed to a cash-balance plan, sued the company in 2001. In 2008, a federal court concluded that Cigna deliberately deceived its employees when it changed its pension plan in 1998, gave them “downright misleading” information about their pensions to negate the risk of an employee backlash. “CIGNA’s successful efforts to conceal the full effects of the transition to [the new pension] deprived [plaintiffs] of the opportunity to take timely action… whether that action was protesting at the time [the change] was implemented, leaving CIGNA for another employer with a more favorable pension plan, or filing a lawsuit like this one.”

  The district court ordered Cigna to restore the pension benefits it had led employees to believe they would be receiving. Cigna appealed to the Second Circuit, and lost, but that wasn’t the end of it. Cigna didn’t try to appeal the court’s finding that it deceived its employees—the memos and documents that surfaced in the case were too damning.

  But in a kind of hail Mary pass, Cigna appealed to the Supreme Court, arguing that in order to get the benefits, each individual employee must prove he’d acted on the misinformation–that is, didn’t change jobs or save more money, and thus suffered financial harm.

  During oral arguments before the Supreme Court late in 2010, it became clear that the majority of justices were troubled by the fact that if they adopted the “detrimental reliance” standard Cigna was advocating, then employers would suffer no consequences even for the most egregious deception. “Doesn’t this give an incredible windfall to your client, Cigna, or to other companies that commit this kind of intentional misconduct?” Justice Elena Kagan asked Cigna’s attorney. In May 2011, the justices sent t
he case back to the lower court with instructions that it review its decisions, based on the portion of pension law that requires employers to tell employees, clearly and unambiguously, when it is cutting their pensions.

  If the judge comes to the same decision to award the benefits to the employees—a total of $82 million—this would be the biggest award for employees whose employer hid pension cuts.

  But Cigna has already taken steps to soften the blow: It froze the pension plan in 2009 and cut health, disability, and life insurance benefits for retirees, giving it a gain of $92 million.

  Chapter 3

  PROFIT CENTER

  How Pension and Retiree Health Plans Boost Earnings

  IN ACTUARIAL CIRCLES, there’s a joke that goes something like this: A CFO is interviewing candidates for a job as a benefits consultant. He calls the first one, an accountant, into his office and asks, “What’s two plus two?” The accountant says “Four.” The CFO sends him away, calls an actuary into the room, and asks, “What’s two plus two?” The actuary closes the door, pulls down the blinds, then leans in and whispers, “What do you want it to be?” He gets the job.

  As much as this anecdote unfairly maligns the vast majority of actuarial professionals, it nonetheless sums up the view that some in the profession have toward their more aggressive brethren. Until the 1990s, benefits consulting firms generally handled standard pension tasks, like helping companies figure out how much to put into their pension plans, based on the ages and life expectancies of their employees, plus other factors. More closely aligned with the human resources department, they were one of the costs of operating a business, like accountants and the janitorial staff. But over the next two decades, large benefits consulting firms began aggressively marketing themselves to the finance departments. Their pitch? They could help employers turn pension plans into profit centers.

  Their primary tools included the new accounting rules[8] that employers implemented in 1987, which require employers to disclose the size of their pension obligations, as they do other kinds of debts, and show how these pension debts affect income each quarter. Though the new accounting standard, FAS 87, was intended to increase transparency—allowing shareholders to see the full liability on a company’s books—it was the beginning of the end for pensions. Before the new rules went into effect, employers got only one benefit from cutting pensions: The money that would someday have been paid to retirees would instead remain in the pension plan. Under the new accounting rules, employers got a second benefit when they cut pensions: Reducing the liability generated gains. These are paper gains, not cash, but when it comes to calculating earnings, the gains are treated the same as income from selling software or trucks. IBM’s pension cuts in 1999 reduced its pension obligation by $450 million, resulting in a pot of gains worth roughly $450 million that the company could add to income either right away or over time. IBM added $200 million of these gains to its 1999 income.

  The ability to convert pension benefits that would have been paid out to retirees over the coming decades into immediate profits for shareholders, today, changed the game: Pension plans weren’t just piggy banks to tap for cash. They were also cookie jars of potential earnings enhancements.

  It works something like this: Let’s say a person earns $1,000, but he and his employer agree that he won’t be paid until next year. Under FAS 87, this IOU is a debt, which the employer records on his books: Deferred compensation, $1,000.

  But what if the employer decides to cut the employee’s salary to $600 after the company has already recorded this debt on his books? Two things happen. The following year, the employer pays only $600—a cash savings of $400—and enjoys a secondary benefit: It has reduced its debt by $400. Under accounting rules, a forgiven debt is recorded as a gain, and boosts income.

  To see how this plays out in the retirement heist, add a few zeros to the $400 and think of the deferred pay as a pension: You’re earning it today, but it will be paid later. Add ten thousand colleagues and the resulting obligation is billions of dollars. Reducing that obligation by $400 million generates gains.

  PENSION TEMPTATION

  There’s nothing magical about these accounting rules. What made pension debt different from other kinds of debt was that it was easier to erase. A company that borrows $100 million to build a factory can’t later wave a wand and make the debt go away; it can restructure the debt, or shed it in bankruptcy, but otherwise it’s sticking around.

  Pensions are different. Companies have a lot of leeway to change the benefits, and thus the size of the pension debt—but not all of it: A company can’t touch the retirees’ monthly checks. And it can’t take away amounts people have already earned. But it can slow the growth of their pensions or halt it altogether by freezing the plans or laying off workers. This explains why, even when a pension plan has plenty of money, a company will profit if it cuts benefits.

  It didn’t take benefits consultants long to realize that every dollar a company had promised a retiree—for pensions, prescription drugs, dental coverage, life insurance, or death benefits—was the equivalent of a dollar that could potentially be added to a company’s income. Suddenly, the $1 trillion that companies owed three generations of employees and retirees for pensions and retiree health benefits became potential earnings enhancements. Cuts generate gains, which lift earnings, which help the stock price, which boosts the compensation of the executives whose pay is based on performance. What CFO could resist that?

  Not too many, and not for long. By the late 1990s, roughly four hundred large companies, most of which had well-funded or overfunded pension plans, had cut pension benefits, primarily by changing to a less generous cash-balance plan, which for many older workers was no different from freezing their pensions.

  Pension managers faced a fresh conflict of interest: Should they manage the plans for the benefit of shareholders (and themselves) or for the benefit of retirees? Pension law requires that the plan be managed for the “exclusive benefit” of its participants. But on this point, pension law is like a toothless dog: It might sound scary, but it has no bite. Short of outright theft of pension assets, employers have been fairly free to make a lot of self-interested decisions when it comes to managing pensions.

  Accounting professors at Cornell and the University of Colorado examined hundreds of companies that had converted their pensions to a cash-balance formula and found that the average incentive compensation for the chief executive officers jumped to about four times salary in the year of the pension cut, from about three times salary the year before. When companies didn’t change their pensions, CEO pay also didn’t change much. “You could have real economic wealth transfers away from employees,” concluded Julia D’Souza, a Cornell associate professor of accounting and lead author of the study.

  Pensions with Benefits

  Gains from benefits cuts were only one way the pension plans were lifting earnings. The investment returns in the plan were another. Under the old system, employers got only one benefit from the investment returns in the pension plan: If the investments did well, the company would have to contribute less to the plan to keep it well funded.

  Under the new rules, employers got a second benefit: If investment returns on pension assets exceed the pension plans’ current costs, a company can report the excess as a credit on its income statement. Voilà: higher earnings. The bigger the pool of assets, the greater the potential gains.

  This gave employers an incentive to cut benefits, even when the plan had a surplus. By the end of the decade, ten of the twelve companies with the most pension income had cash-balance or similar benefits-reducing pension plans. In 1998, Bell Atlantic Corp.’s pension plan produced a $627 million pretax credit for the company, and GTE Corp. reaped a $473 million pretax credit. US West, Boeing, IBM, and Ameritech had pension income ranging from $100 million to $454 million.

  The desire for pension income also encouraged employers to increase stock holdings in the pension plans, in an effort to g
enerate more income. The percentage of pension assets invested in stocks rose from 47 percent of assets in 1990 to more than 60 percent since the mid-1990s. A peculiar result of the accounting rules was that, instead of earnings driving the stock price, the stock market was driving earnings. In 1998, more than $1 billion of GE’s pretax profit of $13.8 billion came from the pension plans. Caterpillar Inc. scored a $183 million credit. At Northrop Grumman Corp., 40 percent of first-quarter pretax profit was attributable to the surplus. USX–U.S. Steel Group would have reported a first-quarter loss except for its overfunded pensions.

  In the euphoria of the bull market, few analysts noticed that a big chunk of company profits was coming from the pension plans. Patricia McConnell, a senior managing director at Bear Stearns, was one of the few who noticed the trend. Concerned that investors didn’t understand that pension income was the result of smoke and mirrors, not improved sales or some other tangible achievement, she conducted an eight-month study and found that pension income accounted for 3 percent of the operating income of the S&P 500 companies in 1999. At some, it made a big difference. Without pension income, the income at People’s Energy, Westvaco, U.S. Steel, and Boeing would have been 20 percent to 30 percent lower. Northrop Grumman’s income would have been 43 percent lower.

  Pensions not only generated profits; they also became tools to manage earnings, thanks to the enormous control employers had over the size and timing of pension profits. Need to lift the stock price before a merger? About to miss earnings targets by a few cents per share? No worries: The pension plan could get you there. The new accounting rules gave a whole new meaning to the words “pension fund management.”