Retirement Heist

by Ellen E. Schultz

  So lawmakers awarded employers a generous subsidy. Beginning in 2006, the companies would receive a subsidy of 28 percent of what they paid, up to $1,330 per retiree, per year, to help pay for prescription drug coverage.

  That sounds straightforward, but there were windfalls within windfalls. Not only was the subsidy tax-free, but employers could deduct the government handout. In other words, they could treat the free government money as if it were coming out of company coffers, and deduct every cent. Employers did the happy dance.

  Even better: The legislation said that employers would receive a subsidy of 28 percent of the cost of the coverage, but it didn’t say the employer’s cost. Thanks to the lack of one critical word, companies maintained they could receive the subsidy based on what the retirees spent. This created a situation in which, even if the retirees paid for 100 percent of the prescription drugs themselves, their former employer would get a tax-free subsidy of 28 percent of what they paid, and then deduct that amount. This combination made it possible for some employers to restructure their programs so that 100 percent of the prescription drugs was paid for by the government and the retirees.

  It isn’t clear whether this boondoggle was the result of a drafting error—after all, these bills tend to be nailed down in the dead of night, after a lot of horse trading among various interested parties. Or, more likely, it was the result of the stealthy fingers of lawyers and lobbyists for employers. Regardless of how it got there, this unintended benefit for employers went unnoticed until after the Medicare drug law was passed.

  When the Treasury discovered it in early 2004, it complained about this gravy train, which was, as tax loopholes go, pretty impressive. The federal Centers for Medicare & Medicaid Services, among others, criticized the deduction as a windfall. From the first, it was tops on the list of execrable giveaways that some in the Treasury had their knives out for, though they didn’t get a chance to take a stab at rescinding it until late in 2009.

  At that point, the Obama administration was scrambling to identify dubious tax breaks it could eliminate to help offset the cost of the new health care program. The Medicare subsidy deduction was a prime candidate. Employers launched their lobbyists to try to save what some critics were calling double deduction. Echoing the threat they’d made in 2003, employers said that unless they were allowed to keep the deduction, they wouldn’t be able to afford to continue to provide the prescription drug coverage and would drop it altogether. This time, the argument didn’t work. The deduction would end, but not right away. Employers still had four more years to deduct the free money they received to subsidize benefits that the retirees, in many cases, were paying for.

  But when health reform passed, employers correctly assumed that almost no one knew this backstory, or how the accounting worked, and were able to make some political hay.

  AT&T announced that, because of health reform, it was taking a $1 billion hit. As predicted, shareholders, analysts, lawmakers, and the media assumed this meant that AT&T’s health care bills would rise by $1 billion. AT&T didn’t disabuse the public of this misperception.

  What was really happening was that AT&T had to reverse part of the gain it had taken after the subsidy was granted in 2003. When it was awarded the subsidy, it estimated how much it would receive in government subsidies over the years, including the value of the deduction, which is recorded as a “deferred tax asset” (which simply means that when a company knows it will pay pensions, deferred comp, or other retiree benefits in the future, and deducts the amounts, it reports the value of those future deductions as an asset).

  AT&T estimated how much it would receive in subsidies over the lives of its retirees and reduced its obligation by $1.6 billion in 2003.

  Like many other companies, AT&T went ahead and cut prescription drug coverage for salaried retirees anyway. Less than a month after the Medicare Prescription Drug Act was passed, AT&T announced steep increases in deductibles and co-pays for prescription drugs, which shaved its costs by $440 million in 2004 alone.

  Fast-forward to 2010: Because it would no longer be able to deduct the subsidy after 2013, AT&T had to reverse the value of the deduction it had recorded as a deferred tax asset. Although AT&T could continue to deduct the subsidy until 2013, accounting rules required it to recognize the change right away.

  Under the alchemy that is retiree benefit accounting, AT&T, which in 2003 had estimated that the total value of the subsidy would be $1.6 billion, was now saying that losing the ability to deduct the subsidy—which it would still receive, tax-free—would erase $1 billion in deferred tax assets. Other companies reported surprisingly high charges but wouldn’t say how they calculated the amounts.

  Towers Watson released a “study” concluding that the loss of the deduction would cost corporate America $14 billion in profits, though it, too, was thin on details about how it summoned up that figure. The irony was that if anyone had an incentive to inflate the figure, it was the administration, since a bigger figure would make it look like it was raising more revenue to pay for healthcare reform. Its estimate: $4.5 billion.

  Henry Waxman, chairman of the House Energy and Commerce Committee, was suspicious of the figures, and called for a hearing of the Subcommittee on Oversight and Investigations. He invited the CEOs of Caterpillar, Verizon, Deere, and AT&T to disclose the assumptions they used to generate their giant accounting charges.

  This provided fresh fodder to critics of health care reform. “Waxman Convenes the First Death Panel” was the eye-catching headline of an online editorial on the Wall Street Journal Web site. “Dems Threaten Companies for Revealing Obamacare Costs” was a flash line on Fox Nation. “Are they going to pressure these big companies into not really telling the truth about the economic effects of health care on their organizations?” asked Gretchen Carlson, co-host of Fox & Friends. The more animated online critics regressed to fifth-grade, calling Waxman a variety of names, including Nazi, Czar, and hobbit.

  Though Representative Waxman’s doubts had to do with the size of the charges, not the timing, the companies, in an effective public relations move, accused the White House of playing political games with the accounting. A Wall Street Journal editorial pointed out (correctly) that “accounting rules require that corporations immediately restate their earnings to reflect the present value of their long-term health liabilities, including a higher tax burden.” Then it pointed out (incorrectly) that the administration was trying to force companies to commit accounting fraud. “Should these companies have played chicken with the Securities and Exchange Commission to avoid this politically inconvenient reality? Democrats don’t like what their bill is doing in the real world, so they now want to intimidate CEOs into keeping quiet.”

  Meanwhile, Wall Street Journal reporters, who some believe were put on earth so that they and the Wall Street Journal editorial writers would cancel each other out, explained—take a deep breath—that the companies were merely taking noncash charges to reflect the loss of a deduction for the projected amount of tax-free money the companies expected to receive in the future, to pay drug benefits that retirees were paying for anyway.

  That less-than-snappy message was what Commerce Secretary Gary Locke tried futilely to explain to reporters seeking a sound bite. In the wake of the backlash, Waxman postponed his hearing indefinitely. But the American Benefits Council, which represents three hundred large employers and has for years diligently worked to help eviscerate retiree health benefits, hosted a media briefing “to set the record straight” and urged the White House and Congress to repeal the change. The “new tax,” it said, would discourage companies from hiring new workers and lead to hardship for retirees. “The fact of the matter is, oneand-a-half to two million retirees will not be able to keep the coverage they like,” concluded James Klein, the spokesman.

  AT&T, which had again slashed retiree health coverage in 2009 and 2010, said it was considering dumping its prescription drug coverage altogether. That prospect cheered shareholders;
following the announcement, AT&T shares closed nine cents higher.

  TROUBLEMAKERS

  The false alarm about the impact of health reform on retiree health benefits is just one of the latest ways employers have used the opaque retiree accounting rules to dupe a gullible public. When it comes to retiree benefits, stirring people into a frenzy about supposed problems has always been an effective way to distract them from real problems and disguise the purpose of the proposed solutions.

  Employers blame the growing ratio of retirees for some of their woes. Yet as we’ve seen, a growing number of retirees leads to falling pension obligations. Once employees retire, their pensions stop growing, and the liability for their pension declines with each dollar paid out. If the retirees take their pensions as a one-time lump sum, the obligation for their pensions falls to zero, and liabilities are further reduced when the lump sums are worth less than the monthly pension, as is common. Lump sums also shift longevity risk to retirees, as well as investment risk, interest rate risk, and inflation risk.

  “Spiraling retiree health obligations” are another often overblown peril. The reality is that many employers face little exposure to the risk of rising health care costs because they’ve capped the amounts they will pay. As retirees shoulder a greater share of the costs, the healthier ones get cheaper coverage elsewhere, and the sicker ones remain in the plans, driving up costs. The spiraling costs are passed on to the retirees, forcing more to drop coverage. The drop-outs and benefit cuts further reduce the obligations and generate gains. And, as counterintuitive as it seems, as retirees age, the cost for their health coverage falls. When retirees reach sixty-five, most of the costs are picked up by Medicare, and employers receive a taxpayer subsidy to pay for much of the remaining prescription drug costs.

  Paying for the benefits isn’t always as onerous as employers make it sound. Utilities are subsidized by ratepayers, and military contractors are subsidized by taxpayers. Salaried employees often subsidize union retirees, whose benefits are contractually bargained for and thus can’t be unilaterally cut by employers. (But don’t blame the unions: Employers often promise to maintain their benefits in lieu of salary increases, a deal that saves the companies money.) As in the cases of Lucent and others, many employers have the ability to tap their pensions to pay the benefits.

  What’s having a bigger impact on earnings at many companies is the cost for their executive deferred-compensation plans, which affect income the same way unfunded retiree health plans do: They’re unfunded obligations and, without income from assets to offset their expense, they hit earnings hard. Unlike retiree health obligations, these executive obligations are steadily growing, and aren’t subject to the same steady hatchet employers have taken to their retiree health plans.

  The growing burden employers don’t want to talk about is for their executive liabilities, which are growing steadily behind the scenes and at some companies now exceed the obligations for the rank-and-file pensions. And for all the beefing people are doing about public pensions, they don’t realize that executive liabilities are the equivalent of having a public pension plan buried in the balance sheet: The liabilities can spike in the final years, are hidden, understated, growing, and underfunded (actually, they’re completely unfunded, which makes them a bigger burden).

  SELF-INFLICTED

  Employers that freeze pensions blame their “volatility” and their unpredictable impact on their balance sheets. But if pension plans are volatile, employers should blame no one but themselves. In the 1990s, a lot of them stopped managing pension plans as long-term investment portfolios and began treating them like casinos. Pension managers shifted more of the assets into stocks to take advantage of the accounting rules that let investment income flow, indirectly, into company profits and lift earnings.

  These accounting rules further encouraged risk by letting companies use hypothetical, or assumed, rates of return for the assets in the pension plans, rather than the actual returns, when calculating the pension plan’s impact on company earnings. Consequently, any investment, regardless of quality or risk—leases in overbuilt strip malls, timber rights, dodgy bonds, cash, or the company’s own stock—can provide a guaranteed “return” of 8 percent to 10 percent, or whatever assumed rate of return the employer adopts. On paper, anyway.

  These rules give pension managers a false sense of security because they delay the impact of the investment losses. With no immediate consequences for bad investment decisions in the pension plans, it’s not surprising that the percentage of equities in pension plans doubled, from 35 percent of assets in the early 1990s to more than 60 percent by 1999, a level that remains today.

  Companies should have learned their lesson when the tech bubble burst in 2000, ushering in a grinding three-year bear market. Pension plans lost billions, but many companies could draw on their stockpiled credits to delay the impact on earnings. These stockpiles were quickly depleted, which led to a frenzy of pension freezes.

  Thanks to double-digit returns during the ensuing mortgage bubble, combined with gains from pension cuts, the plans were collectively fully funded by 2007. But pension managers had no margin for error. The percentage of plan assets in stock still exceeded 60 percent, and when the subprime crisis arrived in late 2008 and 2009, it erased as much as one-third of the assets in pension plans.

  By then, employers had already consumed the huge cushions of surplus and had used up the stockpile of credits. Their solution: Many that hadn’t already done so froze their plans.

  This ability to cut pensions when the plans had investment losses effectively shifted the investment risk to employees and retirees. It’s a trend that has upended the risk-reward trade-off in retirement plans: In 401(k)s, employees bear the investment risk but also keep all the upside. In pensions, employers are supposed to bear the investment risk and keep the upside. Not anymore.

  The real problem with pensions isn’t “volatility.” It’s that the accounting rules enable employers to gamble with retirees’ money and then shift the risk to them. And if the plans collapse altogether, companies can shift the risk to the PBGC.

  Having shot off their own toes, employers are now seeking “funding relief,” which would enable companies with weak pension plans to delay putting money into them: Forcing them to contribute to their pensions, they say, will divert precious cash they need to avoid layoffs, hire new workers, and create more jobs.

  Their argument, some version of which has been around since the dawn of ERISA funding rules sounds plausible to many lawmakers on both sides of the aisle. But companies seeking funding relief fail to acknowledge that most of their current woes are self-inflicted. They took on too much risk but failed to fund when the party inevitably wound down. They withdrew too much money—and in many cases paid their executives too much compensation—instead of contributing to the pension plans for retirees. Their pleas for funding relief are little different from the banks asking for bailouts after their own risky lending practices and financial shenanigans brought the economy to its knees.

  Companies in financial trouble, and with chronically deficit-riddled pensions—notably automakers and steelmakers—are the ones pushing most aggressively for funding relief, though they’re the very companies that shouldn’t get it. Likewise, financially troubled companies with well-funded plans don’t need relief, either: What’s really needed is laws that make it tougher for companies to terminate their pensions to capture the surplus money.

  Healthy companies with well-funded pensions certainly don’t need “relief.” Many are sitting on record amounts of cash and are happy to contribute billions to their plans. The contributions are deductible and grow tax-free, while the expected investment returns provide a guaranteed lift to profits. Because remember: If the investments were outside the pension plan, the only way to get income from them would be to sell them, pay taxes on the gains, and report what’s left as income. Add to these tax benefits the variety of ways employers can tap the assets and the pensio
n plan looks like a pretty nice place to park money. And, as the ERISA Advisory Council demonstrated in their meeting in 1999, the surplus is never really locked up.

  What these healthy companies with healthy pensions really want is the ability to stuff even more money into their pension plans, which they’re prevented from doing. Congress enacted the full funding limit in 1987 to prevent employers from using their pension plans as tax shelters. It prohibits employer contributions if assets exceed 150 percent of the current liability. Employers have lobbied to undo this regulation ever since.

  Bottom line: When it comes to funding rules, employers don’t want to be forced to contribute, yet they also want to be able to contribute as much asas they’d like. They argue that these freedoms would enhance retirement security. We’ve seen how well the current laws work. These “solutions” would only lead to more of the same.

  Another reality check: Analysts’ reports on the state of pension funding, which employers, lawmakers, and the media routinely cite, overstate the amount of underfunding. The funding figures come from SEC filings, which include the value of executive pensions and foreign pensions. These are typically unfunded, which brings down the funding percentages, thus making the supposed “underfunding” of employee pension plans in the United States appear worse than it is.

  BAD PLAN

  As employers phase out pensions, 401(k)s are becoming the dominant way to save. But 401(k)s won’t save the day. Many excellent books have been written about the inadequacies of these plans. They’ve already proven to be failures for young and lower-paid workers, who don’t participate, contribute too little, and then spend whatever they have saved when they change jobs.