Gary North's REALITY CHECK
Issue 370 August 17, 2004
THE PENSION IDEA REVISITED
In 1950, free market economist Paul Poirot wrote a little
book, "The Pension Idea." For 31 years, 1956-1987, he edited
"The Freeman," a monthly magazine that promoted free market
ideas. Through him, I got my first national audience, beginning
in February, 1967. I helped support myself in grad school by
writing for "The Freeman."
In his book, he warned against trusting in anyone else to
support you in your old age, especially the government. He also
warned against expecting investments in private assets -- stocks
or bonds -- to support you. Hope is fine, if backed up by
wisdom. Confidence is foolish.
Why? First, because the government can tax bonds through
inflation. Second, because stocks are threatened by the
existence of pension guarantees for employees. There is no way
to guarantee the future decisions of consumers, but they are the
people who will determine the profitability of a company. To the
extent that the government will enforce the claims of a company's
retired workers at the expense of shareholders, the shareholders'
claims are at risk. On page 48, Poirot offered this warning:
Does not investment in the stock of business
corporations afford some security against the hazards
of inflation? Ordinarily, one might think so. But
today, it is pure speculation. It is speculation in
the face of multiple taxation of corporate earnings.
It is speculation as to how far the corporate
management, willingly or under compulsion of
government, may sacrifice the equity of stockholders in
acquiescence to the demands of the leaders of organized
labor. It is speculation as to how the courts will
rule concerning priority of claims against company
surplus. If the courts rule that employee pensions,
for which contracts are already signed, shall have
prior claim over the stockholders' equity, then the
stock of many corporations today is worth less than its
current market price. Ownership of stock is an
illusion in a company whose management has pledged to
employees that future buyers of that company's product
will pay enough more for the product to provide
pensions for those who have ceased producing. An all-
powerful government, with the power to tax, is the only
management which can claim that kind of control over
the "buying" notions of its customers. When a private
corporation undertakes to guarantee the future behavior
of its customers, who are stockholders in the
government, then that corporation is a sitting duck for
governmental control.
Poirot is still alive. I call him every couple of years,
just to see how he is doing. He lives on a pension. His
employer, the Foundation for Economic Education, offered no
pension plan. He made good decisions with his own investments.
Most people don't. Most people won't.
THE ERA OF PENSIONS
He worked during the era that inaugurated the pension. In
1936, the Roosevelt Administration began Social Security. Under
that Administration and under Truman's, the idea spread to
organized labor. The country was under wartime price controls,
1942-45. Truman kept them on until the fall of 1946. Under the
rules governing wages, pension contributions were not counted as
a wage. So, businesses worked out a mutually beneficial
arrangement with trade union leaders. The leaders could announce
to their members that the leaders had played hardball and forced
management to hand over the money. The money came in the form of
pension funding.
This was a good deal for workers, who under wartime controls
were limited in what they could receive as wages. This was also
a good deal for management, who would not have to fund these
pensions 100%, even though the agreement was a legal document.
It looked as though management was giving up a great deal, but
management in those early years, like the Social Security
Administration, did not feel the pain. The pain would come
later, long after that generation's retirement and interment.
The promise was great: guaranteed income apart from
children's obligations to support aged parents. Government
pensions -- minimal -- had come under Bismarck in the 1880s. It
bought him time. It bought him votes. It kept conservatives in
power. Country by country, the idea spread.
Of course, it was the productivity of capitalism that made
this promise believable. Ever since the late 18th century,
output in the West, even with its wars, has increased above 2%
per annum. That seemingly slow rate of growth has been
sufficient to pay off the dreams of retirees. A small percentage
of the population has been able to retire in comfort because of
government extractions, corporate growth, and their own wise
decisions regarding investments.
But the pension idea has spread. It has spread to hundreds
of millions of European and American workers, who have believed
the promises of government, union leaders, and corporate
management. They assume that those making the promises know what
they are doing. And they really do know what they are doing:
making self-interested promises today at the expense of managers
who will come later.
The economy no longer grows sufficiently to make possible
the pension dreams of the vast majority of these workers,
especially with government-funded medical care siphoning off most
of the money that would have gone to pensions. There are too
many expectant beneficiaries, who think that they can get more,
now, at the expense of others, later.
The day of reckoning will arrive within my lifetime,
actuarially speaking, and surely yours. Most people will run out
of pension before they run out of time.
MAULDIN'S WARNING
John Mauldin writes a weekly free email letter. You can
subscribe here:
[EMAIL PROTECTED]
He is the author of a new book on investing, "Bulls Eye
Investing," which is high on the New York Times' best-seller
list. It is a very good book. It points out why it is unlikely
that the stock market will perform well over the next two
decades, given its above-average performance, 1982-2000. This
book would not have been published in 2000. There is nothing
like running into the brick wall of reality to create new
markets.
In his weekly letter for August 13, he discussed the pension
liability problems facing major corporations. Because John
writes well, and because he is a numbers guy (he used to be my
company's manager), I will quote extensively from his letter.
That's because I can't make the numbers any clearer. I assure
you, no one in Congress is warning his constituents this campaign
year about the numbers and the limits that they impose. They
tell voters, "Vote for us, and you will get what you deserve."
They will, indeed. Mauldin writes:
Specifically, I want to look at defined benefit pension
plans. These are pension plans which in theory
guarantee a worker a specific set of benefits for his
retirement years.
Let's do a simplified analysis. Let's say the pension
of Company ABC has $1 billion dollars. The actuaries
work to figure out what the fund will need in future
years. The managers of the fund make assumptions about
how much the fund portfolio will grow in the future
from a combination of investments and more
contributions by the company. Let's assume Company ABC
is going to need its investment portfolio to grow by 9%
per year in order to stay fully funded. The more you
assume the portfolio will grow, the less ABC will need
to dig into its pockets from pockets to fully fund the
pension plan.
Assuming a typical 60% stocks/40% bonds mix, what type
of returns does the company need from its stock
portfolio? Let's be generous and project a 5% return
from its bond portfolio over the next decade. That
means it will need over 11% from the equity portion of
its portfolio!
But let's not be so negative. Let's assume bonds will
return more and increase our stock investments.
Assuming an asset allocation mix of 70% equities and
30% bonds (yielding 6%), stocks would still have to
earn 10.7% to attain a 9% composite return.
Is that attainable? My answer is, "Not really." Quoting
from a private paper by Robert Arnott:
"Stock returns have only four constituent
parts:
* 1.5% current dividend yield
* +2.5% consensus for future
inflation
* +0.0% P/E expansion (dare we
assume more??)
* + ?? real growth in dividends and
earnings
"This arithmetic suggests that, to get to a 7
percent return estimate, we need a mere 3
percent real growth in dividends and
earnings. We can do far better than that, no?
"No. Historical real growth in dividends and
earnings has been 1 percent to 2 percent. To
get to the 3 percent real growth in the
economy, we have turned to entrepreneurial
capitalism, the creation of new companies.
Shareholders in today's companies don't
participate in this part of GDP growth. So,
even a 7 percent return for equities may be
too aggressive. To get 10.7 percent from
stocks, we need nearly 7 percent real growth
in earnings, far faster than any economist
would dare project for the economy at large,
let alone for the economy net of
entrepreneurial capitalism."
Here we have the problem: management wants to minimize the
deductions made from the pension system for its workers.
Management, paid by stock options, prefers high returns on
shares, which come from earnings after expenses. Expenses
include the pension system.
To get a high rate of earnings (profits), management tells
the actuaries to make the highest possible assumptions for the
rate of return on portfolio investments. Because of the stock
market boom, 1982 to 2000, high rates of projected return became
commonplace. Actuaries were told to push the envelope by making
the highest projections they could get way with. The Pension
Benefit Guarantee Corporation, a government agency under the
ERISA law, which stands as a final guarantor of corporate
pensions, allowed these high expected rates of return.
The problem has come since 2000. The stock market has
showed a loss since then. Until 2004, dividends have been low --
under 2%. This is beginning to change, slowly. A recession
killed earnings until 2003. Everywhere management looked, there
was a sea of red ink. Yet the corporate pension obligations for
defined benefit programs kept growing at the pre-2000 rates of
return, which the envelope-pushing actuaries had projected.
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THE METER KEEPS TICKING
The obligations do not go away because the economy hits one
of Greenspan's "soft patches." It ticks away, night and day, day
in and day out. Today's management is trapped by the decisions
of yesterday's management, stretching back to World War II. The
game went on, decade after decade: pushing the day of reckoning
into the future. "Buy now, pay later" became the strategy. Buy
trade union cooperation, buy workers' loyalty, buy a higher rate
of quarterly earnings by means of decades-long promises.
We live in a society in which this strategy has become
business as usual in every area of life. We buy now and promise
to pay later. When the bills ad up, we change the accounting
rules. This is what Lyndon Johnson did with Social Security. He
took it off-budget, then raided the income produced by Social
Security taxes to reduce the official budget deficit. This scam
is still in force.
The public is naive. Nobody reads the fine print. The
promise-makers are not the same people as the promise-keepers.
There will be no promise-keepers. The government, with cheering
from overburdened corporations, will get the Federal Reserve
System to inflate the money supply, making more fiat money
available to pay off the obligations.
Problem: that will kill the bond market.
Mauldin continues:
What if pensions start getting less return in their
bond portfolios? It is tough to get 5 percent today
without taking some real risk. To get to a 9 percent
assumption in a 5 percent bond environment, and if you
have 70 percent in stocks/30 percent in bonds, that 9
percent overall return assumes you are getting almost
12 percent returns on your stock portfolio. But what if
the Dow drops to 6,000 as it might during the next
recession and the NASDAQ goes to 600? What if your
returns are negative for the next few years?
How much are you underfunded then, as your portfolio
drops another 20 percent? The number becomes
mind-boggling. If each of the S&P 500 companies lowered
its expected rate of return from the current average of
9.2 percent to 6.5 percent, the total cost to earnings
would be $30 billion, according to a report by CSFB.
But if the Dow drops to 6,000 the number goes off the
chart. Remember, the average drop in the markets is 43%
during recessions.
Is it realistic to suggest we will not see a recession
within a few years? I think not. As I demonstrated in
my book and have written here many times, there has
never been a period in history where the stock market
has out-performed money market funds over the next ten
years when valuations are at current levels (The core
P/E for the S&P is around 21).
Everyone wants to beat the market. Hardly anyone can. If
you wanted a secure retirement, you would have bought 100 shares
of Berkshire Hathaway for $1,500 in 1965, when you heard that
Warren Buffett had purchased control. You would now be sitting
on a nest egg of $8.5 million. That's a return of 24.82% on your
money, give or take a decimal point. But you didn't. Neither
did I.
BAD MOON RISING
What has this got to do with where we are today? A lot.
The meter is ticking loudly, but hardly anyone pays attention.
We have all grown bored with bad news. We have all grown used to
the idea that the day of reckoning can be avoided. This
mentality governed France in the 1780s. It hit the brick wall in
1789: the French Revolution, which began as a fiscal reform. Red
ink went to blood red. Eventually the piper demands payment.
The piper must therefore be stiffed. Mauldin continues:
If we were starting from a point of strength, it might
be less troublesome. But the Pension Benefit Guaranty
Corporation notes that defined benefit pension plans
are under-funded to the tune of $450 billion (the
combination of single and multi-employer plans). But
that is likely an understatement. How you figure full
funding is actually quite flexible. It is an arcane art
rife with assumptions and wiggle room. And employees
are in the dark about how well their pensions are
funded. As an aside, the Bush administration has
proposals to require disclosure to employees, but
strangely Congress has yet to act on this obviously
common sense and long overdue proposal. Let's make sure
hedge funds are regulated (we gotta protect the rich),
but let corporations hide their pension fund
liabilities. I mean, you have to establish priorities.
For example, in its last filing prior to termination of
its plan, Bethlehem Steel reported that it was 84%
funded on a current liability basis. At termination,
however, the plan was only 45% funded on a termination
basis - with total underfunding of $4.3 billion. PBGC
had to assume that liability. In Congressional
testimony, PBGC notes:
"... in its last filing prior to termination,
the US Airways pilots' plan reported that it
was 94 percent funded on a current liability
basis. At termination, however, it was only
35 percent funded on a termination basis -
with total underfunding of $2.2 billion. It
is no wonder that the US Airways pilots were
shocked to learn just how much of their
promised benefits would be lost. In practice,
a terminated plan's underfunded status can
influence the actual benefit levels."
You may have read that US Airways now faces bankruptcy if it
cannot get reductions in wages from the pilots' union. The
pilots are playing hardball with a company on the ropes. If the
company goes under, the pilots will have to live on their
pensions. Unfortunately, the company's weakness is not limited
itself to current income.
Who will foot the bill? You and I, of course.
The PBGC insures pension benefits worth $1.5 trillion
and is responsible for paying current and future
benefits to nearly 1 million people in over 3,200
terminated defined benefit plans. Benefit payments
totaled $2.5 billion dollars in 2003. Benefit payments
are expected to grow to nearly $3 billion in 2004.
The PBGC is also underfunded to the tune of $11.2
billion, up from a mere $3.6 billion last year. But
buried in footnote 7 is a more ominous number. The PBGC
makes an estimate as to what its liability in the
future might be for companies which will go belly-up.
The "reasonably possible" exposure as of September 2003
ranged from $83-$85 billion, up from $35 billion in
fiscal 2002.
PBGC was set up by the government as an insurance
program. Pension plans pay an insurance premium
(currently only $19 per covered employee per year) to
have their funds participate in the program. As
recently as a few years ago, the fund was well in the
black. But with the problems in the steel and airline
industries, costs have simply gone off the charts.
THE STOCK MARKET
There have been many promises made. There has been
insufficient funding to redeem these promises at full market
value. This lack of funding has been across the boards -- and
boardrooms.
The PBGC insures $1.5 trillion in plans. That is $1.5
trillion that pension funds are assuming will grow by
7-9% over the next decade, depending upon how
conservative they are. They are currently underfunded
by $450 billion.
If I am right about stock market returns being well
below 4% for the rest of the decade as we get further
into a secular bear market, and given the clear ability
of pension funds to overstate their funding positions,
it means that companies are going to have to come up
with a huge amount of money over the decade to fund
their pension plans.
How much? If a pension fund assumes an 8% growth, your
principal doubles in about 9 years. But 9 years at 5%
is only a 55% growth. On the amount the PGBC insures,
that would be a shortfall of about $650 billion, give
or take a few hundred billion. That would be on top of
the current $450 billion underfunding.
Now, spread out over 9-10 years, corporate America is
easily making enough to fund that amount. But such a
number would significantly eat into profits. Total US
corporate profits (with the odd adjustments) are
running north of $900 billion from all companies. How
much of that is from companies with defined benefit
pension plans? I can find no data to answer that
question.
But we can guess where the bulk of the problem lies. It
is in the 360 companies in the S&P 500 that have
defined benefit pension plans. Credit Suisse First
Boston (CSFB) estimates unfunded pension liability as
of 2002 for this group was $243 billion. Morgan Stanley
estimated $300 billion. The upshot is that companies
with defined benefit programs are going to see their
earnings under pressure as they will have to divert
more and more of their profits into their pension
funds.
His conclusion: don't invest in companies that have offered
their workers defined benefit pension programs. The problem is,
that list comprises 72% of the S&P 500.
We are now facing the reality that Paul Poirot wrote about
in 1950: the companies are legally owned by shareholders, but in
fact are owned by the retirees, who have legal claims against the
companies.
Many of these companies are essentially owned by their
retirees, who are going to get more and more of the
profits. This is not going to be good for shareholders
in the company, or for S&P 500 index mutual funds.
During the next recession, these companies are going to
be required to make up the underfunding in their plans
at a time when their earnings will be down. The
projected growth in their investment portfolios will be
hurt because they will have so much money invested in
large cap companies just like themselves who are facing
underfunded pension problems.
The problem facing every company with a defined benefit
program is that current pension obligations must be factored into
retail prices. Consider the auto industry.
In a study by the FDIC, we note that: "The U.S.
automobile industry shows the effects of higher pension
costs on the bottom line. The results of a Prudential
Financial study state that pension and retiree benefits
represent $631 of the cost of every Chrysler vehicle,
$734 of the cost of every Ford vehicle, and $1,360 of
the cost of every GM car or truck. In contrast, an
article in the Detroit Free Press reported that pension
and retiree benefit costs per vehicle at the U.S.
plants of Honda and Toyota are estimated to be $107 and
$180, respectively."
They later casually note, "GM recently has used about
$13 billion of a $17.6 billion debt offering - the
largest ever made by a U.S. company - to help close its
pension gap. On average, GM will pay a 7.54 percent
yield on the debt, and hopes to earn 9 percent on the
proceeds contributed to its pension fund. While cash
flow requirements have been eased for now, if this long
term expectation regarding returns proves problematic
over time, GM will need to find other sources to pay
their obligation."
But costs do not determine prices. Supply and demand
determines prices. If a new supplier comes along who is not
burdened by past pension fund obligations, this supplier can
undersell the firm that made such promises. For American and
European firms, the four letter word that confronts them is 'Asia.'
Asians, Japan excepted (an American satrapy, 1945-55), came
to capitalism late. Their governments, not being democratic, did
not pay off trade union members with special legislation, unlike
Western governments, beginning with Bismarck. The least
democratic nation of all, The Peoples Republic of China, has no
pension obligations, only state-owned factory obligations, which
the government is shedding. As state-run factories go the way of
all flesh, China will compete without one arm tied behind its
back: the arm of past promises.
CONCLUSION
The lessons are simple:
Read the fine print of your pension program.
Assume that your future is not guaranteed.
Your past employer regards you as a liability.
It is easier to create money than to create wealth.
The government is not your friend.
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