MOVING THE GOALPOSTS
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By Eric J. Fry
The Daily Reckoning
Americans will do almost anything to avoid saving money. They hate
it like a five-year-old hates broccoli. And just like that five-
year-old, they will grimace, whine, kvetch, and, yes, even lie to
avoid doing what is good for them.
They will tell themselves that stocks always go up in the long run
.. or that their home equity is all the "savings" they will ever
need. But such comforting delusions seem to be colliding head-on
with a very different reality. America is "savings-lite" -- a
condition that is likely to weigh on corporate profits and stunt
economic growth for years to come.
Most Americans don't save enough money in a year's time to buy a
week's worth of groceries. And what's true at the individual level
is also true collectively. Our government is borrowing about half
a trillion dollars a year, just to make sure that the barrels
never run low on pork. At the same time, America's pension plans -
- both in the private and public sectors -- are woefully
underfunded.
"For the past three years," Business Week observes, "the damage
from corporate pension-plan losses has been piling up like a slow-
motion train wreck. As stock prices stayed low and interest rates
declined, on average, plan assets have lost 15% of their value,
while their liabilities have soared 59%, according to money
manager and researcher Ryan Labs. The squeeze has vaporized
surplus assets in nearly all funds. Pension plans of companies in
the Standard & Poor's 100 index were showing a 16% deficit to
liabilities at yearend, down sharply from a 30% surplus two years
before."
Meanwhile, the accounts of the Pension Benefit Guaranty Corp.
(PBGC), the federal government-sponsored insurer of most pensions,
have swung from a surplus of $7.7 billion last year to a deficit
of $5.4 billion in the past 18 months.
Out in the public sector, a record 79% of U.S. public pension
plans are underfunded, according to Wilshire Associates of Santa
Monica, Calif. "The phrase 'unfunded pension liability' has
returned to public officials' vocabularies," writes Bloomberg's
municipal bond guru, Joe Mysak. "And to the vocabulary of bankers.
States and municipalities are thinking about selling more than $20
billion in pension obligation bonds." Is it not American ingenuity
at its finest, this idea of selling bonds to plug the gap created
by non-saving? Somehow, an apparently dysfunctional American
system seems to work, over and over again.
But maybe, the age of easy accommodation has about run its course.
Maybe the slumping dollar is signaling a change in the wind. Maybe
our savings-lite nation will not be able to borrow money as
effortlessly as it has in the past.
The bear market of the last three years has exposed America's
savings deficiency like a low tide exposes skinny-dippers. We've
been "swimming naked" for years, hidden from public view by a bull
market in stocks that kept us all chest-deep in capital gains. But
now, as the stock market ebbs, pension plan liabilities flow. The
PBGC estimates that the U.S. private pension system alone is
underwater by over $300 billion.
It's hardly surprising, therefore, that CFOs are scared to death
about the pension plan underfinding crisis. "Global outsourcing
and consulting firm Hewitt Associates found that pension
shortfalls, pension regulations, and pension accounting are high
on CFOs' lists of concerns these days," CFO Magazine reports.
"More than half of the CFOs and treasurers at the 174 midsize to
large companies in the survey said they will need to fund a
pension liability this year.... More than 60% of the respondents
believe that pension cost volatility is either a major problem or
a serious concern."
Not only do the mounting corporate pension liabilities threaten to
divert cash flow away from productive uses like investing in R&D,
but also from unproductive uses like boosting corporate executive
compensation packages - including the packages CFOs receive. These
high-priced accountants thus have a very personal vested interest
in re-jiggering the pension accounting assumptions, rather than
taking legitimate measures to shore up the financial integrity of
the plans under their stewardship. Re-jiggering rather than
repairing is precisely the tack that Congress seems to be taking.
One prudent response to pension underfunding might be to rein in
costs while simultaneously accelerating contributions. But that
two-pronged approach would be painful, and, besides, it would
severely constrain the "profit growth" of many American
corporations...which could severely constrain the desire of
investors to pay 35 times earnings for stocks. And if investors
won't pay 35 times earnings for stocks, share prices might fall.
And if share prices fall, the pension plan deficits would become
an even bigger problem.
So in order to keep the game alive, the powers that be must
prevent the grim reality of pension underfunding from encroaching
upon the delightful fantasy of a bull market at 35 times earnings.
The solution is obvious, move the goalposts. In other words,
change the underlying assumptions about future expenses or future
pension plan asset growth.
To illustrate, let's imagine a hypothetical family breadwinner who
earns $80,000 per year. Now imagine that the breadwinner's family
spends $100,000 per year. (Sadly, this scenario is all too easy
for many of us to "imagine.")
The breadwinner is in deficit to the tune of $20,000 per
year...unless he changes his assumptions to achieve a balanced
budget, pension-accounting style. Which means he could either
assume expenses of $80,000, even though they are actually
$100,000, or he could assume annual income of $100,000, even
though it is actually $80,000.
Eventually, of course, the real-world gap between income and
expenses would produce unavoidable insolvency. But in the
meantime, the breadwinner and his family could enjoy the happy
illusion of budgetary balance, without having to curtail their
outsized spending.
This "solution," self-evidently, would be nothing more than a
charade, a tragic farce. But it would make life much more
enjoyable for a while...and that, dear reader, seems to be the
spirit of the new Portman-Cardin bill that is currently snaking
its way through the House of Representatives.
For starters, the pension bill would let companies use a separate
mortality table for blue-collar workers. "In essence," the Rocky
Mountain News notes, "companies would not be required to pay as
much into the pension plan because they could assume blue-collar
workers will die sooner than other employees."
Such actuarial sleight-of-hand would be welcome relief for
companies like General Motors Corp. and Deere & Co., two companies
with the ignominious distinction of having amassed pension plan
deficits that exceed their respective market capitalizations. Not
coincidentally, these two companies also share the distinction of
having been selected as promising short-sale candidates by Apogee
Research.
GM, which strains under the weight of a monstrous $25.4 billion
pension plan deficit, possesses a market capitalization of only
$19.67 billion.
Another of the bill's ingenious measures is to allow the companies
with the most severely "funding-challenged" plans to reduce their
insurance premium payments to the PBGC, the federal pension fund
insurer. In other words, the companies that are most likely to
require a government bailout would pay the least amount for
insurance.
The last innovation proposed in the House bill would reduce the
present value of future pension liabilities, simply by changing
the interest rate used in the calculation. Specifically, the bill
would replace the 30-year Treasury bond rate with a higher-
yielding corporate bond index, thereby reducing the present value
of future liabilities by an estimated 10% to 15%. All together,
the House bill could save a company like GM about $2 billion per
year...for a while. And that would be welcome and immediate relief
for the cash-strapped automaker.
Sadly, however, none of the maneuvers proposed by the Portman-
Cardin bill would fortify our nation's pension plans. To the
contrary, they would weaken them, and further jeopardize their
ability to meet future obligations. The "good news" is that
corporations with underfunded plans could continue to report
illusory earnings growth while retaining cash for other uses like
research and development, capital investment and executive
compensation.
We will not quarrel with the possible merit of deferring pension
plan contributions. But we will point out that deferring the Day
of Reckoning does not eliminate it.
The pension-plan funding crisis will likely weigh on corporate
earnings for years. Likewise, the national savings shortfall will
probably stunt economic growth for years to come. "In order to get
out from under the 16-ton sledgehammer of debt, companies use cash
flow to build reserves or retire bonds -- they don't invest,"
observes Bill Gross, the legendary bond fund manager. "Consumers
begin to put away money instead of spend.... And the combination
induces a negative spiral or vicious cycle of even more
conservative behavior including job layoffs, which leads to muted
growth in personal income.... As the U.S. private sector
retrenches to a more normal historic average level of total
savings, it necessarily acts as an economic drag."
The Day of Reckoning beckons...
Eric Fry,
The Daily Reckoning
Eric J. Fry, the Daily Reckoning's "man-on-the-scene" in New York
has been a specialist in international equities since the early
1980s. He is also a renowned portfolio manager, author, and
financial commentator and is the editor of Apogee Research. For
investment recommendations consistent with the ideas Eric has
expresses in the Daily Reckoning, please click here:
Apogee Research
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