A Growing Problem
Anyone who doubts the potential scale of the problem only has to look at the case of the American Civil War veterans’ pension fund—one of the earliest defined benefit schemes. Originally set up during the war to pay pensions to disabled veterans, the scheme was gradually extended to include all veterans and their dependants, making its final payment only in 2004—nearly 140 years after the war ended. By then, the scheme had cost the US government hundreds of billions in today’s dollars, and at its peak in the early 1890s, it had even constituted over 40% of the annual federal budget.
It’s a stark warning for many pension schemes and their corporate sponsors today.
Any views on interest rates over the next decade? Your debt financing may have excellent terms, and it may seem a moot point, but the pension fund’s liabilities and their associated accounting costs will swing violently over the next few decades with movements in the prevailing interest rates. By some estimates, the drop in long-term interest rates from 1999 to 2002 increased the value of pension liabilities by 30–40%.
How about inflation—any thoughts on how it might evolve over the next half century? Many scheme members, particularly in the United Kingdom, have index-linked pensions, and the burden of payments can quickly become onerous. Figures from Britain’s Office for National Statistics show that from 1970 to 2007, annual employer contributions to pension schemes went up a factor of 53, and they have trebled over the last seven years alone (Figure 1). Wage inflation too can rapidly push up costs.
And what about people living longer? For individuals and society, increased longevity is desirable, but living longer can often also create large unanticipated costs. Ever since German Chancellor Otto von Bismarck thought he’d pulled off a politically brilliant move back in 1889, by promising pensions at 70 when the average German lived to less than 50 years of age, the continual improvements in life expectancies have rapidly unraveled the best-laid pension plans. Even more troubling, the current upward trend shows little sign of leveling off, and it is increasingly clear that this is the most significant risk to the finances of pension schemes and their sponsors. The rising life expectancies for males and females in the United Kingdom are shown in Figure 2.
In a field typified by extremes, the case of Jeanne Calment is a situation that’s humorlessly reminiscent of reality for many pension schemes. When Madame Calment’s lawyer agreed in 1965 to pay her an annual income worth one-tenth of the value of her flat on the understanding that he would inherit the property on her death, it seemed like a shrewd bargain. Madame Calment was then 90 years old, and it seemed unlikely that she had much longer to go on this particular journey. Unfortunately, bearing testament to perhaps one of the most misjudged investment decisions ever, Jeanne went on to live to the ripe old age of 122. Along the way, she also became the oldest rap artist ever, releasing an album at 121, but that is unlikely to have provided much consolation to her poor aforementioned lawyer. By then, he was long dead and his widow was still making the payments.
The Dangers of Volatile Markets
It’s a complex basket of risks and, in the short term, changing economic and demographic perceptions can materially alter the valuation of a pension scheme’s liabilities from one day to the next. Even the assets are not immune, as many pension schemes have more than half their assets in equities—a consequence of their long-term perspective, adherents argue. In the short term, however, volatility in the markets can materially alter the valuation of a pension scheme from one day to the next. It’s a headache for many finance directors, who are left with an uncontrolled liability on otherwise well-managed balance sheets.
It becomes extremely difficult under these circumstances to determine the ability of a defined benefit pension scheme to pay its annuities 40 years down the track. Throw in the increasingly common belief that the economic environment in the coming years is likely to be far less favorable than in recent years, and increased volatility seems inevitable.
In 2008 alone, Aon Consulting estimated that sharp falls in the FTSE caused UK pension schemes to lose $60 billion in just a single week, wiping out all the gains made in 2007. More worryingly for companies, equity markets—excluding the buoyant energy and mining sectors—have declined significantly since mid-2007, and are now close to the depths reached at the bottom of the last recession in 2003. Given that these companies are often older, and therefore have a much greater role as pension sponsors than the percentage of market capitalization that they represent, sponsor risk is also an increasingly major concern across the board.
It’s a growing headache for many firms, for whom such risks often lie far from familiar territory and who are charged with looking after a broad church of stakeholders, not just pensioners. Though the increased pension fund liabilities are often longer term than most corporate horizons, they must be carried on the company’s balance sheet, reducing net asset value and increasing financial leverage. As the corporate sponsor, they generally also have an obligation to fund at least part of these unexpected costs, giving them an uncertain command over their own cash flow and reducing future distributions to investors. The impact can go far beyond the immediate cash flow hit—filtering through to the P & L, lowering profits, hurting competitiveness, and, ultimately, even impacting the share price.
In the case of General Motors, for example, net obligations are estimated to be about $170 billion across all of GM’s US operations, dwarfing its current market cap of $3 billion. To meet its soaring obligations, the company contributed an astonishing $30 billion to its US pension plans in 2003 and 2004, but the accounts are still tens of billions of dollars in deficit. Now, pension and healthcare costs make up more of the average GM vehicle’s price tag than the steel used to build it. Consequently, the company is inexorably losing ground to a wave of foreign competitors with lower cost bases and less debt on their balance sheets—resulting in a catastrophic decline in stock price for investors, from $55 in January 2004 to under $10 today.