The failing pension system in the U.S. private sector: have we seen the worst yet?

Introduction

During 2000, U.S. employers spent about 15.3 percent of their company's total worker compensation package on benefits. Pensions are now the single largest benefit expenditure that employers pay. Retirement benefits fell from about 60.0 percent of a worker's benefit portfolio in 1960 to 48.0 percent in 2000 (Okunade & Wunnava, 2002). According to a recent survey of workers 18 years old and older conducted by the National Association for Variable Annuities (NAVA) published in USA Today (2006), 49.0 percent of employees believe that their current or future employers will offer or continue to offer a guaranteed pension plan. This compares with 47.0 percent responding negatively. Therefore, statistically speaking, workers are evenly split on whether their employers will default on promised pension payments. On August 17, 2006, President George W. Bush signed into law the pension reform bill. The enforcement of the core provisions of the Pension Protection Act of 2006 could reinstate worker confidence in the pension system.

The nonprofit Employee Benefit Research Institute (EBRI), using retirement survey data developed during the past two years (Barr, 2006), reported that federal employees are guaranteed inflation-adjusted pensions (only 21.0 percent in the private sector are eligible for a defined benefit pension), can take their health insurance plans into retirement (compared with only 33.0 percent of large private-sector employees), and 53.0 percent plan to retire before age 62 (compared with 12.0 percent of all Americans who plan to retire at 65 years or older). Surprisingly, the EBRI also found that more federal workers are better prepared for retirement than are private-sector employees whose retirement proceeds are less assured, despite factual evidence that corporations are increasingly defaulting on retiree pension promises, while also changing the design structure of the portfolio of worker benefit plans to reduce corporate outlays.

The share of U.S. workers in defined-benefit pensions declined from 80.0 percent in 1985 to 36.0 percent in 2000, and this trend is likely to continue as workers become more uncertain of their future pension proceeds (Dominitz & Manski, 2006). Private pensions decline when companies file for bankruptcy protection and transfer their retirement obligations to the federal government's Pension Benefit Guaranty Corporation (funded by premiums, the nearly 30,000 defined-benefit plans managed by private-sector employers pay for coverage). This federal insurer, in turn, pays out about one-third of the amount due private-sector retirees. (The federal insurer of private-sector pensions itself operated with a $23.3 billion deficit in mid-2005.) as a result, affected retirees are returning to active workforce status. President Bush recently signed a new public policy initiative targeted at slowing pension default rates. The goal of this article is to discuss the recent trend in pension defaults and its implications, with special focus on the U.S. private sector, including the airline, energy, and automotive industries. Current survey data and literature on the reported gaps between pre-retirement plans and postretirement reality on expenses are used to caution baby-boomers currently in their 50s who are planning to retire.

The U.S. Department of Labor recently announced that wages and benefits rose at a robust 6.6 percent annual rate during the second quarter of 2006. After adjustments for inflation, primarily driven by energy price shocks, the gain was about 1.6 percent annually (Anderson, 2006). This short-term rise in compensation masks an increasingly important development in the market for employee benefits, notably pensions. Private-sector retiree pension benefit defaults increasingly occur at a time when senior executive compensation packages are ballooning (Brush, 2006). Because executive stock options are performance-based, the strategy since 1993 has been to tilt senior executive compensation toward stock options to save taxes on I annual executive incomes exceeding $1.0 million (Forelle & Scannell, 2006).

Pension Defaults Across Major Industries

According to Standard & Poor's ranking of the top S&P 1,500 companies with the worst pension funding problems (Ford, Exxon Mobil, IBM, Delta, Lockheed Martin, Delphi, Boeing, Raytheon, DuPont, United Technologies, Goodyear, Pfizer, Dow Chemical, Excelon, Procter & Gamble, ConocoPhillips, Hewlett-Packard, Altria, and Alcoa), the top five offenders are in the automotive, energy, and airline industries (Brush, 2006). In the U.S. automotive industry, Ford and GM experienced deep deficits in pension contributions, whereas United and Continental did so in the airline industry.

Since the September 11, 2001, attacks, 10 U.S. airlines have filed for bankruptcy, with industry losses totaling over $40.0 billion, in addition to the loss of about 150,000 fulltime jobs. This gloomy scenario is compounded by high jet fuel prices, reduced passenger miles flown, aviation security costs, rising labor unrests (pilots, flight attendants, mechanics) (Foss, 2006), and more expensive contract renegotiations. More specifically, "salary reductions ... are the centerpiece of the aggressive cost-cutting regimens embraced by the largest airlines" (Winship, 2006). In other words, compared with the 2001 level, 30.0 percent fewer employees now do more work and receive less compensation and fewer benefits.

Shortfalls in periodic pension contributions arose gradually over time in part because legal corporate accounting reporting practices had not required that pension contributions be explicitly reported. Therefore, U.S. corporations were able to hide their falling pension contributions in the face of dwindling profits, rising prescription drug bills of retirees that employers pay (CNN.com, 2005), and growth of executive compensation including stock options. The typical U.S. corporate executive's pay of $11.3 million in 2005 is 262 times the average worker's pay and represented a 27.0 percent increase from the 2004 level (Brush, 2006). Corporate earnings generated in the U.S. represented 10.7 percent of the economy's gross domestic income, the highest share since the 1960s (Petruno, 2006). Despite the accompanying phenomenal growth in worker productivity since the mid 1990s, labor's share of income remained fiat in the face of falling worker benefits and uncontrolled outsourcing of jobs to foreign countries. In the two years preceding United Airlines' (UAL) 2002 bankruptcy filing, for example, UAL pensioners were projected to lose in excess of $3.0 billion in promised pension payments at the same time that UAL's chief executives received over $13.0 billion. At Ford, the pension loss estimate was over $12.0 billion, and at GM the shortfall was roughly $8.0 billion. Similar to the situation at United, at GM the CEO received roughly $41.0 million. During 2004, the chief executive at Continental took a lump sum payment of $22.0 million from his retirement at the time that the company under-funded its pension funds by $1.58 billion.

Northwest Airlines (NWA), like United, has been operating under federal bankruptcy Chapter 11 protection since 2005. This means that its under-funded pension plan obligations have been transferred to the federal insurer with a significantly reduced payout to retirees. In June 2006, a U.S. bankruptcy judge extended Northwest Airline's deadline to file a reorganization plan until January 15, 2007 (Memphis, Business Journal, 2006). As recently as September 2006, NWA has continued to seek additional wage concessions from its flight attendants to trim operating losses. A federal bankruptcy judge ruled earlier in favor of NWA to cancel its contracts on delivery of large-capacity airplanes. The NWA fleet is now reduced and operates more regionally, with the goal of competing more efficiently with low-cost carriers. Thus far, the Association of Flight Attendants has not succeeded in ordering a work stoppage or random disruption of work. The airline is seeking a 21.0 percent wage cut and significantly reduced benefits for flight attendants, to the tune of about 40.0 percent in concessions that include reduced health benefits.

Summary, Implications, and Conclusion

Many important individual private decisions in the U.S., ranging from job relocation to retirement timing, marriage and divorce, and childbearing, are implicit in the structure of defined-benefit pension plans such as Social Security and a number of private-sector pensions. A rising trend in the U.S. is the gradual decline in the proportion of private-sector companies that fully fund employee pensions. Private pension funds are currently under-funded to the tune of about $450.0 billion, and slightly less than a quarter of this amount is with employers having serious funding deficits, which is potentially problematic as an unprecedented 77 million baby-boomers are expected to retire in the next 25 years (Knowledge @ Wharton, 2006). These retirees are most likely to face the twin challenges of managing their medical care bills and dealing with the problem of the "lump-sum illusion"--the tendency to view retirement savings as a lump sum rather than a prospective income stream.