By Hilda Ochoa-Brillembourg
A good number of average profitable and taxpaying corporations with underfunded pension plans could increase their yearly earnings roughly 2% to 30% by borrowing to fully fund their plans.
Corporations are losing this advantage by scrapping their defined benefit plans and moving entirely to a defined contribution system.
Terminating DB plans without understanding their benefits to corporations and employees is not a smart executive action for profitable, tax-paying companies. All other things being equal, the termination will end up increasing after-tax payrolls at the expense of shareholders and employees as well as top management.
Defined benefit plans provide an extraordinarily tax-efficient, diversified and risk-controlled source of post-employment benefits for employees and employers as well as offering a tax-advantaged mechanism for increased national savings, investments and corporate productivity.
Borrowing to fully fund DB plans could improve corporate earnings. Looking at randomly selected companies, the percentage of annual net income would increase by 27.1% at Electronic Data Systems Corp.; 7.2% at Baxter International Inc.; 0.4% at Merck & Co.; and 4.7% at Eaton Corp. The increase is based on an arbitrage of borrowing at a lower rate and investing to get a higher pension return, which is then recorded as part of the corporate income statement. The scenario uses each company's cost of debt, tax rates and pension investment return assumptions. The conclusions do not change if the average cost of capital is used instead of the cost of debt, although clearly corporations should have the option to decide on the most appropriate funding mix.
At the national level, increasing corporate debt at a time of relatively low corporate indebtedness, high profitability and high liquidity levels makes eminent sense.
So why have DB plans become so misunderstood and unappreciated by many employees and employers, making them the jolie-laide of the benefit ball?
• DB plans are not portable, although they could be. DB plans can be made portable by allowing employees who change jobs to take with them some estimate of their accrued pension benefit, including an assumed unbiased return from inception to termination of employment (a "fair" version of cash balance plans and a modified version of DC plans in which the assets are more efficiently managed and terminal life, intergenerational risks more efficiently diversified).
• Some corporate sponsors have abused funding provisions and taken advantage of better-than-average past earnings in their DB plans to reduce current funding and boost current earnings under accounting rules, funding stock and public debt buybacks and higher bonuses to top executives. Some corporations have simply "appropriated" temporary tax-deferred pension surpluses, through contribution holidays, to book short-term higher profits. The tax code, quite myopic on this score, does not help, since it discourages companies with fully funded plans from contributing further to their plans (as if too much of a good thing is a bad thing) by not allowing tax deductions for surplus contributions. Therefore, corporate myopia is encouraged by government tax-policy myopia and its constraints on funding.
• Finally, defined contribution plans — despite their popularity — are not as attractive for either the corporate sponsor or the employee. DC plans are not as well-managed and yield lower productivity. Investment options are more limited than those available to DB plans; the plans are subject to higher administrative and management costs; and most importantly, they do not encourage the same level of tax-advantaged savings and investments, nor do they diversify horizon and capital market risks efficiently.
The nation will be truly surprised at how poorly capitalized DC plans are and how little they will contribute to individual retirement needs. The June 2006 issue of Barclays Global Investors' Investment Insights, by M. Barton Waring and Laurence B. Siegel, reported that the current median holding in defined contribution plans at the time of retirement is $44,000, not enough to fund 10 to 20 of years of individual retirement needs.
The current pension accounting reform proposal by the Financial Accounting Standards Board would move us in the right direction in terms of forcing recognition of that long-term liability on the balance sheet, not just in a footnote. Unfortunately, given the current misunderstanding of the value of a defined benefit plan as a tax-efficient reward for human capital, such recognition might increase corporate motivation to freeze them.
The Pension Protection Act of 2006, hastily cleared by Congress in early August, brings welcome protection to sponsors of 401(k) plans to facilitate investment advice and smoothes the impact of yield curve moves on DB plan liabilities, in addition to many other changes in funding rules. But the act does little or nothing to allow companies to pre-fund liabilities on a tax-deductible basis when corporate profits are strong, thus creating reserves when profits are weak.
By a combination of neglect in plan design and portability provisions, poor tax policy, shortsighted use of good return years to boost short-term corporate profitability and, in a few cases, pure abuse of trust, we are faced with a significantly underfunded defined benefit plan universe and an even more underfunded DC plan structure. With a focus on the flaws in the current structure and short-term risk and profitability, an increasing number of healthy, tax-paying corporate sponsors are looking to freeze their DB plans, depriving themselves and the country of one of the most important tax benefits for induced savings.
These corporations are killing the goose that lays the golden egg. They are eating the seed corn. They are trading a higher sustainable level of long-term earnings for unsustainable short-term perceptual boosts to profitability. If university endowments did the same thing, the future of higher level private education would be gravely threatened. Can we conclude that with this quality of decision making the future of corporate America is highly threatened? I am afraid the answer is yes.
Hilda Ochoa-Brillembourg is president and CEO of Strategic Investment Group, Arlington, Va.
