Bush's Pension Protection Act is undergoing vicious attack in the media this month. In the wake of several major companies' "pension freezes", including those of IBM, Hewlett-Packard, Verizon, Delta Airlines, and, most recently, DuPont, commentators seem to be spinning the new legislation as something that is giving Corporate America the OK to rip money right out of Grammy's handbag.

Hasn't anyone considered the fact that freezes might be a good thing?

The Pension Reform Act, signed on August 17th, makes several requirements for companies that offer pensions to their employees. These requirements include:

* A provision that requires companies that under-fund their pension plans to pay additional premiums for the Pension Benefit Guaranty Corporation (the country's last-resort insurance system for pensions that go bankrupt: see Market Racket archive) ;
* An extension of a requirement that companies that terminate their pensions provide extra funding for the pension insurance system;
* Improved accounting rules to increase the transparency of pension funding;
* Elimination of loopholes that allow under-funded plans to skip pension payments;
* Increased caps on the amount that employers can put into their pension plans, so they can add more money during good times and build a cushion that can keep their pensions solvent in lean times; and
* Protection against companies with under-funded pension plans that dig deeper holes by promising extra benefits to their workers without paying for those promises up front.

The short version? Basically companies have to pay what they promise to pay and 'fess up when they're running short.

The idea of the new legislation was to prevent disasters à la GM whereby companies used to be able to promise boatloads of pension benefits to employees without taking a hit to their financial statements, only to find out later that they weren't able to pony up the cash when the checks became due. Whereas promises to employees used to be buried in footnotes to financial statements, soon companies will have to recognize these under-funded liabilities directly on their balance sheets.

So, it may seem logical that companies who in fact have under-funded pensions would want to put the brakes on the imbalance in light of these harsher consequences. One way to do this is to "freeze" pension plans, either by no longer enrolling new employees, or by no longer contributing to the pensions of existing employees. This seems pretty rational, but what is really grabbing people's attention is that even companies with fully funded pensions are implementing freezes. To some, the Pension Protection Act is motivating even companies that are in the black to stop offering pension benefits. Isn't this a bad result?

Well, maybe not. One tricky thing about pensions is that there is generally a long time lag between when a promise is made to an employee and when that employee starts collecting. An employee considers a pension benefit as a component of compensation, and may accept a lower salary now for a higher pension later. However, in the span of, say, an employee's 20 year career, this individual's employer could easily witness huge economic swings, major industry revolutions and several generations of management, all which could affect that employer's ability to live up to the pension that it promised. Before the Pension Protection Act and recent changes in accounting rules, that company could show the benefit of paying lower salaries to its employees without directly recognizing the detriment of the pension that it would have to pay out later. Here we have a classic case of informational asymmetry: the lack of transparency leads employees to make misinformed decisions because he doesn't know enough to place a high risk factor on the pension to be collected.

Improving accounting disclosures and closing loopholes that encouraged this risk mismatch is better for everyone. Investors will have a better idea of a company's health, employees will better understand the nature of the promises made to them, and the strain on our country's pension insurance system (PBGC) from "surprise" collapses like GM's will be less severe. This is all vitally important for our economy's health, especially as we enter the coming dark cloud of baby boomers who will soon swamp our retirement protection capacities.

Given all this, is it any wonder that companies across the board are taking a hard look at their pension plans? Even those that aren't in an underfunded position now can't be criticized for recognizing that expenses in the future will be larger than ever before. Would it really be better for them to continue providing pension benefits until they reach a point where they can no longer fund them?

It may be the case that recent criticisms of the Pension Protection Act are spawning from our country's slow wakening to the reality that our citizens are going to have to find alternative means for funding their retirement. Easy roads like defined benefit pension plans, 401(K)s and social security are developing more and more potholes each day.

Perhaps energy spent critiquing these market forces might be better spent taking a fresh look at Investing 101.

Posted by Michelle Smith on August 29, 2006 10:19 PM