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Pension peril

Congress wants companies to swallow some bitter pills to strengthen defined benefit plans. Many would rather cut them loose.

In a December 5 speech to workers at a Deere-Hitachi construction machinery plant in North Carolina, President Bush urged U.S. companies to do whatever it takes to safeguard their employee pension funds. "My message to corporate America is: You need to fulfill your promises," Bush declared.

Corporate America apparently wasn't listening. Less than 24 hours later, Verizon Communications announced that it would freeze its defined benefit plan for 50,500 nonunion employees, making it the fourth major employer, after Hewlett-Packard Co., Sears Holdings Corp. and Motorola, to take that step in 2005. "Companies today, including many we compete with, are not adopting defined benefit pension plans," Verizon chairman and CEO Ivan Seidenberg said in an e-mail to employees. "We must ensure that we remain competitive."

So as of July 2006, Verizon will stop contributing to its salaried employees' defined benefit pensions, although employees will be entitled to collect any benefits they have already earned. Verizon will increase its 401(k) matching contribution for nonunion employees from a maximum of 5 percent of salary to 6 to 9 percent, depending on the company's financial performance. Defined benefit plans for Verizon's 105,000 union employees will continue unchanged. The restructuring is expected to save the company $3 billion over the next ten years. Verizon declines to comment.

What makes Verizon's decision startling is that despite the widely lamented U.S. pension crisis, the company's plan isn't hurting. Far from it. At the end of 2004, it reported $39.1 billion in pension assets, or 105 percent of its liabilities, making it one of the best-funded plans in the country. And unlike the ailing airlines and automakers at the center of the pension meltdown, Verizon is doing well financially: It reported net income of $5.7 billion in the first nine months of 2005, up 19.8 percent from the year-earlier period. But competition and cost pressures are prompting even those companies with well-funded plans to dump them.

"We're worried that this will be the start of a race to the bottom," says Karen Ferguson, director of the Pension Rights Center, a workers advocacy group in Washington.

Ferguson has good reason to worry. Even as Verizon and other companies chafe under the burden of their costly defined benefit plans, Congress is wrestling with legislation that would impose tough new rules on plan sponsors. Legislators hope that the proposed changes -- increased funding levels, tougher pension accounting standards and higher insurance premiums -- will help secure the safety of corporate retirement plans and shore up the finances of the Pension Benefit Guaranty Corp., the federal corporation that protects worker pensions. But many observers fear that some reforms, by adding new administrative burdens, will only accelerate the demise of traditional corporate pensions. Certainly, the proposed reforms would make running retirement plans costlier and more volatile. Because funding levels would have to be raised, carefully managing liabilities, always a tricky business, will become much more critical.

Faced with these new burdens, some observers believe employers may simply throw up their hands. Companies can't just abandon their retirement plans altogether. But they can terminate them, giving their employees either an annuity or a lump-sum payment equal to the benefits a participant has earned. Alternatively, they can freeze the plans, either by halting the accrual of benefits to existing participants or by making the plans unavailable to new employees. (Verizon did both.)

By any measure, U.S. corporate pension funds are already in a weakened state. The PBGC estimates that in 2000 some 36,000 company defined benefit plans covered about 34.1 million workers and retirees; their combined funding shortfall that year was $39 billion. By 2005, after a rash of high-profile corporate bankruptcy filings (including Bethlehem Steel Co. and UAL Corp., the parent of United Air Lines), roughly the same number of beneficiaries were covered by just 28,000 plans, whose combined funding shortfall had mushroomed to $450 billion. PBGC's own net position has slumped from a $10 billion surplus in September 2000 to a $23.1 billion deficit in September 2005, largely because the PBGC had to assume the liabilities of newly bankrupt companies.

Congress hopes that its new pension legislation, which would be the most significant since 1974's Employee Retirement Income Security Act, will spark meaningful reform. Before the holiday recess the House and Senate each overwhelmingly passed legislation that would strengthen the PBGC over time. But important differences between the bills remain, particularly with regard to the pace at which companies must increase their contributions to pension plans. One likely result of the proposed legislation: increased volatility in corporate earnings. Although the PBGC's deficit will continue to increase, its growth and ultimate size will be sharply curtailed, analysts say. President Bush has threatened to veto any legislation that he believes does not adequately strengthen the government insurer.

In both bills the funding targets -- the minimum levels at which plans are considered to be fully funded -- would rise from 90 percent to 100 percent so that the present value of liabilities could not exceed the value of plan assets. To reach that new level, companies would be forced to increase contributions to their pension plans, making them more expensive in the short term.

Companies would also have to increase their funding at an accelerated pace. Currently, corporations may amortize any funding shortfalls by increasing contributions over a five- to 30-year period (the bigger the shortfall, the faster the funding). Under the proposed legislation all companies, except for airlines, would be required to amortize over no more than seven years.

The House and Senate bills would also impose a 58 percent hike on insurance premiums paid to the PBGC. With the boost, companies would pay $30 per participant annually, up from $19, a yearly increase of $374 million.

Finally, the bills would impose a major discomfort and financial burden on companies by sharply limiting the practice of smoothing, an accounting technique that gives companies a critical tool to manage their obligations and, ultimately, their profits. By using moving averages to calculate their plan assets and liabilities, companies can reduce the volatility of their pension fund surpluses and deficits. Smoothing allows them to minimize year-to-year fluctuations in their contribution levels and, by extension, in their net profits or losses. Less smoothing could force corporations to boost their pension contributions during economic downturns, when they can least afford it. The House and Senate bills both shorten the periods for which companies can use smoothing. Companies now smooth asset values over five years; liabilities are estimated based on a four-year average of corporate bond yields. The Senate bill calls for one year of smoothing for both assets and liabilities, while the House bill allows three. Many expect a compromise of two years. Still, the new rules are unlikely to have an immediate impact because they will be phased in over several years, and most companies will have seven years to reach the new funding targets.

"All in all," says Colleen Cunningham, CEO of Financial Executives International, an association of more than 15,000 financial managers, "the proposed legislation would probably put the nail in the coffin of defined benefit plans."

Companies face a separate threat from the Financial Accounting Standards Board. FASB is considering a proposal to completely eliminate the use of smoothing, forcing companies to use mark-to-market accounting. Because pension accounting can make the difference between a company reporting a profit or a loss, any such change could wreak havoc on a corporation's bottom line and its credit rating. Mark-to-market accounting would have reduced aggregate earnings among companies in the Standard & Poor's 500 by 1 percent in 2004 but would have increased them by 3 percent in 2003. During the market's dive in 2001 and 2002, aggregate earnings would have declined by 72 percent and 67 percent, respectively. The accounting change would create new winners and losers. In 2004, General Motors Corp.'s $2.8 billion in net income would have risen by 85 percent; Goodyear Tire & Rubber Co.'s net income of $115 million would have fallen to a loss of $14 million, according to David Zion, an accounting analyst at Credit Suisse in New York.

"Potential changes in pension accounting along with proposed legislation may allow the real volatility in the plans -- as well as the true health of the plans -- to shine through, affecting corporate earnings, balance sheets and cash flows," says Zion.

Defenders of smoothing argue that linking the actuarial value of pension assets and liabilities with market gyrations belies the fundamentally long-term nature of pension obligations. "The benefits are going to be paid out over the very long term and do not change one bit by a change in actuarial assumptions from one year to the next," says Kenneth Porter, who oversees employee benefits financing for E.I du Pont de Nemours & Co. in Wilmington, Delaware. "The only thing that changes is what people say the economic value of the plan is in today's dollars."

John Roberts, a senior vice president at Des Moines, Iowa­based GuideOne Insurance, a leading insurer of churches and schools, concurs. "We would argue for smoothing not for the purpose of obfuscating but to match a long-term investment horizon with the funding policy," he says.

The proposed legislative measures and FASB's contemplated move on smoothing are meant to strengthen the PBGC and improve transparency, but no one doubts that they also will add a burden of cost and compliance that may encourage companies to follow Verizon's lead and head for the exits.

"Legislative change will have the primary effect of discouraging strong employers from maintaining DB plans," says Dallas Salisbury, president and CEO of the Employee Benefits Research Institute, a Washington-based think tank. "Ultimately, that is likely to be the most damaging thing you could do to the PBGC."

ALONG WITH ITS PROPOSALS ON SMOOTHING, FASB is contemplating other changes in accounting rules that would further pressure plan sponsors. Perhaps by late this year, it will issue new rules requiring companies to put the funded status of pension and other postemployment benefit obligations on their balance sheets, instead of relegating them to footnotes. Retirement plan assets would become part of total corporate assets; plan liabilities would be considered corporate debt.

Credit Suisse's Zion estimates that adding pension plan assets, including those held overseas, to the balance sheet would have boosted total assets of S&P 500 companies by 5 percent in 2004; at the same time, adding projected benefit obligations would have increased aggregate debt by 20 percent. In 2004 shareholders' equity would have fallen by more than 25 percent at 18 companies in the S&P 500 and by more than half for Boeing Co., GM, Hercules and Visteon Corp. At Goodyear and UST, shareholders' equity would have been wiped out, Zion says. GM would have suffered the single biggest dollar-amount decline: $24.5 billion.

"We look at these changes as a potential tipping point that could spark significant changes in behavior by the companies that sponsor DB plans," says Zion, who expects to see terminations, freezes and negotiated reductions in benefits.

One sector that's cautiously optimistic about proposed pension legislation is the airline industry, even though high-profile bankruptcies of US Airways, United, Delta Air Lines and Northwest Airlines have highlighted the need for pension reform. Although the House bill offers the industry no special treatment, the Senate bill would allow airlines to amortize their unfunded liabilities over 20 years. Under the terms of both the House and Senate bills, other companies could extend their amortization over no more than seven years. "We're very happy," says William Quinn, president of American Beacon Advisors in Fort Worth, Texas, the investment manager for American Airlines' pension plan. "We thought 14 years was reasonable, but we don't object to 20. We'll try to fund it sooner than that, but having the flexibility is nice."

Less enthusiastic are executives in other industries who resent that special treatment, as well as the White House, which opposes any breaks for single industries. "The legislation is based on the problems of these companies in troubled industries, but they're getting additional relief while the rest are being given a very draconian set of rules," says Mark Ugoretz, president of the ERISA Industry Committee in Washington, which represents plan sponsors.

As legislators negotiate the small but critical details of the new rules, they must balance the need for strengthening the PBGC against the risks of weakening traditional pensions. "If we're going to have defined benefit plans going forward, it's critical that we have a gradual progression toward better-funded plans," says Randolf Hardock, a partner at Washington law firm Davis & Harman, who served as benefits tax counsel to the Department of the Treasury from 1993 to 1995. "But if it's more than gradual, it will drive some employers to abandon their plans." Many plan sponsors believe the White House prefers to err on the side of bolstering the PBGC. "They'd like to see DB plans go away," says American Beacon Advisors' Quinn. "It's unsound long-term policy because it will put a bigger burden on Social Security and defined contribution plans."

For Verizon, meanwhile, a new pension battle looms. In two years it will open negotiations with the Communications Workers of America, the union that covers Verizon's approximately 73,000 employees from Maine to the Virginias, for contracts that expire in the summer of 2008. After cutting defined benefits for nonunion employees, the company will likely press for concessions, including pension reductions from its union workers, arguing that it faces tough competition from nonunion shops at wireless providers. Whether the union will be able to resist those demands remains to be seen.

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