Friday, June 24, 2005

A very vicious circle

The Buttonwood column at The Economist lays it out very cleary.

Companies and asset managers have tended to take a laid-back approach to pension underfunding, relying on the markets to right things as they often have before. What is worrying about the latest numbers is that we are seeing them towards the end of a period of strong economic growth and corporate profitability, neither of which is likely to continue. John Mauldin, an investment consultant, calculated in a recent column that total portfolio returns over the next ten years were likely to be around 5%, far less than the 8-9% projected by most funds. He reckoned that the total shortfall in America could be somewhere between $500 billion and $750 billion. And that is without counting companies’ promises to provide health care to employees and retired workers. Nicholas Colas at Rochdale Research, an independent firm, calls these obligations a bigger problem than pensions because they are neither funded nor insured.

There are a couple of weird circularities here. Most of the burden of filling these gaps will fall on the companies themselves, which will depress their profits. That, in turn, will depress share prices, which will make it harder to achieve adequate investment returns. And if asset managers turn en masse to bonds with long maturities to match their assets and liabilities more precisely, which is necessary especially for older plans, that will raise bond prices, depress bond yields and increase the present value of assets they must hold—again, widening the pensions gap. They could, of course, look to other asset classes that pay higher or “absolute” returns (hedge funds of funds, private equity, property) and many are doing so. But “alternative” assets do not typically account for more than one-tenth of the total portfolio, in part because they are labour-intensive to manage.

A the column spells out, there is a huge funding gap and no one –firms, workers, taxpayers, shareholders—wants to end up holding this hot potato.

I’m not an expert on this subject, but I believe it’s likely that that the burden will fall on the weakest link: shareholders, who as always have the largest collective action problem. How so? Well, one solution will be to “capitalize” the pension obligations by swapping the funding obligations for shares. This basically implies, for example, that the United Auto Workers will end up owning General Motors and Ford.

Maybe this is a non-starter under conditions in the United States. But I believe this “solution” is feasible in may contexts. For example, most state-owned firms in emerging economies have pension deficits that make the funding gap in the U.S. or other developed nations look like child’s play. Governments are often very eager to privatize those firms to avoid the inevitable rescue package that will bust the treasury, but unions are adamantly opposed. So, in the end, the likeliest bargain will be to transfer ownership to the workers.