Monday, March 3, 2008

Warren Buffett on Pensions

How you ever wondered what all the fuss is about with pension disputes? We often hear about battles between a company and its workers over pensions. The workers accuse the company of stealing from the pension fund, and the company denies it. The stories rarely make it clear what is going on.

In his usual clear and compelling way, Warren Buffett discusses pensions in his latest letter to shareholders on page 17 in a section called “Fanciful Figures – How Public Companies Juice Earnings.”

Why Should Pension Funds Exist at All?

Let’s consider the case of a 45-year old worker William who works for the fictitious company SomeCorp. A traditional pension is a promise made by SomeCorp to pay William certain amounts of money each month after he retires.

Given this situation, it’s not immediately clear why a pension fund should exist at all. As long as SomeCorp makes the promised payments, the company should be able to run its affairs as it sees fit, right? Not so fast. What happens if SomeCorp goes out of business?

If SomeCorp has not set aside any money to pay pensions or they spend all this money in a failed attempt to save the business, then all retired workers will stop receiving their pension money, and current workers will never get any of their promised pensions. This is definitely a bad situation.

So, there are laws requiring companies to set aside money in a pension fund to cover their pension obligations. Pension payments to William will come out of a pension fund.

How Much Money Should be in the Pension Fund?

If SomeCorp hires more workers, or something else changes that causes the total amount in the pension fund to be less than what is needed to cover future promised pension payments, then SomeCorp has to add more money to the fund. Other changes may reduce SomeCorp’s pension obligations allowing them to take money out of the fund.

But, how can we know that the pension fund holds the right amount of money? The truth is that we can’t tell for certain. SomeCorp has to guess what payments it will have to make, and it has to guess how well the investments in the pension fund will perform over time.

Potential Abuses

This creates the potential for abuses. If SomeCorp makes rosy projections, they will not have to put much money in the pension fund. It will take many years to prove that the projections are unrealistic, and by then the current management will be long gone. In the mean time, SomeCorp management can report higher earnings each year and collect bigger bonuses and stock option gains.

According to Buffett, this kind of abuse is widespread among public companies trying to report the highest profits they can even if those profits don’t reflect reality.

When management and workers disagree over how much money needs to be in the pension fund, the workers accuse management of “stealing from the pension fund.”

A Simple Example

Getting back to the 45-year old worker William, let’s assume that he has a very simple pension. He will get $2000 per month for 20 years starting at age 65. These payments are indexed to inflation (assumed to be 3%) so that William will have the purchasing power each month of 2000 of today’s dollars.

Given the mix of cash, bonds, and stocks in the pension fund, and the costs of managing the fund, suppose that a realistic guess of the long-term investment returns is 6.5% per year. Based on this assumption, we can calculate that SomeCorp needs to have $179,000 set aside in the pension fund to cover William’s payments.

What happens if SomeCorp assumes long-term returns will be 8% instead of 6.5%? Then they only have to put aside $120,000, a savings of $59,000. Of course, these savings aren’t real. If returns turn out to be only 6.5% per year, then this shortfall will have to be made up later or William won’t get his full pension.

If we multiply this $59,000 shortfall by the number of workers, the amounts become very large. If SomeCorp falls on hard times, it might not be able to make up this shortfall when it comes time to pay out the pensions.

If SomeCorp decided to increase its assumed pension fund investment returns to 8.1%, it could pull $3100 per worker out of the pension fund. You can see why workers would accuse SomeCorp of stealing from the pension fund if management played accounting games like this.

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