Why Companies and Governments Shouldn’t Be Allowed to Tinker with Pension Funds

According to a Toronto Star article, one year ago Air Canada had a 3.7 billion dollar pension shortfall. Today it says it has a small surplus. That sounds good—or does it? Here’s why I think companies and governments should have to keep their hands off their employees’ pension funds.

Air Canada Turns Pension Deficit Into a Surplus

According to a Toronto Star story, Air Canada reversed its pension shortfall by

• adding $255 million from the company
• earning a 13.8% return on its pension investments in 2013
• changing reducing the discount interest rate it uses when calculating future pension obligations increasing the discount rate it uses when calculating the present value of future pension obligations
• reducing future benefits for employees by $970 million

It justified changing that discount interest rate by claiming it reflects an increase in long-term bond rates.

Some of those reasons seem, well, reasonable.

• It’s good that they chipped in more money, although that’s bad for investors in Air Canada stock.
• It’s nice that the stock markets went up and increased the value of their investments, although I hope they’ve crystallized some of the those gains so they won’t be wiped out by the next pullback.
• I’m neutral on them changing the discount interest rate for their obligations.
• But I’m not impressed by the line “reducing future benefits for employees.” Any pension fund can be in balance if the solution is just to slash pensions!

2013 Stock Market Returns and Bond Yields Improve Pension Funds

The press is fairly upbeat about pensions for a change.

Mary Thompson at CNBC says that an analysis done by Towers Watson “found the funding ratio for Fortune 1000 companies rose to 93% in 2013 from 77% in 2012.” The article attributes the improvements to “the 29% increase in the S&P 500 index in 2013” and “the increase in high-grade corporate debt yields.”

Janet McFarland of The Globe and Mail wrote Canadian Pension Plans Post Dramatic Rebound. According to the article, a sample of 607 public and private sector pension funds found in 2012 60% of pension plans were less than 80% funded. In 2013, that had changed to 6%. That’s a huge improvement. Again gains were attributed to improved stock market returns and climbing bond yields.

How Dependent Are Pension Funds on the Stock Markets?

According to the CNBC article, “roughly 30% of corporate pensions are held in equities.” That probably refers to pensions in the US as the majority of the article is about US pension funds.

According to the Canada Pension Plan, CPP, website, as of September 2013, Public Equities make up 33.4% of the fund’s investments, and Private Equities make up another 17.2%.

According to the Ontario Teachers’ Pension Plan website about 35-47% of the fund is invested in equities. They’ve posted an “explanatory” graphic (which says their assets are in:

• 47%  equities
• 48% fixed income
• 5% commodities
• 23% real assets
• 9% absolute return strategies and
• -32% money market

I’m betting that graphic was created by the same team that makes the EQAO standardized math tests for Ontario. Anyone care to explain to me how you can have minus 32% of your holdings in an asset class?!

Companies and Governments Rebalance the Asset Allocation of Pension Funds, Too

You likely already know that it’s a good idea to have an investing strategy by asset class and to stick to it. For example, you may decide to invest 60% in equities and 40% in fixed income. If, over time, you end up at 85% in equities and 15% in fixed income, you should theoretically re-balance your portfolio.

Companies and governments who run pension funds usually also re-balance by asset class from time to time.

The CNBC article suggests that once pensions are fully funded, their managers may start to reduce their stock holdings and move more assets into bonds or annuities.

Is that a problem?

It could be.

There are two ways to re-balance a portfolio. You can sell your winners to buy more of your losers. Or you can direct all new contributions to the losing asset class to bring it back up to where it belongs.

The problem with selling winners, if you don’t have to, is that if you sell too fast you cut off your chances to win really big.

Only time will tell if each of these pension funds sells out of the stock market at a good time or the wrong time. Personally, I’d rather see them bring their allocation back in line by re-directing their new contributions.

What Really Worries Me About “Good Times” for Corporate and Government Pension Funds

What deeply worries me, though, isn’t asset allocation or even the Teachers’ fund’s inability to explain itself clearly. It’s knowing what happened to many funds the last time that times were “good.”

There are already some warning signs of what may come.The Globe article says:
“The big swing in pension plans’ fortunes over the past year could reduce the need over the long term for companies to add extra cash to their plans to make up funding shortfalls, removing a major risk from their balance sheets.”

Sounds fine, right? Why should the companies keep dumping cash into the plans if they’re solvent?

Nothing.

Pension Contribution “Holidays” Do Not Make Me Jump with Joy

But what happens next is bad. Once pension funds are doing well, some companies will start offering or taking “premium holidays.” They will reduce both employer and employee contributions.

Yet the best time to invest for the long term for a reasonable return at a low risk level is usually when everyone is making money not when the world’s financial markets are in chaos. During the recent financial crisis, governments could issue bonds with virtually no interest paid and still find hordes of buyers. During good times, investors expect a reasonable return for locking up their money in long-term bonds and governments and corporations raise their offered rates accordingly.

If you don’t buy that theory, do you at least agree that they should be making every effort to make as much profit as possible during the good times so that it gives them enough funds in reserve to sustain them through the next inevitable downturn?

If you never replenish your “rainy day fund” when the sun is shining, what will be in it when the clouds roll in again?

Pension Fund Raiders Could Attack Reserves Again

In the past, governments and corporations got away with something even worse than reducing contributions to flourishing plans. They actually raided the plans and withdrew “surplus” funds from them.

If you don’t remember these “raids” just take a stagger through the internet using the search term string: rules to prevent raiding surplus pension funds. Some of the reports are enough to inspire a Stephen King novel.

I think some of the rules were tightened about raids after several major companies went bankrupt and stranded their former employees with inadequately funded pension reserves.

I’m not sure, though, just how tight the rules are. And it makes me very nervous.

More Reasons Why You Should Be Worried About Pension Meddling

As well as my fears of reduced contributions and reserve raids, I also don’t like the incessant minor tinkering that goes on without much public awareness.

Here’s an example. This quote is from the website of the Ontario Teachers’ Pension Plan: “Earlier this year, OTF and the government resolved the 2012 funding shortfall by changing the level of inflation protection provided by the pension plan.”

What does that mean? It means that the fund and the government “fixed” a funding shortfall problem by reducing the increase in pension payments to teachers intended to help their income keep up with inflation.

That kind of meddling can be deadly.

Imagine you are getting $1000 a month in pension payments. It’s enough to pay your bills but there’s nothing extra left over. Then, your utilities, insurance, taxes, food and other consumables costs increase by 2%. You expect your pension to increase by 2% also, so that you can pay those bills. Instead, your pension plan tells you “Sorry, no, we’re only going to increase your pension 1%.”

Now you’re going to be $10 short a month, every month. You won’t be able to pay your bills. You’ll have to start cutting your consumable costs.

The next year, it happens again.

How long can you keep cutting? Small cuts make big shortfalls quickly.

If inflation is 2% each year but you only get a 1% raise each year you could be in real trouble late in life when you can least expect to go back to work.

Year	Expenses	Pension	Shortfall
1	1000	1000	balanced
5	1082.43	1040.60	(41.83)
20	1456.81	1208.11	(248.70)
25	1608.44	1269.74	(338.70)

There’s only so much budget trimming you can do at 90!

What Can Be Done To Protect Our Pensions?

I urge you to keep a close eye on any pension plans you expect to benefit from.

• Watch out for premium holidays.
• Protest fast and furiously if they try to raid the reserves.
• Don’t let blasé statements blind you to tinkering that could dramatically lessen the value of your pension.
• And save money.

Save lots and lots of money privately where you know what is being done with it, where it is, and what you can expect from it in the future. Relying entirely on a company or a government to keep you well in the future could be a dreadful mistake.

In Conclusion Why Shouldn’t Companies and Governments Be Allowed to Tinker with Their Pension Funds?

‘Cause I said so. So there.

Related Reading

• Defined Contribution Pension Plans are a Ticking Time Bomb Threatening Canada’s Future

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Does it worry you to see companies treat pension funds as something they can change dramatically on a whim? Are you counting on a company or government pension to fund your retirement or are you saving independently because you don’t trust anyone? Please share your views with a comment.