WEALTH TRANSFER
WHEN HENRY SCHACHT was delivering the bad news to Lucent retirees, there was one retiree in the room who wasn’t going to feel the pain. That was Schacht himself. As a former CEO, Schacht had accrued a small fortune, joining the club of executives with enough retirement wealth not only to retire to an island but to buy it.
While Lucent and other companies were cutting benefits for hundreds of thousands of retirees to the bone, they were lavishing increasingly enormous sums on top management. This isn’t simply an issue of disparity; it’s a transfer of wealth. Billions of dollars earmarked to pay pensions and health care benefits to retirees were consumed, one way or another, by management teams who profited from the short-term income lift these maneuvers generated.
The dismantling of retiree plans did something more than boost profits. It helped fuel the growth of a parallel universe of executive pensions and benefits. Largely hidden, these growing executive retirement liabilities are slowly replacing pensions and retiree health obligations on corporate balance sheets.
The retirement party got started in the early 1990s when Congress, in a futile attempt to rein in executive pay, capped the tax deduction a company can take for an individual’s salary at $1 million. Undeterred, managers and compensation consultants simply recharacterized a lot of compensation as “performance-based,” which isn’t subject to the deduction cap.
Compensation committees maintained that tying executive pay to performance would incentivize managers to do a good job. Whatever it may have done, executives with mountains of stock options and awards were motivated to boost earnings, whether that was accomplished by improvements in productivity, layoffs, offshoring operations, creative accounting, or cutting benefits.
Unfortunately for employees and retirees, this new era of incentive pay coincided with companies’ newfound ability to use the pension and retiree health plans to boost income. Knowingly or not, when top management ordered cuts for retirees, they were indirectly boosting their own retirement wealth.
Spiraling executive pay in turn led to spiraling executive pensions. Commonly called SERPs—supplemental executive retirement plans—these top-level pensions generally provide millions of dollars in pension benefits.
Ed Whitacre, AT&T’s former chief executive, was president of the company when it froze pensions, and slashed retiree health benefits. When he retired in 2007, he was granted the usual executive entitlements, including the use of corporate aircraft, AT&T office facilities and support staff, home security, and club memberships, plus payments to cover the taxes he pays on the benefits. Whitacre would also be paid $1 million a year under a three-year consulting contract. On top of all that, he also left with a $158 million payout. This type of retirement package, which no longer shocks people, is detailed in the SEC filings that disclose the compensation of the handful of top officers at a company. But they’re the tip of a well-hidden iceberg.
Spiraling executive pay doesn’t just lead to growing executive pension obligations. It has been creating another giant liability: deferred-compensation obligations. As pay has grown, top earners have channeled more of it into deferred-compensation plans, which enables them to postpone receiving the money and delay paying taxes on it. The deferrals grow with interest and employer contributions, tax-deferred, which further boosts the IOU.
Deferred-comp plans have been called 401(k)s on steroids, because employees contribute pay, employers typically match it, and the employees allocate the funds among a selection of investments. But there’s a critical difference: The compensation employees contribute to 401(k)s is actual cash that goes into a separate account at an outside investment firm. These “defined-contribution plans” don’t create a pensionlike liability. Deferred-comp plans do. The participant doesn’t actually receive the pay before he defers it; it is merely an IOU from his employer. Another way to put it: Employers have been putting much of their spiraling executive pay—pensions and deferred compensation—on the equivalent of a giant credit card.
SCAPEGOATS
Combined, executive legacy liabilities have grown to multi-billion-dollar obligations. General Electric owes an unknown number of executives a total of $5.9 billion in retirement, which amounts to 15 percent of the total pension liability for more than 500,000 workers and retirees. Currently, executive legacy liabilities account for 8 percent to as much as 100 percent of pension obligations at some of the largest
For accounting purposes, executive liabilities are no different from regular pensions and retiree health benefits. They’re debts, and can drag down earnings. There’s a critical difference, though. Unlike pensions (which employers fund) and 401(k)s (which employees fund), supplemental executive pension and savings plans are
With no pool of assets that are earning returns, which offset the annual interest cost on the debt, the IOUs for executives always have an interest cost, which can hit earnings hard. But guess which pensions get the blame?
Employers typically aggregate their regular pensions and executive pensions when reporting pension liabilities and costs, so even if the only costly pensions are for the executives, the public doesn’t know. Nor do many analysts, whose reports overstate the amount of underfunding, because the pension obligations include executive pensions, which aren’t funded. The data, which comes from SEC filings, also includes pensions at companies like Nordstrom. Its pension tables indicate that it owes $102 million in pensions and is 100 percent underfunded. That’s because the cheery shoe clerks and store managers don’t have pensions. The pensions are only for “certain officers and select employees.”
But don’t expect employers to bemoan their spiraling executive obligations. In a letter to stockholders dated March 16, 2006, the chief executive of Unisys, Joseph McGrath, blamed “higher pension expense” for the loss the company had reported the previous year. This was partly true: Financial filings show that pension expenses reduced Unisys’s earnings by $104 million.
But he left out a critical detail: Most of the increase in cost was from a half-dozen supplemental pension and savings plans for top Unisys executives. The regular pension plan had actually been a benefit to the company. From 1995 to 2001, the company’s pension plans actually increased corporate earnings—by an average of $91 million a year. That was because the income on assets set aside for regular workers’ pensions more than covered all of Unisys’s pension expense, with the remainder flowing to the bottom line. In 2003, however, Unisys started to incur pension expenses, because of investment losses, falling rates, and because its executive pensions had become so costly that the gains produced by the regular pension plan were no longer enough to make up for it.
The day after McGrath’s report to shareholders, Unisys announced that it would freeze the regular employees’ pension plan to control “the level and volatility of retirement costs.” McGrath said that “we think these changes have struck the appropriate balance between controlling our pension costs and continuing to help our employees prepare for retirement.” On balance, it was good for Unisys: Freezing the regular pensions generated a quick gain of $45 million and will add a total of about $700 million to earnings over ten years.
A variety of companies froze their pensions in 2006, taking advantage of low interest rates, which had inflated their obligations. Curtailing pensions at a time when the obligations are artificially high results in a larger drop in the obligation, and bigger gains.
Even when a company postpones the effective date of the freeze, it can reduce its obligation immediately. In early 2006, IBM announced that it would freeze the pensions of about 117,000 U.S. employees starting in 2008, citing pension costs, volatility, and unpredictability. Only by drilling into its pension filings would one notice that $134 million, or a quarter of its U.S. pension expense the prior year, resulted from pensions for several thousand of its highest-paid people. The rest of IBM’s U.S. pension expense, $381 million, related to pensions for 254,000 workers and retirees. The only U.S. pensions dragging down earnings are the executive pensions, which have continued to rise. The freeze didn’t hurt CEO Sam Palmisano’s retirement: He’ll receive at least $3.2 million a year in retirement.
