Saturday, August 26, 2006

Why firms should not run DB pension programs

In the context of Indian pension reform, sometimes discussions about pension programs run by the employer come up. I have generally advocated not going down that route, because on the sweep of 70 years (from starting to work at age 21 to death at age 91), the firm is but an ephemeral and temporary coalition of a few people and some capital. Firms come and firms go; what makes sense is a portable individual account that stays with the person across job changes.

Today I saw a fascinating article titled The Risk Pool by Malcolm Gladwell, in The New Yorker magazine. This sheds light on three interesting issues. The first is the problems of an employer-centric DB pension program. The second is the debate about India's "demographic dividend". The third is the woes of large US manufacturing companies such as Ford or GM. These difficulties are sometimes attributed to the innately poor competitiveness of trying to do manufacturing at US wages. But as the author argues, is (to a large extent) merely caused by a bad (DB, firm level) pension program.

The article suggests that one way to solve the problems of GM or Ford would be to take them into bankruptcy, thus getting away from existing pension promises, and then selling off the good parts to a private equity firm which would be able to rebuild these firms as sound businesses; that once the flawed pension plan is out of the way, GM or Ford are actually viable firms. Perhaps Tata Motors should wait in the wings, for the time when GM or Ford go belly up.

I am sometimes accused of being obsessed about financial planning for old age, but I do think that small mistakes on pension policy have far-reaching consequences, and thinking this through requires complex reasoning that spans across many fields. Gladwell's article nicely highlights how an apparently small mistake made by CEOs of these firms, a few decades ago, was big enough to destroy these firms. The same applies for countries, in more ways than is widely understood.

8 comments:

  1. Isn't there something ethically wrong in what you are suggesting? GM/Ford have made some pension promises. You want them to renege on these promises by selling away their business to someone who will not be bound by these promises!

    The way I see it, depending on the way the sale is done, either the original owners, or the new owners of the facilities will continue to be bound by these promises.

    ReplyDelete
  2. That's a very interesting question, and I have pondered the same question often.

    My view is that a firm like Ford or GM is basically a broken business. So consider a scenario where Ford goes bankrupt (never mind why). The essence of bankruptcy is that all obligations of the firm are now null and void. The bondholders lose, the banks lose. Who else loses? A big set of obligations are those to present and past workers in the form of the DB firm-level pension.

    Once the bankruptcy has taken place, the remaining assets of the firm would be put on the block. What's worth buying? The designs of the cars and the R&D departments. That's it. The rest isn't particularly attractive. I think a firm like Tata Motors would do well to then marry the designs and R&D department of Ford, with a manufacturing facility in India. Do you want to call that new firm "Ford Done Right"? Your choice. Basically, it's the old Ford without the broken DB pension.

    Is this unethical? I think it's perhaps inevitable.

    The US PBGC is a broken framework for trying to backstop the risk of firm failure when it comes to DB pensions. I don't even bother to mention it because it's bankrupt and should itself fold when faced with a large firm-failure.

    ReplyDelete
  3. Hi Sir,

    Both GM and Ford are already trading at bankruptcy mcap levels. Their mcap-to-sales ratio i think is less than 0.2 times. And, at USD 18 bln and USD 13 bln, both GM & Ford are now selling for scrap really. Together these two sell more than 15 million cars per annum, 13 times more than the Indian market.

    At a mcap of USD 6 bln, Tata Motors is not too far behind Ford in terms of mcap...it just gotto grow at current rates for another 2 years. Lets see if Mr.Ratan Tata grabs this one!

    ReplyDelete
  4. With regards to your central question on pensions though, I am not sure the alternative model is any good, especially if employees are self-investors. They could lose lot money quickly if they take high risk investment strategy and are not verse in basic portfolio management principles (which is highly unlikely).

    I am not sure if declaring bankruptcy to shed retirement plan is ethically wrong (# of airlines in US have already done it, apparently to survive), but the current employees of GM and Ford get very high retirement payoffs and post-retirement health benefits when compared to normal US retirees.

    ReplyDelete
  5. While it is easy to point out that the DB pension obligations are causing the breakdowns at Ford/GM, we shouldn't forget that they have huge problems in their core business models and this has been exposed over the last 10 years..the fact of the matter is that Detroit just didn't care to learn the importance of fuel efficiency..and thats where the Japanese just beat them..All these companies had as an alternative to the Japanese onslaught was the next fuel guzzling SUV; which is great when oil is at $25/barrel but when people are looking at $100 to a barrel, it'll just break down..In addition their manufacturing processes are no where as efficient as say, a Toyota..I remember reading somewhere that all of Toyota's processes are benchmarked so that they stay competitive at a level of 90 Yen/$..Now thats something remarkable, something that Ford/GM cannot acheive anytime soon..

    The point about taking these companies private is that a lot of the dirty restructuring that needs to be done (firing workers,closing factories etc.) just cannot happen when a company is public with the press, politicians, regulators, unions etc. looking on..

    DB/DC pensions: Of course, there is the old argument that it is often optimal for a firm to bear the risks as a firm can diversify its risk and buy insurance in a more efficient way than an individual worker..Well functioning and well regulated markets should ensure that this condition is void and each worker can hold a well diversified portfolio that meets his risk-return profile..

    ReplyDelete
  6. Mr.Shah,

    Well, if that's the way it works with bankruptcy, then mustn't the money made by the sale be used for giving the ex-workers their pensions?

    I thought that the general practice is for both the employer and the employee to put in a certain amount of money in the pension fund. If the employer hasn't bothered to do it, who's responsible? Certainly not the employee!

    If the company is not able to pay the pensions even after the sale of its facilities, mustn't the shareholders be made responsible? After all, it was they who enjoyed the benefits of the company's negligence (of not contributing to the pension fund). So it upto them to cough up the money, isn't it?

    ReplyDelete
  7. Karthik, GM/Ford are different animals. Their benefits are so generous because of their union negotiating power (Teamsters) - employees get full waging even if not working if a factory closed down - some people have been on this program for decades; retirees (and families) get complete medical insurance with no co-pay. Their plan is not a defined contribution plan that you are refering to. Apparenlty, for every car sold $1500 goes to existing pension plan - one reason they can't make a profit.

    ReplyDelete
  8. Did you read this: I found this after the read the Malcolm Gladwel piece on your blog.

    http://www.janegalt.net/blog/archives/005868.html

    ReplyDelete

Please note: Comments are moderated; I will delete comments that misbehave. The rules are as follows. Only civilised conversation is permitted on this blog. Criticising me is perfectly okay; uncivilised language is not. I delete any comment which is spam, has personal attacks against anyone, or uses foul language.