Some of the folks that brought us the subprime meltdown and the global credit crisis have a bold new idea that could solve a slew of problems for U.S. companies—but also might cause a whole set of troubles for employees.
A broad coalition of Wall Street firms, from banks and insurers to hedge funds and private equity firms, are pushing lawmakers to let them buy and manage so-called frozen corporate pension plans, which no longer accept new members but must continue to cover current ones. Of the $2.3 trillion in U.S. corporate pension fund assets, some $500 billion sits in frozen plans, including those of big companies such as IBM, Hewlett-Packard, Verizon, and Alcoa.
At first blush the idea would seem to be a tough sell in Washington. Not only are Wall Street firms scrambling to boost profits and raise capital to stay afloat—they're also fighting allegations that they knowingly dumped toxic securities on unwitting investors during and after the mortgage boom.
Yet firms are getting a receptive ear from the Treasury Dept. After the IRS ruled that the concept needed legislative approval, Treasury on Aug. 6 offered a blueprint for lawmakers to allow "financially strong entities in well-regulated sectors" to acquire pension plans. Now the debate moves to Congress, which would have to change existing law.
For companies, offloading pension plans could be a boon. Many have struggled in recent years to make good on their generous pension promises, swinging from surpluses to deficits depending on the whims of the stock market. For example, Ford Motor, which reported an $8.7 billion loss in the latest quarter, has a pension plan that's underfunded by $9 billion, according to Credit Suisse analyst David Zion. Problems like that are a big reason why Charles Millard, director of the Pension Benefit Guaranty Corp., the federal insurer of last resort of corporate pension plans, is behind the Wall Street plan. He says it would "create greater security for retirees and the pension system," though he warns that "these deals should only be permitted when the acquiring entity has a higher credit-rating than the seller."
Dumping plans seems especially opportune for companies now. Since 2007, companies have been required to list pension-fund figures on their balance sheets, but that doesn't affect earnings. But new accounting standards that are supposed to take effect over the next two years will require them for the first time to include fluctuations in the value of pension assets or liabilities as part of their quarterly earnings totals, a change that could devastate profit results for some. "We have identified several clients who would be willing to be first to sell a plan," says Scott Macey, a senior vice-president with Aon Consulting, one of the firms lobbying hard for the new rules, alongside Citigroup, JPMorgan Chase, Morgan Stanley, Prudential Financial, Cerberus Capital Management, and others.
Wall Street, of course, has a different motivation—fees. As companies increasingly decide they can no longer offer the lavish benefits they once did and stop using pension plans as a recruiting tool, consulting firm McKinsey & Co. predicts that the assets in frozen plans will more than triple, to $1.7 trillion, by 2012. By taking over frozen plans, Wall Street firms could charge fees based on the total assets, perhaps in line with the standard 1% to 2% levied by many money managers.
"A TERRIBLE IDEA"
But the gambit to turn pensions into moneymakers raises plenty of questions. Critics, including some on Capitol Hill, worry that financial firms won't always have workers' best interests at heart, putting some 44 million current and future retirees at risk. "We think this is just a terrible idea," says Karen Friedman, policy director for the advocacy group Pension Rights Center. "In the wake of the subprime crisis, it would be crazy to allow financial institutions to manage these plans."
Historically, pension portfolios have been managed in a conservative fashion, investing mainly in stocks and bonds.
Alternative investments such as hedge funds, derivatives, and asset-backed securities typically represent less than 25% of pension assets. If financial firms get in, the fees they collect would present a financial incentive to boost assets under management. One way to do that would be to move pension plans into riskier investments. Even worse, critics say, Wall Street firms could use pension portfolios as a dumping ground for ailing investments on their own books. They point to the auction-rate securities market, where, regulators allege, some Wall Street firms pushed stockpiles of failing investments onto unsuspecting clients.
If Wall Street gambles with those pension assets and loses, U.S. taxpayers could be stuck with the tab. When a company with a pension goes under, the PBGC, under federal law, has to pay out the fund's obligations up to a certain amount. It's a costly burden: The PBGC currently runs a $14.1 billion deficit.
Former PBGC Director Bradley D. Belt argues that pension buyouts could strengthen the agency. If financially strapped companies were to jettison their plans, the businesses might avoid bankruptcy, and the PBGC wouldn't have to step in and pick up the pieces. "While there are legitimate regulatory and policy considerations, much of the criticism is misplaced," says Belt, who two years ago teamed up with private equity firm Reservoir Capital Group to form Palisades Capital Advisors, a pension advisory firm.
With Treasury approving the general concept of pension buyouts, lawmakers are gearing up for a legislative battle. Earlier this year, the Government Accountability Office, at the behest of skeptics in Congress, began studying the issue, and it plans to publish a report later this year. The big firms pursuing the idea will likely ramp up their lobbying efforts. JPMorgan has been particularly active, sending a letter in September 2007 to several federal agencies with its own "guidelines for pension transfers." JPMorgan's newest property, Bear Stearns, was among the first to lobby Congress and regulators. It started last year, just as two of its hedge funds were imploding.
Not all firms are on equal footing in the race for pension assets. Under federal pension laws, an employer can deduct from its taxes part of its pension plan contributions. But the IRS recently declared that the tax break doesn't apply to banks, private equity shops, or other financial firms that buy plans merely as a business opportunity. Congress would have to remove the restriction to open the door for those players at all.
Small, independent outfits that aren't tied to the books of a bigger financial entity could be out of luck entirely. The worry is that such stand-alone entities wouldn't have the balance-sheet heft to take on big chunks of pension assets. Belt, a former top aide to presumptive Republican Presidential nominee Senator John McCain (R-Ariz.), has been the most vocal proponent of letting smaller independent firms like his buy pension plans. Although he says it's too soon to tell whether that option is off the table, his proposal has stirred controversy. In its letter to regulators last September, JPMorgan took pains to distance itself from Belt's idea, supporting buyouts only by "institutions and structures that are well regulated" and "subject to high standards of financial strength and stability."
But even if Congress rejects every element of the proposal, at least some Wall Street firms will dip their hands in the pension fund honeypot. They could follow Britain's lead, where companies offload pension assets by purchasing a group annuity from an insurer. The market took off 18 months ago, when British regulators instituted stricter pension-accounting standards. Since then, nearly a dozen small, specialized insurers have begun offering the investments, many backed by Goldman Sachs, JPMorgan, Cerberus, Warburg Pincus, and Deutsche Bank—some of the same firms leading the charge in the U.S.
A dozen U.S. life insurance companies, including John Hancock, Prudential, and MetLife, already offer a way for companies to get rid of their pension burdens through such annuities. Although the market remains small, insurers sold $2.88 billion worth of policies last year, triple the amount three years ago. If Congress stymies Wall Street's frontal assault, big firms could switch to Plan B, setting up little insurance subsidiaries to offer those types of annuities. There's no end to Wall Street's creativity when billions of dollars in assets are up for grabs.