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Cypen & Cypen
NEWSLETTER
for
MARCH 23, 2006

Stephen H. Cypen, Esq., Editor

Never Forget - September 11, 2001

1. DOL IS INVESTIGATING NORTHWEST PENSION FUND:

Remember when we said the Aircraft Mechanics Fraternal Association was requesting that the Pension Benefit Guaranty Corporation conduct an audit of Northwest Airlines’ pension plan (see C&C Newsletter for June 30, 2005, Item 1)? Well, according to the New York Times, the U.S. Department of Labor is investigating whether Northwest Airlines systematically shortchanged its employee pension fund over three years, then avoided having to make a $65 Million payment to the fund by filing for bankruptcy protection just one day before the payment was due. The government has subpoenaed voluminous and detailed information from Northwest going back to January, 2002, when both the airline and its pension fund faced severe financial pressures after the terrorist attacks of 2001 and the bursting of the technology bubble in the stock market. Investigators appear to be tracing steps that led to the pension fund’s recent shortfall of $5.8 Billion, and whether Northwest violated any laws. The investigation has implications for many businesses besides Northwest that have shaky pension plans. It suggests the Labor Department is looking for a way to break an entrenched pattern, in which distressed companies quietly deplete their pension funds over a number of years, then declare bankruptcy and transfer huge obligations to the federal government. Officials of the Labor Department confirmed the investigation but declined to elaborate, other than to say it was a civil matter concerning parts of the pension law that deal with funding and disclosure of information to participants and regulators. The officials also said that the inquiry was looking at whether corporate pension officials had administered the plans “solely in the interest of the participants” in the pension plans, which would fulfill their fiduciary duty. Northwest’s pension fund consists of three individual plans, for about 8,000 pilots, 9,000 salaried employees and 52,000 unionized workers, including mechanics and agents. At the end of 2004, the plans owed a total of $9.2 Billion to their participants but had assets of just $5.4 Billion.

2. WHAT ABOUT STOCK BUYBACKS?:

According to Kipplinger’s, in 2005 U.S. companies announced a record $458 Billion of stock buybacks on the open market. The banquet is still going strong in 2006, with 108 buybacks worth $66 Billion announced so far. By buying their own stock with spare cash, companies are signaling that the shares are a good value at the current price. Still, investors need to be clear on the rationale behind a buyback. Has a temporary cloud put the stock in the bargain bin? If so, then a buyback -- especially if executives are buying for themselves -- is bullish. Similarly, in a slowing economy or maturing industry, buybacks are a decent way to boost return.

3. REIT BOND PREMIUMS FALL ALONG WITH VACANCIES:

Real Estate Investment Trusts are paying the smallest premiums to sell bonds in 11 months, as U.S. office and retail vacancies fall and investors seek protection from debt-finance takeovers. Bonds sold by Real Estate Investment Trusts yield an average of 93 basis points more than Treasuries with similar maturities, compared with 99.5 basis points at the end of January. REITs outperformed the U.S. corporate bond market this year, rising .7%, compared with a .4% loss for the broader market. REITs sold $4.8 Billion in bonds, about 25% more than the same period last year. The bonds appeal to investors because U.S. office vacancies dropped to 12.5% in the fourth quarter from 14.5% in the year-earlier period. The bonds are also attracting investors because they contain covenants that limit the amount of debt an acquirer can use when taking over the companies, protecting credit ratings and returns. Covenants typically limit borrowing to 60% of an REIT’s total assets and collateralized debt to 40% of assets. Restrictions often require companies to produce operating income that is at least 1.5 times interest payments. According to the Daily Business Review, the threat to bondholders increased last year as leveraged buyout groups raised a record $134 Billion to buy companies.

4. DEFINED BENEFIT PLAN FREEZES:

A March 2006 Issue Brief from Employee Benefit Research Institute is entitled “Defined Benefit Plan Freezes: Who’s Affected, How Much, and Replacing Lost Accruals.” Despite recent news reports about the supposedly “new” trend among private defined benefit plan sponsors of “freezing” their pension plans, these decisions have been quite prevalent in recent years, and are part of the well-documented and long-term decline of “traditional” pension plans. According to Pension Benefit Guaranty Corporation analysis of 2003 Form 5500 filings (the most recent year available), more than 2,700 of the 29,000 private-sector defined benefit pension plans for which data are available were already hard-frozen in 2003. Between 1975 and 2004, more than 3,400 terminations of underfunded single-employer plans had taken place, as well as of at least 165,000 adequately funded plans. Many of these plans may well have been frozen at some point prior to termination. The Issue Brief provides a detailed analysis of how such activity is likely to impact existing employees as a function of plan type and employee demographics. A model was used to estimate the financial consequences of a potential pension freeze for the general population of participants in private defined benefit plans in 2006. The analysis provides a construct for employers to estimate the relative impact of certain demographics on those covered by defined benefit plans in general. Here are some general findings:

  • For workers in career-average pension plans -- The median annual contribution rate needed financially to indemnify a participant in a career-average defined benefit pension plan whose plan was frozen in 2006 would be about 7%, assuming an 8% rate of return. A contribution rate of about 15% would cover three-quarters of the employees in this type of plan. (A career-average plan bases annual retirement benefits on the number of years of participation and the average salary during the employee’s entire career.)
  • For workers in final-average pension plans -- The median contribution rate for a final-average plan is slightly larger: 8% (assuming an 8% return); a contribution rate of 16% would cover three-quarters of the workers in this type of plan. (A final-average plan bases its annual retirement benefits on the number of years of participation and the average salary during the employee’s final or highest years.)
  • Cash balance plans -- For workers in hybrid pension plans, the median contribution rate would be about 3%; a contribution rate of 4.5% would cover three-quarters of the workers, based on current interest credits.
  • Interest rate impact -- In all of the above scenarios, the rate of return on investments has a major impact on the contribution rates; lower rates would require higher contributions to offset the benefit loss from a pension freeze.

The entire 18-page scholarly report can be accessed through http://www.ebri.org.

5. FIREFIGHTERS AMONG CANADA’S MOST ADMIRED:

Firefighters, nurses and farmers were the top three most admired members of the community, followed by doctors and teachers, according to Leger Marketing’s annual survey of the most trusted occupations in Canada. The survey results, reported by Plansponsor.com, indicate that bankers win the blue ribbon for most improved image, gaining seven percentage points to take tenth place on the list (with a 72% rate of trust). Less than half trusted journalists, but they still fared better than lawyers, insurance brokers, real estate agents, publicists, unionists and car salespeople. Oh, and politicians -- a big 14%.

6. COURT CANNOT “PREVENT” HUSBAND FROM RETIRING:

In connection with a dissolution of marriage, the trial judge ordered husband to “remain an active member of the military until such time as his retirement benefits are fully vested.” If the husband voluntarily discontinued service in the military prior to obtaining full retirement benefits, he was required to pay directly to the wife the total sum of retirement benefits he would have otherwise received had husband remained an active member of the military. In reversing, the appellate court held that a trial court does not have authority to order a party to remain on a certain job. The higher court also found problems with the other above-referenced provisions, which seemed to entitle the wife to a greater portion of the husband’s pension than that accrued during the marriage. Oglesby v. Oglesby, 31 Fla. L. Weekly D692 (Fla. 2d DCA, March 3, 2006).

7. THE REGIONAL PERSPECTIVE ON PENSION ISSUES:

Michael H. Moskow, President and CEO of Federal Reserve Bank of Chicago, recently spoke to the State and Local Government Pension Forum. Concluding that public pension obligations are growing rapidly and beginning to reduce the ability of governments at all levels to fund other public programs, he provided the following statistics:

  • According to the U. S. Census Bureau, major public pension programs paid out $78.5 Billion in the 12 months that ended in September, 2000. By the same period in 2004, pension payouts had grown by 50%, to $118 Billion.
  • State and local governments currently employ 14 million people, with an additional 6 million retirees. It is estimated that these workers and retirees are owed $2.37 Trillion by more than 2,000 different state and municipal government entities.
  • In 2004, states and municipalities contributed $46.3 Billion to pension plans, a 19% increase over 2002 levels. Pension funding has increased from 2.15% of all state and local spending in 2002 to 2.44% in 2003.
  • Published government estimates suggest that the largest state and local pension funds faced a funding gap of $278 Billion in 2003.

He believes pension issues are even more acute in many Midwestern states, where population growth and demographics are not favorable. As a result, state and local pensions in the Midwest are much more like the legacy costs that domestic automakers face: they are a financial burden and may hurt the competitiveness of these states and cities in the future. Here are Moskow’s suggestions to solve the problem:

First, there must be a better sense of the size of the pension obligation. More uniform accounting standards are likely needed to evaluate the true health of public sector pensions.

Second, it is likely that pension plans will need to be structurally changed, which includes identifying new funding sources and restructuring pension payouts. (He recognizes that many state and local government pensions have strong legal protections that make restructuring current plans difficult, if not impossible.) Restructuring could be particularly painful if it requires higher taxes or reductions in other government services that cover shortfalls.

Third, solving the pension problem is more than an accounting exercise. Pensions must be recognized as part of any employee’s total compensation program. The human resource management dimension is important to consider when redesigning pension programs to be actuarially sound and meet the needs of today’s employees.

Mr. Moskow’s heavy-duty ideas evoked the response in the item that follows.

8. ZORN AND BRAINARD RESPOND TO FED HEAD:

Barely two weeks went by before Paul Zorn, Director of Governmental Research for Gabriel, Roeder, Smith & Company, and Keith Brainard, Director of Research for the National Association of State Retirement Administrators, responded to Michael Moskow’s remarks reported in Item 7 above. Together, authors of the March 15, 2006 letter have over 35 years of experience conducting surveys and other research related to state and local government retirement plan administration, benefit design, investments, actuarial valuations and plan funding. The speech does not accurately reflect the current financial status of plans that cover the vast majority of public employees and does not accurately reflect the reasons for the recent decline in the plan’s funding condition. For the most part, state and local retirement plans in the U.S. are in good financial shape. The average funded ratio of large public retirement plans was 88% in 2004, with 7 out of 10 plans at least 80% funded. The dramatic decline in domestic equity markets that occurred from 2000 through 2002 is the single largest factor influencing recent growth in unfunded liabilities for public pension plans. Prior to 2000, the vast majority of public plans were well funded and there was no talk of a pension crisis. Public plans were not the only ones affected: declines in asset values created problems for all retirement plans alike -- public and private, defined benefit and defined contribution. Increased unfunded actuarial liabilities are usually amortized through increases in employer contribution rates. Consequently, declines in the equity markets caused employer contribution rates to rise. To dampen the immediate impact of large, short-term market fluctuations on employer contributions, most public plans use asset smoothing techniques gradually to recognize investment gains and losses over three to five years. Consequently, even after investment markets improved in 2003, employer contributions continued to increase. The good news is that the investment gains from 2003 through 2005 are also being smoothed into the value of assets, and will likely cause employer contributions to stabilize. Moreover, when viewed in context of total state and local governmental spending, governments (and thus taxpayers) spent less on public pension plans in 2004 than they did during the mid-1990s. In addition, for an unfunded liability figure to have true meaning, it must be measured in the context of available assets. For the fourth quarter of 2005, the Federal Reserve reported that public pension plans held assets of $2.72 Trillion, a figure that has surely grown in ensuing period and that far outweighs estimates of unfunded liabilities. Thus, even if policymakers make no changes to public pension plan designs (including to contribution rates), most public pension plans would still have assets sufficient to continue paying their promised benefits, at a minimum, for decades into the future. While defined contribution plans can be a useful vehicle to supplement pension benefits by encouraging additional employee retirement savings, replacing defined benefit plans with defined contribution plans is not a practical way to reduce government costs or better to meet the needs of workers. Because of the strong legal protections on retirement benefits -- often based in a state constitution -- the defined benefit plan would still need to be maintained (and funded) for currently covered workers. The new defined contribution plan would be established for newly hired workers at an additional cost to the government. Moreover, because the defined benefit plan would be closed to new hires, stricter accounting standards would apply, effectively increasing the annual required contributions to the defined benefit plan. Any savings that would result from this change would likely not be realized for 10 to 15 years. Next, defined contribution plans have not been particularly successful in providing adequate retirement benefits. And last, defined benefit plans can be flexibly designed to meet a broad array of objectives for all stakeholders, including public employers, taxpayers and public employees. So, what steps to Zorn and Brainard suggest to improve public plan sustainability:

First, to reduce downside investment risk, plans should review their asset allocations in light of likely investment returns and duration of their liabilities.

Second, governments should avoid providing benefit increases based on plan “overfunding” or “excess assets.”

Third, governments should consistently contribute the amounts necessary to fund their pension plans and, if feasible, should establish reserves to help ensure contributions are made during cyclical economic declines.

Fourth, to the extent benefits cannot be sustained, new benefit tiers should be established to provide more sustainable pension benefits to new hires.

The authors recognize that, as head of the Federal Reserve Board of Chicago, Mr. Moskow is in a unique position to support sound public policy with regard to retirement benefits. They hope the information contained in their letter will be useful to him in this regard.

9. THANKS, DIVISION OF RETIREMENT:

On March 14 and 15, the Division of Retirement sponsored its Twenty Seventh Annual Police Officers’ and Firefighters’ Trustees’ School in Tallahassee. As usual, the group (Keith Brinkman, Trish Shoemaker, Melody Mitchell, Martha Moneyham and Julie Browning) sponsored a terrific program. The speakers and their topics were beneficial to all trustees, and the materials presented in the handbook provide instant reference and answers to many of your burning questions. Those of you who did not attend this year’s school should make plans to be there next year. You will enjoy the program and increase your knowledge ... thus making your job as trustee much easier.


10. NEW WEBSITE -- “KNOW YOUR PENSION”:

This website is designed to help you understand your pension plan, so you can insure that your retirement nest egg is safe. We all work very hard to have a financially secure retirement. Most of us are counting on our pension plans to be there when we finally get to kick off our boots for good. But too often, today, pension plans are underfunded. People retire and the money they thought would be there for them simply isn’t. Think of this website as a tool you can use to stay on top of your pension, and make sure that the money that is owed to you will be there when you retire. See http://www.knowyourpension.org/index.aspx.

Copyright, 1996-2006, all rights reserved.

Items in this Newsletter may be excerpts or summaries of original or secondary source material, and may have been reorganized for clarity and brevity. This Newsletter is general in nature and is not intended to provide specific legal or other advice.


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