Social Security may be fading out of the news now that President Bush’s proposal to change its structure has stalled in Congress, but don’t expect pension problems to vanish from the paper altogether. Finance and accounting professors at Emory University’s Goizueta Business School say that the U.S. also faces two other pension funding crises, each potentially more serious than the one the president claimed will eventually engulf an un-reformed Social Security.  And Emory scholars note that while not facing a fiscal crisis, 401(k)s also have some significant shortcomings in their management that often make them riskier investment vehicles for individuals than they need to be.

The most imminent crisis in U.S. pension finance may involve defined benefit plans, professors say. Partly because of United Air Lines’ shedding of its pensions, the Pension Benefit Guaranty Corporation (PBGC) is now in a precarious condition. That’s a cause for worry, because the federally sponsored enterprise guarantees $2 trillion in defined-benefit pensions for 44 million Americans and is directly responsible for the current and future pensions of about 1 million Americans whose pension plans have failed.

The PBGC is supported entirely by insurance premiums paid by the companies providing the pensions, and the number of pensions that have failed or are on the verge of failing has exceeded its reserves.  As a result, the agency is running $23 billion in the red this year and it projects that this deficit will continue to grow. Bradley Belt, executive director of the PBGC, testified in Congress on June 15 that using Congressional Budget Office’s methodology the PBGC is likely to have $71 billion in additional liabilities over the next ten years. Yet right now, Belt says, the insurance premium it is allowed to collect from companies of $19 per participant, per year (supplemented by a small variable rate premium of up to 0.9% on any unfunded liabilities), yields only $600 million a year.

Even healthy plans appear to be taking larger risks now than in the past. Over the last 30 years, the amount of investment in fixed income assets among the 100 largest plans has declined from 30% to 20% with the difference increasing the plans' investments in equities, according to a February survey by PIMCO, a bond company based in Newport Beach, Cal. The bond managers argue that because there is no fixed relationship between equities and interest rates, an equity-heavy portfolio creates more risk because pension managers may find it more difficult to create a well-timed match between the investments they make now and their long-term liabilities.

At the same time, the bond experts have said that more pension funds are choosing to invest more of their fixed income dollars in short and medium-term bonds now than in the past, according to PIMCO. Since the funds’ liabilities are long-term, this behavior may also create what analysts call a “duration mismatch” for a portfolio down the road.

To make matters worse, the problems facing defined benefit plans may be somewhat understated. Companies have a number of ways to manipulate the figures to understate the present obligation, according to Al Hartgraves, a professor of accounting.  Two factors determine the amount that companies report for defined pension liabilities on their balance sheet: (1) the estimated future payments to pensioners and (2) the amount of pension fund assets available for paying the pensioners.  “The amount reported as the unfunded pension liability is increased by the discounted future payments to the pensioners and decreased by the present value of the appreciated assets available in the future to pay the pensions,” explains Hartgraves.  “Accordingly, management must select separately a discount rate and a pension fund growth rate.  By overstating the discount rate and/or the pension fund growth rate, the pension liability is reduced.” 

Reporting pension liabilities based on very long-term future estimates is part of a larger shift by the Financial Accounting Standards Board (FASB) toward requiring companies to accrue all future obligations based on past employee services , according to Hartgraves. “More and more, FASB over the last 20 years has required companies to accrue expenses currently that are not going to be paid until years out into the future and the amount that will be paid out into the future will not be known until the future gets here. You’re making a guess of what those costs are going to be, then you’re making guesses about what assets are going to do that you invest to fulfill those obligations and what is going to happen to the interest rates and the market… It’s very, very subjective,” he says. “Much of accounting these days is based on estimates and not on facts, so it gives companies a lot of latitude,” he says.

Not that companies necessarily have to go to all that trouble: George Benston, a professor of economics, accounting, and finance at Goizueta and Emory, says he does not believe that any agency conducts regular audits of plan funding levels. “To my knowledge, nobody really audits whether they’re really putting away the money,” he says.

In spite of the scale of the problem, the defined-benefit crisis may prove the easiest to solve -- easy because it’s a single fund and easy because Congress can choose to allow the PBGC to raise its premiums or change its premium structure. In the worst case, it could also choose to bail the independent agency out (although the government is not required to do so by law, according to Belt of the PBGC). Already, Congress is considering some proposals to stabilize the PBGC, in part by allowing the agency to raise its premiums on riskier companies.

The second pension crisis now looming is in the public sector. Benston predicts it may prove much more serious, in terms of expense and complexity.

In Benston’s view, resolving the governmental pension crisis presents a much more serious problem than Social Security. “I think it’s much more important than Social Security. Social Security is not as big a concern as the administration is making out. That one can be solved very easily – when I say solved, I mean by economists, not by politicians,” Benston says. Technically, if not politically, the answer is simple, according to Benston: just raise the retirement age.  When Social Security was enacted, people were expected to live an average of 1.2 years after age 65.  As of 2002, the expected average number of years during which social security will be collected has increased to 18.2 years.  Furthermore, most retirees are much healthier now and able (and often willing) to continue working, compared to those who retired when Social Security was established.

The state and local problems, however, are another matter. Some policymakers now estimate that as much as $350 billion in public and municipal pension liability is unfunded.  “That expense is going to be astronomical,” Benston warns. To make matters worse, many of these governments haven’t pre-funded any of their pension liability and most if not all have inadequately funded that liability, he says.

For public sector workers, these problems present fewer risks: courts have held that the governments can’t renege on their promises easily. This puts financially strapped government plans in a tricky situation. They typically must rely instead on the taxpayer to make up a shortfall, yet many states also often have strict limits on tax increases and deficit spending, putting the government in a severe bind.

Solving this crisis is likely to prove messy, in Benston’s view. Governments coming up short on their pensions have three choices – cut expenses, raise taxes, or declare bankruptcy.  Politically, all the choices are difficult. Benston says he doesn’t know what the states will do if they don’t raise taxes. “If the state’s costs go up but the voters don’t want to pay taxes… I don’t know, I guess you cut back on services, such as schools and support for the sick and needy. But a lot of times there’s a limit to how much you can cut back on legally,” he says.

All of this might make 401(k) holders breathe a sigh of relief, because 401(k)s are funded on a pay-as-you-go basis. But that’s where the good news ends. A frequently cited study by Dalbar, a Boston-based financial market research firm, found that over the last 20 years the average individual mutual fund investor earned 3.7% annually – a feat that doesn’t sound bad today but considering that the S&P 500 rose roughly 13.2% per year on average over that period, seems in its own way a remarkable underachievement.

Jeff Busse, a professor of finance at Goizueta, notes that companies face a dilemma when it comes to 401(k)s. On the one hand, people clearly need advice to make reasonable decisions. On the other, most firms don’t want to accept the responsibility if some of that advice doesn’t work out as planned.

Another contributing factor in their risk-adjusted performance may be the fact that many employees don’t have many choices.  Busse notes that many employers don’t give their employees choices of fund families in which to invest.  Often, he says, employees are forced to choose all their funds from a single fund family.

In a recent paper, Goizueta Finance Professor T. Clifton Green and colleagues noted that funds within the same family tend to correlate more than those belonging to different families, which means adding 50 to 70 basis points’ worth of the firm’s standard deviation, according to Green.

“It’s not necessarily going to directly show up in any returns. It’s just that in any one year if you have to get out, it’s likely if one of your funds is down, there’s a good chance the other funds are going to be down as well,” Green explains.