Pension Funds: Ticking Time Bomb for CSR

April, 2003

by Jon Entine

The socially responsible investment community should pay more attention to corporate governance and financial issues and focus less on trendy but largely irrelevant concerns, writes Jon Entine

One would think that corporate social responsibility and social investing advocates would have learned something after failing abysmally to anticipate the accounting and corporate governance mess that has ravaged European and American markets. Unfortunately, most were too busy playing the casino stock market, investing in high-flying technology stocks and singing the virtues of environmentally-friendly Internet and communications companies which inopportunely crashed, wiping out the nest eggs of so many families.

Well, you ain’t seen nothing yet. History is about to repeat itself. Pension fund liabilities at private companies are soaring into the stratosphere, savaging balance sheets, pushing many firms into or near bankruptcy, forcing R&D cutbacks and layoffs and generally making life miserable for stakeholders. Yet many of these firms are considered models of social responsibility. Moreover, social research advocates not only seem oblivious, many are contemptuously wary of turning their focus away from hot-button social issues that have dominated the movement to track such arcane concerns as pensions.

With their historical anti-corporate bias, the CSR and social investing communities for a long time have paid short shrift to corporate governance and financial issues. “Focusing on non-issues such as independent boards, transparency and the like makes it easy to avoid taking stands on real issues of corporate accountability,” writes Peter Kinder, principal of Kinder, Lydenberg, Domini. Even after years of corporate scandals, US social research giants KLD and Calvert have no formal screens for the vast array of corporate practices – in particular whether their favourite companies will be in a financial position to pay benefits to its retired workers.

How serious is the problem? At least 23 million Americans work for companies that offer traditional pension plans that provide a defined benefit – a fixed monthly income based on length of service. According to a recent study by Credit Suisse First Boston, 325 of the Standard & Poor 500 companies now have underfunded plans – that is, the value of assets has sunk below the cost of estimated pension obligations.

This is not just an American problem. Global consulting firm Watson Wyatt puts the UK pension shortfall at £70 billion. In reaction to the crisis, one in three company schemes have been scrapped in recent years, including at BP, Sainsbury, Whitbread, ICI and Lloyds TSB. “To many members – those in their forties and fifties – this will feel like theft,” commented Nicholas Timmins of the Financial Times. “A contract in which the job would deliver a predictable pension has been broken.”

What’s behind the crisis? Pension funds have been hit by a double-whammy of plummeting stock prices and low interest rates. Back in the heady days of the market bubble, companies regularly used pension surpluses to inflate the bottom line. But now, as the value of these funds sinks with the market, pension income is being replaced by pension expense. The current shortfall is US$240 billion and soaring. Yet many companies still are not facing up to the dimensions of the problems. IBM, which once used the pension fund kicker to boost earnings by 10% but was forced to contribute US$4 billion to its plan in December, still fantasises that its pension fund will return more than 8% this year. If the market coasts or sinks, ballooning payments and more layoffs will follow.

Some companies, such as IBM, are embroiled in age-discrimination suits by workers for trying to change how their plans are funded. Oddly, though Domini Funds sponsored a shareholder resolution targeting AT&T for trying to change its plan, it ignores similar concerns among its long-term favourite stocks. Consider Cummins Engine. KLD and Domini Social Investments extols its community involvement and profit sharing plans. What its spotty research hasn’t turned up is that its subsidiary Onan Corporation is being sued over its pension fund under the Employee Retirement and Income Security Act. Cummins is also in pension funding hot water. Its tight free cash flow may barely cover an expected US$105 million shortfall. In the meantime Cummins is still gambling with pensioners’ money by projecting longshot investment returns of 8.5%.

Cummins is not alone among troubled companies that are rolling the dice for their pensioners yet being given free passes by social researchers. Dozens of “socially responsible” companies show up on approved lists. For example, Delphi automotive, a KLD and Domini favourite, recently announced a US$3.5 billion pension gap. Favourites American Airlines and Lucent are on life support.

“We're starting to see billions of dollars of shareholder equity vapourised because of pension underfunding," says Marc Siegel, an analyst at the Center for Financial Research & Analysis in Rockville, Maryland. “It’s much more pervasive than anything Enron was doing.”

Perhaps the most egregious example is Verizon, the Domini Social Fund’s seventh largest holding at 2.4%. According to its annual report released last March, the US’s largest local phone company had a strong fiscal year with profits of US$389 million. Only those investors who dug into the small print at the back of the document learned that Verizon’s reported earnings included US$2.7 billion in gains from its pension fund investments. One problem: those profits didn’t really exist. The company pension fund actually lost US$3.1 billion, a footnote on page 58 of the 68-page report revealed, and US$15 billion since 2000. These are not just abstract accounting issues, mind you. Verizon’s pension fund fiasco has killed more than 30,000 jobs including 25% of the union workforce. If Verizon or any company fails to meets its pension obligations, the US taxpayer will likely shoulder at least part of the bill through emergency funding of the federal agency that insures pensions, the Pension Benefit Guaranty Corporation (which faces its own US$2 billion deficit for bailing out insolvent firms).

Apparently neither Domini nor KLD, nor frankly most social investor advocates, find such shenanigans serious enough to warrant removal from their “socially responsible” high flyers list. Most just don’t consider corporate practices an important enough “social issue”.

This abdication of responsibility recalls a Sixties song by folk singer Tom Lehrer about rocket scientist Wernher von Braun. Von Braun headed the V2 ballistic missile programme for the Nazis until late in World War II, then engineered its transfer to the US, where he developed missiles for the Americans without missing a beat. As Lehrer joked, von Braun didn’t seem to care whether his pet project landed on London or Berlin – he was just doing his job. “‘Once the rockets are up, who cares where they come down. That’s not my department,’ says Wernher von Braun.”

Unfortunately this is no laughing matter for the workers and shareholders at companies with underfunded pension funds. It would certainly mark progress if the social investing watchdogs busily obsessing about banning genetically modified organisms would instead focus on corporate governance and financial issues including pension fund liabilities – an issue that could do more damage to stakeholders than all of the combined trendy concerns currently occupying their attention.

Jon Entine is scholar-in-residence at Miami University (Ohio) and adjunct fellow with the American Enterprise Institute in Washington, DC. Jon is also an award-winning freelance journalist.

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