Retirement Heist

by Ellen E. Schultz

  The dismantling of retiree plans did something more than boost profits. It helped fuel the growth of a parallel universe of executive pensions and benefits. Largely hidden, these growing executive retirement liabilities are slowly replacing pensions and retiree health obligations on corporate balance sheets.

  The retirement party got started in the early 1990s when Congress, in a futile attempt to rein in executive pay, capped the tax deduction a company can take for an individual’s salary at $1 million. Undeterred, managers and compensation consultants simply recharacterized a lot of compensation as “performance-based,” which isn’t subject to the deduction cap.

  Compensation committees maintained that tying executive pay to performance would incentivize managers to do a good job. Whatever it may have done, executives with mountains of stock options and awards were motivated to boost earnings, whether that was accomplished by improvements in productivity, layoffs, offshoring operations, creative accounting, or cutting benefits.

  Unfortunately for employees and retirees, this new era of incentive pay coincided with companies’ newfound ability to use the pension and retiree health plans to boost income. Knowingly or not, when top management ordered cuts for retirees, they were indirectly boosting their own retirement wealth.

  Spiraling executive pay in turn led to spiraling executive pensions. Commonly called SERPs—supplemental executive retirement plans—these top-level pensions generally provide millions of dollars in pension benefits.

  Ed Whitacre, AT&T’s former chief executive, was president of the company when it froze pensions, and slashed retiree health benefits. When he retired in 2007, he was granted the usual executive entitlements, including the use of corporate aircraft, AT&T office facilities and support staff, home security, and club memberships, plus payments to cover the taxes he pays on the benefits. Whitacre would also be paid $1 million a year under a three-year consulting contract. On top of all that, he also left with a $158 million payout. This type of retirement package, which no longer shocks people, is detailed in the SEC filings that disclose the compensation of the handful of top officers at a company. But they’re the tip of a well-hidden iceberg.

  Spiraling executive pay doesn’t just lead to growing executive pension obligations. It has been creating another giant liability: deferred-compensation obligations. As pay has grown, top earners have channeled more of it into deferred-compensation plans, which enables them to postpone receiving the money and delay paying taxes on it. The deferrals grow with interest and employer contributions, tax-deferred, which further boosts the IOU.

  Deferred-comp plans have been called 401(k)s on steroids, because employees contribute pay, employers typically match it, and the employees allocate the funds among a selection of investments. But there’s a critical difference: The compensation employees contribute to 401(k)s is actual cash that goes into a separate account at an outside investment firm. These “defined-contribution plans” don’t create a pensionlike liability. Deferred-comp plans do. The participant doesn’t actually receive the pay before he defers it; it is merely an IOU from his employer. Another way to put it: Employers have been putting much of their spiraling executive pay—pensions and deferred compensation—on the equivalent of a giant credit card.

  SCAPEGOATS

  Combined, executive legacy liabilities have grown to multi-billion-dollar obligations. General Electric owes an unknown number of executives a total of $5.9 billion in retirement, which amounts to 15 percent of the total pension liability for more than 500,000 workers and retirees. Currently, executive legacy liabilities account for 8 percent to as much as 100 percent of pension obligations at some of the largest Fortune 500 companies.

  For accounting purposes, executive liabilities are no different from regular pensions and retiree health benefits. They’re debts, and can drag down earnings. There’s a critical difference, though. Unlike pensions (which employers fund) and 401(k)s (which employees fund), supplemental executive pension and savings plans are unfunded. This is due to taxes: If a company set up a pension fund for executives, it wouldn’t be allowed to deduct the money, and the assets wouldn’t grow tax-deferred.

  With no pool of assets that are earning returns, which offset the annual interest cost on the debt, the IOUs for executives always have an interest cost, which can hit earnings hard. But guess which pensions get the blame?

  Employers typically aggregate their regular pensions and executive pensions when reporting pension liabilities and costs, so even if the only costly pensions are for the executives, the public doesn’t know. Nor do many analysts, whose reports overstate the amount of underfunding, because the pension obligations include executive pensions, which aren’t funded. The data, which comes from SEC filings, also includes pensions at companies like Nordstrom. Its pension tables indicate that it owes $102 million in pensions and is 100 percent underfunded. That’s because the cheery shoe clerks and store managers don’t have pensions. The pensions are only for “certain officers and select employees.”

  But don’t expect employers to bemoan their spiraling executive obligations. In a letter to stockholders dated March 16, 2006, the chief executive of Unisys, Joseph McGrath, blamed “higher pension expense” for the loss the company had reported the previous year. This was partly true: Financial filings show that pension expenses reduced Unisys’s earnings by $104 million.

  But he left out a critical detail: Most of the increase in cost was from a half-dozen supplemental pension and savings plans for top Unisys executives. The regular pension plan had actually been a benefit to the company. From 1995 to 2001, the company’s pension plans actually increased corporate earnings—by an average of $91 million a year. That was because the income on assets set aside for regular workers’ pensions more than covered all of Unisys’s pension expense, with the remainder flowing to the bottom line. In 2003, however, Unisys started to incur pension expenses, because of investment losses, falling rates, and because its executive pensions had become so costly that the gains produced by the regular pension plan were no longer enough to make up for it.

  The day after McGrath’s report to shareholders, Unisys announced that it would freeze the regular employees’ pension plan to control “the level and volatility of retirement costs.” McGrath said that “we think these changes have struck the appropriate balance between controlling our pension costs and continuing to help our employees prepare for retirement.” On balance, it was good for Unisys: Freezing the regular pensions generated a quick gain of $45 million and will add a total of about $700 million to earnings over ten years.

  A variety of companies froze their pensions in 2006, taking advantage of low interest rates, which had inflated their obligations. Curtailing pensions at a time when the obligations are artificially high results in a larger drop in the obligation, and bigger gains.

  Even when a company postpones the effective date of the freeze, it can reduce its obligation immediately. In early 2006, IBM announced that it would freeze the pensions of about 117,000 U.S. employees starting in 2008, citing pension costs, volatility, and unpredictability. Only by drilling into its pension filings would one notice that $134 million, or a quarter of its U.S. pension expense the prior year, resulted from pensions for several thousand of its highest-paid people. The rest of IBM’s U.S. pension expense, $381 million, related to pensions for 254,000 workers and retirees. The only U.S. pensions dragging down earnings are the executive pensions, which have continued to rise. The freeze didn’t hurt CEO Sam Palmisano’s retirement: He’ll receive at least $3.2 million a year in retirement.

  Now, thanks to the pension freeze, the employee pension plan no longer has any expense: In the years since the freeze was announced, the gains from curtailing benefits have added nearly $3 billion to IBM’s income.

  GM also took advantage of low interest rates to lock in a bigger liability. When the automaker announced in 2006 that it would freeze the pensions of 42,000 U.S. salaried workers, it blamed its troubles on “legacy co
sts,” including pensions for its U.S. workers. The move wiped $1.6 billion from GM’s pension obligations.

  How costly were the pensions of GM’s workers at the time? The pension covering nearly 700,000 U.S. workers and retirees had a $9 billion surplus and was adding $10 billion to its income calculations. The executive pension was another matter. The $1.4 billion in executive legacy liabilities for an unknown number of executives generates an expense that hurts GM’s bottom line each year. GM has often claimed that its U.S. pension plans add about $800 to the cost of each car made in the United States. But it doesn’t say how much of this cost is for executive legacy liabilities.

  A MERCANTILE DECISION

  It’s possible that the widening retirement gap is just an unintended by-product of a trend to reduce benefits and enhance executive pay. But at some companies, the disparity was deliberate. In 1996, the pension committee of the board of directors of Mercantile Stores met at the exclusive Union Club in New York City to vote on some critical changes in their retirement plans. The chain of department stores in the Midwest and the South had a pension plan covering 21,000 employees and retirees. The pension plan wasn’t a burden: It had a surplus of about $200 million. The average pension of the retired cashiers and clerks was $138 a month, and employee turnover was so high that many workers never qualified for a pension anyway.

  But the company was in financial trouble, and the pension plan was one place to look for relief. Benefits consultants pondered the situation and concluded that pension cuts would be appropriate. Why? Because the Mercantile pension plan was more generous than those of other retailers, the consultants said. At the same time, the consultants concluded that the executives’ pensions weren’t “competitive” with others in the industry. To resolve this supposed imbalance and bring Mercantile’s retirement benefits in line with those of its peers, the board voted to reduce the pensions of low-paid workers and boost executive pensions. Two years later, Dillard’s Inc., a Little Rock, Arkansas–based retailing chain, bought Mercantile, terminated the pension plan, and captured the surplus.

  Towers Perrin, the consulting firm that helped Mercantile with these kinds of decisions, merged with Watson Wyatt in 2010. Now called Towers Watson, the global consulting firm continues to help the largest companies in the United States, Canada, the United Kingdom, the Netherlands, and Germany shrink retiree benefits and boost executive pay and pensions.

  Towers Watson practices what it preaches. Its employees have a cash-balance pension plan, while top executives have a supplemental pension with all the bells and whistles that have been stripped from rank-and-file pensions, including a generous formula based on final pay, which spikes in value in the later years, and the ability to retire at sixty with full benefits. The company reimburses executives for their FICA (payroll) taxes and “grosses up” the payments (i.e., it pays the taxes on the tax payments). When top managers depart, the company uses an unusually low interest rate, 3.5 percent, to calculate their lump-sum payouts, which results in a larger payment. In fiscal 2010, the executive pension liability for the combined company stood at $627 million, 32 percent of the total pension obligation. The company also paid out $496 million in “discretionary compensation,” i.e. bonuses, of which most, or all, went to executives.

  UNDERSTATEMENT

  Like many public pension plans, executive liabilities have been growing quietly behind the scenes, producing a mounting obligation, much of it hidden. Even when a company owes its executives billions of dollars, it can be almost impossible to tell because of the way companies bundle all their pensions together in securities filings.

  When companies mention executive pensions at all, they typically use terms that only pension-industry insiders would recognize, such as “nonqualified obligations” and “unfunded defined benefit pension plans.” Comparing the obligation and cost of executive pensions to regular ones is possible only at the few companies that actually break out the figures (like GE) or provide enough clues to enable a determined researcher to back the figures out of the totals.

  Executive pensions are like public pensions in another critical way: The liabilities are often lowballed. So even if one is able to identify the current liability for executive pensions, the figure may provide an unrealistic view of what the company will ultimately pay out, for a variety of reasons, including the way they are calculated.

  Like most public pensions, executive pensions are calculated by multiplying years of service and pay—the formula many private employers have abandoned for regular employees because the benefits grow steeply in the final years. With pensions based on final pay, an individual has a big incentive to make sure the final pay is as high as possible. A firefighter or police officer, for example, might work hundreds of hours in overtime in their final years on the job, a move that might add $50,000 a year to a pension.

  Executives do essentially the same thing, with bigger payoffs, and have a variety of ways to boost their pay—and thus their pensions—by millions of dollars prior to departure or retirement. One way is to simply change the definition of “pay” to include more types of compensation. ConocoPhillips included “certain incentive payments” when it totted up CEO Jim Mulva’s pension in 2008, which increased it by $9.5 million and brought it to a total of $68 million. The same year, a $6 million pay increase for Merck’s chief executive, Richard T. Clark, pushed his pension from $11.9 million to $21.7 million.

  Awarding a substantial bonus to executives who are on the verge of retirement or departure can also generate a huge pension windfall. One of ExxonMobil’s two supplemental pension plans for executives calculates executive pension benefits using the three highest bonuses in the five years prior to retirement. A well-timed bonus can make a big difference. A $4 million bonus to CEO Rex Tillerson in 2008 pushed the total value of his pension up by $8 million in a single year, to $31 million. “By limiting bonuses to those granted in the five years prior to retirement,” the company states blandly in its proxy filing with federal regulators, “there is a strong motivation for executives to continue to perform at a high level.” It also encourages top management to make some shortsighted decisions, because a large award can lead to bigger pension benefits for the rest of their lives.

  Awarding additional years of service, a practice that compensation watchdogs have perennially snapped at, is alive and well. PG&E, the giant West Coast utility, awarded its CEO, Peter Darbee, an additional five years, which boosted his pension 38 percent to $5.2 million in 2008. The company said it was doing this because it felt that his pension was less generous than what other executives were receiving. This kind of peer pressure drives executive pay and pensions steadily higher. That same year, the compensation committee of Constellation Energy awarded its chairman and CEO, Mayo Shattuck, an additional 2.5 years of service, boosting his pension by $10.3 million, a 97 percent increase.

  Executive pensions have another characteristic that has been widely criticized in public pensions: Employers have an incentive to boost the benefits and hide the growing (unfunded) liability. In contrast, when it comes to rank-and-file pensions, employers have an incentive to inflate the liabilities and cut benefits.

  Using unrealistic (and sometimes undisclosed) assumptions to estimate the executive liability can shrink it substantially. Some companies assume that executive salaries don’t rise; others, like Towers Watson, calculate the executive obligation using an unusually high discount rate, 7.5 percent in 2010, which results in a lower reported liability.

  Companies can delay reporting some of the liability by waiting until the executive is headed out the door to apply some feature that inflates the total payout. A small change in the interest rate used to calculate a lump sum payout, for example, can increase a pension by millions of dollars.

  In 2008, Goodyear Tire & Rubber adjusted the interest rate and compensation assumptions it used to calculate top executives’ pensions, which increased chief executive Robert Keegan’s pension by $6.3 million, to a total of $17.5 million.
(The company earlier credited him with eighteen additional years of service, which has boosted his pension by $10.5 million.) At the end of that same year, Goodyear froze salaried employees’ pensions, saying its obligations under the plans were so onerous that they “could impair our ability to achieve or sustain future profitability.”

  Joel Gemunder, the CEO of Omnicare, a provider of pharmaceutical care for nursing homes, had amassed retirement benefits worth roughly $91 million by the time he retired at age seventy-one in 2010. As lofty as that figure was, it got even bigger when he left. His retirement triggered immediate vesting for his stock options and restricted shares, which were worth more than $21 million, and he received $16.2 million in cash as a severance payment. Small perks included payments for tax and financial planning ($134,250) and “executive bookkeeping services” ($27,500). Altogether, the total retirement payout was more than $130 million. And ordinary Omnicare workers? Their pensions were frozen years ago, and in 2009 the company imposed salary cuts even as it reported record profits.

  The pension and deferred-comp tables included in annual proxy statements provide a limited snapshot of the value of a top manager’s benefits. But these amounts aren’t what the person is likely to receive. Those numbers are tucked away lower down, under various provisions, such as “voluntary retirement” or “disability.” If someone relied on the pension table in Wells Fargo’s proxy statement, they might conclude that president John Stumpf’s pension in 2008 was $9.6 million, a 3 percent decline from the prior year. But elsewhere, the filing notes that the value of the pension he would receive if he left spiked to $17.7 million from $11.2 million—a 58 percent increase.

  The biggest trigger of a huge pension boost can be a change in control. Scott Ford, president and chief executive of Alltel Corp., had accumulated a pension of $16.8 million through 2007. But after the company was acquired by Verizon, change-in-control provisions tripled Ford’s salary and awarded three additional years of service. He left the company in 2008 with a pension payment of $51.7 million. Altogether, the five departing top executives received pension payouts of $131 million.