Friday, 19 July 2013

Pensions killed Detroit

I originally posted this in 2011 (from a British perspective).  Tonight, as Detroit files for bankruptcy it seems worth revisiting it.

At a time where public sector pensions have been at the heart of our national debate its worth thinking about what happened in the United States.  Why? Because expensive and outdated pension schemes have destroyed the auto manufacturing industry in Detroit and with it the city!
Detroit is a city built around the car manufacturing industry.  It used to be dominated by the big 3 auto companies – GM, Chrysler and Ford.  In recent years the industry and the city have collapsed.  In the 1950s 1.8 million people lived in Detroit.  Today it is less than 800,000.  There has been a 25% decline in population in the last 10 years alone.  At the root of this has been the decline and fall of the car manufacturers at the heart of the economy.
Why have the big 3 auto companies declined?  Well, they had been relying too much on SUV sales and not making enough small and hybrid cars and they have been dogged by poor quality.  However, the biggest single reason has been the massive cost of their employee benefits and pensions programme.
Between 1993 and 2007, GM poured $103 billion into funding their pensions and healthcare scheme.  Over the same period they could only afford to pay out $13 billion in dividends.  GM also had to work hard to play catch up as funding payments into the scheme fell behind.  At the start of the 2000s it had to pay an additional $20 billion to catch up payments and agreed to pay a further $30 billion to fund future healthcare liabilities.  Note I am talking billions here, not millions!
The point is the pensions and benefits schemes totally starved GM of investment and made a massive contribution to GM falling behind developments in the US car market.  Chrysler and Ford had similar stories.
Many other car companies based in southern or mid western states have been able to come in with far cheaper operating costs and beat the big 3 Detroit firms in competition.  Notably Nissan whose costs per worker in the US were more than 40% cheaper – largely because of the costs of the employee benefits package.
The Big 3 employee benefits package had been set up in 1950 in a deal arranged by the Union of Auto Workers UAW that became known as the Treaty of Detroit.  In a time of full employment and little competition the industry committed itself to open ended final salary arrangements with fixed guarantees.  As the workforce has grown and aged and as workers have lived longer these have become more and more expensive than ever envisaged and the companies have found themselves locked into open ended arrangements where they cannot control the costs.
Detroit and the car companies have been not alone in their pension schemes causing catastrophic loses. A huge pension liability created a budgetary nightmare for New Jersey and the city of Vallejo in California actually filed for bankruptcy because it couldn’t handle the costs of police department pensions.
Roger Lowenstein wrote about this further in his 2008 book “While America Aged:  How pension debts ruined General Motors, stopped the NYC subways, bankrupted San Diego and loom as the next financial crisis.”
Change is unavoidable in the UK
The UK faces similar issues.  Through the 50s and 60s – a time of effective full employment - there was a massive growth in Final Salary pension schemes.  The UK developed a parallel system of occupational pensions provision for those in the public sector and larger companies along with growing state provision.
13% of the population had been in occupational schemes before the war – mostly in the public sector.  By the end of the 1960s this figure was 53%.  However, in 1961 life expectancy for men was 68 years and just under 72 years for women.  In 1908, when the first state pensions were introduced they kicked in at 70, an age many failed to ever attain!  Today life expectancy in the UK is 77.9 for men and 82 for women - and growing every year.
Longevity – the fact that we are living longer is making pensions provision more and more expensive.  There are of course other factors like salary inflation but this factor alone is at the root of the problem.  After the war people were retiring at age 65 and expected to live on average about 5 years or so in retirement.  Today people, in pension schemes are retiring at 60 and can expect to live to 80 on average – 4 times longer than envisaged when the pension schemes were conceived.
Private sector Final Salary pension schemes in the UK are therefore dead!  They have been for the last 5 – 10 years.  While existing members are still in the schemes, they are all closed to new entrants.  Companies can no longer afford them and given that the benefits are fixed and guaranteed they are an open ended and growing commitment.  They are no longer commercially tenable and are a risk to the business.  That is why they are dead.
One pensions commentator, I think it was Tom McPhail, said last week that we will probably all have to spend a little less, save a little more and work a little longer to fund our retirements in future.  I think this is sound and reasonable advice and actually one of the most intelligent things I heard last week.
Final Salary pensions continue in the public sector – unfunded by investment and paid for by general taxation.   Yes, their projected costs are set to fall with CPI rather than RPI indexation and workers make a contribution.  But the projected fall in costs are because of these small reforms already in the pipeline.  They are still hugely expensive.
Pensions are in fact deferred pay.  Today, because of the current pensions position it often pays far more working for the public sector than for the private sector.  This means the wider population are being asked to fund pensions which are far more generous than anything available to them.  This means funding something akin to our entire defence spending budget.    And no economy is going to last for very long where it is more attractive to work for the public sector than for the private sector!
Ros Altmann, the Director General of Saga and something of an expert on UK pensions, argues that Final Salary pensions are actually fundamentally unfair as they disproportionately award high flyers being based on one year’s salary at the end of their career rather than taking into account, say, a lifetime of service and contributions.  It is right to reward high flyers when they are working – maybe not to continue to do so often for many years longer than they actually worked for their employer!
The true costs of final salary schemes are unsustainable to fund as the private sector has discovered.  Employers can’t underwrite unquantifiable, open-ended commitments for decades in the future.  Neither can the state or future tax payers – change is unavoidable.    
What to do?
It seems to me that the real issue here is that our occupational pension infra-structure – both private and public is broken.
The government is introducing auto enrolment so that everyone will have a modest occupational pension.  This will help a little with the many who are not in any pension scheme at all.
However, it is very modest provision.  In the second half of the 20th century companies fulfilled a social welfare function providing generous pensions – using tax advantages to provide deferred salary in effect.
With jobs for life long gone and guaranteed final salary schemes for life long gone, companies don’t do social welfare anymore – nor can we really count on them to do so.  Unfortunately, many employers have been replacing old generous schemes with much less generous ‘money-purchase’ schemes with no guarantees and all the investment risk is with the employee.  The new auto enrolment provisions, while welcome for some, just accelerates this levelling down affect.
I’m told both the USA and Australia have been much more effective than the British at replacing old unsustainable pension schemes with new money purchase provision.
I think the public sector unions have a real opportunity here.  They need to be constructive.  Accept the old pensions are unsustainable and come up with some good alternatives.  If they are sustainable and something new that provides decent pensions takes its place, market forces in the labour market could lead the way to improvements in the private sector too.
We all need to save more and we all need something that is more sustainable!