The curse of promises past - Mercer University



The curse of promises past

Oct 13th 2005

From The Economist print edition

American companies must face the reality of their legacy costs

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THE voluntary filing for bankruptcy of the world's biggest maker of car parts might not seem like an especially momentous event. But Delphi's decision on October 8th to seek the haven of Chapter 11 protection has ramifications far beyond its main customer base in Detroit, heartland of America's car industry. As well as symbolising the decline of once-mighty Motown (as recent bankruptcies have done for America's airlines), Delphi's surrender has triggered the first meaningful discussion of a problem that has been creeping up on American business for three decades: that of the unaffordable promises which successive waves of managers have made to meet the living and health-care costs of workers in their retirements.

As these massive costs have become evident, the “legacy” problem has begun to dwarf other challenges facing corporate America—even competition from China. Can firms meet their obligations? Or is the stage set for conflict as they abandon promises and try to bludgeon workers into accepting reduced benefits? A few years ago such questions might have seemed alarmist. Today, they are unavoidable (see article).

Delphi's plight has turned the spotlight on General Motors, its former parent, which guaranteed some of Delphi's pledges to retirees when it spun off the parts-maker in 1999. GM encapsulates the legacy problems that are most severe in, but not confined to, older industries. It has fewer than 200,000 American workers, but nearly 1m retirees and dependants. Its $15 billion stockmarket value is half the size of its unfunded pension liabilities, which in turn are dwarfed by an estimated $70 billion of unfunded health-care liabilities. And these are estimates—the final costs could be much larger, because reality will probably diverge from hopeful actuarial assumptions.

This is a crippling burden for GM as it struggles to compete with Japanese rivals. It has tried to lay off workers and shut factories. But trade unions, notably the United Auto Workers, have been so tenacious that workers are often expensively idled rather than sacked. Investors who fret about GM's decline tend to forget that they, too, have had a hand in this. Under pressure from shareholders, the firm paid out billions in dividends and share buybacks that it sorely needed for investment. GM could soon follow Delphi into bankruptcy.

The really bad news for corporate America, however, is that the legacy problem is widespread (much more so than in Britain and continental Europe, for example). Three-quarters of the country's biggest public companies have defined-benefit pension funds of the kind that have fallen into serious deficit. Provision of health insurance, although not always open-ended, has been a way to attract and appease workers who know there is state provision only in extreme situations.

Called to account today

What can be done? The first thing is to acknowledge that the problem is huge, growing and not susceptible to a quick fix. A couple of helpful measures are relatively obvious, but seem depressingly distant. America should standardise its rules for how companies account for their retirement pledges. Marking-to-market of pension assets matched by application of a set discount rate for bond-like liabilities would make the pension issue more transparent, as well as encourage better management and more sensible asset allocation (ie, fewer equities). Similarly, a transition towards risk-based premiums for the insurance provided by the federally-backed Pensions Benefit Guaranty Corporation would create proper incentives for managers and trustees to reduce the riskiness of their funds.

Other solutions are much more fraught. America should expand forthcoming reforms of its bankruptcy code, stopping abuses of Chapter 11 provisions that allow malingerers to stay in protection and thereby harm competitors, and perhaps forcing more failing companies into liquidation. That will require the sort of political will neither major party has yet demonstrated. The same applies to health-care promises. Congress should force firms to fund their liabilities. Many firms might then have to admit the truth: that they simply cannot keep their promises. Workers would have to buy their own health insurance. This would revive debate about America's lack of a government-backed universal health-care scheme. Whether or not the country should go down that route, it would be helpful if such a complex long-term issue were no longer distorted by false short-term promises made by big companies.

Legacy problems have arisen because, aided by a lax accounting regime and the collusion of shareholders and trade unions, past generations of managers were able to fudge painful decisions and shift the burden of their promises far into the future. Delphi's failure is a signal that the time of reckoning has arrived. Tough decisions have to be taken. Sorting it all out will be neither pretty nor easy.

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