Jubak's Journal
Recent articles:
• Texas tea looks less like black gold, 2/6/2003
• 3 preferred stocks I prefer, 2/4/2003
• My 15% earnings test for finding stock gems, 1/31/2003
More...
| | Jubak's Journal
The war on your retirement
Whether you're in a pension or 401(k) plan, you simply can't ignore the new threats to your nest egg. Here's what companies and the government are doing -- and how you can fight back.
By Jim Jubak
Does it feel like your retirement is under attack?
Well, it is. And not just because declining stock prices have eroded the value of your retirement nest egg. Changes in company policies and in government regulations are working to make whatever losses we investors have inflicted on ourselves even more painful.
All in all, I think this adds up to a war on retirement.
Think Im exaggerating? Well, let me show you the trends one by one and see how you add them up.
Smaller contributions, stingier payouts
Theres no doubt that companies that still offer defined-benefit pension plans are feeling the pain. The cost of meeting fixed corporate pension payouts and contractual health-care obligations to retirees continues to climb as the workforce rapidly ages at many mature companies. And this is going on just as the bear market in stocks has cut the returns that companies earn on their pension assets.
For example, the average age of an autoworker in Detroit is 49, and average seniority is 24 years. That means, according to Sean McAlinden, an economist at the Center for Automotive Research in Ann Arbor, Mich., that half of hourly auto workers in Detroit could retire in the next five years. And after three years of a bear market, General Motors (GM, news, msgs) faces a $19 billion funding deficit in its pension plans. The company contributed $4.3 billion to its pension plan in 2002 and estimates that it will have to contribute $15 billion more over the next five years.
General Motors isnt alone. In the U.S. workforce as a whole, as the baby boom generation retires, there are fewer and fewer workers supporting each retiree. And a long list of companies including IBM (IBM, news, msgs), Avon Products (AVP, news, msgs), and Kimberly-Clark (KMB, news, msgs) have each put big hunks of cash and company stock into their defined-benefit plans.
Reduced benefits
But companies with defined-benefit plans have also responded to this crunch by trying to reduce benefits to cut costs.
One tactic is to change the formula used to set the level of retirement benefits that a worker receives. Traditional defined-benefit pensions provide a monthly retirement payout thats based on a workers age, years of service and final years of income at the company. But the payout from a cash-balance plan is based on a companys annual contribution to the plan of a fixed percentage of a workers salary (not on the age or income of the worker) and on the rate of return the company has guaranteed. For older and higher-income workers, than can mean a big drop in retirement income. For companies, it means big savings.
Converting an existing defined-benefit plan to a cash-balance plan has been off limits thanks to an official Internal Revenue Service moratorium on the conversions imposed roughly three years ago. But newly issued IRS regulations would lift the ban on conversions.
Critics of the plans have claimed that the conversions discriminate against older workers by cutting the higher benefits they get for years of service and the higher income that usually comes at the end of a working career. The IRS regulations would deal with that charge by essentially turning it on its head, in my opinion. Plans would have to be age-neutral and avoid discriminating against either older or younger workers by applying the same formula across all age groups. Plans would not be able to increase the percentage contributed for older workers, for example. An estimated 300 companies have applied to the IRS to convert their plans.
Small shifts, big differences
Why is converting to a cash-balance plan so potentially lucrative? Figuring out how much money each employee is owed by the old pension plan uses a complex calculation that relies on turning the future value of benefits into a present cash value that the company will put into the new cash-balance plan. The higher the discount rate (meaning the projected rate of return on present retirement balances), the less money a company has to put into the new cash-balance plan. Pension law currently requires that companies use the 30-year Treasury bond yield as a discount rate. But the proposed rule will let companies use any reasonable discount rate.
And even a small shift in rate can make a difference. Using a 5% discount rate, a company has to put $165,000 in already-earned benefits into the new cash-balance plan of a 50-year-old entitled to a $2,000 monthly retirement benefit at 65 under an existing retirement plan. Raising the assumed discount rate to 7% cuts the present value of the persons earned benefits to just $122,000.
As unfair as converting from one pension formula to another in midstream may seem, its actually not the most aggressive tactic showing up in the current crunch. That distinction belongs to companies that have proposed junking their pension plans entirely, often through bankruptcy or the threat of bankruptcy.
The bankruptcy threat
For example, on Jan. 31, bankrupt US Airways Group (UAWGQ, news, msgs) filed notice that it would terminate the pension plan for its pilots rather than put up money required to fully fund the plan, which was estimated to be about $3 billion short. The pilots union had said it would sue to stop the company from terminating the plan, but it faced two rather unappealing choices.
If US Airways terminated its plan, it would be taken over by the federal governments Pension Benefits Guaranty Corp. The pilots would then see their retirement payouts cut to $28,000 a year, the maximum payout from the Pension Benefits Guaranty Corp. Thats a 60% reduction from the $70,000 guaranteed to pilots by the existing plan at mandatory retirement.
If the pilots accepted an alternative plan proposed by the airline that would set up a new retirement fund to supplement the insurance benefits paid by the government, the payout on the new plan wouldnt be guaranteed, as it is under the current plan. It would depend on the performance of the financial markets. The benefits to US Airways are very clear: Instead of putting $3 billion into the existing plan, the airline would have to contribute just $850 million.
Ultimately, the pilots and the bankruptcy court went for a plan that reduced benefits 25% to 50%.
The 401(k) concerns
About 42 million workers were still covered by traditional pension plans as of 1998, the last year for which data is available, even though the number is shrinking.
Maybe you arent one of them and instead youre feeling that this war on retirement doesnt have anything to do with you.
But think again. Even aside from the investment losses that the bear market has inflicted on the value of most 401(k) accounts over the last three years, workers depending on 401(k)s face their own version of exactly the same challenges as pension-plan participants.
Companies that offer 401(k)s are cutting back their matching contributions or changing their contributions from cash to company stock.
Companies decreased the percentage of total annual payroll going to 401(k) matches to 2.5% in 2001 from 3.3% in 1999, according to the Profit Sharing/401(k) Council of Americas 2002 survey. Company contributions as a percentage of total net profit also fell to 11.8% in 2001 from 14.1% in 1999.
Companies have also changed the formulas they use to calculate the match for each worker. The most common fixed match remains 50 cents on each employee dollar contributed, but only 45.6% of companies reported this 50% match in 2001, down from 48.9% in 1999.
Melting matches
And more companies have moved to using graded matches that reduce the percentage of an employee's contribution the company matches as the size of an employee's contribution increases. The biggest increase in graded matches took place among smaller companies. Some 15% of companies with 50 to 200 workers offered graded matches in 2001, up from just 6.1% in 1999.
The trend toward reduced matches looks like it continued or even accelerated in 2002. In December 2001, General Motors reduced the company match for salaried employees in its 401(k) to 60 cents on the dollar from 80 cents. Then in January 2002, the company slashed its contribution to 20 cents on the dollar. (Last month, General Motors increased its match to 50 cents, still lower than the 2001 level.)
Ford Motor (F, news, msgs) went even further: In January 2002, it discontinued its matching contribution entirely. Since then, Goodyear Tire & Rubber (GT, news, msgs) and DaimlerChrysler (DCX, news, msgs) have also eliminated their 401(k) matches.
Government rules add to the problem
New rules from the federal government cut retirement benefits, too. Ive already mentioned the proposed federal regulations that would ease the conversion of traditional defined-benefit retirement plans to cash-balance plans. But thats not the only proposal on deck in Washington that would cut into the retirement benefits of millions of U.S. workers.
The biggest change is buried in the details of the new savings plans that President Bush proposed in his budget earlier this year. The new Employer Retirement Savings Accounts, while not very different in most respects from existing 401(k) plans, have one very important wrinkle. By eliminating rules that prevent companies from discriminating against lower-paid workers, theyd make the plans cheaper for companies while cutting the benefits offered to the average worker.
Heres how the change would work. Currently, in return for getting the tax breaks that come from offering a 401(k), a company must offer the plan to the vast majority of its workforce and not just to company managers and its best paid workers.
To make sure this happens, 401(k) plans have to meet certain nondiscrimation tests. Contributions by highly paid workers are, in effect, capped by the contributions of other workers. The more the average worker contributes, the more higher paid workers can put into the company 401(k). For example, under the current rules, if a company wants its more highly compensated workers and managers to be allowed to contribute 8% of their pre-tax pay, the average worker must contribute 6% to the plan.
This has led companies to offer incentives, such as higher company matches for initial employee contributions, to push up contributions by the average worker.
Big changes at small companies
Under the new proposal (which admittedly faces an uphill battle in 2003), the average worker would have to contribute just 4% to enable the most highly paid employees to contribute more. Thats likely to change how companies think about the incentives they offer to encourage the average worker to contribute.
The biggest change in current nondiscrimination rules, however, will affect workers at small companies. Current rules say that if 60% of the retirement plan balances are owned by company officers or owners -- a real possibility at a small, privately owned company -- then the company has to contribute 3% of pay to the retirement plans of other workers. The goal was to prevent small-company 401(k) plans from turning into little more than tax shelters for company owners. The Bush administration proposals simply do away with those rules.
Workers at small companies could face another potential danger to their retirement plans from the Bush's administration's proposal for new savings accounts. With couples able to shelter up to $30,000 outside an employer-sponsored plan ($15,000 per individual), some small-business owners are sure to drop their company-sponsored plans altogether.
Those are the trends I see in the economy and in government regulation. To me they add up to, at best, a huge shift in the retirement rules in what is, for many workers, the middle or late innings of the game. At worst, the changes constitute an attack on the very ability of many workers to retire in reasonable comfort.
How to fight back
Let me be clear on this: The negative effect of these changes on retirement nest eggs isnt something that most individual investors can fix by saving more or picking better stocks. The fix, whether to the IRS regulations on cash-balance pension conversions or to the worst details in the regulations for the new savings plans, requires collective action by everyone whod like to retire in reasonable comfort one day.
At his confirmation hearing, then-Treasury Secretary nominee John Snow, after prodding by Sens. Richard Durban, D-Ill., and Tom Harkin, D-Iowa, agreed to review the proposed IRS cash-balance regulations. And in fact, the Treasury Department withdrew a proposal to rewrite the rules. But the administration is promising to take the issue up again. So, for now, the moratorium on conversions stays in place.
Snow had also agreed that before making a decision, he would meet with senior-citizen groups and with workers, such as the IBM employees who have been fighting a cash-balance conversion at that company for years. More than 100 members of the House of Representatives have gone on record opposing the new cash-balance rules. Contact your senator or representative for more information, to learn how to comment, or to register your opinion.
Thats politics -- at its best.
Updates to Jubak's Picks
Sell Perrigo (PRGO, news, msgs)
Perrigo has done a reasonable job for me in Jubaks Picks since I added it to the portfolio on July 9, 2002, but now I think its time for the stock to go. The shares did more than just hold their value, climbing 7% during a period when the Standard & Poors 500 index ($INX) fell 12%. The companys recently reported earnings for the second quarter of its June fiscal year looked strong -- up 20% -- but appearances were as deceptive much of the increase was due to share buybacks. In fact, sales have stalled due to a weak cold and flu season, and the company faces stiff competition in the over-the-counter allergy market in the second half of 2003 from the recent launch of non-prescription versions of Claritin. All that adds up to a sell for me in this portfolio with its 12-to-18 month outlook.
Nbut appearancees weew developments on past columns
3 preferred stocks I prefer
A number of readers of my Feb. 4 article on preferred stocks e-mailed me saying that Id left out some important details in my discussion of the sector. True enough; I simply ran out of space. So let me try to include a few of the more important details here. First, a number or readers stressed that I should have stressed the difference between "true preferred stocks and a trust preferred, the currently fashionable hybrid instrument that currently accounts for more than 50% of the preferred market. In the case of a "trust" preferred, a trust set up by the company raising capital issues the preferred and uses the proceeds from that issue to purchase a bond issued by the parent company. At maturity, the parent company buys back the bond and the trust retires the preferred security at its issue price. The advantage of the trust preferred to the company raising capital is that it gets to raise debt, instead of equity, and so the interest paid on the bond (and passed along by the trust to investors) is tax-deductible. The disadvantage to investors is that the income they receive isnt considered a dividend by the IRS, but instead as interest. To the investor that means that all the received income is taxable since none qualifies for the 70% dividend-received deduction. Second, a number of readers also pointed out that in the case of a cumulative preferred that skips a dividend or two and catches up with it later, the IRS requires the investor to pay tax on the dividend as if it had been received as scheduled. Third, I made a simpleminded error. I typed yield to maturity (the date when the company must redeem the issue at its issued price) when I meant yield to call (the date at which the company can redeem the issue -- if it chooses -- at its issued price). Yield to call is extremely important to investors because buying a preferred with near-term call date at a price above the issue price can completely wipe out the value of any interest received from the shares.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
|
