Premeditated Fraud

By: Karim Rahemtulla | Fri, Jul 18, 2003
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What other kind of fraud is there?

Picture this - millions of American retirees and those getting ready to retire in the next two decades marching on Washington, demanding a government handout.

It will happen.

American corporations have hundreds of billions of dollars in pension liability. This is money that has been put aside to pay for Joe six-pack's retirement from General Motors, Ford, etc. It's also for current retirees, who are enjoying the fruits of their labor and the fruits of union contracts negotiated when the U.S. Industrial machine was at its peak in the 50s, 60s and 70s. Back then, the American post-war generation had no competition for global trade. We made it, people bought it. End of story.

In the 70's, the Japanese industrial giants were just entering the picture. China was still in industrial backwater, churning out five-year plans with the frequency of Mao's affairs. The Soviets still could not make a car that could outrun the Pinto - even after producing the atom and hydrogen bombs. Western Europe offered some competition, but nothing compared to the mobilized, motivated, and money-hungry Americans.

As the money came rolling in, U.S. pension plans became fatter. As long as locals were willing to pay the price for marginal goods and services, there was no end in sight. With no competition, there was nothing to stop profit margins from getting fatter ad-infinitum.

Of course, this type of short-sighted thinking always comes back to haunt you. As time wore on, the U.S. began to lose its industrial primacy. In the eighties, the U.S. teetered on the verge of exporting the majority of its manufacturing to third-world countries. Other countries quickly caught up: in the nineties, the Japanese could crank out a car in half the time of American companies, and the Chinese were finally getting the hang of capitalism.

Back home, things changed, too - for the worse. The giant corporate handouts in the form of lucrative retirement pensions persisted for many of the largest industrial companies. But the money stopped flowing in at the same rate and with the same margins.

The result? Deficits in the pension plans. Most people did not care, and still don't...as long as the check arrives every month.

They cannot argue that they don't 'understand'; pension plans are really quite simple. In principle, money is set aside from the employer in a special fund. This fund is then invested in the markets to generate a return. This return, along with the principal, is paid out as an annuity after the employee retires. So, as long as the market is not crashing and there are enough investable funds to begin with, everybody is happy.

During the nineties, many large corporations were running pension surpluses because the stock market was doing gangbusters. Companies were obliged to put in money into these funds at a prescribed rate - which was directly related to the expected rate of return on the funds. Much as investors must do when determining how much to pay into private retirement funds, companies would try to estimate the return on the cash they put in and adjust their contributions accordingly.

The obvious chance for chicanery here is for companies to play with the expected rate of return. They can't play with it too much, because there are limitations as to the rate they can use. For the most part, they are supposed to use the rate of return from the 30-year U.S. Treasury Bond.

Well, what if you could somehow tweak the rate higher? Either you could understate your liability, or you could effectively run a deficit. More on this in a moment.

Enter the Bear and lower interest rates. It is now 2003. The markets have fallen, and fallen hard for three years. Interest rates have plummeted. The effects are devastating.

Take GM, for example. At the turn of the century, GM's pension fund was at a surplus. Today, it is running an $18 billion deficit. At this point, the question of insolvency sets in - unless, of course, GM is bailed out by either the government, investors or its own product line. Guess which two stepped up to the plate?

First, investors stepped in by buying over $15 billion in low-interest, convertible debt. This money is not intended to better GM's models or to improve efficiency or to make GM more competitive; no, every penny will go toward funding the underfunded pension plan. For their hard-earned money, the poor schmucks will get a paltry return from a company that is having quite a hard time making a profit after pension liabilities are considered. For GM, this is a sweet deal. They can stay in business and move the liability from one row of the balance sheet to another row.

Not to be left out of the fanfare, the government also stepped in. As I mentioned earlier, companies that still pay a pension are obligated to use a conservative rate of return - usually based on the 30-year U.S. Treasury bond - to calculate the future benefits from a plan. Well, as we all know, the 30-year Treasury Bond has seen its lowest rates ever in the past few months. This means that U.S. corporations have had to put even more money into these plans to make them compliant.

But what if you could raise the rate of return with the stroke of a pen? The answer: the amount of your liability would actually decrease...which means Corporate America would be perpetrating a massive fraud on retirees. After all, doesn't the money have to be paid at some point?

The government has now decided to allow companies to use the rate of return from corporate bonds to calculate the needs and returns from pension plans. What's a few hundred basis points' difference? After all, shouldn't the corporate bond be a standard of safety? Some may think so, but I am sure retirees from Enron, Worldcom, and Global Crossing would argue.

Companies love this idea, since contributions to pension plans can decimate earnings reported to investors. The government loves it, since this means delaying the inevitable pension crisis in America, and it also means more contributions for their re-election efforts. Still, at the end of the day, only the retiree really cares...but as long as the checks come in every month, he's willing to coast along.

And you and I - why should we care?

Here's why. All of these pension plans are guaranteed to some degree by the PBGC, The Pension Benefit Guarantee Corporation. This is not some private insurance company, but one funded by you and me. It operates much like the FDIC - insuring the pensions based on the assumption that it can handle a crisis here or there if only one or two plans go belly-up - but heaven forbid that we have a massive failure.

So...what will happen if the Fed's current effort at reflating does not result in higher rates? Once again, the American taxpayer will be called to step up to the plate, simply to guarantee higher paper profits for companies that need the numbers to send the market higher, so the taxpayer can feel better about the future.

The wheel of life continues.

Best,


 

Karim Rahemtulla

Author: Karim Rahemtulla

Karim Rahemtulla,
The Daily Reckoning

Ed note: Karim Rahemtullah is the investment director of The Supper Club - an exclusive capital venture club for high net worth individuals looking for profitable alternatives to Wall Street. The Supper Club is hosting their annual "private placement" summit in Colorado Springs in November 9-10, 2003. If you're interested in hearing more about dozen or so opportunities that will be presented at the summit, please send an e-mail to club coordinator Vickie Beard: Vbeard@agora-inc.com.

A version of this essay was first published in the free daily e-mail: The Daily Reckoning

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