How the IRS Wrecked Your Pension

Don't blame the fund managers, blame the tax code.

This week, I had a piece in the magazine arguing that retirement is trouble. That's a golden oldie for those of you who've been reading a while; my favorite evergreen topic is haranguing my readers to save 15-20% of their income, or fer goshsakes at least 10%, towards retirement. (I mean it guys. You need to save more.)

But this piece had an interesting peg: Republic Services, Inc. is in the middle of an epic battle with the Teamsters International over the pension plans that cover their workers. Up until recently, Republic teamsters have been covered by the rather notorious Central States pension fund, whose own director told Congress it would be broke in a decade or so unless something drastic was done. Republic wanted to terminate its obligations and put workers in a 401(k) (or at least a more solvent Teamster pension plan). The International Brotherhood of Teamsters was not a fan of this plan.

Central States is in particularly bad shape, but it's far from alone. A whole lot of the big union pension plans are in trouble. This is usually cited as an example of The Trouble With Unions, or alternatively, The Scandalous Underregulation of the Private Sector. As I dug into the details though, I found out something that surprised me: this wasn't just a story about union mismanagement. And it wasn't a story about deregulation, either. Oh, to be sure, the funds could have managed things better (more about that in a little while). But the reason that they're in such deep trouble now is neither bad management, nor inadequate regulation. In fact, the opposite is true: managers wanted to do a better job, and the government actively stopped them. Meet the true culprit behind the crisis in union pension plans: the friendly folks at the IRS.

Back in the day, long before the stock market boom began, the IRS decided that pension funds were a problem, taxwise. As I understand it, this problem was mostly in small professional practices like doctors and lawyers offices. The doctors and lawyers would employ one or two other people, most of them transient single women who could be expected to leave to get married long before their pension vested. So you'd set up a "pension plan" in which, realistically, you were going to be the beneficiary. Then you'd stuff it full of money, far more than you needed to pay out your pension. It was a pretty nice tax shelter.

So the IRS got very strict about pension overfunding: they didn't allow it. Or rather, they allowed it, but they wouldn't let you deduct any payments into an already overfunded plan. Farewell, tax shelter.

This was fine in the 1970s, when the market just sort of lay there like a dying fish, occasionally flopping around, but mostly just gasping for air. However, by the late 1990s, a whole lot of pension plans were overfunded. Which created something of a problem. In popular legend, all these pension fund managers were total idiots who didn't understand that the market was in a bubble, dammit. Undoubtedly, in some cases, this legend is even true. But in most cases, it wasn't. The pension consultants and money managers who were responsible for calculating the required contributions were well aware that the rocket-fuelled 1990s price increases were not likely to continue forever. They even understood that prices were likely to fall, leaving the funds not-so-funded. They wanted to keep pouring contributions into the funds in order to protect against the inevitable decline. But the IRS wouldn't let them.

Now, this is not to let them entirely off the hook, because very few pension funds did what they should have done by 1999, which is sell out of the bubbly stockmarket, put the whole thing in long-term 7% bonds, and leave their fund on flawless actuarial footing for the next thirty years. Britain's Boots Pharmacy did this, and it's not clear why others didn't follow suit. But while the managers may not have been as smart as they could or should have been, they weren't total idiots, either. They knew that what they were doing was dangerous. Unfortunately, the IRS had left them little choice. Many private companies in the United States were essentially forced to stop contributing to their pension plans. Then in 2001, they were left with a gaping hole. Many still haven't recovered.

But the big multi-employer plans (MEPs) run by the unions had an even worse problem. Pension contributions were set by multi-year collective bargaining agreements with each local. Those companies didn't have the option of stopping their contributions; to do so they'd have had to go back and negotiate a whole new contract with the unions (at the height of a labor market boom, to boot). So the money kept pouring into the pension funds even though they were already overfunded.

For obvious reasons, the pension funds didn't want to go to employers and explain why their contributions suddenly weren't tax deductible any more. But the IRS rules had them in a difficult place. The rules were very clear: if the fund was overfunded, you had to either stop making contributions, or increase the benefits. And the IRS refused to budge. So the pension plans increased the benefits.

The MEPs emerged from the dotcom crash not only with less funding than they should have had, but also burdened with a much richer set of benefits they had to pay out. Moreover, the 2001 recession had pushed a number of their member employers into bankruptcy. They left behind big unfunded liabilities--"orphan liabilities"--that by the rules of the plans, ended up spread around the remaining members. Suddenly, a big portion of everyone's hourly wage was going to make up for all those unaffordable promises, many of them made to the unemployed workers of bankrupt firms. Almost overnight, the union pension plan went, as one expert told me, from "an organizing tool, to a disorganizing tool". An open shop competitor that didn't have that big pension gap to fund could come along and woo your workers and customers by paying workers a higher wage, with good benefits and a 401(k), while still undercutting you on price. All because he didn't have to put $1 an hour towards the pension fund's unfunded liability.

This, of course, made the pension problems worse. That's why so many employers are trying to pull out; UPS paid Central States billions to exit in 2008. Naturally, Central States sensibly and responsibly put that money into the market, where it promptly lost half its value.

The government eventually fixed this problem, but only after the market had thoroughly finished crashing and destroying the funding status of these plans. Obviously, this was far too late to help anything. But better late than never, I suppose.