(cross-posted at Deny My Freedom and Daily Kos)
An alternate title for this entry could be David Sirota: left wing pundit uses right wing tactics. Why do I say that? In Sirota’s diary over at Daily Kos today, he wrote a story on the Wall Street Journal’s report on executive compensation – something that I had written about previously. Furthermore, he appeals to the left’s antipathy towards corporations and automatically assigns all the blame for the pension crisis to executives.
It’s disingenuous to put out an argument that negates to comprehend what the other side has to say, and it’s even more egregious to assign all blame on executive pensions. These one-sided arguments sound like something that right-wing pundits would use. What I’m going to do is explain the problem in technical terms that anyone without an accounting background can understand, and then you can determine who’s to blame.
The Problem
Before I start with pensions, I am going to explain the difference between the most common off-balance sheet financing tool and its counterpart. There are two common types of leases in accounting: capital leases and operating leases. Both have the same purpose – a firm is granted a lease on PP&E (short for property, plant, and equipment) for a given period of time in exchange for periodic payments. However, the way they are accounted for are different. Both operating leases and capital leases must be cancellable, but to be a capital lease, one of the following requirements must be met: the lessee assumes ownership at the end of the lease; the lessee can purchase the equipment at a significant discount; the lease term is greater than or equal to 75% of the equipment’s estimated useful life; or the present value of the lease payments are greater than or equal to 90% of the estimated fair market value of the equipment at the beginning of the lease contract.
Essentially, a capital lease assumes that the lessee, for all intents and purposes, will have possession of the equipment for the relevant period of its useful life. Because it is treated as such, both an asset (the equipment) and a liability (the present value of the lease payments) is created on the firm’s balance sheet (the balance sheet is a snapshot of a firm’s assets, liabilities, and equity at a given point in time). There is interest expense and amortization expense to record in each period’s income statement (a summary of a firm’s revenues and its costs over a given period of time), but depending on the life of the lease, this is not always equal to the way that an operating lease is accounted for. An operating lease does not meet any of the four aforementioned requirements; therefore, no liability is created on the balance sheet. Each period, a rent expense is recorded on the income statement, but you do not know how big the liability is by looking at the balance sheet – it’s not there. That is why an operating lease is termed an ‘off-balance sheet’ item. For operating leases, though, firms are required to list the payments that will be occurring in the next few years.
Let’s apply this to the issue of workers’ pensions and executive compensation. In this case, a worker’s pension is like a capital lease. There is an asset on the books (the cash that must be set aside for the pension), and a corresponding liability – the future payments for the plan. Because it is on the balance sheet, the pension plan can actually earn income; most companies will invest the pension funds in something, not just leave it sitting around earning 0%. Likewise, the executive pension is like an operating lease; it is an off-balance sheet liability that is not required to be funded beforehand. Therefore, when it is expensed on the income statement, the amount is much greater than it would otherwise be. Unlike operating leases, companies are not required to report on executive pension plans, leaving investors and analysts largely in the dark about what the actual amount of the future pension payments will be, and how it will be funded.
Who’s to blame?
When you hear corporate executives blame worker pensions for being a liability on their books, technically, they are correct. Working capital that could be used for investing in the company is simply sitting on the books, earning a rate that they probably believe is below their calculated internal rate of return (this is the firm’s derived measure of how much it will earn on its investments). Let’s use GM for an example. They essentially have $9 billion in cash equivalents not being used to fund the company’s projects. It is understandable that they would be frustrated that they cannot access that capital when the company is in such dire straits.
Whether or not the pensions of workers are too big or too small is not the question I am going to address here. What I will say, though, is that scapegoating the workers and the unions is the path of least resistance. Unions have been in decline for a few decades now, and with cheaper labor and less labor unity overseas, firms like GM can simply offer an ultimatum – take our retirement package or beat it. However, this is simply an easy solution to a bigger problem – namely, that the business itself is flawed. Consider that GM’s model this year to get itself back in the black is to produce more SUVs. Is that really the most prudent plan in a time when gas prices are higher than ever? Furthermore, there are several cogs within the company itself that can be looked at. Is the firm operating at full capacity? Can the supply chain efficiency be improved? What is our marketing strategy like? And finally, should top management be paid so much? If a firm is in trouble, it’s more likely than not that the top executives do not deserve a high salary or a hearty pension. The way executive pensions are booked makes it such that their pension expense detracts 100% from the bottom line – directly lowering the firm’s net income, the figure that is used to calculate a stock’s EPS (earnings per share). By doing so, the firm is not maximizing shareholder value. One of the main arguments behind justifying executive compensation is Milton Friedman’s claim that actions should be taken to maximize shareholder value. Giving corporate executives an unnecessary and unjustified largesse for their pensions would seem to be a contradiction. By not getting such large pensions, a firm’s earnings will be higher, thus making it a more attractive investment, and after all, if a firm is in trouble, wouldn’t they want more investment? As you can see, the direction taken on executive compensation can lead to a cycle of self-perpetuation.
All you need to know
In conclusion, the main thing to remember is that executive pensions, as a sum, is still comparatively small to workers’ pensions. Simply telling corporate executives to stop giving themselves a pension will not solve the problem. Might contracts need to be renegotiated? Probably. But in no way does this mean that companies have to start buying people out of their jobs. That’s just the easy way out for a corporation that has a flawed business model and does not want to address more fundamental issues that it needs to deal with. Additionally, Sirota’s claim that Congress has been bought off to ignore this issue is flimsy at best. Forget about the legislative branch; this is a matter of corporate governance. It’s up to the SEC to impose the regulations, and, more importantly, it’s up to people like us to make sure that the whole story is heard – and not just the side of the story that suits you.