catch up with the latter as American workers and their employers take the
steps necessary to meet workers' retirement income goals.
But that is years out. Now, defined-benefit pensions are in trouble. Those
plans can flourish in periods of relatively short life expectancy after retirement
and a rapidly growing population. The unprecedented size of the baby-
boom generation and its projected longevity have dramatically reduced the
advantages of defined-benefit plans. Significant pension obligations have already
been defaulted to the Pension Benefit Guaranty Corporation.
The legal obligation to pay benefits in a defined-benefit plan of course
rests with the employer: the pension fund is there for backup. But since certain
levels of funding are mandated by law, corporations view their defined-
benefit pension fund as a profit opportunity—the greater the pension fund's
investment revenues, the less additional cash the sponsoring corporation is
*In addition, $3.7 trillion was held in individual retirement accounts (IRAs).
tGroup health insurance paid out an additional $581 billion but predominantly to those under
sixty-five years of age.
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required to put into the fund. And the less the cash infusion, the less the current
cost of labor, and the greater the profits. Consequently the corporation
is driven to find ways to reduce payments into the fund.
Since corporations know with reasonable certainty who will retire,
when, and with what promised benefits for years into the future, isn't the
cost a simple calculation? Not quite. The expected cost to a company of a
defined-benefit plan depends in part on the status of pension benefits in
the event of bankruptcy. For example, where pension benefits by contract
have first claim on corporate resources in the event of default, the calculation
of benefit cost is unambiguous. In such circumstances the corporation
might choose to set up a pension fund of riskless U.S. Treasury securities
whose maturities match the timing of the benefit payments. Benefits
would be generated by the principal and accumulated interest of a U.S.
Treasury security maturing in the year the benefits are required to be
paid. In practice, corporations try every which way to get around so simple
a program because it is the most costly. Corporate equity, real estate,
junk bonds, and even AAA corporate bonds yield a greater return than
treasuries. But all have risk of default, and in the event of default, the sponsoring
corporation would have to use its other assets or not pay its pension
obligations.
The debate as to what rate of return a pension fund should seek, and
therefore how much risk it can accept, depends, in the end, on how certain
the corporation wants to be of paying its promised benefits. The greater the
risk to pension assets, the greater the profit margin of the investment.
Financial theory would seem to make the achievement of higher returns
illusory. If the markets are pricing risk correctly, the pension fund's
rate of return should be indifferent to the degree of risk in the portfolio,
since higher rates of return compensate for the losses of risky securities,
which often become worthless. But what is true in theory doesn't always
work out in practice. (Or, more appropriately, you need a new theory.) Pension
managers will tell you that the actual, realized rates of return over the
long run for equities are above the so-called average risk-adjusted rates of
return for the U.S. economy as a whole. Rates of return since the nineteenth
century confirm that diversified holdings of stocks over decades-
long holding periods have invariably yielded above-average real rates of
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THE WORLD RETIRES. BUT CAN IT AFFORD TO?
return. As I've noted, this is probably the result of an innate human aversion
to risk. Anyone willing to stomach the stress of irrevocable long-term
commitments to stocks gains a higher return. Thus, defined-benefit pension
funds that are able to hold investments untouched for decades often
keep a majority of their assets in equities. To lower the cost to the corporation,
defined-benefit pension funds take risks, including the risks of short-
run fluctuations in the prices of their equities and other assets. And those
risks, largely through heavy investments in equities, have consequences,
both good and bad.
When stock prices are rising, capital gains in effect pay for a significant
part of the corporation's contribution to its defined-benefit program. Since
cash contributions are lower, reported profits, accordingly, are higher. Conversely,
when stock prices fall, as they did from 2000 to 2002, a large number
of pension plans became underfunded.
There is no getting around the fact that portfolio risks jeopardize retiree
benefits. Many corporations with very large unfunded pension liabilities in
recent years, such as steel companies and airlines, have chosen bankruptcy
and turned their pension obligations over to the Pension Benefit Guaranty
Corporation—that is, largely to the American taxpayer. Fortunately, the Pension
Protection Act of 2006 significantly reduced taxpayers' exposure to private
pension shortfalls, but it has by no means eliminated them.
All defined-benefit pension funds yield a rate of return that is variable
and, especially in the short run, unpredictable. But the corporation has a legal
obligation to pay a "defined" fixed benefit. This requires a third party
(almost always the sponsoring corporation itself) to swap the variable revenues
of a defined-benefit plan portfolio into the fixed payments required by
contract. In recent years, the cost of that swap has grown. Partly as a consequence,
many corporations have adopted defined-contribution pension
plans. The share of total pension fund assets held under defined-benefit
plans declined from 65 percent in 1985 to 41 percent at the end of 2006.
The trend shows no signs of abating. Corporate sponsors of defined-
contribution plans will likely become more focused on the forms of investments
their employees can make and even on some rules on how quickly,
following retirement, such funds can be disbursed. I anticipate that defined-
contribution plans will also gradually displace part of Social Security as the
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THE AGE OF TURBULENCE
latter's financing capabilities fall with the ratio of workers to retired beneficiaries
over time. As the magnitude and implications of the retirement burden
gradually become evident to potential retirees, an increasingly healthy
elderly population is very likely to find it necessary to postpone retirement.
But of greater relevance, the transfer of real resources from workers to retirees
will of necessity be increasingly financed by 401 (k) plans, private insurance,
and many as yet unidentified new financing vehicles.
In the United States, most higher-income baby boomers have wealth
and sources of income that should prove more than adequate to fund
retirement. Middle- and lower-income boomers will find financing more
problematic. Endeavoring to maintain today's pay-as-you-go government-
backed social insurance programs, whose arithmetic requires high ratios of
workers to retirees, is going to prove increasingly burdensome and unacceptable.
By default, the only viable option almost surely will turn out to
be some form of private financing. I've posed a question in the title of this
chapter: "The World Retires. But Can It Afford To?" The answer is: It will
find ways. The world has no choice. Demography is destiny.
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TWENTY-THREE
CORPORATE
GOVERNANCE
D
D
o I have to accept the Enron Prize?" I asked in November 2001
of my old friend and mentor Jim Baker. "It's part of the Baker Institute
program at which you are speaking/' he replied. I had not
been aware that an award was being given at the dinner. Enron's stock was
collapsing and within three weeks the company would be in default. That
November, "prize" hardly seemed the appropriate term. But I owed Jim
Baker a great deal, so; provided there was no official presentation or money
involved, I agreed to accept the award.
Enron had puzzled me ever since I'd heard Jeffrey Skilling, its soon-
to-be CEO; give a presentation at a meeting of the board of the Federal
Reserve Bank of Dallas in December 2000. He went through a very sophisticated
explanation of how this high-flying twenty-first-century company operated.
It was impressive. But I came away with nagging questions: What did
Enron produce? How did it make money? I understood the company's clever
derivative and hedging strategies, but what profit stream was being hedged?
Enron's demise, according to Skilling after the fact, was precipitated by
a collapse in confidence in the firm, which destroyed its ability to borrow.
That didn't seem quite right to me. I presumed that if a major steel com
THE AGE OF TURBULENCE
pany experienced a collapse of confidence, its steel furnaces would still
have some value. Impalpable Enron, however, went up in a puff of smoke,
leaving little trace except the anger of its employees and shareholders. I had
never seen a major U.S. company fall from icon to pariah to virtual nonexistence
so quickly.
The Enron debacle and the scandal surrounding the collapse of WorldCom
the following summer were particularly worrisome to me. In the
quarter century prior to my joining the Fed, I'd served on fifteen publicly
listed corporate boards (not all concurrently, of course) and had become
quite familiar with the levers of power in those companies. I had also become
increasingly aware of the disconnect between how American corporations
were governed and how that governance was perceived by the
public and our political leaders. The public, already suspicious of business
ethics (if it doesn't consider the term an outright oxymoron), was not, I
feared, prepared to accept revelations undercutting widely held beliefs
about the way corporations were governed. Much of the corporate governance
practices of myth have long since been displaced by the imperatives
of a modern economy.
Throughout the nineteenth and early twentieth centuries, shareholders,
in many instances controlling shareholders, actively participated in governing
U.S. corporations. They appointed the board of directors, who in
turn hired the CEO and other officers and, in general, controlled the strategies
of the company. Corporate governance had the trappings of democratic
representative government. But ownership diffused over the following
generations, and the managerial and entrepreneurial skills of company
founders were not always inherited by their offspring. As financial institutions
evolved over the twentieth century, shareholding became a matter of
investment, not active ownership. If a shareholder did not like the way a
company was managed, he sold his stock. Only rarely was the management
of reasonably profitable corporations challenged. Imperceptibly corporate
governance moved from shareholder control to control by the CEO. Aside
from the outspoken concern of a few academics, the change occurred quietly
and largely by default.
As shareholders became ever less engaged, the CEOs began to recommend
slates of directors to shareholders, who were soon rubber-stamping
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them. Periodically this paradigm went astray when a company or its management
got into trouble. But such episodes were relatively rare. Democratic
corporate governance had morphed into a type of authoritarianism.
The CEO would enter the boardroom, explain the corporation's new capital
investment program, and turn to his chief financial officer for corroboration.
Then, without meaningful deliberation, the board would approve
the project. The CEO of a profitable corporation today is given vast powers
by the board of directors he essentially appoints.
Over the decades government agencies and various interest groups
have pressed large institutional investors, especially pension funds, to vote
their shares in a manner that would resurrect the "corporate democracy" of
earlier decades. But these institutions argue that their responsibility to their
pensioners is to invest profitably, and that their expertise is in judging financial
market value, not in the alien practice of corporate management.
Some public pension funds have become more engaged, but their activities
are marginal. Market forces are driving private equity funds to become increasingly
committed to overseeing the management of the properties they
own, but while the trend is rapidly growing, these funds remain a very
small segment of corporate governance. Market forces are also driving
mergers and acquisitions, processes in which managements rarely survive
unscathed. So-called hostile takeovers may be seen as pure corporate democracy
once we recognize that the only "hostility" is between a set of new
shareholders and the company's entrenched management; the existing
shareholders are voluntarily selling their stock, and in most instances are
eager to do so and presumably delighted with the price they get.
It should not come as a surprise that, as with authoritarianism everywhere,
the lack of adequate accountability in corporate management has
spawned abuse. It was pretty clear during my quarter century on corporate
boards that petty abuse was widespread, and on occasion the abuse rose
above the petty.
Accordingly, I am not surprised that the outsize CEO compensation
packages of recent years have raised public concerns of unseemliness. Most
nettling has been the dramatic rise in the ratio of CEO compensation relative
to gains in average employee salary. Directors who determine executive
salaries argue in response that key decisions by CEOs leverage vast
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