Last December’s announcement by General Motors that it had closed its pension benefits gap was a major event in the debate over the unfunded pension liabilities of US corporations. If GM, with nearly 2.5 retirees for each current worker, could climb out of an abyss that was roughly $20 billion at the start of 2003, couldn’t other companies do so?

They can, but not by depending solely on revised guidelines for calculating those liabilities or on the equity markets. Instead, corporations should consider undertaking two difficult tasks: increasing the level of contributions to the pension funds and improving their performance. For many com-panies, the sums involved are huge. Senior executives should therefore weigh the strategic trade-offs in timetables for paying down pension shortfalls in the same demanding way they now consider the implications—for earnings, balance sheets, and the capital markets—of building a new factory, entering a new territory, or acquiring a new competitor. Few companies take this approach today. Fortunately, as the economy emerges from its doldrums, more of them will have the resources to address their predicament.

The magnitude of the pension problem is epic: roughly 90 percent of all defined-benefit pension plans¹ in the United States were underfunded as of the end of 2002. In October 2003, the Pension Benefit Guaranty Corporation (PBGC) estimated that the total funding gap was roughly $350 billion. Pensions are now in trouble because fluctuations in the capital markets upended fund managers’ forecasts regarding returns and the cost of providing benefits. During the 1990s, strong performance in the equity and bond markets ratcheted up these managers’ expectations and allowed companies to boost their stated earnings when returns actually exceeded forecasts. The bear market of 2000 to 2002 plunged pension plans into the red, and extremely low interest rates exacerbated matters by dampening returns on the fixed-income investments in portfolios and by reducing the rate at which future pension obligations are discounted, thereby increasing their present value.

With the markets bouncing back, it is natural to wonder if higher returns might solve the problem. And they could—but only if the markets’ long-term performance exceeded the returns assumed by fund managers, many of whom have reduced their forecasts of returns slightly, to around 9 percent. This figure is more conservative than previous assumptions but still close to the 10 percent average annual rate of increase for US stocks since 1926—a notion made hazardous by demographic change. As younger workers shift to defined-contribution plans, the workforce grows older, and more workers retire, many companies will have fewer workers contributing to defined-benefit plans even as baby-boom pensioners begin receiving their monthly payments. As a result, in coming years fund managers should shift their assets from higher-risk (and higher-return) equities to lower-risk (and lower-return) fixed-income investments, such as bonds and real estate. These trends, which will make it more difficult than it was in the past to achieve equity-like returns, help explain why Warren Buffett reduced the estimated returns of Berkshire Hathaway’s pension fund to 6.5 percent, from 8.5 percent.

A second possible solution involves government action to let companies change the way future pension liabilities are calculated. Current US law requires them to be discounted at the 30-year Treasury bond rate because they are long-term obligations whose risks and present value are best estimated by comparison with other obligations of similar duration. In March 2002, Congress gave companies a temporary respite by allowing them to discount their plan liabilities at the higher long-term corporate rate until the end of 2003.² This treatment may be extended until 2005, but even if the Pension Stability Bill passes it won’t come close to eliminating current pension deficits. Nor will a bill passed by the US Senate in January 2004 to waive a substantial share of the catch-up payments required of some pension funds over the next two years. Moreover, we are wary of long-term solutions that politicize actuarial assumptions. Any law poses a risk of unintended consequences, particularly when Congress wades into issues involving financial markets, whose future direction is anyone’s guess, and when potential changes affect different corporations differently. Already, companies offering 401(k) programs have complained that the Senate bill favors competitors that provide defined-benefit pensions.

Rather than relying on quick fixes, companies ought to commit themselves to funding their pension gaps over a set period

Rather than relying on quick fixes such as accounting or regulatory changes, companies should commit themselves to funding their pension gaps over a set period that satisfies regulatory guidelines but will vary from company to company.³ On the one hand, moving deliberately might help companies take advantage of interest rate increases and of tax laws that favor topping off funds gradually.⁴ What’s more, it will take time to raise what can be a significant amount of money: Ford Motor contributed $700 million from its free cash flow to its pension fund in 2003, while GM closed the gap by using roughly $4 billion from the sale of Hughes Electronics and by issuing $13.5 billion in bonds. On the other hand, companies that defer the decision run the risk that their pensions will cost even more down the road, since they will have forgone years of potential investment returns. Delays might also make companies miss future opportunities if their pension bills come due when they need capital to finance major acquisitions or new businesses. And there is always the danger that companies won’t be able to finance the gap in the future—producing lawsuits and damaging publicity and abrogating a moral contract with employees.

No matter when companies choose to pay down the shortfall, they should launch efforts now to improve the oversight and operation of pension funds. Few of them generate returns commensurate with the risk inherent in their asset allocations. A large number don’t rebalance their assets frequently—so they become overweighted in equities during bull markets and miss bargains when the bears are growling. Furthermore, many companies hold assets whose duration is inconsistent with the liabilities of their pension funds—creating a risk that they might have to sell low to meet current needs if an asset’s time horizon exceeds the horizon of their liabilities or that they will follow overly cautious, lower-return strategies for assets of relatively short duration. Most pension funds also fail to manage their external fund advisers (or, in some cases, internal money managers) with sufficient rigor. Many, for example, don’t disaggregate performance sufficiently to identify how much of the value that money managers add should be attributed to the market exposure the funds take on.

Part of the solution to these problems lies in changing the way pension funds are governed. In many companies, neither their performance nor their operation receives the attention that other multibillion-dollar corporate activities command. Most pension funds rely on an array of external advisers and money managers, but hiring outsiders is no substitute for good governance: someone must monitor their strategy and performance. Although companies often assign this task to the chief operating officer or the CFO, those executives rarely have the time or the expertise to set policy guidelines, let alone to ensure the coordination of external advisers and managers. Whoever has the responsibility for pension issues must devote more time and attention to them.

To help, companies should involve outside investment experts more deeply in the oversight of their plans. The boards of endowments and foundations have been leaders⁵ in this respect, though admittedly they are exempt from rules that typically treat corporate-investment advisers as ERISA⁶ fiduciaries—a requirement that discourages certain would-be counselors. But some companies have managed to navigate these guidelines successfully. GM’s investment committee has three or more independent financial experts serving on it at all times, reports to the board of directors, and meets at least three times a year. At these sessions, the committee monitors the pension fund’s overall status and considers corporate investment-policy guidelines, the portfolio’s performance, and the decisions of GM’s investment-management company, which oversees the allocation of assets.

As for operations, many pension funds should rebalance their assets, recalibrate the duration of the asset portfolio to match the duration of liabilities⁷ (a practice now followed by fewer than 10 percent of all pension funds), actively measure their performance against appropriate benchmarks, and use more rigorous selection, review, and incentive-structuring processes in dealing with external managers. In addition, pension funds may be able to squeeze out a few basis points by streamlining call-center or fund-reporting operations if they haven’t already been outsourced.

Paying up and paying more attention aren’t trivial steps, but the advantages of slaying the pension-liability beast are worth the pain. Although the idea of salvation through a government bailout or a bull market is alluring, neither would be likely to provide a long-term solution, and the costs of waiting may be substantial. Many companies would be better off addressing their pension problems now—not least because another scary benefits crisis, involving health care, may be just around the corner.