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Thursday, October 20, 2005

By Ralf Seiffe

On Monday, General Motors announced that it had reached an agreement with its largest union to cut current and future health care costs by about $3 billion per year.  This move confirmed what the market has long known: General Motors’ business model no longer works.  Legislators in Illinois should take note of this development because the same problem that’s killing GM has long infected our state.  Will the leadership in Springfield have the same courage to do anything to cure it?  

The problem is legacy costs.  GM, like other old-line industrial companies designed, their retirement benefit plans in the late 1940’s and 1950’s when life expectancies were shorter and it took a lot of labor to assemble a car.  As life expectancies increased, the number of years that a retiree could expect to draw benefits has exceeded the most conservative actuarial estimates.  

General Motors made one out of every two cars Americans bought in 1970; now it’s one out of four. Since those glory days ended, the American share declined because gas mileage and low quality moved Americans toward foreign, especially Japanese cars.  Then, when Detroit finally improved fuel efficiency and quality, they lost the ability to make cars the public found desirable and the industry became addicted to a single market segment, trucks.  

Now, past HR excesses have hit them.  The June 30, 2004 edition of The New York Times reported that GM’s unfunded pension costs exceed the company’s net worth by some $10 billion.  The stock market apprehends this problem and over the last several years, Wall Street has marked down GM’s stock price from $65 to a recent low of about $25.   

These health care and retirement costs have so accumulated that they now add more to the price of a Chevrolet or Cadillac than does steel.  Such facts become known because that the stock exchanges, regulators and the accountants make companies disclose these sorts of problems in their financial statements.  Investors assess these challenges and decide whether management is capable of solving them.  The markets provide a daily vote of confidence and investors have, to a large extent, voted the car companies out of their portfolios.  

What’s bad for General motors is also bad for Illinois .  Like the country’s largest manufacturer, the country’s most politically organized state has a problem with its pension and health care costs.  The difference is that while GM is having trouble paying for its retirees, it truthfully reports the situation.  Illinois does not.  

Like GM, the state’s five major pension funds are “defined benefit” plans.  That means retirees earn a certain, predictable pension when they retire.  Presumably, the state puts away a little every year so that when its employees retire, there will be enough assets to pay the monthly checks.  

The hazard of these types of plans is that the payments to retirees are a long way off and there is usually a fistful of more topical problems.  When funds run short---a perennial condition in government---politicians decide to let immediate problems take precedence and “defer” contributions to pension funds.  

Eventually, the magic of compound interest catches up.  Long-term deferrals accumulate and become large black holes on the balance sheet.   In GM’s case, management has let the abyss grow to approximately $38 billion, according to the Times.  Surprisingly, Illinois politicians have built up a similar-sized deficit.  The most conservative, actuarial estimate I believe shows the state’s retirees and active employees expect about $3,500 from each man, woman and child in the state. 

About a decade ago, the legislature discovered this problem.  To solve it, they developed a remedial plan to rectify the deficit over fifty years.  Well, almost solve it---the plan called for solving only 90% of the problem and, to make sure no legislator then serving then would be inconvenienced by this outbreak of prudence, the pols allowed themselves 15 years before payments became mandatory.  

For this plan to work, the legislature needed the discipline to fix the cause of the problem.  To “catch-up”, they need to pay the pensions earned in each year and make an additional payment to make up for past deferrals.  This past May, the legislature voted to skip the “catch-up” payments and the current payments, too.  The amount they spent on other things was at least $2 billion and if that was not bad enough, they punted next year’s payments, as well.  

One would think the beneficiaries—the park rangers, college professors, teachers and even judges---would be concerned that the state isn’t funding the sound savings plan they’ve been promised...  What’s odd is that public employees are predominantly Democrats and it is the Democrats who universally voted to swipe their pensions.  

On the other hand, Republican legislators voted against the budget just as universally---many because of their objection to the pension pilfer.  One would think that they would object to the situation and be using this issue to drive a wedge into the Democrat’s power base.   

GM’s announcement included news that its employees would be required to contribute something for their health care.  They have also started voluntary defined contribution plans.  I’m afraid the silence from the legislature means they won’t have the courage to make the same request of Illinois ’ employees.  It’s easier to tell us Springfield needs more in taxes to pay for the pensions the people of Illinois have already provided.

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Ralf Seiffe advises business start-ups and product launches from Chicago, Illinois, and is a political analyst and columnist for the Illinois Leader.