Warren Buffett's latest letter to shareholders of Berkshire Hathaway, the Omaha-based holding company Buffett turned into the 9th-largest public company in the world, has a wonderful primer on pensions. It's not from today and it's not directly about public-sector pensions--it's actually a 1975 memo Buffett drafted to Katharine Graham, then-Chairman of The Washington Post Company about her company's pension*, but it has a number of lessons for today.
On the irreversible nature of pension promises:
The first thing to recognize, with every pension benefit decision, is that you almost certainly are playing for keeps and won't be able to reverse your decision subsequently if it produces subnormal profitability....So rule number one regarding pension costs has to be to know what you are getting into before signing up. Look before you leap. There probably is more managerial ignorance on pension costs than any other cost item of remotely similar magnitude. And, as will become so expensively clear to citizens in future decades, there has been even greater electorate ignorance of governmental pension costs. Actuarial thinking simply is not intuitive to most minds. The lexicon is arcane, the numbers seem unreal, and making promises never quite triggers the visceral response evoked by writing a check.
On the deceptive arithmetic in pension promises:
If you promise to pay me $500 per month for life, you have just expended - actuarially, but nevertheless, in a totally tangible sense - about $65,000. If you are financially good for such a lifetime promise, you would be better off (if I have an average expectancy regarding longevity for one my age) handing me a check for $50,000.
On the hidden nature of pension costs:
Pensions costs in a labor intentive business clearly can be of major size and an important variable in the cost picture, particularly in a world characterized by high rates of inflation. I emphasize the latter factor to the point of redundancy because most managements I know - and virtually all elected officials in the case of governmental plans - simply never fully grasp the magnitude of the liabilities they are incurring by relatively painless current promises. In many cases in the public area the bill in large part will be handed to the next generation, to be paid by increased taxes or by accelerated use of the printing press.
On the difficulty of pre-funding pension plans (defined benefit pensions are intended to be forward-funded, that is, they should have sufficient assets today to pay the required liabilities tomorrow):
When salaries move ahead at a substantially higher rate than investment returns and benefits are tied to final salaries (or, even more expensively, cost-of-living increases after retirement as in recent rubber and aluminum contracts), it is virtually impossible to pre-fund obligations. Like it or not, you become much like the Social Security Fund, absent the power to tax. Should that occur, future purchasers of the products of the company must be willing to do so at prices that reflect not only the wages of current workers, but the promises to past workers.
On investors (or pension plans) seeking to outperform the stock market average:
A little thought, of course, would convince anyone that the composite area of professionally managed money can't perform above average. It is simply too large a portion of the entire investment universe. Estimates are that now about 70% of stock market trading is accounted for by professionally managed money. Any thought that 70% of the environment is going to substantially out-perform the total environment is analogous to the fellow sitting down with his friends at the poker table and announcing: "Well, fellows, if we all play carefully tonight, we all should be able to win a little."
The one area Buffett got wrong was his worry about persistent periods of double-digit inflation. Inflation was high when Buffett was writing his letter in the mid-1970s, and stayed high through the rest of the decade, but it has been relatively low since the early 1980s.
Read the whole thing starting on page 118 here.
*The Washington Post's company pension performed very well thanks to Buffett and his memo. As of late 2013, it was 140 percent funded, meaning it had accrued $604 million more than it owed.