According to a relatively recent Fortune article, “one of the (many) things that surprised people about the recent $250 million sale of the Washington Post to Amazon AMZN founder Jeff Bezos was the health of the Washington Post’s pension plan. At a time when most pension plans are struggling, the Post has $1 billion more than it needs. (As part of the deal, Bezos is getting $333 million for the new newspaper company’s pension fund, which Post chairman Don Graham says is $50 million more than Bezos needs to meet his current obligations.) Graham told Fortune there are two words that explain why: Warren Buffett (Trades, Portfolio).”
Buffett’s 1975 memo to Katherine Graham is one of my all time favorites by the Oracle of Omaha. In this memo, Buffett discussed in details the inherent problems with pension plans, the potential magnitude of problems, the investment management problem inherent in all pension plans, and his suggested solutions on how to solve those problems for Washington Post.
I deeply believe that this memo is just as relevant today as it was in 1975. Most of the problem Mr. Buffett shrewdly pointed out in 1975 are still prevalent today. Pension obligations are still not getting the deserved attention from investors, partly due to the complexity in the accounting rules for pension and partly due to the “promise now, worry future” mentality of both management and shareholders. In this article series, I would like to try my best to explain the concept of pension obligations, the accounting for pension obligations, why an investor should pay close attention to the pension footnote for a businesses with significant pension obligations and pension plan assets and how to evaluate the performance of pension managers. This is a huge project to take on so I will have to break it down by parts. In the first part of the article, I’d like to revisit a few great points from Buffett’s 1975 memo using his own words to provide the readers the big picture. Below are my most important takeaways from the memo:
There is probably more managerial ignorance on pension costs than any other cost item of remotely similar magnitude. The Lexicon is arcane, the numbers seem unreal, and making promises never quite triggers the visceral response evoked by writing a check.
In no other managerial area can such huge aggregate liabilities - which will be reflected in progressively increasing annual costs and cash requirements - be created so quickly and with so little immediate financial pain. Like pressroom labor practices, small errors will compound. Care and caution are in order.
Thus, the really devastating possibility regarding private pension plans is sustained double-digit inflation. When salaries move ahead at a substantially higher rate than investment returns and benefits are tied to final salaries, it is virtually impossible to pre-fund obligations.
So (in 1972), while U.S Steel had a visible $3.6 billion in net operating assets which management probably spent 99% plus of their business hours thinking about, they had $2.2 billion in the “bank”, whose economic results would impact future values for the shareholder, dollar for dollar, with the economic results of the steel assets. There literally were years when the savings account earned more than was earned out of all operating assets of the steel business.
The returns actually realized on the “savings account” had an enormous impact on costs. A sustained 1% change in earning rate could easily swing the annual cost to the contributing company by 15%.
During a period when equities had produced fabulous returns, many of the plans had been invested largely in bonds - which not only bore low fixed rates of 3%-5% in the earlier periods, but also had suffered significant shrinkages in market values as interest rates increased secularly. (If interest rates go up, bond prices must go down - and if the bonds are long-term and the rates rise sharply, prices go into a power dive.)
Many managements thus saw their largest division earning dismal rates of return with substantial market value shrinkage in the bond component, while all around them high returns were being realized from stocks with little apparent effort or talent. If a company had $100 million invested in its engine division earning 12% by managerial zel and ingenuity, why tolerate 100% million in its pension fund “division” poking along at only 4% because of inattention - particularly when increasing the $4 million to some larger figure would have the same impact in the future earnings for owners as raising margins on engines. Intensive effort on production, research and sales might only produce an increase from 12% - 13% in the engine area, since decisions already had been so near to optimal, but it was easy to imagine 4% becoming 10% in the pension fund area if just average results were attained in equity investment. And, of course, who would settle for being just average.
In addition to the ones benefitting from short-term luck, I believe it possible that a few will succeed - in a modest way - because of skill. I do not believe they can be identified solely by a study of their past records. They may be operating with a coin that they know favors heads, and be calling heads each time, but their bare statistical record will not be distinguishable from the larger group who have been calling flips indiscriminately and have been lucky - so far.
In a more orderly world, the care with which promises have been worded remains important, but on a scale that diminishes as inflation moderates. Conventional approaches to management should not be expected to produce above average results. But average will be perfectly acceptable at low inflation rates.
A mildly non-conventional investment approach, emphasizing a business approach to security selection, gives some opportunity for long - term results slightly above average without corresponding increase in investment risk.
I highly encourage every serious investor to take some time and carefully read Buffett’s 1975 memo a few times. This is a truly under-appreciated problem in Corporate America.
In my next article, I will get into some boring technical details about pension accounting.
