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  • Defined Benefit Pensions Reduce Customer Value and Threaten Companies

    Posted by Shannon Love on November 21st, 2012 (All posts by )

    Hostess is being bought down by in part by unfunded defined benefit pensions forced on the company by its unions over the last 50 years. In a previous post, I explained how, as a company’s products age, its profit margins decline and pension costs consume an ever increasing percentage of revenue.

    Defined benefit pensions are especially destructive:

    In economics, a defined benefit pension plan is a major type of pension plan in which an employer promises a specified monthly benefit on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age, rather than depending on investment returns.

    ….

    The most common type of formula used is based on the employee’s terminal earnings (final salary). Under this formula, benefits are based on a percentage of average earnings during a specified number of years at the end of a worker’s career.

    Obviously, if the pension payout is based not on the success of investments or current company revenues but instead on the particular worker’s performance years or decades ago, a company has to make up any difference between investments and pension cost with current revenue. Revenue diverted to pensions contributes nothing to value for the current customers who provide the revenue. The current customer literally doesn’t get what they paid for. If they had instead bought the product from another company identical in all respects to the first except for the defined benefit pension cost, they would have paid less and/or gotten a higher value.

    The value delivered to the customer is the single determiner of business success. High pension costs undermine delivered value and thereby harm both the customer and the company.

    It was Taiichi Ohno most often credited with formalizing the business folk wisdom that all business profit arises from value delivered to the customer. In the Toyota Production System (“Lean” in the US,) he defined a wasteful business process as a process of any scale, complexity or origin, that did not add value for the customer. The customer has no significant knowledge of the production process. The customer knows only if the value they receive from the completed and delivered product justifies the price they pay for it. They communicate their net assessment of the product by the price they will pay to purchase it and by whether they purchase a product repeatedly.

    To ensure high customer value, Ohno asked managers and workers to look at the production process through the eyes of the customer and to evaluate processes as if a customer was actively present and making comments like, “I’ll pay for making the graphics on the label easier to read but I won’t pay for labor cost incurred while a worker wastes time looking for tools in a disorganized toolbox.”

    Since customers aren’t actually present during production, managers and workers must act as the customer’s proxy and reduce waste and enhance value on the customer’s behalf.

    Defined benefit pensions paid out of current revenue or capital are a waste from the customer’s perspective because the customer can’t distinguish pension cost from any other form of production waste that gives them no value. The customer just knows they pay more for less value and eventually they seek alternatives.

    Companies like Hostess with multi-billion dollar unfunded defined benefit pension obligations are stuck with a massive and inescapable chunk of waste lodged in their system like a cat with a hairball bigger than its esophagus. No amount of skillful  process improvements from workers and management can reduce that big lump of waste and its drag on the value customers receive. The best a company can do is optimize everything else and hope their competitors are inept or equally burdened.

    The inability to reduce the waste caused by defined pension benefits and other union imposed waste means that unionized companies are on an inevitable death spiral. As their industry ages, their profit margins shrink but those profits have to pay for more pension costs which customers interpret as production waste and reduction of the value they receive from the company. Customers leave, which reduces overall revenue while pension cost remain the same or increase. Less revenue must support more pension meaning less revenue left to provide customer value. Customer value decreases… and the feedback loops through again.

    Someone once described GM as retiree pension and healthcare system that funds itself by selling cars. That’s not far from the truth and is likely true of Hostess as well. Progressively over the last decades, the price you pay for a Twinkie related less and less to the value provided by the Twinkie and instead paid for the “waste” of an ill conceived pension system doomed to fail from inception.

    Don’t despair though. Some other company, most likely a younger, non-union and probably foreign company will buy the Twinkie brand and recipe and start churning out Twinkies at a lower cost and higher customer value. Instead of paying for stupid and ill conceived pensions through pastry, you can pay for them through increased taxes and/or reduced government services whether you ever had a Twinkie or not.

    It’s the first rule of unions: They get paid, everyone else gets screwed.

     

    12 Responses to “Defined Benefit Pensions Reduce Customer Value and Threaten Companies”

    1. Bill Waddell Says:

      “Obviously, if the pension payout is based not on the success of investments or current company revenues but instead on the particular worker’s performance years or decades ago, a company has to make up any difference between investments and pension cost with current revenue. Revenue diverted to pensions contributes nothing to value for the current customers who provide the revenue. The current customer literally doesn’t get what they paid for.”

      With very few changes this paragraph could easily be describing Social Security

    2. John Johns Says:

      And the largest defined benefit pension plans with the largest number of unionized employees is the fatal combination of federal, state, and local governments.

    3. Shannon Love Says:

      Bill Waddell,

      With very few changes this paragraph could easily be describing Social Security

      Kind of with the key differences that (1) that government is a violence enforced monopoly the citizen “customers” have no individual choice except to emigrate and (2) the government doesn’t have to fulfill its social security promises in any form. The supreme court was quite clear on the latter. Anyone can have their SS benefits yanked and have no recourse. As I understand it, the formula used to calculate payout is powerfully biased against people who have saved for their old age or had higher income jobs when working so they are being cheated out their benefits stealthily. Again, no recourse.

    4. Michael Kennedy Says:

      ” As I understand it, the formula used to calculate payout is powerfully biased against people who have saved for their old age or had higher income jobs when working so they are being cheated out their benefits stealthily. Again, no recourse.”

      My benefits are taxed as I have too much income but I foxed ‘em. Most of my income is tax exempt and doesn’t go on the 1040. I paid both halves on the tax for many years and am not shy about collecting.

    5. PenGun Says:

      From the wiki:
      “The liability of the pension lies with the employer who is responsible for making the decisions. However there is an equal chance of a surplus as there is of a deficit.”

      This is why employers like defined benefit as a scheme for a pension.

      When they neglect the pension fund they often get into a situation like at Hostess. It’s the employer’s fault not the people who have a pension coming.

      Probably far too simple an explanation for the giant brains here.

    6. IGotBupkis, Legally Defined Cyberbully in All 57 States Says:

      }}} When they neglect the pension fund they often get into a situation like at Hostess. It’s the employer’s fault not the people who have a pension coming.

      No, it’s the fault of the dumbass who actually thought an unsecured pension was a good idea in the first place. They heard the amounts being offered, and, being greedy morons, said “Ooooh, doggie, get me some o’ THAT!!”… and, as with greedy idiots, they wind up with exactly what they deserved… nothing.

      Anyone who accepts — voluntarily — an unsecured pension is an idiot studying to be a moron and failing. BADLY.

    7. Tim Says:

      There is a principal-agent problem. The incentives of union bosses are not the same as those of the workers. By the time the pensions become due, the bosses are generally long gone.

      I know from my own union that very few workers participate in the union. In my case, the dues are a complete rip-off which is why I don’t join. Millions going in to Democratic Party coffers while the Democrats sack the country. Thanks a lot.

    8. David Foster Says:

      It is possible to create a defined-benefits plan which is safe. Simply set up an annuity for each employee and define the plan such that the benefits which are vested at any age and service level are equal to the annuity payout as contracted by the annuity provider and funded by whatever mix of employee and company contributions is defined in the plan.

      There is still market risk in the underlying investments which are made by the annuity provider, of course, but insurance companies have been selling annuities for a long time, and I believe the track record is pretty good. (Since the annuity is a contractual obligation of the provider, losses owing to lower-than-expected returns will be borne first by the provider’s equity holders.)

    9. TMLutas Says:

      Pengun – it is simply not the case that employers like defined benefit pensions. For several decades there has been a move away from them and they largely survive only in union arrangements and in the public sector.

      IGotBupkis, Legally Defined Cyberbully In All 57 States – The idea of corporate lifecycles long post dates the defined benefit pension. Given the dominance and global strength of industrial giants at the start of these arrangements, it was unwise, but not monumentally stupid to start such pensions. When the 1970s rolled around and exposed the fact that these companies had feet of clay, that was the time when they should have transitioned out. It is the union leadership that extended those arrangements for 40 extra years that should get the brickbats.

    10. grey eagle Says:

      Goverment is the enemy of any pension plan. Only government can cause inflation. Furthermore, government regulations often destroy a market for a company’s product. Government supported fantasies (such as scarce resources
      ) are harmful.

      Therefore it is foolish for any employee to rely on promises of a pension. Pensions should be illegal becauae by their very nature the company’s employees or the shareholders or the stakeholders are defrauded.

      Fraud exists because the company promises certainty when the government feels it has a duty to make the business environment uncertain and unpredictable.

    11. IGotBupkis, Legally Defined Cyberbully in All 57 States Says:

      }}} TML: It is the union leadership that extended those arrangements for 40 extra years that should get the brickbats.

      LOL, isn’t that inherent in what I said? :-D

    12. Shannon Love Says:

      Pengun,

      This is why employers like defined benefit as a scheme for a pension.

      Employers didn’t “like” defined benefits. No company would. Why would any company commit themselves to cost down the road which would add no value to their products for the customers at that time? If we did any kind of business deal between us, would you commit to pay a fixed cost decades after I had stopped providing you whatever benefit you originally contracted for? No you wouldn’t. It defies common sense.

      The purest proof that employers resisted defined benefits is the claims of the unions themselves. The unions are very proud of the fact that they forced the companies to provide defined benefit pensions by striking. If the companies desired the defined benefit package for their own benefit, they would have spontaneously provided them yet they did not. The unions had to hurt the companies badly to coerce them into committing to the benefits. The companies clearly did not want to commit to such cost and their stockholders certainly didn’t.

      You’re just doing that leftists thing in which you reflexively try to recraft every failed leftists idea into a narrative about your exploitation targets evil. Leftists pushed unions and benefits like define benefit pensions, at least the latter failed, it’s unthinkable that the leftists were wrong, ergo the businesses must be at fault.

      When they neglect the pension fund they often get into a situation like at Hostess.

      I can’t find any evidence that Hostess “neglected” it’s pensions. The company has been limping along for at least 20 years hamstrung by union work rules which in effect put the union in control of designing and managing many of the companies operations e.g. their teamster dominated distribution system.