Saturday, October 29, 2005

Moral hazard never goes out of style.

October 30, 2005
The End of Pensions

By ROGER LOWENSTEIN

I. THE LATEST FINANCIAL DEBACLE

When I caught up with Robert S. Miller, the chief executive of Delphi Corporation, last summer, he was still pitching the fantasy that his company, a huge auto-parts maker, would be able to cut a deal with its workers and avoid filing for bankruptcy protection. But he acknowledged that Delphi faced one perhaps insuperable hurdle - not the current conditions in the auto business so much as the legacy of the pension promises that Delphi committed to many decades ago, when it was part of General Motors. This was the same fear that had obsessed Alfred P. Sloan Jr., the storied president of G.M., who warned way back in the 1940's that pensions and like benefits would be "extravagant beyond reason." But under pressure from the United Auto Workers union, he granted them. And as future auto executives would discover, pension obligations are - outside of bankruptcy, anyway - virtually impossible to unload. Unlike wages or health benefits, pension benefits cannot be cut. Unlike other contracts, which might be renegotiated as business conditions change, pension commitments are forever. And given the exigencies of the labor market, they tend to be steadily improved upon, at least when times are good.

For the U.A.W., Miller noted forlornly, "30 and Out" - 30 years to retirement - became a rallying cry. Eventually, the union got what it wanted, and workers who started on the assembly line after high school found they could retire by their early 50's. "These pensions were created when we all used to work until age 70 and then poop out at 72," Miller told me. "Now if you live past 80, a not-uncommon demographic, you're going to be taking benefits for longer than you are working. That social contract is under severe pressure."

Earlier this month, Miller and Delphi gave in to the pressure and sought protection under the bankruptcy code - the largest such filing ever in the auto industry. It followed by a few weeks the Chapter 11 filings of Delta Air Lines and Northwest Airlines, whose pension promises to workers exceeded the assets in their pension funds by an estimated $16 billion.

The three filings have blown the lid off America's latest, if long-simmering, financial debacle. It is not hedge funds or the real-estate bubble - it is the pension system, both public and private. And it is broken.

II. THE MORAL HAZARD OF INSURANCE

The amount of underfunding in corporate pension plans totals a staggering $450 billion. Part of that liability is attributable to otherwise healthy corporations that will most likely, in time, make good on their obligations. But the plans of the companies that fail will become the responsibility of the government's pension insurer, the Pension Benefit Guaranty Corporation. The P.B.G.C., which collects premiums from corporations and, in theory, is supposed to be self-financing, is deeply in the hole, prompting comparisons to the savings-and-loan fiasco of the 1980's. Just as S. & L.'s of that era took foolish risks in part because their deposits were insured, the P.B.G.C.'s guarantee encouraged managements and unions to raise benefits ever higher.

In such situations, individuals are tempted to take more risk than is healthy for the group; economists, in a glum appraisal of human nature, call it "moral hazard." In effect, America's pension system has been a laboratory demonstration of moral hazard in which the insurance may end up bankrupting the system it was intended to save. Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators have found it easier to pay off unions with benefits tomorrow rather than with wages today. Since the benefits were insured, union leaders did not much care if the obligations proved excessive. During the previous decade especially, when it seemed that every pension promise could be fulfilled by a rising stock market, employers either recklessly overpromised or recklessly underprovided - or both - for the commitments they made.

The P.B.G.C. is now $23 billion in the red - a deficit that is expected to grow, significantly, as more companies go under. The balance sheet for the end of September will very likely show a deficit of more than $30 billion. If nothing is done to fix the system, the Congressional Budget Office forecasts, the deficit will mushroom to more than $100 billion within two decades. This liability will almost certainly fall back on the taxpayers, since the alternative to a bailout - letting the pension agency fail - would force aging former auto workers and other retirees onto the street.

As bad as that sounds, the problem of state and local government pensions is even worse. Public pensions, which are paid by taxpayers and thus enjoy an implicit form of insurance, are underfunded by a total of at least $300 billion and arguably much more. While governments have been winking at these deficits for years, they are now becoming intolerable burdens for taxpayers. In San Diego, pension abuse has effectively bankrupted the city. Thanks to a history of granting sweeter and sweeter pension deals that it has neglected to fund, the city has been forced to allocate $160 million, or 8 percent of the municipal budget, to the San Diego City Employees Retirement System this year, with similar allocations expected for years to come. San Diego has tabled plans for a downtown library, cut back the hours on swimming pools, gutted the parks and recreation budget, canceled needed water and sewer projects and fallen behind on potholes.

State or local governments in New Jersey, New York, Illinois, Ohio, West Virginia and elsewhere face similar budget strains aggravated by runaway pension promises. According to Carl DeMaio, director of the Performance Institute, which advocates better government accountability, "There is a San Diego brewing in every community."

Not only are taxpayers certain to suffer, but senior citizens in the future may also have to settle for less secure retirements anchored only by Social Security and whatever they've managed to put away into their 401(k) accounts. A backlash already has begun in state capitals, where the political forces that have been lobbying for Social Security reform have been rallying lawmakers to get out of the pension business altogether. Alaska's Legislature recently passed a shotgun bill to deny pensions to future employees. This mimics a trend in the private sector, in which corporations have been leaving the system, either by paying off their workers and terminating their pension plans or by "freezing" their plans, a step recently taken by Hewlett Packard, so that many current employees will no longer accrue benefits and new employees will not participate at all.

If the pension system continues to wither, it is not hard to envision a darker future in which - as was true until early in the 20th Century, before the advent of pensions - many of the elderly would be forced to keep working to stave off poverty.

III. THE SHRINKING PENSION SYSTEM

Congress has been debating legislation to fix the private system, but it has been unable to resolve a basic tension: anything it does to ease the burden on failing or failed pension plans lessens the penalty for failure and enhances moral hazard. By making it easier for, say, a Delta or a Delphi to offer benefits, it raises the possible cost of a future bailout.

The tough medicine favored by the Bush administration, which would eliminate loopholes in the system as well as much of the subsidy that now exists in the insurance system, would lead to more companies freezing their plans or leaving the system outright. The number of pension plans would continue to shrink and in time all but disappear. This would strip the elderly of the future of what is still the most secure form of retirement income.

The fear of runaway pension costs plainly echoes the Social Security debate, and many suspect that the Bush administration would not much mind if pensions did disappear. "I don't think the administration is very interested in creating a future for traditional pensions," says Julia Coronado, a senior research associate at Watson Wyatt, a human-resources consulting firm. "It doesn't fit very well with their vision of the ownership society."

Bradley Belt, executive director of the P.B.G.C., shrugs off the charge. "The last thing we want to do is chase people out of the system," he says. Besides, the government doesn't need to chase. As Belt points out, the number of workers covered by pensions is shrinking without government help. In 1980, about 40 percent of the jobs in the private sector offered pensions; now only 20 percent do. The trend is probably irreversible, because it feeds on itself. Hewlett Packard, for instance, must compete with younger companies like Dell Computer that do not offer traditional pensions. Freezing its plan, which was a legacy of the company's famously employee-oriented founders, was an embarrassing step for H.P.'s present managers - but freeze it they did.

This may have made economic sense, but federal law has long recognized a social purpose to pensions as well. By allowing companies to deduct from taxes the money they contribute into their pension funds, the government encourages employers to provide a safety net for their workers. This remains a legitimate function, and if pensions were allowed to die, we would need something to take their place.

IV. WHY PENSIONS MATTER

To understand why pensions are still important, you have to understand the awkward beast that benefits professionals refer to as the U.S. retirement system. It is not really one "system" but three, which complement each other in the crudest of fashions. The lowest tier is Social Security, which provides most Americans with a bare-bones living (the average payment is about $12,000 a year). The highest tier, available to the rich, is private savings. In between, for people who do not have a hedge-fund account and yet want to retire on more than mere subsistence, there are pensions and 401(k)'s. Currently, more than half of all families have at least one member who has qualified for a pension at some point in his or her career and thus will be eligible for a benefit. And among current retirees, pensions are the second-biggest source of income, trailing only Social Security.

During most of the 90's the decline in pension coverage was barely lamented. It was not that big companies were folding up their plans (for the most part, they were not) but that newer, smaller companies weren't offering them. As the small companies grew into big ones (think Dell, or Starbucks, or Home Depot), traditional pensions covered less of the private-sector landscape. This did not seem like a very big deal. Younger workers envisioned mobile careers for themselves and many did not want pension strings tying them to a single employer. And most were able to put money aside in 401(k)'s, often matched by an employer contribution.

It happened that 401(k)'s, which were authorized by a change in the tax code in 1978 and which began to blossom in the early 1980's, coincided with a great upswing in the stock market. It is possible that they helped to cause the upswing. In any case, Americans' experience with 401(k)'s in the first two decades of their existence was sufficiently rosy that few people shed tears over the slow demise of pension plans or were even aware of how significantly pensions and 401(k)'s differed. But 401(k)'s were intended to be a supplement to pensions, not a substitute.

From the beneficiary's standpoint, pensions mean unique security. The worker gets a guaranteed income, determined by the number of years of service and by his or her salary at retirement. And pensions don't run dry; workers (or their spouses) get them as long as they live. Because the employer is committed to paying a certain level of benefits, pensions are known as "defined benefit" plans. Since an individual's benefit rises with each year of service, the employer is supposed to sock money away, into a fund that it manages for all of its beneficiaries, every year. The point is that workers don't (or shouldn't) have to worry about how the benefit will get there; that's the employer's responsibility. Of course, the open-ended nature of the guarantee - the very feature that makes pensions so attractive to the individual - is precisely what has caused employers to rue the day they said yes. No profit-making enterprise can truly gauge its ability to meet such promises decades later.

A 401(k), on the other hand, promises nothing. It's merely a license to defer taxes - an individual savings plan. The employer might contribute some money, which is why 401(k)'s are known as "defined contribution" plans. Or it might not. Even if the company does contribute, it offers no assurance that the money will be enough to retire on, nor does it get involved with managing the account; that's up to the worker. These disadvantages were, in the 90's, somehow perceived (with the help of exuberant marketing pitches by mutual-fund firms) to be advantages: 401(k)'s let workers manage their own assets; they were a road map to economic freedom.

Post-bubble, the picture looks different. Various people have studied how investors perform in their 401(k)'s. According to Alicia Munnell, a pension expert at Boston College and previously a White House economist, pension funds over the long haul earn slightly more than the average 401(k) holder. Among the latter, those who do worse than average, of course, have no protection. Moreover, pensions typically annuitize - that is, they convert a worker's retirement assets into an annual stipend. They impose a budget, based on actuarial probabilities. This might seem a trivial service (some pensioners might not even realize that it is a service). But if you asked a 65-year-old man who lacked a pension but did have, say, $100,000 in savings, how much he could live on, he likely would not have the vaguest idea. The answer is $654 a month: this is the annuity that $100,000 would purchase in the private market. It is the amount (after deducting the annuity provider's costs and profit) that the average person could live on so as to exhaust his savings at the very moment that he draws his final breath.

So the question arises: what if he lives longer than average? This is the beauty of a pension or of any collectivized savings pool. The pension plan can afford to support people who live to 90, because some of its members will expire at 66. It subsidizes its more robust members from the resources of those who die young. This is why a 401(k) is not a true substitute. Jeffrey Brown, an associate finance professor at the University of Illinois at Urbana-Champaign and a staff member of the president's Social Security commission, notes that as baby boomers who have nest eggs in place of pensions begin to retire, they will be faced with a daunting question: "How do I make this last a lifetime?"

V. FROM MANAGEMENT TOOL TO EMPLOYEE BENEFIT

The country's first large-scale pension plan was introduced after the Civil War, when the federal government gave pensions to disabled Union Army veterans and war widows. Congress passed an act in 1890 that extended pensions to all veterans 65 and over. This converted pensions into a form of social welfare. Over the next 20 years, states and cities added pensions for police officers and firefighters. By World War I, most teachers had been granted pensions as well. Governments couldn't offer big paychecks for workers - teachers, the police, firefighters - so it offered stability and pensions instead.

In the private sector, the first pension was offered by American Express, a stagecoach delivery service, in 1875. Railroads followed suit. Employees were required to work for 30 years before they qualified for benefits, and thus pensions helped companies retain employees as well as ease older workers into retirement. These employers thought of pensions as management tools, not as employee "benefits." But in the first half of the 20th century, as the historian James Wooten put it, government policies turned pensions into a tool of social policy. First came the tax deduction. This feature was abused, as companies used pensions to shelter payments to their executives. The rules were gradually tightened, however, forcing plans to include the rank and file. World War II gave more incentives to create pensions: punitive tax rates made the pension shelter enormously attractive and a government freeze on wages meant that pensions were the only avenue for increasing compensation.

The effect of these policies was to encourage unions to bargain for pensions and to pressure employers to grant them. After the war, John L. Lewis, the legendary labor leader, staged a strike to win pensions for miners. Ford Motor capitulated to the U.A.W. in 1949. G.M., headed by the reluctant Sloan, followed in 1950. This led to a so-called pension stampede; by 1960, 40 percent of private-sector workers were covered. Meanwhile, in the auto industry, the seeds of the problem were already visible.

Companies might establish plans, but many were derelict when it came to funding them. When companies failed, the workers lost much of their promised benefit. The U.A.W. was acutely aware of the problem, because of the failing condition of several smaller car manufacturers, like Packard. The union didn't have the muscle to force full funding, and even if it did, it reckoned that if the weaker manufacturers were obliged to put more money into their pension funds, they would retaliate by cutting wages.

Thus in 1959, Studebaker, a manufacturer fallen on hard times, agreed to increase benefits - its third such increase in six years. In return, the U.A.W. let Studebaker stretch out its pension funding schedule. This bargain preserved the union's wages, as well as management's hopes for a profit, though it required each to pretend that Studebaker could afford a pension plan that was clearly beyond its means. Four years later, the company collapsed.

The Studebaker failure was a watershed. Thousands of employees, including some who had worked 40 years on the line, lost the bulk of their pensions. Stunned by the loss, which totaled $15 million, the U.A.W. changed its tactics and began to lobby in earnest for federal pension insurance. A union pension expert tellingly explained to Walter Reuther, the U.A.W. chief, that insurance would reconfigure the "incentives" of both labor and management. Though business was skeptical of the idea, a decade later, in 1974, Congress finally passed the Employee Retirement Income Security Act, or Erisa, which, among other protections, established the P.B.G.C. to insure private pensions. Erisa, according to Wooten, who wrote a history of the act, completed the transition of pensions into a part of the social safety net. It was also the birth of moral hazard.

VI. THE SURPRISINGLY PLIABLE SYSTEM OF PENSION ACCOUNTING

Erisa, which would be amended several times, was supposed to ensure that corporate sponsors kept their plans funded. The act includes a Byzantine set of regulations that seemingly require companies to make timely contributions. As recently as 2000, most corporate plans were adequately funded, or at least appeared to be. Their assets took a serious hit, however, when the stock market tumbled. (In retrospect, they had been cavalier in assuming the bull market would continue.) And they were burned again when interest rates fell.

Since pension liabilities are, for the most part, future liabilities, companies calculate their present obligation by applying a discount rate to what they will owe in the future. As interest rates move lower, they have to set more money aside because it is assumed that their assets will grow more slowly. The principle is familiar to any individual saver: you need to save more if you expect, say, a 5 percent return on your investment instead of a 10 percent return. What is much in dispute is just which rate is proper for pension accounting.

Corporations have been gaming the system by using the highest rates allowable, which shrinks their reported liabilities, and thus their funding requirements. The P.B.G.C., when calculating the system's deficit, uses what is in effect a market rate; whatever it would cost to buy annuities for everyone covered in a pension plan is, it argues, the plan's true "liability." The difference between these measures can be extreme. Depending on whom you talk to, General Motors' mammoth pension fund is either fully funded or, as the P.B.G.C. maintains, it is $31 billion in the hole.

What is not in dispute is that when interest rates fell, the present value of pension liabilities (by whatever measure) soared. The confluence of falling stock prices, plunging interest rates and a recession in the beginning of this decade was the pension world's equivalent of the perfect storm. An unprecedented wave of pension sponsors failed and then dumped their obligations on the P.B.G.C. (To do so, a sponsor generally must prove that it could not re-emerge as a viable enterprise without shedding its pension plan.) By far the most costly failures were in airlines and steel, although the list ranges from Kemper Insurance and Kaiser Aluminum to Murray, a lawn-mower manufacturer.

As the P.B.G.C. assumed responsibility for more and more pensioners, it became clear that the premium it charged was way too cheap. Mispriced insurance, like mispriced anything, sends the market a distorted signal. Belt, the P.B.G.C. director, who served as counsel to the Senate Banking Committee in the late 1980's during the savings-and-loan crisis, says that cheap pension insurance gave rise to flawed incentives: namely it kept companies in the pension business who didn't deserve to be there. He also argues, rather convincingly, that lax rules allowed pension sponsors to get away with inadequate funding.

For example, United Airlines did not make contributions to any of its four employee plans between 2000 and 2002, when it was heading into Chapter 11, and made minimal contributions in 2003. Even more surprisingly, in 2002, after two of its jets had been turned into weapons in the Sept. 11 disaster, and when the airline industry was pleading for emergency relief from Congress, United granted a 40 percent increase in pension benefits for its 23,000 ground employees.

Bethlehem Steel similarly enjoyed a three-year funding holiday as it was going through hard times, letting its liabilities swell in advance of turning them over to the government. Meanwhile, in order to gain its unions' approval for plant shutdowns, it agreed to costly benefit enhancements. In 2001 Bethlehem filed for Chapter 11 bankruptcy. It was guided through its bankruptcy by none other than Miller, now the Delphi C.E.O. Miller disputes the notion that capital-scarce companies like Bethlehem intentionally game the system by shirking funding. "Companies don't like falling behind," he says. "When you have a hard choice between starving the capital base to feed the pension plan, or making capital investments to become more productive, to the extent there is permission that's what you do." The point is, they had permission.

Neither Bethlehem nor United broke any laws. Both companies made the full contributions required under Erisa. When the P.B.G.C. seized their plans, however, Bethlehem was only 45 percent funded, and United was only 42 percent funded. For companies that terminate their pension plans, such gross underfunding has become the norm. Either assets suddenly vanish when the P.B.G.C. walks in the door, or, evidently, the system for measuring "full" funding is broken. As Belt testified to the Senate Committee on Finance in June, "United, US Airways, Bethlehem Steel, LTV and National Steel would not have presented claims in excess of $1 billion each - and with funded ratios of less than 50 percent - if the rules worked."

Even leaving aside the debate over which rate to use in calculating pension liabilities, there is no doubt that Erisa permits companies to use some doubtful arithmetic. For instance, the law lets corporations "smooth" changes in their asset values. If the stocks and bonds in their pension funds take a hit (as happened to just about every fund recently), they don't have to fully report the impact. Nor do they have to ante up fresh funds to compensate for the loss for five years. A similar smoothing is permitted on the liability side. And though, in theory, Erisa discourages underfunding by requiring offenders to pay higher premiums, its various loopholes render the sanction toothless. Thanks to another loophole, companies that contribute more than the required amount get to skip future contributions even if they later become underfunded. These companies are awarded so-called "credit balances," which remain in place even if the actual balance is showing red.

Incredibly, when United's plans were terminated, earlier this year, even though they were groaning under $17 billion in pension liabilities and a mere $7 billion in assets, they still had credit "balances" according to Erisa. (By law, the P.B.G.C. will be on the hook for most, but not all, of United's shortfall. The agency guarantees pensions up to $45,000 a year; employees, mostly pilots, who were owed richer pensions are uninsured above the cap.)

Their dubious funding history notwithstanding, corporations - airlines in particular - have been lobbying for greater permissiveness for several years. And they have gotten it. Congress has twice relaxed the rules, permitting pension sponsors to use a higher rate to calculate their liabilities.

VII. WHAT BUSH WOULD DO?

Enter the Bush administration: it has essentially declared the era of permissiveness over. Among other changes, it wants the funding rules tightened. To tackle moral hazard, it wants to stop companies with poor credit ratings from granting benefit hikes, or from doling out unfunded pension benefits to unions who agree to plant shutdowns. It even wants to prevent workers at some companies whose bonds are given a "junk" rating from accruing more years of service. This would be painful to employees at many industrial companies, possibly including G.M.

Indeed, one reading of the administration proposal is that, having seen the steel and airline industries raid the P.B.G.C., it is drawing the line at the auto industry - whose initial distress, of course, prompted the agency's founding. Asked about that before Delphi went bust, Belt admitted: "Eight auto-parts suppliers have come under Chapter 11 so far this year. No question our single largest source of exposure is the auto sector."

Since G.M.'s stock was downgraded to junk status earlier this year, the possibility that it would file for bankruptcy has been the subject of on-again, off-again debate on Wall Street. G.M.'s pension plan totals an astronomical $90 billion; a bankruptcy filing would be the P.B.G.C.'s biggest nightmare. G.M. says the notion is far-fetched. The company seems to have plenty of liquidity and, just two weeks ago, with retiree costs a major concern, it reached an agreement with the U.A.W. to trim health benefits. G.M. and other industrial companies, along with their unions, have harshly attacked the Bush pension proposal, which would force many old-economy-type corporations to put more money into their pension funds just when their basic businesses are hurting.

Alan Reuther, Walter's nephew and the U.A.W.'s legislative director, says the provisions to restrict benefits would be "totally devastating for workers and retirees." He makes no apologies for "30 and out" - a fair reward, he maintains, for hard service on the assembly line - and he wonders at the post-modern notion that blue-collar workers should be responsible for their own retirements because giant corporations can't handle it. Also, a typical G.M. pension for someone with 30 years on the job is about $18,000 a year. That is hardly to be compared with an airline pilot's. "The P.B.G.C. is focused on protecting themselves from claims and not on protecting the claims of workers," he says. "They forget why they were created." Social safety nets have their price - in this case, a little moral hazard - and that is really what the debate is about.

What has emerged from the Beltway skirmishing thus far are bills on either side of Congress that would in some ways tighten funding but give a special break to airlines. Premiums to the P.B.G.C. would rise from $19 per plan participant to $30, and variable premiums on distressed companies would be enforced. The bills would chip away (but not eliminate) gimmicks like "smoothing."

The Senate is still divided, however, on how to treat corporations with junk credit ratings - the ones most likely to wind up in the P.B.G.C.'s lap. Hard-liners like Senator Chuck Grassley insist they should be forced to strengthen their pension plans in a hurry; Senators Mike DeWine and Barbara Mikulski (both from states with blue-collar constituencies) want to give such companies lenience. So after months of lobbying, politicking and deal making, moral hazard is still alive.

VIII. PENSION VS. POTHOLES

The P.B.G.C. does not protect government pensions, but dynamics similar to those in the private sector have also wrecked the solvency of public plans. Even in states where budget restraint is gospel, public-service employees have found it relatively easy to get benefit hikes for the simple reason that no one else pays much attention to them. In the corporate world, stockholders, at least in theory, exert some pressure on managers to show restraint. But who are the public sector "stockholders"? The average voter doesn't take notice when the legislature debates the benefits levels of firemen, teachers and the like. On the other hand, public-employee unions exhibit a very keen interest, and legislators know it. So benefits keep rising.

As a matter of practice, those benefits are as good as insured. Because public pension benefits are legally inviolable, default is not an option. Sooner or later, taxpayers will be required to put up the money (or governments will be forced to borrow the money and tax a later generation to pay the interest). Thus, unions can bargain for virtually any level of benefits without regard to the state's ability, or its willingness, to fund them. This creates moral hazard indeed. At least in the private sphere, there are rules - ineffectual rules maybe, but rules - that require companies to fund. In the public sector, legislatures wary of raising taxes to pay for the benefits that they legislate can simply pass the buck to the future. This explains how the West Virginia Teachers Retirement System has, embarrassingly, only 22 percent of the assets needed to meet its expected liabilities. It also explains how Illinois, a low-tax state, is underfunded by some $38 billion, or $3,000 per every man, woman and child in the state.

California is a good example of the political forces that have driven benefits higher. In the 90's, Gov. Gray Davis, a Democrat who was strongly supported by public-employee unions, pushed through numerous bills to increase benefits. One raised the pension of state troopers retiring at age 50 to 3 percent of final salary times the number of years served. (Previously, the formula was 2 percent at age 50, more if you were older.) Thus, a cop hired at age 20 could retire at 50, find another job and get a pension equal to 90 percent of his final salary.

The higher benefits trickled down to the local level, as counties that feared losing police officers to the state felt forced to copy the formula. Counterintuitively, as benefits were going up, the California Public Employees Retirement System (Calpers), which was boasting high returns in the stock market, allowed state agencies and local governments to reduce their contributions.

Contra Costa County, which adopted the "3 percent at 50" formula for its Police Department, got by with contributing only $55 million to retirement costs in 1999, near the market peak. When the market tanked, the county found itself with lower assets and greater obligations. Six years later, the county's retirement bill had more than tripled to $180 million. Bill Pollacek, the county treasurer-tax collector, says the excess earnings from the bull market were spent, among other things, on higher benefits; "the losses were left for the taxpayers."

This example was repeated with various twists across the country. In New Jersey, for example, Christine Whitman, the Republican governor in the 90's, ultimately relied on buoyant stock-market predictions to finance hefty tax cuts, which were the centerpiece of her administration. In 1997, New Jersey borrowed $2.8 billion, at an interest rate of 7.64 percent. The money was advanced to its pension system, on the convenient theory that its pension managers would make more in the market than the state paid out in interest. For a while, they did. The state even raised benefits.

Meanwhile, Trenton achieved a sort of transitory budget balance by contributing less to its pension system. New Jersey's contribution to the Police and Firemen's Retirement System was zero in 2001 through 2003. But during the dot-com debacle, its investments plunged. And the state came under intense budget pressure because of the recession, and so gave itself a few years more to start paying down its pension liability (which further widened the gap). This year, the last easy-funding year, New Jersey will contribute $220 million to its pension system; by 2010, the annual bill will be an impossible-seeming $2.5 billion.

I spoke to Jon Corzine and Doug Forrester, the candidates in next Tuesday's gubernatorial election, and while each expressed the proper horror with regard to past mismanagement, neither had much to say about how they would replenish New Jersey's pension system. State pension officials say that if New Jersey were a private corporation, its system would be nearly bankrupt. "In the real world this is a P.B.G.C. takeover," Fred Beaver, the head of the pension division, told me. Raising taxes is politically forbidden (Forrester has been campaigning to cut property-tax rates).

And the state's reported pension underfunding, officially $25 billion, is undoubtedly optimistic. It assumes that New Jersey's pension assets will earn 8.25 percent, a number collectively determined - some say pulled from thin air - by the state's pension council. Even Orin Kramer, a private hedge-fund manager who also is also chairman of the council, says that any assumption higher than 7.5 percent is unrealistic. "The published numbers are divorced from economic reality," Kramer says. "No one even does the math for what will happen if you only do 7 percent because it's too serious. You start firing cops and teachers."

According to Barclay's Global Investors, if you use realistic assumptions, the total underfunding in all public plans is on the order of $460 billion. If this figure is even close to true, future taxpayers will be hopelessly in hock to the police, firefighters and teachers of the past.

Cutting pensions (unlike health benefits) is simply not an option. State constitutions forbid public entities, even prospectively, from reducing the rate at which employees accrue benefits. They can tinker with, or abolish, benefits for future employees, as Alaska did, but for a worker already on the payroll, benefits - even benefits that might not be earned for many decades hence - are sacrosanct. These benefits are like headless nails; once driven in they can never be removed. This year, New York's Legislature approved 46 new bills - more headless nails - to increase pension benefits, according to E.J. McMahon, an analyst at the Manhattan Institute. New York's benefits already rank among the most generous in the country, and the new bills would expand categories of workers who can retire early, or who can qualify for higher rates. Such bracket creep is pervasive.


One of the biggest pension offenders is San Diego, where six members of the pension board, including the head of the local firefighters' union and two other union officials, have been charged with violating the state's conflict-of-interest code, a felony. What is interesting about San Diego is that, juicy details aside, its pension mess actually looks rather commonplace. The six board members are accused of making a deal to let City Hall underfund the pension system in return for agreeing to higher benefits - including special benefits for themselves. Explicitly or otherwise, this is what unions and legislators have been doing all over the country. A senior adviser on pensions to Gov. Arnold Schwarzenegger told me he fears that ever higher benefits are inescapable, given the fact that legislators control the benefits of people whose support is vital in elections.

Calpers, the country's biggest state-employee retirement system, responds that the pension system has worked well. And for Calpers's 1.4 million members, it has. The average benefit for retirees is $21,000 a year, more than most at General Motors. But at some point, the interest of the public and the interests of public employees diverge.

Earlier this year, Schwarzenegger tried to move California to a 401(k)-style defined contribution plan (for new employees), but the Legislature refused to go along. Schwarzenegger has vowed to revisit the issue in 2006. This battle is being fought from statehouse to statehouse. Michigan (mimicking Alaska) has closed its pension plan to some new employees, and various states, including Florida, Colorado, South Carolina, Arizona, Ohio and Montana, are taking a partial step of letting employees choose between defined contribution plans and traditional pensions. This compromise does not really change much. Most employees who are given the choice opt, quite naturally, to keep their pensions.

Partly for that reason, the Citizens Budget Commission, a politically neutral watchdog, concluded that only by ending pensions outright (for new employees) could New York avert a future fiscal calamity. "Changes in pension benefits for future workers would yield fiscal gains only slowly," the commission noted in a position paper, "but the service to the future fiscal health of the City and State would be enormous."

Most legislatures are not about to do that anytime soon. There is a legitimate argument for preserving public pensions, however, if only they could be put on a sound fiscal basis. Critics like Grover Norquist, the tax-cut crusader, lampoons pensions as remnants of a stodgy, Old World economy. The desire to collect a pension, he argues, keeps workers from moving to better opportunities and shackles employers to workers who are just marking time.

But while mobility is generally considered a virtue in the modern economy, it isn't appropriate everywhere. It may be desirable for a software engineer to move from job to job, notes Robert Walton, a Calpers assistant executive; "for teachers, firefighters, nurses, engineers, that isn't the type of work force you want." Stability is a virtue. The trick is to force legislatures to commit to funding with the same zeal with which they commit to benefits.

De Maio, the San Diego watchdog, is lobbying for a federal law that would impose Erisa-type rules on public plans. Another solution might be found in the Texas Municipal Retirement System, which represents 800 cities and towns in the state. It has a blended system of automatic employer and employee contributions that are managed by the system and turned into an annuity upon retirement. These sorts of remedies could avert plenty of future San Diegos. In principle they are quite simple. It is only the politics that are difficult.

IX. HOW DO YOU MAKE SAVINGS LAST A LIFETIME?

On the private side, benefits professionals have been touting so-called cash-balance plans, a hybrid that in some ways looks like a 401(k), as the best hope for saving the pension industry. With a traditional pension, employees accrue benefits very slowly during their first 20 years and very rapidly during their next 10 (this is why pension plans act as retention tools; you pay a penalty for leaving early). Thus, an employee who stays at a company for 30 years gets a much bigger pension than one who works at three companies for 10 years each. Cash-balance plans were devised to appeal to younger workers, most of whom do not envision retiring at the firm that hired them out of college. In these plans, employees accrue benefits steadily, one decade to the next. There is no penalty for leaving, and workers who change jobs simply roll their accrued benefits into their next plan, as with a 401(k). Many firms converted to cash-balance plans in the 90's to attract younger and more mobile workers.

But the downside of giving more to junior employees is that senior employees get less. When I.B.M. converted, it reduced the rate at which some employees of long standing would accrue benefits, touching off a firestorm. The company was sued, I.B.M. lost and the legal status of similar plans remains in doubt. The pension industry has been lobbying Congress to clarify the status of existing cash-balance plans, but neither the administration nor anyone on Capitol Hill has done so.

To some people, this is further evidence that the Bush administration would just as soon be done with pension plans altogether. I put that recently to Elaine Chao, the secretary of labor, and while her answer was diplomatic, she made no bones about the fact that, in the administration's view, traditional pensions are losing their relevance. "Defined benefit plans have their advantages," she told me, "but in an increasingly mobile 21st-century work force, the lack of flexibility of D.B. plans is yielding to greater usage of defined contributions plans."

It's hard to argue with her, if you look at the numbers. Although 44 million people are covered by private-sector plans, half are people who have already retired and are collecting benefits or whose plans have been frozen or terminated. In other words, on-the-job employees accruing benefits - once the backbone of the system - constitute only half. At that rate, even without legislation, the private-sector pension community will mostly die off in a generation.

And pension sponsors are likely to get another jolt soon. Under current accounting standards, companies can "smooth" their earnings reports, so that each quarter's net income reflects the average assumed performance of the company's pension assets, whether up or down, but not the actual performance. (Discrepancies from the average are sifted back into the earnings stream over time.) This means that reported earnings are often wildly misleading. Robert Herz, chairman of the Financial Accounting Standards Board, has criticized this practice as "a Rube Goldberg device." If FASB follows up and disallows it, corporate pension sponsors would have to cope with a lot more volatility in their earnings. Managers hate volatility, and such a change would prompt many of them to fold their plans.

If defined benefits are on their last legs, then it would make sense to try to incorporate their best features into 401(k)'s. The drawback to 401(k)'s, remember, is that people are imperfect savers. They don't save enough, they don't invest wisely what they do save and they don't know what to do with their money once they are free to withdraw it. Quite often, they spend it.

Here there is much the government could do. For instance, it could require that a portion of 401(k) accounts be set aside in a lifelong annuity, with all the security of a pension. Behavioral economists like Richard Thaler have demonstrated that you can change people's behavior even without mandatory rules. For instance, by making a high contribution rate the "default option" for employees, they would tend to deduct (and save) more from their paychecks. If you make an annuity a prominent choice, more people will convert their accounts into annuities.

Otherwise, it's not hard to predict that as octogenarians and nonagenarians become commonplace in society, many are going to outlive their savings, which is even more scary than outliving the savings of the P.B.G.C. Promoting an annuity culture is probably the single best way to make up for the demise of pensions. Yet most companies that provide 401(k)'s don't even give the option of purchasing an annuity when people cash in their accounts. As Brown, the Illinois professor, notes, "There is no box to check that says 'annuities."' That is a minor scandal. "I wish someone in Washington were thinking bigger thoughts about what the optimal retirement package should look like," says Watson Wyatt's Coronado.

What are Secretary Chao's thoughts? She bounced the question to the Treasury Department. Mark Warshawsky, the Treasury's top economist, has written about the need for annuities, and in an interview he allowed that as 401(k)'s become the primary, or the only, source of retirement income for more people, "I think it is a concern that annuities are not being offered in those plans." When I asked what the Treasury was doing about encouraging annuities, Warshawsky merely said that it was under study. Anything that smacks of regulation (like rules to make sure employees get a particular menu of choices, whether for annuities or for their portfolios) gives the administration shivers. This is what you would expect, given the administration's strong free-market tendencies.

But the government is already deeply involved, since it shelters retirement savings - pensions, yes, but also 401(k)'s, which are similarly permitted to grow tax-free. When it passed Erisa, Congress agreed that corporations that invested tax-sheltered retirement funds - pensions - should have to live by certain rules. But in the defined contribution world - the world of 401(k)'s - there are no rules. Employers can contribute or not. Employees can diversify or blow it all on the company stock (even if it is Enron). If nothing else, the century-long experiment with pensions has proved that in the absence of the right rules, the money will not always be there. The purpose of pension reform should be not merely to avoid a fiscal disaster but to find a fiscally sound way to preserve the likelihood of secure retirements. If people are going to retire on 401(k)'s, those should be subject to rules, and guidance, as well.

It would be nice to think that reform would include a future for pensions, but on the private side at least, it is doubtful. As Delphi's Miller put it simply: "A pension plan makes no sense in today's world. It's not wise for a company to make financial promises 40 or 50 years down the road." Most American executives would agree. Miller says he has not decided what to do at Delphi. If workers grant wage concessions, he has said, the pension plan, which is $4.5 billion shy of what it needs, might even survive. This has the sound of a bargaining ploy. Knowing that the P.B.G.C.'s guarantee is in place, the unions will probably insist on keeping their wages as close to intact as they can, and Miller will probably end up handing the pension plan over to the agency, just as he did at Bethlehem. Then, Miller and other executives will get stock and dandy bonuses in a new Delphi that is happily stripped of pension obligations, and some 45,000 employees and retirees will, in time, happily collect their pensions - courtesy of the U.S. Government. Moral hazard at work.

Roger Lowenstein, a contributing writer, has written about Social Security and health care reform for the magazine.


Copyright 2005 The New York Times Company

all you ever wanted to learn about getting others to believe.

Thursday, October 27, 2005

New Names for Old Companies

When, why, and how to change a company’s most valuable asset.

By Thomas Mucha, November 2005 Issue, Business 2.0.

Among the biggest problems facing Kodak (EK) recently -- and it has a ton of them -- was what to do about a name.

Battered by declining revenues and a stock price hovering near 20-year lows, Kodak had pinned its hopes on Ofoto, the Internet-based photo-services firm it acquired in 2001, to establish the company’s relevance in a postfilm world. But that raised an issue: If Ofoto was to become a key element of Kodak’s turnaround strategy, shouldn’t the website feature the name of, well, Kodak? “Do you spend tens of millions of dollars building the Ofoto brand,” Kodak VP for online services David Rich asks, “or do you leverage the legacy of a hundred years of Kodak?”

After six months of study, Kodak dropped the Ofoto name in March and redubbed the site the Kodak EasyShare Gallery. Why the mouthful? EasyShare is the name of Kodak’s popular digital cameras, which today command an industry-leading 22 percent share of the market. Likewise, the company has shipped more than 2 million EasyShare-branded printers since 2003. “EasyShare Gallery telegraphs the brand and the services customers will receive,” Rich explains. “It tested well with our target.”

Such naming dilemmas have become increasingly common in American business: Corporate name changes are up 12 percent since last year. Consider all the companies that want to distance themselves from the taint of Internet excess or corporate scandal. (Think of MarketWatch dropping its “.com,” or WorldCom changing its name back to MCI.) Then fold in mergers and acquisitions. Last year more than 9,000 M&A deals were struck in the United States -- the most since 2000 and a 50 percent jump from the previous year. Suddenly, renaming has become a big priority for many companies.

The Name of the Game

Different circumstances present different challenges. Start with mergers, by far the leading trigger for corporate name changes. When one company gobbles up another, executives face three choices: Settle on one of the old names, combine the two names, or come up with something entirely new. The decision usually comes down to picking a name that best fits the strategic direction of the combined entity. Sometimes the choice is easy, as in the case of Atlanta-based ValuJet Airlines, which in 1997 adopted the name of its merger partner, AirTran, as part of an effort to rebuild passenger confidence following the 1996 crash of a ValuJet DC-9 in the Florida Everglades.

In less dramatic cases, it’s important to evaluate the relative strength of each M&A partner’s brand. “You do substantial quantitative research,” says William Lozito of Minneapolis-based Strategic Name Development. The survey techniques are rigorous, but the questions themselves are necessarily subjective: “Can the brand be described as a leader or a follower?” “Does it feel young or old?”

As a result, these decisions often turn out to be judgment calls. This year, for instance, former Baby Bell SBC (SBC) has proposed adopting the 120-year-old name of its takeover target -- AT&T (T). That might be a good idea, given AT&T’s superior name recognition among consumers, but it’s also risky, given AT&T’s tarnished image on Wall Street. Sprint (PCS), meanwhile, decided that its well-known name was a better strategic fit than Nextel (NXTL), the name of its acquisition target. Yet, in a compromise, Sprint adopted Nextel’s yellow-and-black color scheme, along with the tagline “Together with Nextel,” to signal that the combined firm will still offer the unique network capabilities that Nextel’s customers have long enjoyed. “It’s a perfect example of co-branding,” says Lozito, whose firm wasn’t involved in the effort.

Some merged companies start over with an entirely fresh name. The 1996 marriage of Swiss pharmaceutical giants Ciba-Geigy and Sandoz Laboratories yielded the all-new name Novartis. However, the delicate nature of managerial politics and employee sensitivities means that not all mergers result in one tidy moniker -- recall ConocoPhillips, DaimlerChrysler (DCX), ExxonMobil, JPMorgan Chase (JPM), and Konica Minolta. When two names are mashed together, the cumbersome result is often difficult for consumers to remember.

A decision to change the corporate name may also make sense when a company outgrows its original business model or a product outgrows its parent company. In the 1930s, Galvin Manufacturing sold a successful car radio called the Motorola 5T71 -- leading the manufacturer to adopt the name in 1947. The company now known as Xerox (XRX) -- shorthand for a patented xerography copying method -- was originally called Haloid. And in 1983, Relational Software changed its name to Oracle (ORCL) to reflect its top-selling database product. The change doesn’t always have to be formal; in its marketing, Citibank often truncates its name to Citi to deemphasize its ties to traditional banking as it expands into other financial services.

Some companies simply conclude that their original name has become a hindrance. Following the humiliation of the Internet crash, dozens of companies dropped their “.com” suffixes, including About, Autobytel, and Infospace. (Likewise, the magazine you’re holding was formerly eCompany Now.) Primordial, a St. Paul, Minn., startup that began by selling vision-enhancement systems to the military, was called Soldier Vision until founder Randy Milbert decided that the old name was scaring off civilian clients. After an exhaustive search -- “Every other name in defense has ‘stealth,’ ‘hawk,’ or ‘systems’ in it,” Milbert says with a laugh -- he hit on Primordial, a word that suggests newness. Since the switch earlier this year, Milbert says, Primordial has landed two new contracts with non-defense companies: “The new name has been a huge plus.”

Making the Switch

Whatever the reason for the renaming, engineering a successful name change is hard work, and it can cost a bundle. Many companies enlist the expertise of a branding agency -- a service that usually costs between $30,000 and $150,000. For that price, agencies typically provide detailed market research and a list of about 60 possible new names. To make the exercise more realistic, many shops also produce “demos” of the best potential names, including mock-ups of annual reports, business cards, and websites. “Black and white on paper isn’t the same thing as the real world,” says Julie Cottineau of global branding agency Interbrand. “You need to try it out.”

The process should also include legal and URL vetting -- a serious headache when trying to navigate the 11.8 million active trademarks and 83 million registered domain names around the world. “Names should always be prescreened to avoid the risk of having executives fall in love with one that’s unavailable,” Cottineau adds. There’s more than just potential disappointment at stake: In 2003, Philip Morris changed its corporate name to Altria Group, which prompted a costly trademark fight with Altira Group, a Denver venture capital firm founded in 1996. (A court eventually decided against the VCs at Altira, ruling that trademark law doesn’t protect names that merely look similar.)

Once a new name has been chosen, the practical mechanics of the switch begin. Selling the new name and explaining its rationale to workers is the first step. Suppliers, clients, and customers should be the focus of a similar effort. Then comes the most expensive part: introducing the new name to the world. In addition to buying new letterhead and business cards or altering logos and signs, many companies also launch a formal marketing campaign -- advertising and promotions that call attention to the new identity.

But even with solid research and big marketing budgets, companies still make silly naming decisions. In 2002, PwC Consulting (spun off from the equally unwieldy PricewaterhouseCoopers) began changing its name to Monday -- a widely ridiculed plan that was quietly dropped when the firm was acquired by IBM a few months later. And no name change, no matter how clever, can save a company from bad management or scandal. The 1985 merger of Houston Natural Gas and InterNorth produced a new company called Enron. That name remains an albatross for CrossCountry Energy, PipeCo, and Prisma Energy International -- firms trying to create new businesses from the ruins of the former energy-trading giant.

“At the end of the day, you’ve got to deliver a great-quality service. That’s what consumers buy,” says Kodak’s Rich. So are consumers buying Kodak EasyShare Gallery? It’s still early; the Ofoto name vanished just last spring. Since then, Kodak says, the online service has gone from 18 million to more than 25 million users, while revenues have grown at a double-digit pace. Yet the site’s more intimate affiliation with its parent company may not be as much of a help as Kodak executives might like to believe. Thanks to Eastman Kodak’s strategic woes, Interbrand today values the Kodak brand at $4.9 billion -- 55 percent less than in 2001, the year the company bought Ofoto.

Wednesday, October 26, 2005

Software vs. wetware.

Nature 437, 1230-1231 (27 October 2005) | doi: 10.1038/4371230a

Patent reform prompts intellectual tug-of-war

Reform of the patent process in the United States is shaping up as a battle of wills between the software and biotechnology industries. The outcome has global consequences, as Emma Marris reports.

Two draft bills for patent reform are circulating in Congress, with the chance that one of them could pass into law as soon as next month. And the whole world of patents could be shaped by the reforms.

"The United States has been the experimental test bed for reform," says Francis Gurry, deputy director for patents at the World Intellectual Property Organization in Geneva, Switzerland. "The issues there often turn out later to be issues for the rest of the world. So the world watches them closely."

The reform plan has brought two of the industrial sectors that rely most heavily on intellectual property into conflict.

Biotechnology companies make their money by licensing out their inventions, or by using promising patents to attract venture capital. They spend a lot of money defending these patents — but have no strong incentive to change the current system.

The computer-software industry, on the other hand, is growing restless about 'patent trolls', who buy up software patents with the aim of filing lawsuits and extracting licensing fees or settlements from companies. The Washington DC-based Business Software Alliance has therefore been leading the charge for reform — and pushing for changes that would limit the rights of those suing for patent infringement.

Change to a 'first-to-file' system would clear a major obstacle to global harmonization of patent systems.

The two draft bills under consideration draw heavily from recommendations made by the National Academy of Sciences, the Federal Trade Commission and the US Patent and Trademark Office (PTO) itself.

They contain several provisions that have broad support. One such change is a 'first-to-file' provision, which would grant patent rights to the first inventor to file, rather than to whoever can prove they had the idea first. Although it might seem fairer that the person who thought of the idea first should get patent rights, determining who this is can require lengthy and costly adjudication. A change would bring the United States into line with the world's other main patent offices, in Europe and Japan — and remove a major obstacle to the global harmonization of patent systems.

Universities and independent inventors have expressed concern in the past that first-to-file would favour large corporations that can file patents fast, and in volume. But Gerald Mossinghoff, a former commissioner of the PTO who now works as a patent lawyer near Washington DC, says that when he totted up the winners and losers of such adjudications, he found that the large parties gained no advantage.

Both versions of the reform bill would retain another quirk of the US patent system — the one-year grace period. Under other systems, inventors are required to file for their patent at the time that they first disclose their invention to the world. In the United States and a few other countries, data on an invention can be published or presented up to a year before a patent is filed.

Joseph Straus, director of the Max Planck Institute for Intellectual Property, Competition and Tax Law in Munich, Germany, says that he hopes Europe will introduce the grace period in exchange for the United States accepting first-to-file patenting. He says the grace period helps innovation by letting scientists speak and write more freely about their work.

The draft bills also install a new vetting procedure called 'post-grant opposition', which would allow a patent to be contested in the first nine months after its approval, without a court hearing. The proceeding would take place in the patent office and the burden of proof would rest with the contester. Under present rules, companies dubious about the legitimacy of a competitor's patent must wait until the patent holder complains that they are infringing it. Only then can they make a counter-complaint that the patent is no good. Sometimes firms just avoid researching in the area of the patent.

Most agree that post-grant opposition could be a useful way of cutting down on litigation and improving patent quality. Earlier drafts of the bill allowed a second window for such challenges, in the six months after the patent holder sues someone for infringement. But biotechnology companies, in particular, feared the idea of patents with an air of reversibility about them, and successfully opposed its inclusion.

Capital attraction

Robert Chess, head of Nektar Therapeutics, a California-based biotechnology firm, says that early post-grant review could help innovative companies to attract capital. "We need certainty and early certainty, so investors will be willing to invest," he says. Under another provision, competitors' input could also be submitted during the patent examination process.

One early version of the bill, favoured by the software industry, included a provision that markedly curtailed a patent holder's right to stop another company that was infringing their patent from selling the invention. The industry hoped this would help them deal with their litigation woes. But such a provision would have been anathema to biotechnology firms, and it was eventually dropped.

The main outstanding disagreements concern whether damages should be calculated from the value of the whole product, or just the portion of it covered by the infringed patent, and rules that would limit the courts in which such infringement trials could be pursued. In both cases, software companies want to make things harder for those claiming infringement, whereas the biotechnology and pharmaceutical industries want to make it easier.

Despite these areas of dispute, Mossinghoff says he thinks a bill could be passed next month, before Congress packs up for the year. Nicholas Godici, another former PTO commissioner who also now works as a patent lawyer near Washington DC, says there is "a 50–50 chance" that the bill will pass either this year or next.

But the bill won't set funding for the over-worked PTO. As the number of patent applications increases, the office is stretched to its limit, and some observers say that the quality of patent decisions is suffering as a result. The PTO calls the situation a "workload crisis" in its strategic plan, but denies that its standards are dropping. "Questions of bad quality are overblown and anecdotal," claims Brigid Quinn, a spokeswoman for the PTO.

If there was single filing and examination of patents for the United States, Europe and Japan, the strain in each region would be considerably reduced. "The three major offices in the world are beginning to buckle under the workload, so we really have to get cooperation," says Mossinghoff. "This deep harmonization will remain theoretical until we get first-to-file in the United States."

Failure of the US bills would spell trouble on that front, declares Eugen Stohr, head of international affairs at the European Patent Office in Munich, "because then the rest of the world will know that the United States is not able to move to first-to-file — and that discussions on deep harmonization are useless".

Patagonia as paradigm.

Let My People Go Surfing

Can you take a company to the top when you can't stand nearly everything about traditional business and what it represents? You can if you're Yvon Chouinard. In an exclusive excerpt from his new management guide, Let My People Go Surfing, Patagonia's contrarian founder talks about breaking the rules—and creating the world's most iconoclastic adventure-apparel company.

By Yvon Chouinard

I'VE BEEN A BUSINESSMAN for almost 50 years. It's as difficult for me to say those words as it is for someone to admit to being an alcoholic or a lawyer.

I've never respected the profession. It's business that has to take the majority of the blame for being the enemy of nature, for destroying native cultures, for taking from the poor and giving to the rich, and for poisoning the earth with the effluent from its factories. Yet business can produce food, cure disease, control population, employ people, and generally enrich our lives. And it can do these good things and make a profit without losing its soul.

My company, Ventura, California–based Patagonia Inc., maker of technical outdoor apparel and gear, is an ongoing experiment. Founded in 1973, it exists to challenge conventional wisdom and present a new style of responsible enterprise. We believe the accepted model of capitalism, which necessitates endless growth and deserves the blame for the destruction of nature, must be displaced. Patagonia and its thousand employees have the means and the will to prove to the rest of the corporate world that doing the right thing makes for good, financially sound business.

One of my favorite sayings about entrepreneurship is "If you want to understand the entrepreneur, study the juvenile delinquent." The delinquent is saying with his actions, "This sucks. I'm going to do my own thing." Since I had never wanted to be a businessman, I needed a few good reasons to be one. One thing I did not want to change, even if we got serious: Work had to be enjoyable on a daily basis. We all had to come to work on the balls of our feet and go up the stairs two steps at a time. We needed to be surrounded by friends who could dress whatever way they wanted, even be barefoot. We all needed flextime to surf the waves when they were good or ski the powder after a big snowstorm or stay home and take care of a sick child. We needed to blur the distinction between work and play and family.

Breaking the rules and making my own system work is the creative part of management that's particularly satisfying for me. But I don't jump into things without doing my homework. In the late seventies, when Patagonia was really starting to grow some legs, I read every business book I could find, searching for a philosophy that would work for us. I was especially interested in books on Japanese and Scandinavian styles of management, because I wanted to find a role model for the company; the American way of doing business offered only one of many possible routes.

In growing our young company, however, we still used many traditional practices—increasing the number of products, opening new dealers and new stores of our own, developing new foreign markets—and soon we were in serious danger of outgrowing our breeches. By the late eighties we were expanding at a rate that, if sustained, would have made us a billion-dollar company in another decade. To reach that theoretical mark, we would have to begin selling to mass merchants or department stores. This challenged the fundamental design principles we had established for ourselves as the makers of the best products, compromised our commitment to the environment, and began to raise serious questions about the future. Can a company that wants to make the best outdoor clothing in the world be the size of Nike? Can we meet the bottom line without giving up our goals of good stewardship and long-term sustainability? Can we have it all?

It would take 20 years, and the near collapse of our company, to find the answers.

MY LIFELONG ADVENTURE IN BUSINESS took root in Southern California. My family had moved from Lisbon, Maine, to Burbank, California, in 1946, when I was eight, because my mother, the real adventurer among us, thought the drier climate would help my father's asthma. My father was a tough French Canadian who worked as a journeyman plasterer, carpenter, electrician, and plumber, and I had an older brother and two older sisters.

It was in California that I would discover climbing, at age 15, in the outskirts of Los Angeles, after helping found the Southern California Falconry Club in the early fifties. One of the adult members, Don Prentice, taught us how to rappel down to the falcon aeries on cliffs, showing us how to wrap manila rope (stolen from the telephone company) around our hips and over our shoulders to control the descent. Through high school and into my years as a student at Valley Junior College, in Valley Glen, California, I started hanging with young members of the Sierra Club—a group that included Royal Robbins, who would go on to start his own successful clothing company, and Tom Frost, an aeronautical engineer who would become my business partner from 1966 to 1975—and climbing the sandstone cliffs of Stoney Point, at the west end of the San Fernando Valley, and at Tahquitz Rock, near Palm Springs.

By the time I was 18, my climbing buddies and I had migrated to the big walls of Yosemite. Because we were pioneering long routes requiring hundreds of piton placements, I bought an old forge and taught myself blacksmithing so I could make my own hard-steel pitons. (The softer European kind didn't work well in Yosemite's uneven granite cracks.) During the sixties, I worked on my equipment in the winter months, spent April through July on the walls of Yosemite, and during the heat of summer headed out for the Alps and the high mountains of Wyoming and Canada—all interspersed with surf trips down to Baja and mainland Mexico. I supported myself by selling homemade gear out of the back of my car, supplementing my meager income by diving into trash cans and redeeming bottles for cash.

By 1971, two important things had happened: I'd met and married Malinda Pennoyer, an art student at Fresno State who spent summers working as a cabin maid in Yosemite and who would go on to become my partner in all aspects of the Patagonia business; and I had produced my first clothing: knickers and double-seated climbing shorts made from superheavy corduroy produced by an old mill in Lancashire, England. Back then, "active sportswear" consisted of your basic gray sweatshirt and pants, and standard issue for Yosemite climbing was tan cutoff chinos and white dress shirts bought from the thrift store. Though I just wanted more durable and comfortable climbing clothes for myself and my friends, I soon realized I had stumbled onto an entirely untapped market.

In the early seventies, my company, Chouinard Equipment, took over an abandoned meatpacking plant in Ventura and began to renovate its old offices as a retail store. Customers were responding to our "hand-forged" clothing, and we sold more and more items, including Chamonix guide sweaters, classic Mediterranean sailor shirts, canvas pants and shirts, and a technical line of rainwear—a predecessor of Gore-Tex—called Foamback. The apparel was such a success we decided it needed its own name to distinguish it from Chouinard Equipment's hardware line.

A few years earlier, in 1968, several friends (including Doug Tompkins, founder of The North Face) and I had taken a six-month road trip to the tip of South America, surfing the west coast of the Americas down to Lima, Peru, skiing volcanoes in Chile, and climbing 11,073-foot Fitz Roy, in Argentina's Patagonia. To most people, especially then, Patagonia was a name like Timbuktu or Shangri-La—far off, interesting, not quite on the map. It seemed like just the right idea for our clothing. To reinforce the tie to the real Patagonia, in 1973 we created a logo with a stormy sky, jagged peaks based on the Fitz Roy skyline, and a blue Southern Ocean.

We debuted our pile sweater—the precursor to our Synchilla fleece—in 1973; it was made from a polyester fabric intended for toilet-seat covers. Then we launched our first polypropylene underwear, in 1980, and became the first company to preach the virtues of layering. This new type of high-performance "system" amounted to blockbuster success: From the mid-eighties to 1990, sales skyrocketed from $20 million to $100 million. Most companies would relish such rapid growth, but for us it was nearly disastrous.

BY 1991, I HAD TRANSFORMED from a modest smithy and adventurer in business with a few friends—including Kris McDivitt (now Kris Tompkins), our CEO and general manager on and off for 15 years, between 1979 and 1994—into the guy in charge of a multi-million-dollar corporation with 650 employees. But with a big company came big problems.

In the late eighties, Chouinard Equipment became the target of several lawsuits. None involved faulty equipment or climbers. We were sued by a window washer, a plumber, a stagehand, and someone who broke his ankle in a tug-of-war contest using our climbing rope. The basis of each suit was improper warning—that we had failed to properly warn these customers about the dangers inherent in using our equipment for uses we could not predict. Then came a more serious suit, from the family of a lawyer who was killed when he incorrectly tied into one of our harnesses in a beginner climbing class.

The litigators thought that Chouinard Equipment and Patagonia were the same company and that, since Patagonia was doing so well, they could milk the corporation. Our insurance company refused to fight any of the suits, because of the costs involved, and settled out of court. Our premiums went up 2,000 percent in one year. Eventually, Chouinard Equipment filed for Chapter 11, a move that gave the employees time to gather capital for a buyout. They successfully purchased the assets, moved the company to Salt Lake City, and built their own company, Black Diamond Equipment Ltd., which to this day continues to make the world's best climbing and backcountry-ski gear.

Still other issues loomed. The general interest in outdoor sports and adventure was exploding in the U.S. and overseas, and we were riding the growth. We expanded internationally, opening retail stores in Chamonix and Tokyo. At the beginning of the nineties, we added another 100 employees, and projected continued annual growth of 40 percent, a rate we'd been experiencing for the past several years. But we made some classic mistakes. We failed to provide the proper training for the new company leaders, and the strain of managing a company with eight autonomous product divisions and three channels of distribution exceeded management's skills. We never developed the mechanisms to encourage them to work together in ways that kept the overall business objectives in sight.

Several planning efforts had to be aborted; no one could solve the Rubik's Cube of matching market-specific product development with such a complex distribution mix. Organization charts looked like the Sunday crossword puzzle and were issued almost as frequently. The company was restructured five times in five years; no plan worked better than the last one. I personally love change, but I was driving everyone crazy by constantly trying new ideas without a clear direction for where we were trying to go.

We desperately needed some help, so in early 1990 Malinda and I, along with our CEO, Pat O'Donnell, and CFO, Bill Bussiere, made arrangements to meet with Michael Kami, a well-regarded consultant who had run strategic planning for IBM and helped turn Harley-Davidson around in the eighties. The next thing we knew, we were boarding a Florida-bound plane to see him.

Kami was a small man in his late sixties with a squeaky, Swiss-German-accented voice, a full beard, and a lot of restless energy. We met on his enormous yacht, and he wore a captain's cap and an open shirt with epaulets.

Before he could help us, he said, he wanted to know why we were in business. I told him I'd always had a dream that when I had enough money, I'd sail off to the South Seas looking for the perfect wave and the ultimate bonefish flat. We told him the reason we hadn't sold out and retired was that we were pessimistic about the fate of the world and felt a responsibility to use our resources to do something about it. We told him about our tithing program—our pledge to donate 10 percent of our profits to environmental causes—and how we had given away a million dollars just in the past year to more than 200 organizations, and that our bottom-line reason for staying in the business was to make money we could give away.

Kami thought for a while and then said, "I think that's bullshit. If you're really serious about giving money away, you'd sell the company for a hundred million or so, keep a couple million for yourselves, and put the rest in a foundation. That way you could invest the principal and give away six or eight million dollars every year. And, if you sold to the right buyer, they would probably continue your tithing program because it's good advertising."

My managers protested.

"What are you worried about?" Kami said, turning to them. "You're young. You'll find other jobs!"

I said I was worried about what would happen to the company if I sold out.

"So maybe you're kidding yourself," he said, "about why you're in business."

It was as if the Zen master had hit us over the head with a stick, but instead of finding enlightenment, we walked away more confused than ever.

I WAS STILL WONDERING why I was really in business when, in 1991, after all those years of 30 to 50 percent compound annual growth, Patagonia hit the wall. The country had entered a recession, and the growth we had always planned on, and bought inventory for, stopped.

Our sales crunch actually came not from a decline from the previous year but from a "mere" 20 percent increase; still, it nearly did us in. Dealers canceled orders, and inventory began to build. Neither the mail-order nor the international division could meet its forecasts, and both returned inventory as well. We cut back production as much as we could for spring and fall. We froze hiring and nonessential travel. We dropped new products and discontinued marginal sellers. On July 31, 1991, Black Wednesday, we let 120 employees go—20 percent of the workforce. That was certainly the darkest day of Patagonia's history.

Our own company had exceeded its resources and limitations; we had become dependent, like the world's economy, on growth we could not sustain. We were forced to rethink our priorities and institute new practices. First step: I took a dozen of my top managers to Argentina, to the windswept mountains of Patagonia, for a walkabout. In the course of roaming around those wildlands, we asked ourselves, once again, why we were in business and what kind of business we wanted to build.

When we returned, we put together our first board of directors, made up of trusted friends and advisers, including author and deep ecologist Jerry Mander. At one of our board meetings, when we were struggling to put our mission into words, Jerry skipped lunch and went off by himself. He returned with a perfectly crafted article that outlined "an ‘ecology' of values that can mitigate the environmental and social crisis of our time." Those words became the basis for Patagonia's philosophies, clear and specific principles that expressed our thinking as it applied to different parts of the company: design, production, distribution, images, human resources, finance, management, and the environment.

I had long practiced my M.B.A. theory of management—management by absence—while I wear-tested our clothing and equipment in the most extreme conditions of the Himalayas and South America. It fueled new and exciting ideas for products, new markets, or new materials, but it also fueled my growing awareness of the environmental and social devastation going on around the world. Rather than bailing out in disgust, I saw an opportunity to create an entirely new kind of company. I wanted to make sure every employee at Patagonia understood our business and environmental ethics, so I began to lead multi-day employee seminars in the philosophies, going by bus to Yosemite or the Marin Headlands, north of San Francisco, where we'd camp out and gather under the trees to talk.

I realize now that I was trying to instill in my company the lessons I'd already learned as an individual and a climber, surfer, kayaker, and fly-fisherman. I had always tried to live my own life fairly simply, and by 1991, knowing what I knew about the state of the environment, I had begun to eat lower on the food chain and reduce my consumption of material goods. Doing risk sports had taught me another important lesson: Never exceed your limits. You push the envelope, and you live for those moments when you're right on the edge, but you don't go over. You have to be true to yourself; you have to know your strengths and limitations and live within your means. The same is true for a business. The sooner a company tries to be what it is not—the sooner it tries to "have it all"—the sooner it will die.

HAVING THE PHILOSOPHIES IN WRITING, and the shared cultural experiences of our classes, played a critical role in the company's turnaround, at the end of 1991. Within a few years we had eliminated several layers of management, consolidated inventories, and brought our sales channels under control—meaning that for the next decade and a half we would refocus on living up to our mission statement: "Make the best product, cause no unnecessary harm, and use business to inspire and implement solutions to the environmental crisis."

But what good does having fixed philosophies do when everything in the business world is so dynamic? How does Patagonia follow its philosophies in light of the expanding Internet market, the effects of NAFTA and the WTO, dozens of technological leaps that significantly affect design and production, new and different employee demographics, and the ever-changing styles and lifestyles of customers?

The answer is that our philosophies aren't rules—they're guidelines. For example, our mission statement says nothing about making a profit. In fact, Malinda and I consider our bottom line the amount of good that a business has accomplished over one year. At Patagonia, profit is not the goal, because, as the Zen master would say, profits happen when "you do everything else right." In many companies, the tail (finance) wags the dog (corporate decisions). We strive to balance the funding of environmental activities with the desire to continue in business for the next 100 years.

Our financial decision-making reflected our environmental ethics. Back in the mid-nineties, to cite just one instance, we changed the packaging of our thermal underwear. We were using a thick, wraparound cardboard header inside a heavy Ziploc plastic bag. Instead, we decided to hang up the heavier long underwear like regular clothing and simply bundle our lighter underwear with a rubber band. The first year after the change, we saved 12 tons of material from winding up in a landfill, saved $150,000 in packaging, and boosted sales by 25 percent—largely because the product wasn't hidden in a wrapper and people could feel the material and appreciate its quality.

Because we are a privately held company, we could make these kinds of decisions without worrying about the demands of shareholders. This allowed us to grow at a natural rate. When our customers told us they were frustrated by not being able to buy our products because of constant out-of-stock situations, we made more. We have not created artificial demand for our goods by advertising in Vanity Fair or GQ, or on buses in inner cities, hoping to get kids to buy black down jackets from us instead of The North Face or Timberland. We want customers who need our product, not just desire it.

Of course, we also want—and need—to make money, but we believe that's best accomplished by remaining nimble and efficient. One of our goals has been to have no debt. A company with little debt, or with "cash in the kitty," can take advantage of opportunities as they come up or invest in a startup without having to go further in debt or find outside investors. One of our most recent examples is a Japanese fabric mill we're working with to help us switch all of our polyester items, like our Capilene underwear, to 100 percent recycled material—something we probably couldn't have done if we carried a lot of debt. Managing our finances this way helps the company remain in yarak, a falconry term derived from Persian and meaning "superalert, hungry but not weak, and ready to hunt."

This kind of independent thinking applies to our management philosophy as well. In fact, our employees are so independent, we've been told by psychologists, that they would be considered unemployable in a typical company. We don't want drones who will simply follow directions. We want the kind of employees who will question the wisdom of something they regard as a bad decision but, once they buy into something, will work like demons to produce something of the highest possible quality—whether a shirt, a catalog, a store display, or a computer program. How you get these highly individualistic people to align and work for a common cause is the art of management at Patagonia.

Part of the key is strong communication. We have no private offices at our Ventura headquarters; everyone works in open rooms with no doors or separations. What we lose in "quiet thinking space" is more than made up for with better communication and an egalitarian atmosphere. Managers try to lead by example. We don't have special parking places; the best spots are reserved for fuel-efficient cars, no matter who owns them. Malinda and I pay for our own lunches in the cafeteria, so that we don't send a message that it's OK to take from the company. And we have an open-book policy; financial details are available with all employees to promote full transparency.

A familial company like ours runs on trust rather than authoritarian rule. Maybe a few people take advantage of our flextime and our "let my people go surfing" policy, but none of our best employees would want to work in a company that didn't have that trust. They understand that my M.B.A. style of management is as much a sign of my trust in them as my desire to be out of the office.

Because style is so important, I often use climbing mountains as an illustration. You can solo-climb Everest without using oxygen or you can pay guides and Sherpas to carry your loads, put ladders across crevasses, lay in 6,000 feet of fixed ropes, and have one Sherpa pulling you and another pushing you. Rich, high-powered plastic surgeons and CEOs who attempt to climb Everest this way are so fixated on the target—the summit—that they compromise on the process. The goal of climbing big, dangerous mountains should be to attain some sort of spiritual and personal growth, but this won't happen if you compromise away the entire process.

WHEN IT COMES TO THE ENVIRONMENT, it's probably no secret that I'm a total pessimist about the fate of the natural world. In my lifetime I've seen nothing but a constant deterioration of all of the processes that are essential to maintaining healthy life on Planet Earth. Most of the scientists and deep thinkers in the environmental field who I know personally are also pessimistic, and they believe that we are experiencing an extremely accelerated extinction of species—including, possibly, much of the human race.

In Edward O. Wilson's 2002 book The Future of Life, he describes the time we live in as "nature's last stand." His "living planet index," which measures the condition of the world's forests and freshwater and marine ecosystems, puts humanity at an environmental bottleneck of our own making. The 21st century must become the Century of the Environment, Wilson insists. If government, the private sector, and science don't begin to cooperate immediately to address issues of environmental degradation, the earth will lose its ability to regenerate. In other words, life as we know it is toast.

Thinking these dark thoughts doesn't depress me; in fact, I'm a happy person. I'm a Buddhist about it all. I've accepted the fact that there is a beginning and an end to everything. Maybe the human species has run its course and it's time for us to go away and leave room for other, one hopes, more intelligent and responsible life forms.

Then again, maybe there's something we can do about it. Patagonia's environmental efforts began in the seventies with simply trying to prevent physical damage to the rock walls of Yosemite. It was about clean climbing and making high-quality products that weren't disposable. Later we started looking at minimizing the environmental harm associated with manufacturing our products.

One of the hardest things for a business to do is to investigate the environmental effects of its most successful product and, if it's bad, change it or pull it off the shelves. We confronted this when we were looking into switching over to organic cotton, in the mid-nineties. Though we successfully made the transition, we still haven't completely solved the problem. Even when cotton is grown without toxic chemicals, it still uses an inordinate amount of water and cannot be grown year after year without permanently depleting the soil. When a cotton garment is worn out, it is usually thrown away. We have to dig deeper and try to make products that close the loop—clothing that can be recycled infinitely into similar or equal products, which is something we continue to strive for.

Despite the challenges involved, we've found that every time we've elected to do the right thing, even when it costs twice as much, it's turned out to be more profitable. This strengthens my confidence that we're headed in the right direction. Our Environmental Assessment Program educates us, and with education we have choices. When we act positively on solving problems instead of trying to find a way around them, we're farther along the path toward sustainability. Plus we're constantly discovering more things we can do, both internally and externally.

Back in the early eighties, one of the maintenance employees asked if I knew how much it cost to line every wastebasket with a plastic bag: $1,200 a year. I said get rid of them, but he returned the next day to report that the janitorial service refused to clean unlined baskets if people threw away wet garbage like coffee grounds or food. So we gave each employee a personal trash can for recyclable paper and made everyone responsible for disposing of wet garbage in separate containers scattered throughout the offices.

No matter how diligent we are at Patagonia, everything we make causes some waste and pollution. So our next step is to pay for our sins until such a time that we hope to stop sinning. Since the early eighties we have donated $22 million in cash and in-kind donations to activist groups committed to environmental causes. In 1996, we pledged to give 1 percent of our total sales to environmental causes, meaning that whether we turned a profit or not, whether we had a great year or a bad one, we had to give. Last year this meant donations of $2.4 million. In 2001, we helped start 1% for the Planet, an alliance of 148 companies committed to giving at least 1 percent of their sales to saving the planet.

Our efforts, and those of others who work toward similar goals, are making an impact. The organic-food industry is growing at a rate of more than 20 percent a year. Worldwide demand for organic cotton has tripled in the nine years since we changed over. As this drives costs down, large companies like Nike buy organic cotton to blend in with their industrial cotton as a way to support the cause but not price themselves out of the market. Some of the fiber mills we work with, at our prodding, are actively researching ways to eliminate toxic materials like antinomy and methyl bromide in polyester.

If Patagonia can continue to be successful operating under the constraints of our environmental philosophy, then perhaps we can convince other companies that green business is good business, and they can gain the confidence to take a few steps in the right direction.

WHEN MALINDA AND I made the decision to stay in business, we faced a personal challenge: Could we run a company that does much good and very little harm? Could we turn the company into a model, capable of effecting reform that we as individuals would be unable to accomplish? Could we actually change the way others treat the natural world?

The Zen master would say if you want to change government, you have to aim at changing corporations, and if you want to change corporations, you first have to change the consumers. Whoa, wait a minute! The consumer? That's me. You mean I'm the one who has to change?

The original definition of consumer is "one who destroys or expends by use; devours, spends wastefully." It would take seven Earths to provide enough raw materials to allow the rest of the world to consume at the same rate Americans do. Ninety percent of what we buy in a mall ends up in the dump within 60 to 90 days. It's no wonder we're no longer called citizens but consumers. Our politicians and corporate leaders are fair reflections of who we've become.

When I look at my business, I realize one of the biggest challenges I have is combating complacency. If I say we're running Patagonia as if it's going to be here a hundred years from now, that doesn't mean we have a hundred years to get there! Our success and longevity lie in our ability to change quickly. Continuous innovation requires maintaining a sense of urgency—a tall order, especially in Patagonia's seemingly laid-back corporate culture. In fact, one of the biggest mandates I have for my managers is to instigate change. It's the only way we're going to survive in the long run.

The American dream is to own your own business and grow it as quickly as you can until you can cash out and retire to the golf courses of Leisure World. The business itself is really the product, and it doesn't matter whether you're selling shampoo or land mines. When the company becomes the fatted calf, it's sold for a profit, and its resources and holdings are often ravaged and broken apart, disrupting family ties and the long-term health of local economies. The notion of businesses as disposable entities carries over to all other elements of society.

When you get away from the idea that a company is disposable, all future decisions in the company are affected. The owners and the officers see that, since the company will outlive them, they have responsibilities beyond the bottom line. Perhaps they will even see themselves as stewards of the earth.

Patagonia will never be completely socially responsible. It will never make a totally sustainable, nondamaging product. But it is committed to trying. We simply don't have any other choice. As the late environmentalist David Brower once put it, "There's no business to be done on a dead planet."

Perhaps we should measure a blog's popularity in terms of years wasted.

WHAT BLOGS COST AMERICAN BUSINESS

In 2005, Employees Will Waste 551,000 Years Reading Them
October 24, 2005
QwikFIND ID: AAR05Y
By Bradley Johnson
LOS ANGELES (AdAge.com) -- Blog this: U.S. workers in 2005 will waste the equivalent of 551,000 years reading blogs.

Currently, the time employees spend reading non-work blogs is the equivalent of 2.3 million jobs.

About 35 million workers -- one in four people in the labor force -- visit blogs and on average spend 3.5 hours, or 9%, of the work week engaged with them, according to Advertising Age’s analysis. Time spent in the office on non-work blogs this year will take up the equivalent of 2.3 million jobs. Forget lunch breaks -- blog readers essentially take a daily 40-minute blog break.

Bogged down in blogs

While blogs are becoming an accepted part of the media sphere, and are increasingly being harnessed by marketers -- American Express last week paid a handful of bloggers to discuss small business, following other marketers like General Motors Corp. and Microsoft Corp. into the blogosphere -- they are proving to be competition for traditional media messages and are sapping employees’ time.

Case in point: Gawker Media, blog home of Gawker (media), Wonkette (politics) and Fleshbot (porn). Said Sales Director Christopher Batty: “The Gawker audience is very at-work; it’s an at-work, leisure audience -- a.k.a., people screwing off on the job. “

Bosses accept some screwing off as a cost of doing business; it keeps employees happy and promotes camaraderie. Andy Sernovitz, CEO of the Word of Mouth Marketing Association, said blogs have become the favored diversion for “office goof-off time,” though he notes it’s hard to segregate blog time since blogs often bounce readers to professional media sites.

But at the end of the day, more blogging means less working. Jonathan Gibs, senior research manager at Nielsen/NetRatings, said at-work blog time probably comes in addition to regular surfing -- meaning more time on the Web but less time on the job.

Expansion of online behavior

“Since for the most part blog readers tend to be the most engaged readers of online content,” he said, “they do not appear, at least for now, to be sacrificing time from their favorite news sites. Instead, it looks like blog usage is in addition to existing online behavior.”

Some blogs do relate to work, but deciding just how relevant they are to the employer is open to debate. For this analysis, Ad Age chose a simple score: Count all business blog traffic, half of tech and media blogs and one-fourth of political/news blogs as directly related to work.

Based on ComScore’s tally of blog categories, this suggests just 25% of blog visits directly connect to the job. Employees this year will spend 4.8 billion work hours absorbing wisdom from other blogs that may enlighten visitors but not amuse the boss.

Wasted time

Hard and detailed data on blogging time is limited, so Ad Age’s analysis is a best-guess extrapolation done by reviewing blog-related surveys and data. By Ad Age estimates:
Work time spent reading and posting to blogs this year will consume 2.2% of U.S. labor force hours.

Work time spent at blogs unrelated to work will eat up 1.65% of labor force hours.

U.S. workers this year will waste the equivalent of 551,000 years (based on a 24-hour day) or 2.3 million work years (based on a typical nearly 40-hour work week) reading blogs unrelated to the job.

There is strong evidence of workday blogging. Server traffic for Blogads, a network of sites that take ads, spikes during business hours, reflecting page views on about 900 blogs. FeedBurner, a blog technology company, also sees a jump in work-time hits.

Workday traffic patterns

“Traffic rockets at 8 a.m. EST, peaks at 5 p.m. EST and then slides downward until L.A. leaves the office,” said Blogads founder Henry Copeland. “You see the same thing in the collapse of traffic on weekends. … Bottom line: At work, people can’t watch TV or prop up their feet and read a newspaper, but they sure do read blogs.”

And they create and post to them. Technorati, a blog search engine, now tracks 19.6 million blogs, a number that has doubled about every five months for the past three years. If that growth were to continue, all 6.7 billion people on the planet will have a blog by April 2009. Imagine the work that won’t get done then.