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Confronting Employer Pension Underfunding â" And Sparing Taxpayers the Next Bailout
By Charles Blahous
Hoover Institution PressCopyright © 2011 Board of Trustees of the Leland Stanford Junior University
All rights reserved.
The Nature of Single-Employer Defined-Benefit Pensions
AT ITS HEART, a defined-benefit (DB) pension is a promise of compensation in lieu of wages, made by an employer to an employee, to be provided as post-retirement income. A DB pension is distinguished from a defined-contribution (DC) retirement benefit such as a 401(k) account primarily in its allocation of risk.
In a DC retirement plan, funding contributions (and appreciation thereon) directly determine the worker's ultimate benefit. The worker therefore accepts the implicit risk that funding contributions and investment returns may be inadequate to provide benefits that last throughout her full retirement. By contrast, a DB pension promises periodic defined retirement benefit payments that continue for the life of the worker — a commitment that the sponsor promises to uphold regardless of previous funding inadequacies or investment returns.
A defined-benefit pension is distinct from a defined-contribution plan in a related respect. The DB pension's promise is only as good as each of the following factors: the funding contributed by the sponsor, the sponsor's investment choices, the sponsor's financial health, and any insurance system standing behind the pension. If these four pillars all topple, the worker's defined benefits are jeopardized.
The insurance for single-employer defined-benefit pension plans is provided by the Pension Benefit Guaranty Corporation, a government-chartered insurance system governed by rules set in federal statute. In the event of a pension plan's termination, the PBGC assumes the assets of the plan as well as the responsibility to pay benefits up to a statutory cap. For 2010, this cap is $54,000 annually for a single worker retiring at the age of 65.
Considering these four pillars of DB pension security — adequate funding, successful asset management, employer viability, and insurance protection — American workers as well as taxpayers have ample reason for concern. All four factors are now under considerable strain, with no clear path toward correction.
The ongoing recession has simultaneously depressed pension plan asset values, lowered interest rates, weakened pension sponsors, and strained the finances of the pension insurance system. Moreover, even before the downturn, pension plan contributions were generally inadequate to meet future obligations. The resulting shortfall is an imminent threat to the retirement security of American workers. It's also an implicit threat to the U.S. taxpayer, who is at risk of being asked to stand behind a weakened pension insurance system.
Challenges are pronounced throughout America's entire system of defined benefit pensions — from single-employer plans, to multi-employer plans (also insured by the PBGC), to state and local pension plans, and indeed to our national defined-benefit pension program, the Social Security system. While the challenges to public sector defined-benefit pensions are enormous, they do not bear directly upon the viability of the nation's private-sector pension insurance system. Treating them in detail would enormously expand the scope of this monograph. We will thus focus our attentions primarily on the system of single-employer defined-benefit pensions, which are the largest current source of financial strain upon the pension insurance system.
The Nation's Pension Insurance System: The Condition of the PBGC
SINGLE-EMPLOYER defined-benefit pensions (along with multi-employer pensions) are insured by the PBGC. This government-chartered corporation insures the pensions of roughly 44 million workers in plans operated by roughly 29,000 sponsors. Roughly 1.3 million workers are in pension plans that have already been taken over by PBGC, of which approximately 700,000 received pension benefit payments in 2009.
In November 2009 the PBGC reported that its combined financial condition had declined to a negative $22 billion in present value, $21 billion of which shortfall was attributable to the insurance program for single-employer defined-benefit pensions. This was a decline of more than $10 billion in the financial condition of the single-employer pension insurance system in only one year.
PBGC's net financial condition is determined by comparing the values of its assets and liabilities. On the asset side are the values of past premiums collected as well as the assets of plans assumed by the PBGC, plus any earnings on the investment of those assets. The PBGC invests the premiums it collects in Treasury securities, though it also inherits a variety of other assets assumed from pension plans. Generally, PBGC will gradually rebalance its portfolio after it absorbs these assets, with an eye toward conforming with PBGC's general investment policy (to be discussed later in greater detail) while at the same time avoiding precipitous or un-profitable asset dumps.
The largest part of PBGC's liabilities consists of the corporation's future obligations to pay benefits to the workers in terminated pension plans. Each year, PBGC estimates the present value of future benefits expected to be paid from plans it has already "trusteed" (taken over), from plans that are pending termination, and from plans facing "probable terminations." PBGC determines the present value of these liabilities by employing interest rates generally designed to parallel the method of pricing annuities in the private sector.
"Probable terminations" are described by the PBGC as plans that are "likely to terminate and be trusteed by the PBGC." In its annual report, PBGC explains this as follows:
In accordance with the FASB Accounting Standards Codification Section 450 (formerly SFAS No. 5, Accounting for Contingencies), PBGC recognizes net claims for probable terminations with $50 million or more of underfunding, which represent PBGC's best estimate of the losses, net of plan assets and the present value of expected recoveries (from sponsors and members of their controlled group) for plans that are likely to terminate in the future. These estimated losses are based on conditions that existed as of PBGC's fiscal year-end. Management believes it is likely that one or more events subsequent to PBGC's fiscal year-end will occur, confirming the loss. Criteria used for classifying a specific plan as a probable termination include, but are not limited to, one or more of the following conditions: the plan sponsor is in liquidation or comparable state insolvency proceeding with no known solvent controlled group member; sponsor has filed or intends to file for distress plan termination and the criteria will likely be met; or PBGC is considering the plan for involuntary termination. In addition, management takes into account other economic events and factors in making judgments regarding the classification of a plan as a probable termination. These events and factors may include, but are not limited to: the plan sponsor is in bankruptcy or has indicated that a bankruptcy filing is imminent; the plan sponsor has stated that plan termination is likely; the plan sponsor has received a going concern opinion from its independent auditors; or the plan sponsor is in default under existing credit agreement(s).
The inclusion of "probable terminations" in the PBGC's financial outlook often means that there is little change in PBGC's reported deficit immediately after a high-profile plan termination occurs. It is frequently the case that PBGC has already entered the expected loss on its books before the actual termination takes place.
On the other side of the coin — even though "probable terminations" represent only a small fraction of PBGC's expected liabilities — variations in PBGC's expected outlook can occur as plans move in and out of "probable termination" status. For example, when substantial funding relief was provided to sponsors of airline pension plans, at least one plan moved out of the "probable termination" category owing to its being a smaller immediate financial burden to its sponsor. This produced an illusory improvement in PBGC's finances, as the plan's worsened funding status could not be fairly construed as an improvement of PBGC's long-term outlook.
The 2009 decline in PBGC's financial condition brought it almost equal to its historically high shortfall of $23 billion reported over 2004– 2005, with a substantial risk that the shortfall will grow further in the years ahead. This decline in 2009 occurred despite growth in PBGC's investment income and was primarily attributed to a change in interest rates, followed in magnitude by additional expected losses from completed and probable pension terminations.
PBGC's multibillion-dollar shortfall (see figure 1) is problematic for a number of reasons. Ultimately, PBGC's operations must balance if the PBGC insurance system is to avoid insolvency. As PBGC's deficit grows, ever-higher premium payments must be collected from plan sponsors to close it. If it is eventually judged that the plan sponsor community is unable to bear this growing burden, then taxpayers may be asked to fill the fiscal hole. If in turn plan sponsors and taxpayers are not required to fill the hole, there exists the risk of substantial benefit losses for hundreds of thousands of workers who depend on the PBGC for their retirement income.
The Magnitude of Pension Underfunding Nationwide
PBGC'S DEFICIT is but one symptom of systemic underfunding in the defined-benefit pension world as a whole.
Unfortunately, estimates of this underfunding are imprecise and out of date. The PBGC has ceased providing annual estimates of systemic underfunding throughout the pension system, owing to gaps in reported data. (The need for improved and updated disclosure of plan funding levels will be discussed later.) Given such factors as recent trends in interest rates, the recent worsening of PBGC's financial condition, recently enacted funding relief, the generally weakened economy, and the fact that systemic underfunding in PBGC-insured single-employer plans topped $400 billion in each year from 2003 through 2005, it is reasonable to believe that system-wide underfunding now also exceeds $400 billion, and perhaps far exceeds it.
The magnitude of underfunding in private sector pension plans (see figure 2) doesn't directly translate into the magnitude of the threat to the PBGC. To the extent that this underfunding is in plans that are expected to remain ongoing and where the sponsors can be reasonably expected to make their future pension payments, PBGC need not take a hit. As of the end of 2007, however, roughly 20 percent of this aggregate underfunding was in plans sponsored by below-investment-grade sponsors or sponsors who might otherwise be expected to pose a risk of shedding their pension obligations upon the PBGC. If this percentage is holding constant, a conservative guess of underfunding in plans reasonably likely to terminate could well exceed $80 billion — costs that remain to be distributed among pension plan sponsors, directly affected workers, and, potentially, taxpayers.
Technical Reasons for Pension Underfunding
REASONS OFFERED for pension underfunding can range from narrowly technical issues to general principles of incentives and political economy. In the narrow technical sense, the leading "reason" for weakened pensions is that the recent financial market decline has simultaneously depressed plan asset values, lowered interest rates, and weakened the conditions of plan sponsors. This, however, raises the question of why pension plan funding was so vulnerable to a financial market plunge at the moment that it occurred. To answer this requires a thorough examination of existing methodology for valuing pension assets and liabilities, the statutory rules governing required funding and premium contributions, and the incentives driving the behavior of plan sponsors.
Even a thorough technical examination, however, cannot fully explain the current condition of America's employer-provided defined-benefit pensions. Current valuation methodologies and funding rules exist in the form that they do for reasons that lie in the realm of political economy. They reflect the perspectives and incentives of the various actors in the political process that constructed them. It is all very well to find that the public policy process should design better funding rules and incentives with respect to defined-benefit pensions. It is unrealistic to expect this outcome, however, when flawed incentives pervade the public policy process itself.
We will accordingly examine the reasons for pension underfunding from the ground up. We will begin first with the building blocks — the factual basics of measuring pension plan assets and liabilities — and then proceed to explain the statutory funding rules and their application in an environment of financial market stress. Finally, we'll examine the political economy realities that shape the ongoing evolution of these various factors.
Pension Plan Assets
IN AN IDEALIZED, simplified perspective, pension plan funding would be a function of two straightforward variables:
1) The value of pension plan assets
2) The value of pension plan obligations If these quantities are accurately known, then so is:
3) The difference between them, or 1) - 2), which = positive if the plan is overfunded, negative if the plan is underfunded
The three factors above are in theory all objectively measurable factual quantities. They lead us to a fourth factor, which is a policy choice:
4) The method of resolving any gap between 1) and 2).
In the real world of federal pension law, however, nothing is as simple as the basic schematics above. Though in theory pension plan assets, obligations, and underfunding are objectively measurable, the calculated quantities are highly dependent upon factors ranging from assumptions about participant behavior to methods of discounting future flows of funds.
Accuracy in measuring pension plan assets and liabilities is the linchpin of sensible pension funding policy. Reasonable parties can differ in their views as to how rapidly pension plan sponsors should be required to address underfunding of their pension plan obligations. Absent an accurate picture of plan liabilities and obligations, however, no sensible evaluation of competing value judgments can be made.
There is, of course, a practical limit even to the desirability of measurement accuracy. Pension plan assets vary in value from day to day. It would be unreasonable to expect pension plan sponsors to generate new funding plans at every instant that a plan's funding status materially changes. The policy goal should be to value pension plan assets as accurately as possible within the limits of practicability. Under current pension law, these redeterminations are made primarily on an annual basis (the valuation date being January 1 for most plans).
Beyond limiting the frequency of information updating, however, current federal pension funding rules (last revised comprehensively in the 2006 PPA) grant considerable additional leeway to plan sponsors in defining the value of their assets. While funding requirements for plans are determined annually, sponsors are not required to quantify plan assets according to their actual market value at the times of these annual determinations. Instead, they are permitted to "smooth" the values of plan assets — in practice, to only partially incorporate the extent to which asset values have varied from their expected rate of appreciation. The sponsor can "smooth" these deviations over a period of two years (under the old law, smoothing was permitted up to four years).
To take a specific example: Suppose that a plan sponsor had $100 of plan assets at the start of last year and that the plan actuary had projected an "expected" annual gain of 5 percent, so that plan assets would have appreciated to $105 at the start of this year. Suppose, too, that it was a terrible investment year, in which plan asset values in reality declined by 40 percent — down to $60.
The above calculation yields a difference of $45 between actual market values and the previously "expected" value. Under current pension law, the sponsor need not recognize the entirety of this gap right away; he need not assess plan assets at the current market value of $60 for funding purposes. Instead, the $45 loss relative to expectations is "smoothed" over two years. This is done in three parts, so that the first two-thirds ($30) of the difference is recognized in the first plan year and the remaining one-third ($15) in the next year.
The "smoothed" value of the pension plan assets, therefore, is recorded as $105 minus $30, which equals $75 instead of the market value of $60.
Another provision of law, however, limits the applicability of such smoothing. The PPA also stipulates that smoothing cannot be used to arrive at a valuation of pension plan assets that deviates from market value by more than 10 percent. In this case, the sponsor would be obligated to record the plan's assets as being worth no more than $66.
Excerpted from Pension Wise by Charles Blahous. Copyright © 2011 Board of Trustees of the Leland Stanford Junior University. Excerpted by permission of Hoover Institution Press.
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Table of Contents
List of Figures and Tables
The Nature of Single-Employer Defined-Benefit Pensions
The Nation’s Pension Insurance System: The Condition of the PBGC
The Magnitude of Pension Underfunding Nationwide
Technical Reasons for Pension Underfunding
Pension Plan Assets
Pension Plan Liabilities
Addressing Underfunding: Statutory Contribution Requirements
Other Funding Safeguards Established by the PPA
Recent Developments: Legislation and the Financial Markets’ Plunge
Additional Reasons for Underfunding: Structural Issues Facing the PBGC
Political Economy Factors
Pension Funding Policy Principles: Separating Measurement Accuracy from Value Judgments
Can the Hole be Filled? Separating Fairness from Risk Issues
Going Forward: General Principles for Pension Insurance System Reform
Conclusions and Recommendations
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