Can the Pension Benefit Guaranty Corporation Be Restored to Financial Health?

Order Code RL32702

CRS Report for Congress

Received through the CRS Web

Can the Pension Benefit Guaranty Corporation

Be Restored to Financial Health?

December 16, 2004

Neela K Ranade

Actuary

Domestic Social Policy Division

Congressional Research Service { The Library of Congress

Can the Pension Benefit Guaranty Corporation Be

Restored to Financial Health?

Summary

The Pension Benefit Guaranty Corporation (PBGC) is a federal government

agency created by the Employee Retirement Income Security Act of 1974 (ERISA)

to protect the pensions of participants covered by most private sector, defined benefit

pension plans. The primary source of revenues offsetting PBGC’s claims is

premiums paid by the sponsors of covered pension plans. These premiums are

established by Congress. The PBGC receives no appropriated funds. The PBGC’s

single-employer program has posted growing deficits for the last three years. The

deficit on September 30, 2004 was at an all-time high of $23 billion. Currently, the

pension plans of major airlines present an enormous threat to the financial condition

of the PBGC. Underfunded pension plans of sponsors with below-investment-gradebond ratings represented reasonably possible exposure of another $96.0 billion as of

September 30, 2004 according to the PBGC.

An independent organization has projected that without reform, the PBGC’s

single-employer program will run out of cash in 2020 or 2021. Because of the risks

to its long-term financial viability, the Government Accountability Office (GAO) has

placed the PBGC single-employer program on its high-risk list of agencies with

significant vulnerabilities to the federal government. PBGC failure could require a

tax-payer funded bailout. Major systemic issues include the PBGC’s premium

structure, funding requirements for defined benefit pension plans and PBGC’s access

to a bankrupt company’s assets.

Current PBGC premiums may be too low for the risks that PBGC underwrites.

Furthermore, premiums do not vary based on the credit risk for the company, assetliability mismatch for the pension plan, participant demographics, or benefit design

features such as whether or not the plan allows lump sum payouts. Sponsors that

have made pension plan contributions in excess of the minimum required in the past

may not be required to make contributions to the pension in the current year even

when the pension plan is underfunded in the current year. Cyclical companies that

wish to make higher contributions during profitable periods may find that maximum

deductibility rules prevent them from making such contributions. Under current

bankruptcy law, the PBGC cannot perfect a lien to force a company that has filed for

bankruptcy to make minimum required pension plan contributions.

In 2003, the Bush administration made a proposal for reform to strengthen

pension plan funding and the financial condition of the PBGC. Various bills with the

goal of reforming the PBGC were proposed in the 108th Congress but none were

enacted into law. The doubling of the PBGC deficit from fiscal 2003 to fiscal 2004,

has heightened awareness about the PBGC deficit situation. Congressional leaders

from both parties have announced their intention to move aggressively on legislative

solutions in the 109th Congress.

This report will be updated upon major developments affecting the PBGC’s

financial condition.

Contents

Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1

Funded Status of the PBGC Single Employer Program . . . . . . . . . . . . . . . . . 1

Impact of Older Airline Pension Plans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

Pension Underfunding and Credit Ratings of Older Airlines . . . . . . . . 4

Impact on the PBGC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

Pension Funding Rules . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Reporting and Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

PBGC Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

The PBGC Versus Private Insurance Companies and State Insurance

Guaranty Funds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

Prognosis for the PBGC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Policy Issues and Congressional Action . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

Strengthen Funding Rules for Pension Plans . . . . . . . . . . . . . . . . . . . . 14

Restructure PBGC Premiums . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

Improve Transparency of Information . . . . . . . . . . . . . . . . . . . . . . . . . 15

Change Bankruptcy Law . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Reduce Disparity between Executive and Non-Executive Benefits . . 15

Review Cash Balance Regulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

Glossary of Terms — Table 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

List of Tables

Table 1. PBGC Funded Status . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Table 2. Pension Underfunding by Airline . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Table 3. Unfunded ABO and Credit Rating of Older Airlines

at End of Fiscal 2003a . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

Can the Pension Benefit Guaranty

Corporation Be Restored

to Financial Health?

Background

The Pension Benefit Guarantee Corporation (PBGC) is a federal government

agency created by the Employee Retirement Income Security Act (ERISA) of 1974

to protect the pensions of participants covered by most private sector, defined benefit

pension plans. The primary source of revenues offsetting PBGC’s claims is

premiums paid by the sponsors of covered pension plans. These premiums are

established by Congress. The PBGC receives no appropriated funds.1 In the last

three years, the combination of a slow economy, low stock market returns and low

interest rates have left the PBGC in a steadily worsening financial position.

Currently, the pension plans of older airlines present an enormous threat to the

financial condition of the PBGC. United Airlines and US Airways have indicated

that they may need to terminate their pension plans in the near future on account of

financial problems.2 Delta Air Lines has been able to avert bankruptcy by reducing

costs, including freezing its pilots’ pension plan.3 But it too has warned that if it is

unable to reduce operating expenses and if it continues to experience significant

losses, it will have to file for bankruptcy.4 PBGC’s problems may not be confined

to the airline industry. Systemic issues related to PBGC’s premium structure,

funding requirements for defined benefit pension plans and PBGC’s limited access

to a bankrupt company’s assets may contribute to a repeat of the airline scenario with

some other industry.

Funded Status of the PBGC Single Employer Program

The PBGC covers both single-employer and multiemployer pension plans.

Multiemployer plans are collectively bargained plans to which more than one

company makes contributions. As of September 30, 2004, the single-employer

1

See CRS Report 95-118 EPW, Pension Benefit Guaranty Corporation: A Fact Sheet, by

Paul J. Graney for further information.

2

UAL Corporation’s (parent of United Airlines) 10-Q filing with the Securities and

Exchange Commission for the quarterly period ended September 30, 2004; “US Air Asks

Court to End Labor Contracts,” The New York Times, Nov. 13, 2004

3

When a pension plan is frozen, participants do not earn any additional pension accruals on

account of increased service. Also, no new entrants are admitted into the plan.

4

Delta Airlines 10-Q filing with the Securities and Exchange Commission for the quarterly

period ended Sept. 30, 2004

CRS-2

program accounted for virtually all of the PBGC’s deficit. This report will focus on

the single-employer program.

The PBGC’s single-employer program posted a deficit of $23.3 billion as of

September 30, 2004, the largest deficit in its history. Table 1 illustrates how quickly

the funded status of this program has deteriorated. Definitions for the terms used in

Table 1 are provided in the “Glossary of Terms — Table 1” at the end of this report.

Table 1. PBGC Funded Status

(amounts in billions)

Sept. 30,

2004

Sept. 30,

2003

Sept. 30,

2002

Sept. 30,

2001

Assets

$39.0

$34.0

$25.4

$21.8

Liabilities

$62.3

$45.3

$29.1

$14.0

Net position

$(23.3)

$(11.2)

$(3.6)

$7.7

Benefit payments

for prior fiscal year

$3.0

$2.5

$1.5

$1.0

Reasonably possible

exposure

$96.0

$83.9

$35.4

$10.9

Sources: PBGC 2004 Performance and Accountability Report, PBGC 2003 and 2002 Annual Reports.

Note: On account of rounding, Assets minus Liabilities may not exactly equal Net position.

According to Table 1, while PBGC’s assets grew by 79% from 2001 to 2004,

its liabilities grew by a far larger 345%. The liabilities shown in Table 1 include

both claims for plans that have already terminated as well as claims for probable

terminations. Under Statement of Federal Financial Accounting Standard No. 5 —

Accounting for Contingencies, when an economic event that is likely to lead to plan

termination has occurred on or before the date of the financial statement, the

estimated amount of the “probable” claim (net of estimated recoveries and plan

assets) must be accrued.

Although the decline in interest rates from 2001 to 2004 contributed to the

increase in liabilities, the predominant factor was the termination of a number of

plans with large claims during this period. Notable among these were pension plan

terminations for Bethlehem Steel, LTV Steel, National Steel, and US Airways Pilots’

Pension Plan that accounted for total claims of $ 7.5 billion.5 In addition, net claims

for probable pension plan terminations for United Airlines and US Airways (for its

5

Termination of the US Airways Pilots’ Pension Plan in 2003 resulted in a net PBGC claim

of $0.75 billion. The first bankruptcy filing did not solve US Airways’ financial problems,

which had to file for bankruptcy again in 2004. US Airways has announced its desire to

terminate some of its remaining pension plans as part of the new bankruptcy filing.

CRS-3

non-pilot pension plans), estimated by the PBGC at $8.5 billion, are presumably

included in the September 30, 2004 liability figure of $62.3 billion. By way of

comparison, total claims for all single employer pension plan terminations for the 29

years between 1975 and 2003 were $ 17.59 billion.6

Table 1 shows that the “Reasonably Possible Exposure” as of September 30,

2004 was at an all time high of $96 billion.7 Reasonably possible contingent claims

generally represent underfunding in plans sponsored by companies with belowinvestment-grade bond ratings.8 While losses from “reasonably possible” plans are

not yet “probable terminations” and are not accrued for financial statement purposes,

under generally accepted accounting principles, this financial exposure must be

disclosed in the footnotes to the PBGC’s financial statements. Some of the plans

included in the exposure for reasonably possible terminations can be expected to end

up under PBGC trusteeship in the next few years. Therefore the large reasonably

possible exposure in 2004 is a sign of possible escalating problems in coming years.

6

Claim figures are from Table S-5 of Pension Insurance Data Book 2003. Claims are

defined as liabilities on a termination basis for benefits guaranteed by the PBGC less plan

assets.

7

The “Reasonably Possible Exposure” as of Sept. 30, 2004 was determined by the PBGC

based on the estimated unfunded vested benefits as of Dec. 31, 2003 for those plans

considered to be reasonably possible but not probable terminations. The PBGC adjusted the

unfunded vested benefits reported by these companies to the Dec. 31, 2003 PBGC select

interest rate of 4.0%. The underfunding associated with these plans would generally tend

to be greater at Sept. 30, 2004 because of the economic conditions (e.g., lower interest rates

and/or low investment returns) that existed between Dec. 31, 2003 and Sept. 30, 2004. The

PBGC did not reflect the events that occurred between Dec. 31, 2003 and Sept. 30, 2004 in

the “Reasonably Possible Exposure” of $96 billion.

8

Below-investment-grade bonds are also called junk bonds or speculative bonds.

CRS-4

Measurement of Liability

The PBGC liability is measured as the actuarial present value of estimated future

benefits to be paid by the PBGC less the present value of estimated recoveries from plan

sponsors and the assets of pension plans. Both plans already terminated as well as plans

that will probably terminate in the near future are taken into account in measuring the

liability. To measure the actuarial present value, PBGC adjusts the value of future

benefits to reflect the time value of money by discounting with the appropriate interest

rate. The present value of estimated recoveries is determined by adjusting estimated

future recoveries to reflect the time value of money by discounting with the appropriate

interest rate. The actuarial present value and the liability are highly sensitive to the

interest rate used for discounting. The lower the interest rate, the greater is the liability.

The interest rate is chosen such that, along with the mortality assumption, it produces

an actuarial present value that reflects the price of single-premium nonparticipating

group annuities in the market.

Interest rates declined between 2001 and 2004. The interest rate used to value

PBGC’s liabilities as of September 30, 2004 was a 25-year select rate of 4.80% followed

by an ultimate rate of 5.00% for the remaining years. The interest rate used to value

PBGC’s liabilities as of Sept. 30, 2001 was a 20-year select rate of 6.70% followed by

an ultimate rate of 5.25% for the remaining years.

Impact of Older Airline Pension Plans

Pension Underfunding and Credit Ratings of Older Airlines. The

older airlines9 include the number one and number two airlines in the world,

American and United Airlines, as well as other big names such as Delta Air Lines,

Continental Airlines and US Airways. The eroded profit margins of these airlines

after September 11, 2001, took a further hit with the steep increase in fuel prices in

2004. Some airlines are in worse position than others. United Airlines filed for

bankruptcy in December 2002 and US Airways filed for bankruptcy for the second

time in September 2004, after emerging from a previous bankruptcy filing in March

2003. Delta was able to stave off bankruptcy by negotiating benefit and salary cuts

with its pilots’ union. Under the agreement, Delta will freeze the airline pilot

pension plan and replace it with a less expensive 401(k) plan.10

United Airlines and US Airways are both seeking approval from federal

Bankruptcy Court for termination of their defined benefit pension plans. Both

9

Airlines that were in operation before the 1978 Airline Deregulation Act and whose goal

is to provide service to multiple destinations by using large, complex hub-and-spoke

operations are sometimes called “legacy airlines.” Others define legacy airlines as those

with “legacy costs,” the millions of dollars paid by the airlines for the defined benefit

pensions and health care costs of retirees. Most of the airlines established since

deregulation do not have defined benefit pension plans.

10

A 401(k) plan is a defined contribution pension plan authorized under Section 401(k) of

the Internal Revenue Code. Pension benefits under a defined contribution plan are not

guaranteed by the PBGC.

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airlines wish to replace their traditional defined benefit pension plans with cheaper

retirement benefits such as 401(k) plans. Both have suspended contributions to the

defined benefit pension plans. Table 2 shows estimated underfunding for United

Airlines and US Airways.

Table 2. Pension Underfunding by Airline

(amounts in billions)

Termination basis

Termination basisPBGC guaranteed

benefits only

United Airlines

$8.3

$6.4

US Airways

$2.3

$2.1

Airline

Source: Testimony PBGC, Bradley D. Belt, Executive Director in U.S. Congress, Senate, Commerce,

Science, and Transportation, Oct. 7, 2004.

Under Section 4010 of ERISA, plans with large unfunded vested11 benefits are

required to file information on the plan’s termination liability with the PBGC.12

However, ERISA also requires the PBGC to maintain confidentiality of this

information. Although the termination liability for benefits guaranteed by the PBGC

is not available for Delta or the other major airlines, public data is available for

another measure of liability. The Accumulated Benefit Obligation (ABO) is defined

by the Statement of Financial Accounting Standard 87 as the actuarial present value

of benefits (whether vested or nonvested) attributed by the pension benefit formula

to employee service rendered before a specified date and based on employee service

and compensation (if applicable) prior to that date. Under generally accepted

accounting principles, a private sector company is required to disclose the unfunded

ABO in its annual financial statements, when the ABO exceeds the market value of

assets for the plan. The unfunded ABO differs from the termination liability for

PBGC guaranteed benefits for several reasons. The discount rate used to determine

the ABO is different (generally higher) than that used to determine the liability for

PBGC guaranteed benefits. On the other hand, claims guaranteed by the PBGC are

often lower than those provided under the pension plan. Overall, the liability for

PBGC guaranteed benefits is often significantly greater than the unfunded ABO. In

the absence of better information, the unfunded ABO can be used to provide a lower

bound for the liability for PBGC guaranteed benefits.

Table 3 shows the unfunded ABO and the Standard & Poor (S&P) credit ratings

and outlook for the six older airlines at the end of fiscal 2003. The unfunded ABO

11

A vested pension benefit is a benefit that cannot be taken away from an employee even

if he leaves the company prior to retirement. Typically, an employee has to serve a

minimum number of years to become vested in his pension benefit.

12

Section 4010 requires disclosure of the plan’s termination liability when the aggregate

unfunded vested benefits for all plans sponsored by the employer exceed $50 million.

CRS-6

is a measure of the underfunding in a pension plan. Underfunding of a pension plan

is not per se a problem for the PBGC. However, when the pension underfunding is

coupled with the plan sponsor being in financial difficulty, the result can be

significantly increased exposure for the PBGC.

The Standard and Poor’s credit ratings, used to evaluate the quality of bonds

issued by the borrowing company, are also a measure of the financial health of the

company. The credit ratings are based on the issuer’s financial ability to make

interest payments and repay the loan in full at maturity. AAA is the highest credit

rating and D is the lowest credit rating. AAA is better than AA which is better than

A. Standard and Poor’s also uses a plus or minus indicator. B+ is better than B and

B is better than B-. Bonds rated at less than BBB are considered to be junk bonds.

A rating of D indicates that the company is bankrupt or nearly so.

All of the airline credit ratings in Table 3 are in the junk bond category. US

Airways and United Airlines are currently in bankruptcy and have the D rating. Delta

Airlines is ranked only slightly better with a rating of CC. Presumably the United

Airlines and US Airways pension plans are considered ‘Probable Plan Terminations’

and included in the liability posted in PBGC’s September 30, 2004 financial

statement.13 The rating of Delta is low enough that its pension plans would fall under

either the ‘Reasonably Possible Exposure’ or ‘Probable Plan Termination’ category.

Table 3. Unfunded ABO and Credit Rating of Older Airlines

at End of Fiscal 2003a

Airline

Unfunded ABO

($ billions)

Expected benefit

payout — 2004

$ millions

S&P

credit

rating

United Airlines

$5.69

$795

D

Not applicable

Delta

$5.04

$779

CC

Negative

Northwest

$3.28

$349

B

Negative

American

$1.98

$410

B-

Stable

Continental

$0.68

$188 (Estimatedb)

B

Negative

US Airways

$0.90

$115

D

Not applicable

S&P outlook

Source: 10K filings of airlines, Standard and Poor’s.

Notes: (a) Unfunded ABO figures are as of Dec. 31, 2003 for UAL, Northwest, American and

Continental and Sept. 30, 2003 for Delta and US Airways. The Unfunded ABO and Expected Benefit

Payout figures were obtained from the 10K filings of the airlines for the fiscal year ending 2003. The

13

PBGC does not name the companies included in its “Probable Plan Termination” or

“Reasonably Possible Exposure” categories. However, it discloses the criteria used for

inclusion in these categories. While most of the criteria are objective, PBGC judgement is

also used.

CRS-7

S&P Credit Ratings and Outlook were obtained from Standard and Poor’s website at

[http://www2.standardandpoors.com] as of Nov. 5, 2004.

(b) Continental did not release its expected benefit payout for 2004. The figure shown is its actual

benefit payout for 2003.

Table 3 also shows the Standard and Poor’s outlook for the credit ratings of the

airlines. A negative outlook indicates that Standard and Poor’s may further lower the

credit rating of the company.14 The negative outlook for Delta, Northwest and

Continental indicates that their ratings may slip further.

Impact on the PBGC. If any of the airline plans were to be taken over by the

PBGC, the benefit payout for claims guaranteed by the PBGC would be somewhat

lower than the benefit payouts shown in Table 3. This is because the PBGC imposes

a cap, set by statute, on the annual benefits it will pay for a participant.15 In addition,

PBGC does not fully guarantee the benefit increases granted by a plan sponsor in the

five years prior to plan termination. Nonetheless, the benefit payouts shown in Table

3 provide a rough idea of the magnitude of problem that PBGC faces on account of

the older airlines. If United, Delta and US Airways were to terminate their pension

plans, PBGC’s $3.0 billion payout would increase by roughly $1.7 billion.

In its 2003 Annual Report, PBGC described results from the Pension Insurance

Modeling System (PIMS), a model used to evaluate its exposure and expected

claims. The model produces results under 5,000 different simulations. PBGC does

not release the mean or median benefit payout figures between 2003 and 2013

produced by PIMS.

Congressional Research Service (CRS) estimates that termination of either the

United Airlines or Delta pension plans would increase PBGC’s 2004 fiscal payout

of $3.0 billion by about 0.8 billion. PBGC’s 2004 Performance and Accountability

Report states that expected benefit payments in 2005 are $3.4 billion. According to

the PBGC, this reflects payment of four months for probable plan terminations.

Some of the probable plan terminations are assumed to occur part way through 2005.

Assumption of UAL or Delta’s unfunded liability would dwarf PBGC’s largest

loss from one company in its history. With the trusteeship of Bethlehem Steel

pension plans in 2003, PBGC absorbed a loss of $3.6 billion. PBGC has estimated

that the termination of United Airlines pension plans would result in a loss of $6.4

billion. Based on the unfunded ABO figure in Table 3, CRS estimates that the

termination of Delta’s pension plans will result in a loss of at least $5 billion. The

14

Moody’s Investor Service and Fitch Ratings also rate bonds issued by companies and

provide ratings outlook for companies. The rating scales used by these agencies are

different than the scale used by Standard and Poor’s. PBGC uses Standard and Poor’s and

Moody’s ratings in evaluating whether a company’s pension plan should fall in either the

“Probable Plan Terminations” or “Reasonably Possible Exposure” category.

15

For plans terminating in 2005, the cap is $45,614 per year for a single-life annuity

beginning at age 65. If plan assets are greater than liabilities, beneficiaries may receive

benefits greater than the cap.

CRS-8

termination of US Airways pension plans will result in a loss of $2.1 billion

according to the PBGC.

When the sponsoring employer of an underfunded pension plan is close to

bankruptcy, plan participants are likely to take steps to protect individual interests

that further increase the underfunding of the plan. Delta pilots, for instance,

responded to the company’s financial troubles by taking lump sum early retirement

benefits in large numbers. When early retirement benefits are subsidized (as for

Delta), a greater number of early retirements than expected by the pension plan

increases the actuarial losses for the plan. Payment of lump sums further increases

the underfunding of an underfunded pension plan. Greater pension underfunding

means, of course, greater potential liability for the PBGC.

If the bankruptcy court permits United to terminate its pension plans, this could

set up a domino effect with other airlines seeking to reduce labor costs by filing for

bankruptcy and passing unfunded pension costs on to the PBGC. While plan

termination is the worst case scenario, the airlines may make other pension plan

changes that could also have negative implications for the PBGC. Such changes

include conversion to a cash balance plan design, freezing of the defined benefit plan

to new employees or replacement of the defined benefit pension plan by a defined

contribution plan. The cash balance plan design can exacerbate underfunding of a

pension plan since these plans typically pay pensions as lump sums instead of

monthly instalments. A steady flow of premiums is an important source of revenue

for closing PBGC’s current large deficit. Freezing of a defined benefit plan to new

employees or replacement of a defined benefit pension plan by a defined contribution

plan would drain PBGC’s premium base since PBGC premiums are based partly on

the number of covered participants.

Pension Funding Rules

Section 412 of the Internal Revenue Code specifies the minimum funding

requirements for a defined benefit pension plan. The minimum required contribution

is the sum of the “normal cost” (present value of pension benefits earned during the

year) and amortization of liabilities including past service credit and experience gains

and losses.16 Sponsors of plans with over 100 participants are required to make

additional contributions called “deficit reduction contributions” (DRCs) when the

value of plan assets is less than 90% of the “current liability.”17 Companies that

contribute more than the minimum required amount establish a credit balance in their

“Funding Standard Account.” In any subsequent year when they are low on cash,

the law permits the companies to make the minimum required contributions

(including the DRC) out of the credit balance instead of paying cash into the pension

fund. This is true even if the credit balance that existed on paper has melted away

16

Amortization of a liability means paying off the liability over a number of years in level

instalments consisting of principal and interest.

17

Current liability is the liability of a plan determined as though the plan is an ongoing

entity. It is based on employee service and compensation to date. The interest rate used to

determine the current liability must fall in a range specified by law that is based on an

average of long term interest rates over several years.

CRS-9

on account of assets being invested in investments, such as stocks, that have dropped

in value. Thus United Airlines was not required to make cash contributions to the

flight attendant’s pension fund in 2001 even though it had slid to 88% funding.18

The Pension Funding Equity Act of April 2004, P.L. 108-218, gave commercial

airlines and steel producers breaks in the funding of pension plans on account of the

adverse financial conditions faced by these industries. Under the act, these

employers can elect temporary relief from required deficit reduction contributions for

plan years beginning after December 27, 2003, and before December 28, 2005,

provided they were not subject to the deficit reduction contribution in 2000.

Companies that qualify for DRC relief still are required to make the “regular

contribution” that they would have to make without regard to the DRC provision, but

the required DRC is to be reduced by 80% in 2004 and 2005.19 Congress legislated

the targeted relief for certain employers with the belief that the action was necessary

to preserve the pension plans. The older airlines in fact availed themselves of this

provision thereby reducing the funding of their pension plans below what it would

have been otherwise. A few months after passage of the legislation, United and US

Airways announced their intent to terminate their employee pension plans.

Section 404 of the Internal Revenue Code specifies rules for determining the

maximum deductible contribution to a pension plan. The Code also defines the “full

funding limit” (generally 90% of the current liability). Any contributions in excess

of the maximum deductible contribution are not tax deductible.

Reporting and Disclosure

While detailed information is available on pension plan funded status to

regulatory agencies, information available to plan participants and investors is fairly

limited. Pension plans are required to furnish plan participants with a Summary

Annual Report that contains information regarding the plan’s net assets,

contributions, income, and expenses. The Summary Annual Report must contain the

current value of a plan’s net assets as a percentage of its current liability only if the

percentage is less than 70%.

In addition to the above disclosure, plans that are less than 90% funded on a

current liability basis (with some significant exceptions) must distribute notices to

employees that describe the plan’s funding status and the limits of PBGC’s

guarantees.

Even when plans disclose their current liability, plan participants may be

unaware of the plan’s termination liability. While the current liability reflects the

pension plan’s liability assuming the employer’s plan will continue indefinitely, the

termination liability reflects the cost to a company of terminating its pension plan by

paying lump-sums and purchasing annuities in the private market that reflect the

18

“For Pension Plans Like United’s, a Healthy Glow That’s Paper Thin,” The New York

Times, Nov. 6, 2004

19

See CRS Report RS21717, H.R. 3108: The Pension Funding Equity Act, by Patrick

Purcell and Paul Graney for further information.

CRS-10

benefits workers have earned. Often the termination liability is considerably higher

than the current liability.

Section 4010 of ERISA does require plan sponsors with more than $50 million

in aggregate plan underfunding to furnish information on the plan’s termination

liability and assets to the PBGC. However, on account of the law’s confidentiality

requirements, this information is not available to plan participants or the public.

PBGC Premiums

The primary source of PBGC revenues, other than assets of terminated pension

plans under PBGC trusteeship, is the premiums set by Congress and paid by the

private sector employers that sponsor defined benefit pension plans. The PBGC

premium structure for the single-employer program consists of flat-rate premiums

and variable-rate premiums. All covered single-employer plans are required to pay

a flat annual premium of $19 per participant. Underfunded plans are required to pay

an additional variable-rate premium of $9 per $1,000 of unfunded vested benefits.

However, the variable premium is waived if contributions to the plan for the prior

year were at least equal to the Full Funding Limit. Bethlehem Steel, the largest plan

termination to date in PBGC’s history, paid no variable-rate premiums for five years

prior to plan termination.

The PBGC Versus Private Insurance Companies and State

Insurance Guaranty Funds

The PBGC is often thought of as an insurance company that protects the pension

benefits of employees of bankrupt companies. However, there are key differences

between commercial insurance companies and the PBGC. State regulations require

an insurance company to hold adequate reserves to back promises behind the

products they sell. When the products involve particularly unpredictable risks

(variable annuities, for instance), additional reserves are required. Insurance

companies develop their premiums such that after allowing for administrative

expenses, enough is left over to build the required reserves. The PBGC’s premiums,

on the other hand, do not always reflect the true cost of insurance. In particular,

PBGC premiums do not reflect the market risk that a poor economy may lead to

widespread unfunded plan terminations during the same year. A 2002 article

estimated that PBGC premiums were about half of the market price for the

insurance.20

In an effort to attract better risks, insurance companies usually subdivide policy

applicants into subgroups and base premiums for a particular subgroup on the level

of risk that the subgroup presents. Applicants that are better risks are charged lower

premiums. The PBGC premium is based only to a limited extent on the risk that a

particular pension plan represents. The variable component of the premium is based

on the unfunded vested benefit which reflects the degree of underfunding of the

pension plan. However, the premium rate is not higher for a company that has a low

20

Stephen Boyce and Richard A. Ippolito, “The Cost of Pension Insurance,” The Journal

of Risk and Insurance, vol. 69, no. 2, pp. 121-170.

CRS-11

credit rating or a pension plan that has a marked mismatch between its assets and

liabilities. The PBGC premium structure may encourage “moral hazard”.21 A

company could make its workforce promises for higher pensions instead of paying

higher wages, then file for bankruptcy and transfer the pension obligation to the

PBGC. The Boyce and Ippolito article notes that the moral hazard resulting from

higher risks not being charged appropriate premiums was not taken into account in

determining the underpricing of PBGC premiums. Presumably the estimate of

underpricing would be even greater than 50% had moral hazard been taken into

account.22

A better analogy to the PBGC might be a state insurance guaranty fund. State

insurance guaranty funds are established for the protection of insurance

policyholders. They are administered by the states and funded by assessments on

insurers. Upon insolvency of an insurer, the insurers that are members of the state’s

guaranty association assess themselves proportionate to their premium volume in the

state to fund the difference between the insolvent company’s assets and the residents’

claims. Upon liquidation of a property-liability insurer, responsibility for payment

of claims is transferred to the state’s guaranty association. Upon liquidation of a life

insurer, the state’s guaranty association sells or transfers its insurance policies to

another life insurer.23

Unlike the PBGC, a state’s guaranty fund does not actually contain monies until

an insurer has become insolvent and participating insurers are assessed their share of

the shortfall from the insolvent insurer. To date, state guaranty funds have not had

the same financial problems as the PBGC. This is because a state’s control over an

insurance company’s finances is greater than the PBGC’s control over funding of a

pension plan. In addition to monitoring that adequate premiums are being charged

for insurance premiums, a state can intervene when an insurance company faces

financial problems. When a state’s insurance commissioner determines that the

insurer is financially troubled, he can order the insurer to suspend business. If he

believes that the insurer’s problems cannot be corrected, he can petition for an order

of liquidation. The PBGC on the other hand cannot perfect a lien to force an

employer that has filed for Chapter 11 reorganization to make pension contributions

that are required under minimum funding rules. Typically, an underfunded pension

21

“Moral hazard” is a term used in the insurance industry to characterize a premium

structure that does not appropriately reflect the risk presented by certain policyholders and

therefore encourages disproportionate enrollment by these policyholders. The result is

losses for the insurer that must be corrected by a revised premium structure. In the worst

case, the result is insolvency of the insurer.

22

Not everyone believes that PBGC premiums are too low for the risks that it covers.

Christopher W. O’Flinn, Chairman of the ERISA Industry Committee, in his Sept. 15, 2003

testimony indicated that the use of conservative discount rates may be resulting in the

overstatement of PBGC liabilities and excessive PBGC premiums. The testimony was given

before the Subcommittee on Financial Management, the Budget and International Security,

Committee on Governmental Affairs, United States Senate.

23

See CRS Report RL32175, Insurance Guaranty Funds, by Carolyn Cobb for further

information.

CRS-12

plan of a company on the verge of bankruptcy becomes far more underfunded by the

time the plan terminates.

Prognosis for the PBGC

Many of the older airline pension plans were adequately funded in 1999. Yet

they are all significantly underfunded today. The airline industry can serve as an

example of how fast profit conditions can deteriorate for an industry. Some say that

the auto industry may be next in line.24 The credit ratings of the auto companies have

been worsening, with the rating for General Motors, the biggest of the autos, standing

at just above junk bond status. These companies have expensive defined benefit

pension plans with low funded ratios. The autos face continued pressure on their

profit margins as a result of global competition as well as the prospect of expensive

redesign to meet new emission controls that may be established by major states.

Because of the risks to its long-term financial viability, the GAO has placed the

PBGC single-employer program on its high-risk list of agencies with significant

vulnerabilities to the federal government.

The PBGC does not release cash flow projections from its stochastic PIMS

model. However, estimates were recently released by an independent non-partisan

organization called The Center on Federal Financial Institutions (COFFI) based on

deterministic modeling of the cash flows from PBGC’s single-employer program.25

While results from a stochastic model are more detailed and would have been

preferable, the COFFI analysis has been useful in providing rough order of magnitude

numbers and furthering debate and discussion on issues facing the PBGC. Some of

the major conclusions from COFFI’s analysis are:

Under COFFI’s base scenario, PBGC’s single-employer program

will run out of cash in 2020 or 2021.26 By way of comparison, the

Social Security fund is expected to run out of cash in 2042. PBGC’s

own stochastic modeling shows a less than 10 percent chance that

the program will deplete its assets by 2020. However, according to

the PBGC such “tail events” can and do happen. The PBGC’s large

surpluses of the late 1990s and its record deficits of the early 2000s

were scenarios with a less than 10 percent chance of occurring.

! In order to return PBGC to solvency, while honoring new claims

from underfunded pension plans, it would be necessary to transfer

$78 billion from taxpayers to the PBGC.

!

24

“Pension Tension,” The New York Times, Aug. 8, 2004

25

See PBGC: Updated Cash Flow Model from COFFI, at [http://www.coffi.org].

26

The base scenario assumes new claims from underfunded pension plans at $2.7 billion

each year (the level assumed in PBGC’s PIMS model), incoming PBGC premiums starting

at the 2004 level of $1.5 billion and grading down to the historical average of $900 million

per year, and an annual investment return of 5.2% consistent with the predominantly bond

portfolio held by the PBGC.

CRS-13

The taxpayer rescue amount would rise from $78 billion to $95

billion if in addition to claims assumed in the base scenario, there

were claims from plan terminations of all the legacy airlines. As a

basis for comparison, we note that the bailout of the Savings & Loan

federal insurance program (S&L) in 1989 cost taxpayers $200

billion in today’s dollars.

! Shutdown of the PBGC program without any new claims or any new

premiums would still require a taxpayer transfer of $30 billion.27

While legislation could be enacted to shut the PBGC to new claims,

this could be difficult since employees in firms that had paid PBGC

premiums would expect to be protected with respect to vested

guaranteed benefits earned to date.

!

COFFI’s analysis also quantifies alternatives to taxpayer transfers for solving

the PBGC problem. These include raising PBGC premiums or earning a higher rate

of return on the assets held by the PBGC. Large increases in premiums may be

untenable since they may cause the healthiest plans to drop out of the program.

Earning a higher rate of return may be possible in some years by investing a larger

proportion of assets in volatile investments such as stocks, but the resulting mismatch

with PBGC’s liabilities could ultimately result in lower returns on account of the

need to liquidate assets in a down market to meet cash flow needs. During 2004,

PBGC adopted a new investment policy that will increase investments in fixed

income securities and reduce the percentage of assets invested in equities to 15% 25% of total invested assets. The investment policy will reduce balance sheet

volatility arising from a mismatch between assets and liabilities.

Many observers note that the prognosis for the PBGC is not good. Several

leading Congressional members have announced their intention to move aggressively

on legislative solutions in the 109th Congress.

Policy Issues and Congressional Action

The GAO in its 2003 report on the PBGC’s single-employer program made

several suggestions for improving the long-term financial health of the program.28

The Bush Administration made reform proposals in 2003 for accurate measurement

of pension liabilities, increased transparency of pension plan information, and

improved safeguards against deterioration of pension plan funding.

Pension underfunding in financially troubled companies is concentrated in

industries subject to global competition such as the steel, airline, and auto industries.

Some believe that PBGC insurance for pensions may have, in many instances, turned

27

This amount is $7 billion greater than PBGC’s fiscal 2004 deficit. According to COFFI,

the difference of $7 billion is attributable to a difference in treatment of future expenses.

The COFFI model includes future expenses associated with the payment of claims, whereas

under generally accepted accounting principles, the PBGC is not allowed to take all future

expenses into account in determining the liability.

28

GAO-04-90, Single-Employer Pension Insurance Program Faces Significant Long-term

Risks.

CRS-14

out to be insurance for reorganizing in a globally competitive environment and that

the solutions to strengthen PBGC’s finances should be examined in this light.29

Various bills were introduced in the 108th Congress with the goal of improving

the financial condition of PBGC’s single-employer program. The various proposals

for strengthening PBGC’s single-employer program can be categorized as follows:

Strengthen Funding Rules for Pension Plans. GAO suggestions

include restricting sponsors with low credit ratings from using their Funding

Standard Account credit balances for reducing contributions, limiting lump sum

distributions from severely underfunded pension plans, and raising the level of tax

deductible contributions.

A key element of the Administration proposal is that pension contributions

would be determined by using interest rates for discounting pension benefits taken

from a corporate bond yield curve (a graph that plots the interest rates on bonds that

mature at different dates in the future). This would ensure that the calculation of

pension liabilities is more accurate than the current practice of using the same

discount rate for all future payments regardless of when they occur. Sponsors of

plans with older workforces would probably be required to increase pension

contributions under this proposal. Small employers are also concerned about this

proposal on account of the added complexity it would entail. The Administration

also proposes that companies with below investment grade ratings whose plans are

severely underfunded would have to immediately fully fund or secure any new

benefit improvements, benefit accruals or lump sum distributions.

The

Administration has put forth several other reform principles that would also have the

effect of strengthening pension funding.

The Pension Rights Center has suggested that companies not be allowed to use

pension assets for payment of non-pension benefits such as retiree health benefits or

to merge underfunded and overfunded pension plans.

The National Employee Savings and Trust Equity Guarantee Act of 2004, S.

2424, provided that an employer with a below-investment grade rating and plan

assets valued at less than 50% of current liability would have its plan frozen and

could not improve benefits or pay lump sums. It was approved by the Senate Finance

Committee in September 2003 but not acted on by the Senate.

Restructure PBGC Premiums. The GAO has noted that the current fixedrate premium of $19 per participant has not been changed since 1991 and indexing

it to the rate of CPI increase might be appropriate. The variable-rate premium could

be restructured based on the risk posed by different plans. Different variable-rate

premiums could be charged depending on the financial strength of the plan sponsor,

asset-liability mismatch, participant demographics, and the plan’s benefit structure,

e.g., whether the plan has a lump sum option.

29

Remarks of David Walker, Comptroller General of the United States, at COFFI Policy

Forum, Nov. 19, 2004

CRS-15

Improve Transparency of Information. The Administration proposes that

the Summary Annual Report furnished by employers to plan participants include the

plan’s termination liability in addition to its current liability. The Administration

also would like information collected by the PBGC under Section 4010 for the plan’s

termination liability to be made public.

The House version of the Appropriations bill for fiscal 2005 for Labor-Health

and Human Services-Education, H.R. 5006, was approved in September 2004. The

version would have repealed the ERISA provision that bars the PBGC from releasing

to the public information it receives under ERISA Section 4010 (e.g., the plan and

sponsor financial information that must be filed when a plan is more than $50 million

underfunded). The Senate Appropriations Committee approved its version of this

bill, S. 2810, in September 2004. However, this version did not include any changes

to ERISA Section 4010. The Fiscal Year 2005 Consolidated Appropriations Act

(P.L. 108-447); signed by the President into law in December, 2004, did not include

any changes to ERISA Section 4010 either.

The ERISA Industry Committee recommends that the PBGC disclose analyses

of the long-term projections of its cash flow as well as its funded status (assets

divided by liabilities) under various scenarios.30

Change Bankruptcy Law. Under current law, the PBGC is not allowed to

perfect a lien to force a company that is in bankruptcy reorganization to make

required minimum pension contributions. The PBGC would like the authority to do

this so that plans do not become even more underfunded by the time they terminate.

Reduce Disparity between Executive and Non-Executive Benefits.

H.R. 5292, introduced in October, 2004, would have prohibited employers from

paying or promising nonqualified deferred compensation31 to executive officers or

directors for five years following a shift in pension liabilities to the PBGC during

bankruptcy.

Review Cash Balance Regulation. The regulatory climate for cash

balance plans32 is highly uncertain. Employers have indicated that unless favorable

30

Testimony of Christopher W. O’Flinn, Chairman of the ERISA Industry Committee, on

Sept. 15, 2003 before the Subcommittee on Financial Management, the Budget and

International Security, Committee on Governmental Affairs, United States Senate.

31

Nonqualified deferred compensation plans are benefit plans offered to executives that

allow them to defer part of their compensation for payment at a later date, often with

compounding at attractive interest rates. These plans do not have the same tax advantages

as qualified pension plans offered to rank and file employees.

32

Cash balance pension plans combine the characteristics of both traditional defined benefit

pension plans and defined contribution pension plans. Like a traditional defined benefit

pension plan, the employer has control over the investment of pension assets. Employees

are provided periodic statements of amounts accumulated in their accounts, as for a defined

contribution pension plan. Employees usually have the option of receiving a lump sum

distribution from the plan when they leave the employer. For more information, see CRS

(continued...)

CRS-16

regulations are issued, they may be forced to terminate their cash balance plans in

favor of defined contribution plans. Cash balance plans tend to be sponsored by large

employers and are generally well funded. Termination of cash balance plans in large

numbers would leave the PBGC in a more vulnerable position.

The doubling of the PBGC deficit from fiscal 2003 to fiscal 2004, has

heightened awareness of the PBGC deficit situation. Representative Boehner,

Chairman of the House Committee on Education and the Workforce, Senator Gregg,

Chairman of the Senate Health, Education, Labor, and Pension Committee, Senator

Grassley, Chairman of the Senate Finance Committee, and Senator Baucus, ranking

Democrat on the Senate Finance Committee are among those that have announced

their intention to move aggressively on legislative solutions in the 109th Congress.33

32

(...continued)

Report RL30196, Pension Issues: Cash Balance Plans by Patrick J. Purcell.

33

“Pension Agency’s Deficit Hits Record,” Washington Post, Nov. 16, 2004; “PBGC Incurs

Fiscal 2004 $12.1 Billion Loss, Record $23.3 Billion Deficit, Congress to Act,” Pensions

& Benefits Daily, Nov. 16, 2004; “Grassley, Baucus Say PBGC Finances Highlight Need

for Pension Law Reforms,” Pensions & Benefits Daily, Nov. 16, 2004.

CRS-17

Glossary of Terms — Table 1

Assets — PBGC’s investable assets for the single employer program, consisting of

premium revenues, assets from terminated pension plans and assets recovered from

their sponsors.

Liabilities — The present value of net guaranteed benefits with respect to

underfunded terminated plans as well as the estimated present value of net

guaranteed benefits for probable plan terminations. The interest rate used to calculate

the present value is determined by the PBGC such that along with the assumed

mortality table, it reflects the cost to purchase an annuity.

Net Position — Excess of assets over liabilities.

Benefit Payments — Benefits paid by the PBGC to retirees and beneficiaries in

trusteed plans.

Reasonably Possible Exposure — Potential loss to the PBGC from underfunded

pension plans of sponsors experiencing financial problems. This amount excludes

the potential losses from pension plans that the PBGC believes will be probably

terminated in the foreseeable future.