In 1974 Rep. John Erlenborn (R-Ill.), one of the principal architects of that year’s pension reform legislation, argued in vain against setting up a government agency to insure pension benefits. He offered two objections: first, that empirical studies showed that participant losses from plans that terminated without being able to pay all benefits were insignificant (less than one percent of participants lost anything, and the present value of their average loss was $2,500); second, that an insurance program would create a mechanism for companies to run up large unfunded liabilities, then dump them into the lap of the federal government, giving an impetus to precisely the kind of behavior that ERISA’s minimum funding standards aimed to forestall.
Hardly anybody listened back then. Nowadays Rep. Erlenborn’s points are conventional wisdom, confirmed by the $23.3 billion deficit shown in the Pension Benefit Guaranty Corporation’s financial statement for fiscal 2004. The Wall Street Journal has called the PBGC “The Next S&L Crisis” [link for on-line subscribers only]:
The big problem is that the agency, by insuring private pension plans, has created its own moral hazard. Essentially, PBGC is writing a put option for which any private plan that is not fully funded is in-the-money; therefore, exercising the put by dumping liabilities onto the PBGC is attractive. Ultimately, of course, the put is written by taxpayers to the tune of tens of billions of dollars.
This slow motion train wreck is almost a perfect re-enactment of the thrift crisis in the 1980s. Back then, the government kept trotting out short-term fixes that deepened the problem until, finally, the thrift industry collapsed, presenting taxpayers with a $200 billion bill. Republicans in Congress are now promising a comprehensive overhaul early next year. They don’t have a moment to spare.
There is a mild degree of exaggeration here. Thanks to patches enacted in 1987, a plan sponsor can exercise its “put option” only if it is bankrupt – not the most attractive of financial strategies. Furthermore, the size of the deficit is somewhat overstated. The PBGC values its liabilities using interest rates of 4.8 to 5.0 percent, compared to 6.5 to 7.5 percent commonly used for FAS 87 valuations in the private sector. A valuation at a standard interest rate would lop several billions off the deficit (though one could counter-argue that FAS 87 assumptions are too sanguine). In any event, PBGC insolvency is not imminent. It has $39 billion in assets and cash outflow equal to only 25 percent of income. The Journal quotes a prognostication, “At the current pace of pension plan takeovers, PBGC could run out of money in 16 years.” Interestingly, when I headed the agency’s Policy and Regulations Department in the mid-1980’s, our staff prepared an estimate of how long the insurance program’s funds would last if then-existing trends continued. The answer was 16 years. That was 18 years ago.
Still, whether or not the PBGC is destined for a future bailout approximating the savings and loan industry’s, its situation promises no good cheer and demonstrates that “moral hazard” is not merely an economist’s shibboleth. In 1974 pension insurance looked like a cheap way to deal with a petty problem. The cure has, however, aggravated the disease.
The disease is conspicuous in many of the plans that wind up on the PBGC’s books. While I was there, we had several cases in which companies and unions had collaborated to hike pension benefits and minimize funding, on the overt understanding that a de facto government guarantee made that a risk-free course of action.
Minimum funding standards were not much of an obstacle. The original ERISA standards were based on traditional actuarial concepts, whose objective was to spread the cost of the plan equitably over the working lives of participants, not to ensure solvency at any particular moment. One noteworthy example of how strangely minimum funding could work was a termination in which plan assets were three percent of the value of liabilities, yet the plan’s funding standard account had a significant credit balance.
Amendments to the funding standards make a recurrence of that experience unlikely, but the price has been great volatility in required contributions, which is such a burden that Congress regularly lightens it for troubled industries. At the moment, airline and steel companies are enjoying a semi-holiday from “deficit reduction contributions”, which eases the strain on their cash flow but heightens the PBGC’s exposure. The government is gambling that this step will stave off insolvency, at the risk of bigger losses if it doesn’t.
At this point, not much can be done to mitigate the losses that the insurance program has already realized, except to invest terminated plans’ assets as profitably as possible. To limit the further growth of the deficit, the conventional wisdom, as put forward by the WSJ and many others, is yet more stringency in imposing and enforcing minimum funding standards, a remedy that has already been tried and hasn’t worked. We can’t expect elected officials to ignore pleas for amelioration from the very plan sponsors whose financial condition is most perilous. Moreover, the sponsors’ arguments are not necessarily frivolous. Making a near-bankrupt company double or triple contributions to its pension plans is not unlike prescribing vigorous exercise for a heart patient; his health will be better in the long run, if the regimen doesn’t kill him first.
Since not even the Wall Street Journal’s editorialists suggest it, I presume that there is no sentiment for phasing out the PBGC and will leave that option unexplored. Instead, I should like to suggest an indirect approach to improving the program’s future prospects, based on reducing exposure rather than trying to bludgeon employers into a policy of instantaneous full funding of all benefits.
1. Restore the freedom to reclaim surplus pension assets by reinsuring liabilities. Only a few years ago, almost all large pension plans were overfunded. A major part of my professional work consisted of advising sponsors on how to gain some economic benefit from surplus assets. That was a difficult task, because ERISA restrictions and punitive excise taxes make it uneconomical to recover the surplus directly. The ironic effect is to increase, rather than diminish, the risks to the PBGC.
Before 1986, a company could obtain a reversion of plan assets in excess of the value of liabilities at the price of paying an insurance carrier to assume responsibility for all benefits. The plan’s assets and liabilities effectively vanished from the purview of the PBGC, and the plan started over with no surplus or deficit. To the PBGC the reduction in exposure was unambiguously advantageous, since it would never run the risk of having to shoulder the reinsured liabilities at some future point when the assets supporting them might have diminished.
Many plans that have terminated during the past few years were once overfunded, sometimes heavily so. Had their sponsors been able to draw down their surpluses back then, at the same time transferring their liabilities to insurance companies, both their own financial situations and the PBGC’s would now be better. Alas, Congress succumbed to ignorant demagoguery in the late 1980’s and cracked down on what Senator Howard Metzenbaum (D-Ohio) called “pension raids”. Weak-minded Republicans like Howard Baker and Bob Dole supinely went along. The result was worse-funded plans and a weaker PBGC. Restoring the status quo ante would help stanch future bleeding. It would also bring in short-term tax revenue, since reversions to the employer are taxable income.
2. Allow plan sponsors to eliminate lump sum distribution options and subsidized early retirement benefits. Largely through Senator Dole’s efforts, Congress in 1984 enacted draconian restrictions on employers’ ability to alter their plan designs. It was made almost impossible to get rid of an optional form of benefit once it had been offered or to reduce early retirement benefits that exceeded the value of the plan’s normal retirement benefit.
The prohibition against eliminating lump sum options has had a particularly deleterious impact. Thanks to other rules, this form of benefit is invariably more valuable than the normal retirement benefit, and it tends to be very popular with departing employees. Its availability drastically shortens the duration of the plan’s liabilities, aggravating underfunding at any particular moment. Worsening the problem is the fact that financially troubled companies tend to have the highest rate of employee terminations. Quite a few plans have undergone severe asset drains from this cause shortly before being terminated and turned over to the PBGC. In theory, the PBGC can force participants to restore their lump sums and accept annuities instead, but that is scarcely a practical recource.
Under present law, underfunded plans are not allowed to pay lump sums to the employer’s 25 highest paid employees. That rule ought to be extended to all participants or should at least be a permissible plan amendment. Fewer lump sum payouts would also be sound retirement policy; many workers are not especially well served by the receipt of a big chunk of cash that they are tempted to spend right away and may be ill-equipped to invest for the rest of their lives.
The same principle applies to early retirement benefits, which tend to swell the liabilities of companies that are reducing their work forces. It is true that workers’ expectations would sometimes be disappointed by such take-aways, but the same individuals have the most to lose when their employers are driven into bankruptcy by inability to pare pension costs. What’s more, subsidized benefits usually disappear when the PBGC assumes responsibility for a plan (it ignores subsidies in providing benefits to post-termination retirees), so the promise is frequently a toxic illusion.
3. Remove the barriers to cash balance plans. Cash balance pension formulae, where benefits are expressed as lump sum amounts rather than lifetime annuities, have become a liberal bête noir for irrational reasons that I won’t debate at length here. What I wish to point out is that funding a cash balance plan on a sound basis is easier than funding a traditional defined benefit plan.
The value of liabilities expressed in the traditional form fluctuates with interest rates. The promise of $n a year for life is “worth” a lot more at a five percent than an eight percent interest rate. The upshot is that funding requirements can be volatile, all the more so if one of the goals of the funding standards is to ensure full funding at all times.
In a cash balance plan, by contrast, the value of liabilities is the starting point, not a derivative from the benefit formula. A fully funded plan whose investment results meet its actuarial assumptions cannot abruptly plunge into an underfunded status simply because interest rates decline, nor can higher rates in and of themselves produce the appearance of sound funding.
Reduced volatility in funding requirements is desirable for plan sponsors and, by leading to a steadier accumulation of plan assets, indirectly helps the PBGC.
These measures are not a complete solution. There is probably no way to construct a fully viable pension insurance scheme. They would, however, limit the severity of the PBGC’s future problems. Without these or other reforms, we can be certain that its exposure and realized claims will steadily grow, until comparisons to the savings and loan debacle will no longer be far-fetched at all.
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