Knowledge@Emory Newsletter – September 8, 2004 – Entire Article

Will Corporate Pension Plans Implode?

United Airlines retirees got an unpleasant surprise recently when their former employer filed court papers indicating that it might seek to shed some or all of its $13 billion defined-benefit pension obligations as part of a bid to emerge from bankruptcy. But the taxpaying public itself may also be in for a shock if other airlines try to bail out of their pension plans in a bid to remain competitive with United—and if the federal Pension Benefit Guaranty Corporation (PBGC), which is already running a multi-billion-dollar deficit, has to take over the plans and fund them with billions of taxpayer dollars. The problem behind the apparent crisis is multi-layered, according to professors at Emory University’s Goizueta Business School and other experts. They say the causes include financial assumptions, accounting rules, and government regulations; and note there’s no single, simple solution. Further, unless politicians show more backbone, industries are likely to lurch from one pension crisis to another, putting retirees at risk and threatening taxpayers with the prospect of another Savings & Loan-style bailout.

United Airlines retirees would be the first to suffer if the PBGC does take over the plan, since the annual defined benefits of many retirees will be subject to lower limits—currently a maximum of $44,386 a year under PBGC payout guidelines—and this amount only applies to maximum age and service retirees. For these people and plenty of others—including Bethlehem Steel retirees, which terminated its plan, and Lucent Corp., where retirees are seeking better information on the health of their pension fund—one part of the American Dream is turning into a bad dream.   Many retirees thought their pensions were fully protected by the PBGC, but the reality is that they are only protected to a degree.  If  they were expecting pensions larger than the maximum payout, they will need to adjust accordingly.  If they retired early or accepted an “early out” package from their employer, the PBGC payout may be only a fraction of their expected pension.  Of course it’s no thrill ride for taxpayers in general either, who may be left holding the bill.

Political pressure may have sapped regulatory defenses
“Pension plan sponsors were allowed to invest in risky assets, to fall behind on contributions; and the Financial Accounting Standards Board—FASB, which sets accounting standards—bowed to political pressure and signed off on pension reporting rules that artificially inflated the funding and misrepresented the cost to shareholders,” says George J. Benston, a professor of economics, finance, and accounting at Emory and Goizueta, who is conducting research on pensions  “Companies wanted to push off their pension obligations to the future, but the future has arrived. If United Airlines succeeds in unloading its pension plan onto the PBGC, it’s likely that other airlines will seek to do the same; and well-run companies and taxpayers will be the ones to foot the bill.”

Benston says the Congress has made this situation worse with the Pension Funding Equity Act of 2004.

“It increased the PBGC’s deficit by raising the allowable discount rate, which reduced companies’ reported pension liabilities but not their actual liabilities,” he says.  “In addition, by making the change retroactive to 2003, fully funded pension plans generally did not have to contribute to their pension plans in 2004.  The act also exempts underfunded plans in the commercial airline and steel industries from paying, in 2004 and 2005, all but 20% of the expedited contributions that are required when a plan is less than 90% funded.”

An early protection plan goes sour
Of course it wasn’t supposed to turn out like this back in 1974, when the Pension Benefit Guaranty Corporation was created as a federal corporation by the Employee Retirement Income Security Act of 1974 (ERISA). The idea was to safeguard—without placing taxpayer money in jeopardy—the pensions of nearly 44 million workers and retirees in more than 32,000 private defined benefit pension plans. Under the defined benefit model—which is being replaced with 401(k) and other defined contribution plans—companies promised to pay employees a specified monthly benefit at retirement, commonly based on salary, bonuses, and overtime paid in the last years before retirement and years on the job. Unlike a 401(k) plan, employees are not required to make contributions to a defined benefit plan.

As it was originally structured, the PBGC was not going to be funded by general tax revenues; and has so far avoided a taxpayer bailout. Instead it collects insurance premiums from employers that sponsor insured pension plans, it earns money from investments and it receives funds from pension plans it takes over. The problem is that following spectacular failures in the steel and other industries—Bethlehem Steel’s underfunded pension plan alone cost the PBGC $3.6 billion in 2002, while US Airways pilots’ pension plan had a shortfall of about $2.5 billion when the PBGC took it over—and the PBGC itself ran up a $9.7 billion deficit as of March 31, 2004 that threatened its ability to steer clear of subsidies. And published reports note that if United unloads its pension plan onto the PBGC and other airlines follow suit, the government agency could be facing up to $31 billion in liabilities. Benston says that when other companies balk at having to pay much higher premiums to cover the deficit and bring pressure on politicians to bail them out, taxpayers will be tapped to pay off the debt.

It might be tempting to suggest that the PBGC should refuse to take on the liability, but that’s not an option according to Loretta Berg, a Pension Benefit Guaranty Corporation spokeswoman. “We don’t have much discretion when it comes to taking over failed pension plans,” she says, adding that “Companies pay into the system,” and if the pension plan fails and certain conditions are met the PBGC generally has to take it over.

But that’s where things get sticky, according to Benston, who points to a dichotomy.

“Adequate” funding may in fact be inadequate
“Theoretically, sponsor companies are supposed to maintain an ‘adequate’ level of funding for their pension obligations,” he says. “The problem is that the degree of funding is based on a number of assumptions, including the projected rate of retirement, the annual dollar amount of pension obligation for each employee upon retirement, the rate of return on invested pension assets, and the anticipated lifespan of the covered retirees. When some of those assumptions are off, there’s a great potential for a funding crisis like we’re seeing now.”

Benston says the defined benefit pension model became popular around WWII, driven in part by a feeling of paternalism on the part of businesses, and also in part by the increasing clout of unions. Further, when wages were frozen during the war, employers found that pensions were an effective way to get around wage controls as a way to bid for scarce labor.

“Another reason had to do with retaining skilled labor,” notes Benston. “A defined benefit plan is not portable and thus tends to tie an employee to his employer on a long-term basis.”

The foundations of today’s crisis were laid even before interest rate and stock market gyrations played havoc with pension plan funding, according to Benston. Part of the problem was that employees began living longer.

“It’s like Social Security, which was fiscally prudent when it was first introduced in 1935,” relates Benston. “It promised benefits after retirement at age 65 at a time when the average lifespan was under 64 years; which limited the projected payout. But as people live longer they spend more time in retirement, which means a pension plan, just like Social Security, has to pay out more in benefits.”

In 1950, according to PBGC data, an average male worker spent only 11.5 years in retirement, while by 2000 the span had risen to 18.1 years. The agency adds that medical advances are expected to increase life spans even more in coming years

Funding “safeguards” may be failing
There are some safeguards—like ERISA’s requirement that firms fund their pension obligations “adequately”. But Stephen Brown, a professor of accounting at the Goizueta Business School notes that, “If firms wish to minimize the resources that they are required to transfer to a pension fund, they have an incentive to reduce the reported obligation.” Brown recently authored a paper titled The Impact of Pension Assumptions on Firm Value.

He explains that managers have some discretion in such areas of the discount rate and assumed future compensation rate increases, both of which can significantly affect the reported pension obligation (PBO). The discount rate is the interest rate used to compute the present value of the pension obligation, which, by definition, is not payable until several years in the future. Therefore, managers can reduce the size of the reported PBO by choosing a higher discount rate or a lower assumed rate of increase in compensation.

“Pension funding assumptions typically cover a 15-to-25 year range, and a 1% change in the assumed discount rate can result in a 15% change in the company’s reported pension benefit obligation, thereby affecting the extent to which a company’s pension plan is reported as being adequately funded,” details Brown. “Studies indicate that many firms do use discount rates that are higher than the implied rate of 30-year Treasury Bonds—which have long been used in pension funding calculations—and that they are more likely to use higher rates when the plan's assets are less than the net present value of the promised benefits.”

According to Benston there appears to be plenty of blame to go around.

“This problem has been in the making for decades,” he notes. “And for decades, Congress and regulators like FASB and others have been trying to paper over it with quick fixes. Meanwhile, many sponsor companies placed their pension funds in risky investments or invested heavily in their own stock. We all got lucky in the 1990s when interest rates dropped and the value of pension assets rose—but now our luck appears to have run out.”

Should the PBGC be overhauled?
Benston notes that some characteristics of the Pension Benefit Guarantee Corporation itself may have contributed to the crisis.

“Generally, the cost to the sponsor companies of PBGC’s coverage is based on fixed guidelines,” he observes. “It does not take into account such forward-looking factors as the degree of risk of the sponsor company’s investments.”

The PBGC premium has two parts: a flat-rate charge of $19 per participant, and a variable-rate premium of 0.9% of the dollar amount of a plan's underfunding, measured on a "current liability" basis. But as long as a plan is at the "full funding limit," which generally means 90% of current liability, the sponsor company does not even have to pay the variable-rate premium. That’s why Bethlehem Steel, for instance, paid no variable-rate premium for five years prior to termination, despite being drastically underfunded on a termination basis.

And because there were no penalties—in the form of higher insurance premiums—for investing in risky or volatile securities, sponsor companies were more likely to disregard risk as they sought out higher yields. Of course that raises another question—why wasn’t anyone watching?

The answer’s not as simple as it might appear, and in fact points to what appears to be an additional weakness in the administration of defined benefit pension plans. First, consider the point raised in Brown’s paper that financial reporting incentives likely influence managers' choices of the discount rate and the assumed future compensation rate increases, and hence the reported pension obligation. Even though the chase for higher returns and better P&L results may have gone beyond the level of prudent behavior, regulatory agencies would generally not raise an alarm as long as no laws were violated.

In contrast, Brown finds that equity investors do not accept the reported obligation at face value when there are apparent incentives for managers to mask the size of the obligation. He says the tip-off is the fact that“ typically the value of the assets assigned to the pension plan are insufficient to fully fund the obligation.”

And the very nature of pension reporting may also contribute to the problem. Under ERISA, for example, each plan is required to report its funding status annually on Form 5500 to the Department of Labor. But Brown notes that such important information as the assumed rate of return on plan assets is not required for ERISA reporting purposes. He adds, however, that the assumed rate of return on plan assets affects “only the reported income in the financial statements and does not affect the present funding status of the plan. Consequently, it is of no interest to ERISA. However, the rate is disclosed in footnotes in the financial statements.”

Meanwhile, despite statutory rules about disclosure, many employees who are covered by defined benefit plans say they are not well informed about the state of the underlying funding assets. Under ERISA, the plan administrator must each year give participants a copy of the plan’s “summary annual report,” which captures the financial information reflected on Form 5500 that most plans must file with the Department of Labor.

The current PBGC executive director, Bradley D. Belt, addressed this issue in an August 2004 speech, titled "Strengthening Retirement Security: The Role of Defined Benefit Plans" presented at the 6th Annual Conference of the Retirement Research Consortium. Among other comments he called for “new rules to improve timeliness and completeness of disclosure to workers, markets and regulators, so that decisions affected by the health of a company's plan can be made in a timely fashion.”

Belt also said that plans should also be required to disclose their liabilities annually, accelerate disclosure of plan information to workers, and provide funding-trend data in participant disclosures. Addressing the agency he heads, Belt added that, the PBGC should, “be authorized to publicly release pension underfunding data that is nondisclosable under current law.”

Walter Ehmer, a 67-year old retiree who spent more than 42 years at Lucent Technologies Inc. and its predecessor companies, says he knows first hand that pension disclosure can be opaque to many people, even to accounting professionals. Ehmer was a vice president of optical fiber cable manufacturing when he retired about two years ago, and is now a director of the Lucent Retirees Organization, or LRO.

“Lucent has already cut back on retirees’ medical benefits, causing a great deal of hardship for many senior citizens who are on a fixed income; and now we’re concerned about the underlying strength and safety of our pension plan,” he says. “In an effort to better understand the plan the LRO has hired forensic accountants to dig for information, but the company doesn’t make it easy to get details. We feel like we’re still in the dark about funding levels, investment strategies and other issues.”

Lucent spokesman William Price disputes that, saying that the company has made “all appropriate disclosures and filings.” He adds that the Lucent plan is “adequately funded” and notes that under current regulations and based on current projections, Lucent “is not required and is not allowed to make any contributions through fiscal 2006.”

When it comes to the true state of a pension plan’s funding, Ehmer and the LRO aren’t the only ones who believe they’re out of the loop.

Pension reporting standards may be outdated
In one high-profile case, the Pension Benefit Guaranty Corporation itself was unaware of the level of liabilities at Bethlehem Steel, according to Oct.2003 Senate testimony by the PBGC’s then-executive director Steven A. Kandarian. He says that in the steel manufacturer’s last filing, in 2001 prior to termination, the company “reported that it was 84% funded on a current liability basis. At termination, however, the plan was only 45% funded on a termination basis – with total underfunding of $4.3 billion.”

Apparently the “current liability” disclosed in pension reports doesn't recognize the full cost of providing annuities as measured by group annuity prices in the private market. “If the employer fails and the plan terminates, pension benefits are measured against termination liability, which reflects an employer's cost to settle pension obligations in the private market,” according to Kandarian’s testimony.

Similarly, in another 2001 last filing before termination, the US Airways pilots’ plan reported that it was 94% funded on a current liability basis. Yet at termination it was only 35% funded on a termination basis—with underfunding that totaled $2.2 billion.

Commenting on this, Brown notes that, “Firms certainly do not report a termination liability in the financial statements and, I believe, neither do they have to report this figure to ERISA. So when firms report they are ‘fully’ funded, they mean that plan assets are at least equal to an obligation measured on the assumption that the plan will continue for some time.”

He adds that there are alternate measures of this figure for financial reporting purposes, but the main figure is the one that takes into account anticipated future service and anticipated future increases in compensation rates.

Can the system be repaired?
The defined benefit pension system may be in dangerous territory with retirees and taxpayers at risk, but it could be fixed, say some experts. But any solution is bound to be complicated and will probably be painful.

“It would be great if interest rates dropped and the stock market jumped,” says Benston. “That would solve the funding problems neatly, at least for the short term.”

But he says that any long-term solution would first require a change in pension requirements.

“Congress should repeal the Pension Funding Act, and companies’ liabilities should be calculated with a long-term U.S. Treasury or equivalent risk-free rate,” he explains.  “Pension funds should be invested in assets that match pension liabilities in terms of interest-rate and market risk.  Pension assets and liabilities should be audited and companies that fall short should be assessed a penalty rate sufficient to get them to bring their funds up to full compliance.  There should be greater transparency so that employees, well-run companies, and taxpayers will understand the extent to which there is or might be a problem.”

Finally, he says, the concept of defined benefit plans should go the way of the horse and buggy.

“Individual control like 401(k) plans is the only way to go with this,” he says. “The corporate structure simply allows too much ‘walk away’ room. It could be argued that companies should never be in the business of guaranteeing an employee’s financial retirement future.”

Pamela Perun, an independent consultant on retirement income policy issues who co-authored Reality Testing for Pension Reform with C. Eugene Steuerle of The Urban Institute, says the complexity of pension regulation adds to the problem. For example she notes, the Pension Preservation and Savings Expansion Act of 2003 recently introduced by Representatives Rob Portman and Ben Cardin, “is a massive bill with more than 200 pages and 13 lengthy sections of highly technical changes to employee benefits law.”

Equally important, she advises an increase in pension funding ceilings, which are currently “too low,” and can act as a disincentive to cover a plan’s liabilities.

“Today’s funding ceilings were enacted in the 1980s and 1990s, and were designed to help relieve the budget deficit by restricting corporate tax deductions for pension plan contributions,” she explains. “But although the time is long overdue for change, including a consolidated approach to pensions, it’s questionable whether the political will exists to transform the system.”

But as Benston says, if changes aren’t made, today’s crisis is likely to get worse and the savings and loan disaster of the 1980s is likely to be repeated.