Testimony of Bradley D. Belt
Executive Director
Pension Benefit Guaranty Corporation
Before the Committee on Finance
United States Senate

Just a little over three months ago, my colleagues, Assistant Secretary of the Treasury for Economic Policy, Mark Warshawsky, and Assistant Secretary of Labor for the Employee Benefits Security Administration, Ann Combs, and I appeared before this Committee to discuss the challenges facing the defined benefit pension system and the pension insurance program, as well as the Administration’s proposals for meeting these challenges. In a supplement to this testimony, I again describe in detail why comprehensive pension reform is so urgently needed and how the Administration’s comprehensive reform proposal will stabilize the defined benefit system, strengthen the insurance program, and protect the retirement benefits earned by tens of millions of American workers. I also address the claims made by some commentators regarding the Administration’s proposals.

For this hearing, you have asked what lessons can be learned from the United Airlines pension situation. As discussed more fully below, United offers important, albeit painful, lessons that illustrate the flaws in current law and which should guide us in reforming the defined benefit system and pension insurance program.

But first, I would like to briefly highlight new information and marketplace developments in the three months since the last hearing that amplify the growing pressures on the insurance program and provide further evidence why the comprehensive reform measures proposed by the Administration should be enacted as promptly as possible.

The most recent source of information about the financial status of certain pension plans comes from 4010 reports that are required to be filed by companies with pension plans underfunded by more than $50 million. The filing deadline for most companies is April 15, and PBGC has now aggregated the information from those reports. While the number of companies required to file such reports grew only modestly, the amount of underfunding reported by the 4010 filers grew by 27 percent as compared to a year ago – from $279 billion to $354 billion. These 1,108 plans covering 15 million workers and retirees had $786.8 billion in assets to cover over $1.14 trillion in liabilities, for an average funded ratio of 69 percent.

Fortunately, not all of that underfunding is in plans sponsored by weak companies. Still, as I stated in my prior testimony, at the end of fiscal year 2004, PBGC estimated that non-investment grade companies sponsored pension plans with combined underfunding of $96 billion, almost three times as large as the amount recorded at the end of fiscal year 2002. We anticipate that this number will increase significantly by the end of fiscal year 2005 due to growing underfunding in financially weak companies. I would also note that PBGC has approximately 350 active bankruptcy cases, a record for the agency, 36 of which have been opened in the past four months. Of the open cases, 37 have underfunding claims of $100 million or more, including six in excess of $500 million.

And, the growing financial challenges being faced by certain companies and industry sectors are a subject of almost daily coverage in the nation’s newspapers. We have previously testified about the extent of pension funding problems faced by the “legacy” carriers in the airline industry. In addition to the potential $10 billion in total losses from US Airways and United, the other legacy carriers – Delta, Northwest, American, and Continental – have plans with total underfunding of $22 billion. Losses continue – in first quarter earnings reports, Delta reported a loss of $1.1 billion, Northwest a loss of $458 million, Continental a loss of $184 million, and American a loss of $162 million. Delta has publicly warned that the company may have to consider bankruptcy. If it does, it may follow United and US Airways and seek to terminate its defined benefit pension plans.

The pension insurance program also faces substantial exposure from other industries, the largest of which is the automotive sector. Assets of pension plans sponsored by this industry fall short of pension promises by $55-$60 billion. Credit rating agencies in May downgraded the debt of General Motors and Ford to below investment-grade status. While the manufacturers have substantial liquidity, their financial problems may cascade down to other companies in the automotive industry. For example, some auto supply firms have had their credit lines restricted because of the downgrades in the debt ratings of General Motors and Ford. At least a dozen auto suppliers’ credit ratings have been downgraded to below investment-grade status. More significantly, half a dozen automotive parts suppliers have filed for bankruptcy in recent months – three of them since the last Committee hearing. These bankrupt companies sponsor defined benefit plans with more than $800 million in unfunded pension obligations that would become a loss to the pension insurance system should those companies’ plans terminate during their bankruptcies.

I would now like to turn to the focus of this hearing – the implications of the proposed United pension plan terminations for the stakeholders in the defined benefit system. In my view, there are two broad lessons stemming from the United pension situation.

The first lesson is that the current funding rules are demonstrably flawed. Simply put, they have failed to ensure that companies make good on the commitments they make to their workers and retirees. Indeed, the funding rules even allow companies to make new benefit promises when their plans do not have enough assets to meet existing obligations. United, US Airways, Bethlehem Steel, LTV, and National Steel would not have presented claims in excess of $1 billion each – and with funded ratios of less than 50 percent – the rules worked. Given its size and visibility, United provides an illustrative, if tragic, case study of the shortcomings of the current funding rules.

Provided below are four charts covering United’s four pension plans from 1996 to 2003. During the period from 2000 onward, when the true funded status of each of the company’s pension plans was deteriorating and the financial health of the company was becoming more precarious, the company:

Yet these companies still could claim that their plans were “fully funded” on a current liability basis.

This rosy picture is clearly in contrast with what we know to be the true status of the United plans – currently with an aggregate shortfall of almost $10 billion and an aggregate funded ratio of only 41 percent. There are several aspects of the current funding rules that contributed to this disaster scenario, but I would single out two in particular, which were also noted in GAO’s report released last week.1

One is the use of so-called credit balances. Just at the point in time when contributions to the plans were most needed as asset values were falling and liabilities growing, the company was able to use credit balances built up during the 1990s bull market to avoid putting cash into the plans. Remarkably, notwithstanding the fact that the United pilots plan is underfunded by almost $3 billion, the company has not made, and has not been required to make, a cash contribution to that plan for the years 2000 through 2004 (and none would have been required until the end of this year). Some have argued that without credit balances, companies will have no incentive to make more than the required minimum contribution during good times. As discussed more fully in the supplement to my testimony, we believe the Administration’s proposal provides ample incentives to appropriately fund pension plans.

The other aspect of the funding rules that merits mention is the ability to “smooth” assets and liabilities. (Plans can smooth assets over 5 years and can smooth liabilities based on a four-year weighted average interest rate.) Those who want to retain these mechanisms argue that it is necessary to reduce volatility. But, of course, the volatility isn’t reduced, it is simply masked – hidden from the view of participants. The smoothed asset and liability calculations not only allowed companies to report a distorted funded ratio, it also enabled them to avoid the deficit reduction contribution (DRC) requirements, the variable rate premium, and the notice to participants. I would emphasize that these issues are hardly unique to United Airlines.

The second lesson is that the termination of underfunded pension plans adversely affects stakeholders in the defined benefit system. It can have particularly harsh consequences for workers and retirees. Their expectations of a secure future may be shattered, because in underfunded plans not all promised benefits are guaranteed. While United employees, in the aggregate, should receive about 80 percent of their accrued pension benefits, they could still lose more than $3 billion in accrued benefits and would not accrue any future benefits that they had been counting on receiving. Many United employees, especially pilots, would be hard hit by the maximum guarantee limit.

Other companies that sponsor defined benefit plans also pay a price through higher premiums. Because the PBGC receives no federal tax dollars and its obligations are not backed by the full faith and credit of the United States, losses suffered by the insurance fund must, under current law, be covered by higher premiums. Not only will healthy companies be subsidizing weak companies with underfunded plans, they may also face the prospect of having to compete against a rival firm that has shifted a significant portion of its ongoing labor costs onto the government. This is clearly at issue in the airline industry. The CEOs of the legacy carriers have publicly stated that this scenario will give United an unfair advantage and may cause them to seek to terminate their pension plans.

Finally, taxpayers are at risk of being called upon to bail out the pension insurance program if losses continue to mount.

Mr. Chairman, the Administration is committed to strengthening the pension insurance program and keeping defined benefit plans as a viable option for employers and employees. This requires a careful balancing of interests and inevitably will require trade-offs among various stakeholder interests. We believe the Administration proposal strikes an appropriate balance and will best protect the pension benefits earned by workers and retirees, minimize the need for future premium increases, and lessen the possibility that taxpayers will have to be called upon to rescue the insurance program.

Footnotes

¹ United States General Accountability Office, “Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in Funding Rules” GAO-05-294, p. 22 (May 2005). Back to Text



Supplement to Testimony: Challenges Facing the Defined Benefit System and Pension Insurance Program and the Administration's Proposals for Meeting Those Challenges

Introduction

Private-sector defined benefit plans have been and are intended to be a source of stable retirement income for more than 44 million American workers and retirees. Unfortunately, as I discuss more fully below, the defined benefit system is under severe stress – the number of defined benefit plans has fallen precipitously over the past two decades, the percentage of the workforce covered by such plans has dropped by half, and, in many cases, benefits are being frozen or the plans are being closed to new participants.

More ominously, there have been a growing number of instances in which plans have been terminated by their sponsors with assets far insufficient to pay the promised benefits. This results in lost benefits for a number of participants in those plans, threatens the long term financial solvency of the insurance program, requires sponsors that have acted responsibly to pay higher premiums, and potentially could lead to a call for a rescue of the program with taxpayer funds.

I would emphasize that this has occurred under the current statutory and regulatory framework. In order to stop the hemorrhaging in the system, to put the insurance program on a sound financial footing, and to best protect the benefits of millions of workers and retirees, the Administration believes that comprehensive pension reform is critically needed. If we do nothing or merely tinker at the margins the inevitable outcome will be a continued erosion of this important retirement security leg and continued large losses for participants, premium payers and potentially taxpayers.

State of the Defined Benefit System

Traditional defined benefit pension plans, based on years of service and either final salary or a flat-dollar benefit formula, provide a stable source of retirement income to supplement Social Security. The number of private sector defined benefit plans reached a peak of 112,000 in the mid-1980s. At that time, about one-third of American workers were covered by defined benefit plans.

In recent years, many employers have chosen not to adopt defined benefit plans, and others have chosen to terminate or freeze their existing defined benefit plans. From 1986 to 2004, 101,000 single-employer plans with about 7.5 million participants terminated. In about 99,000 of these terminations the plans had enough assets to purchase annuities in the private sector to cover all benefits earned by workers and retirees. In the remaining 2,000 cases, companies with underfunded plans shifted their pension liabilities to the PBGC.

Of the roughly 30,000 defined benefit plans that exist today, many are in our oldest, most mature industries. These industries face growing benefit costs due to an increasing number of retired workers. Some of these sponsors also face challenges due to structural changes in their industries and growing competition from both domestic and foreign companies.

In contrast to the dramatic reduction in the total number of plans, the total number of participants in PBGC-insured single-employer plans has increased. In 1980, there were about 28 million covered participants, and by 2004 this number had increased to about 35 million. But these numbers mask the downward trend in the defined benefit system because they include not only active workers but also retirees, surviving spouses, and separated vested participants. The latter three categories reflect past coverage patterns in defined benefit plans. A better forward-looking measure is the trend in the number of active participants, who continue to accrue benefits. That trend is moving downward.

In 1985, there were about 22 million active participants in single-employer defined benefit plans. By 2002, the number had declined to 17 million. At the same time, the number of inactive participants has been growing. In 1985, inactive participants accounted for only 28 percent of total participants in single-employer defined benefit plans, a number that has grown to about 50 percent today.

In a fully advance-funded pension system, demographics wouldn’t matter. But when $450 billion of underfunding must be spread over a declining base of active workers, the challenges become apparent.

 

The decline in the number of plans offered and workers covered doesn’t tell the whole story of how changes in the defined benefit system are impacting retirement income security. There are other significant factors that can undermine the goal of a stable income stream for aging workers.

For example, in lieu of outright termination, companies are increasingly “freezing” their plans. Surveys by pension consulting firms show that a significant number of their clients have frozen their plans or are considering instituting some form of plan freeze1. Freezes not only eliminate workers’ ability to earn additional pension benefits but often serve as a precursor to plan termination, which further erodes the premium base of the pension insurance program2.

Given the increasing mobility of the labor force, and the desire of workers to have portable pension benefits that do not lock them into a single employer, many companies have developed alternative benefit structures, such as cash balance or pension equity plans that are designed to meet these interests. The PBGC estimates that these types of hybrid structures now cover 25 percent of participants in defined benefit plans3. Unfortunately, the legal status of these types of plans is in question, further threatening the retirement security of millions of workers and retirees4.

The Role of the PBGC

The Pension Benefit Guaranty Corporation (PBGC) was established by the Employee Retirement Income Security Act of 1974 (ERISA) to guarantee private-sector, defined benefit pension plans. Indeed, the Corporation’s two separate insurance programs—for single-employer plans and multiemployer plans—are the lone backstop for hundreds of billions of dollars in promised but unfunded pension benefits. The PBGC is also the trustee of nearly 3,500 defined benefit plans that have failed since 1974. In this role, it is a vital source of retirement income and security for more than 1 million Americans who would have lost benefits without PBGC’s protection, but who currently are receiving or are promised benefits from the Corporation.

PBGC is one of the three so-called “ERISA agencies” with jurisdiction over private pension plans. The other two agencies are the Department of the Treasury (including the Internal Revenue Service) and the Department of Labor’s Employee Benefits Security Administration (EBSA). Treasury and EBSA deal with both defined benefit plans and defined contribution benefit plans, including 401(k) plans. PBGC guarantees benefits of defined benefit plans only and serves as trustee for underfunded defined benefit plans that terminate. PBGC is also charged with administering and enforcing compliance with the provisions of Title IV of ERISA, including monitoring of standard terminations of fully funded plans.

PBGC is a wholly-owned federal government corporation with a three-member Board of Directors—the Secretary of Labor, who is the Chair, and the Secretaries of Commerce and Treasury.

Although PBGC is a government corporation, it receives no funds from general tax revenues and its obligations are not backed by the full faith and credit of the U.S. government. Operations are financed by insurance premiums, assets from pension plans trusteed by PBGC, investment income, and recoveries from the companies formerly responsible for the trusteed plans (generally only pennies on the dollar). The annual insurance premium for single-employer plans has two parts: a flat-rate charge of $19 per participant, and a variable-rate premium of 0.9 percent of the amount of a plan’s unfunded vested benefits, measured on a “current liability”5 basis.

The PBGC's statutory mandates are: (1) to encourage the continuation and maintenance of voluntary private pension plans for the benefit of participants; (2) to provide for the timely and uninterrupted payment of pension benefits to participants; and (3) to maintain premiums at the lowest level consistent with carrying out the agency’s statutory obligations. In addition, implicit in these duties and in the structure of the insurance program is the duty to be self-financing. See, e.g., ERISA § 4002(g)(2) (the United States is not liable for PBGC’s debts).

These mandates are not always easy to reconcile. For example, the PBGC is instructed to keep premiums as low as possible to encourage the continuation of pension plans, but also to remain self-financing with no recourse to general tax revenue. Similarly, the program should be administered to protect plan participants, but without letting the insurance fund suffer unreasonable increases in liability, which can pit the interests of participants in a particular plan against the interests of those in all plans the PBGC must insure. The PBGC strives to achieve the appropriate balance among these competing considerations, but it is inevitably the case that one set of stakeholder interests is adversely affected whenever the PBGC takes action. This conflict is most apparent when PBGC determines that it must involuntarily terminate a pension plan to protect the interests of the insurance program as a whole and the 44 million participants we cover, even though such an action may adversely impact participants in the plan being terminated.

The pension insurance programs administered by the PBGC have come under severe pressure in recent years due to an unprecedented wave of pension plan terminations with substantial levels of underfunding. This was starkly evident in 2004, as the PBGC’s single-employer insurance program posted its largest year-end shortfall in the agency’s 30-year history. Losses from completed and probable pension plan terminations totaled $14.7 billion for the year, and the program ended the year with a deficit of $23.3 billion. That is why the Government Accountability Office has once again placed the PBGC’s single employer insurance program on its list of “high risk” government programs in need of urgent attention.

Notwithstanding our record deficit, I want to make clear that the PBGC has sufficient assets on hand to continue paying benefits for a number of years. However, with $62 billion in liabilities and only $39 billion in assets as of the end of the past fiscal year, the single-employer program lacks the resources to fully satisfy its benefit obligations.

The most recent snapshot taken by the PBGC finds that corporate America’s single-employer pension promises are underfunded by more than $450 billion. Almost $100 billion of this underfunding is in pension plans sponsored by companies that face their own financial difficulties, and where there is a heightened risk of plan termination.

Of course, when the PBGC is forced to take over underfunded pension plans, we will provide the pension benefits earned by workers and retirees up to the maximum amounts established by Congress. Unfortunately, notwithstanding the guarantee provided by the PBGC, when plans terminate many workers and retirees are confronted with the fact that they may not receive all the benefits they have been promised by their employer, and upon which they have staked their retirement security. In an increasing number of cases, participants lose benefits that were earned but not guaranteed because of legal limits on what the pension insurance program can pay. It is not unheard of for participants to lose two-thirds of their promised monthly benefit.

For example, a steelworker in the Bethlehem Steel plan, like many other steelworkers, started working just before his 20th birthday. He worked until he was 50 years old and retired, like many other steelworkers, under his plan’s 30-and-out provision with a $3,600 per month pension. About 6 months later, the PBGC trusteed the Bethlehem Steel plan. Although the maximum monthly benefit for plans terminating in 2003 was about $3,600, we are required by law to reduce the maximum benefit for workers who start receiving their pension benefits before age 65. As a result, this worker’s benefits were cut by two-thirds to about $1,200 per month.

Other companies that sponsor defined benefit plans also pay a price when underfunded plans terminate. Because the PBGC receives no federal tax dollars and its obligations are not backed by the full faith and credit of the United States, losses suffered by the insurance fund must ultimately be covered by higher premiums. Not only will healthy companies that are responsibly meeting their benefit obligations end up making transfer payments to weak companies with chronically underfunded pension plans, they may also face the prospect of having to compete against a rival firm that has shifted a significant portion of its labor costs onto the government.

In the worst case, PBGC’s deficit could grow so large that the premium increase necessary to close the gap would be unbearable to responsible premium payers6. If this were to occur, there undoubtedly would be pressure on Congress to call upon U.S. taxpayers to pay the guaranteed benefits of retirees and workers whose plans have failed.

If we want to protect participants, premium payers and taxpayers, we must ensure that pension plans are adequately funded over a reasonable period of time. As I will discuss in more detail, the status quo statutory regime is inadequate to accomplish that goal. We need comprehensive reform of the rules governing defined benefit plans to protect the system’s stakeholders.

Mounting Pressures on the Pension Safety Net

These broad defined benefit trends, and financial market and business cycles, combined with flawed funding rules, have translated into severe financial pressures on the pension insurance program. In addition to the $23 billion shortfall already reflected on the PBGC’s balance sheet, the insurance program remains exposed to record levels of underfunding in covered defined benefit plans. As recently as December 31, 2000, total underfunding in the single-employer defined benefit system came to less than $50 billion. Two years later, as a result of a combination of factors, including declining interest rates and equity values, ongoing benefit payment obligations and accrual of liabilities, and minimal cash contributions into plans, total underfunding exceeded $400 billion7. As of September 30, 2004, we estimate that total underfunding exceeds $450 billion, the largest number ever recorded.

 

Not all of this underfunding poses a major risk to participants and the pension insurance program. Indeed, the vast majority of companies that sponsor defined benefit plans are financially healthy and should be capable of meeting their pension obligations to their workers. At the same time, the amount of underfunding in pension plans sponsored by financially weaker employers has never been higher. As of the end of fiscal year 2004, the PBGC estimated that non-investment-grade companies sponsored pension plans with $96 billion in underfunding, almost three times as large as the amount recorded at the end of fiscal year 2002.

The losses incurred by the pension insurance program to date have been heavily concentrated in the steel and airline industries. These two industries, however, have not been the only source of claims, nor are they the only industries posing future risk of losses to the program.

The PBGC’s best estimate of the total underfunding in plans sponsored by companies with below-investment-grade credit ratings and classified by the PBGC as “reasonably possible” of termination is $96 billion at the end of fiscal 2004, up from $35 billion just two years earlier. The current exposure spans a range of industries, from manufacturing, transportation and communications to utilities and wholesale and retail trade. Some of the largest claims in the history of the pension insurance program involved companies in supposedly safe industries such as insurance ($529 million claim for the parent of Kemper Insurance) and technology ($324 million claim for Polaroid).

Some have argued that current pension problems are cyclical and will disappear once equity returns and interest rates revert to historical norms. Perhaps this will happen, perhaps not. The simple truth is that we cannot predict the future path of either equity values or interest rates. It is not reasonable public policy to base pension funding on the expectation that the unprecedented stock market gains of the 1990s will repeat themselves. Similarly, it is not reasonable public policy to base pension funding on the expectation that interest rates will increase dramatically8. The consensus forecast predicted that long-term interest rates would have risen sharply by now, yet they remain near 40-year lows.9. And a recent analysis by the investment management firm PIMCO finds that the interest-rate exposure of defined benefit plans is at an all-time high, with more than 90 percent of the exposure unhedged10.

More important, while rising equity values and interest rates would certainly reduce the amount of current underfunding, this would not address the underlying structural flaws in the pension insurance system.

How Did We Get Here?

Unfortunately, the current problems in the system are not transitory, nor can they be dismissed as simply the result of restructuring in a few industries. They are the result of fundamental flaws in the statutory and regulatory framework governing defined benefit plans and the pension insurance program. If we want to retain defined benefit plans as a viable option for employers and employees and avoid insolvency of the insurance program, fundamental changes are needed.

The defined benefit pension system is beset with structural flaws that undermine benefit security for workers and retirees and leave premium payers and taxpayers at risk of inheriting the unfunded pension promises of failed companies.

The first structural flaw is a set of funding rules that are needlessly complex and fail to ensure that pension plans are adequately funded. Some companies that have complied with all of the statutory funding requirements have still ended up with plans that are less than 50 percent funded when they terminated.

A second structural flaw is what economists refer to as “moral hazard.” Unlike most private insurers, the PBGC cannot apply traditional risk-based insurance and premium methods.

A third flaw is the lack of information available to stakeholders in the system. The funding and disclosure rules seem intended to obfuscate economic reality. The PBGC’s record deficit and the historic levels of pension underfunding underscore these structural defects – flaws that must be corrected to better protect workers’ benefits, responsible plan sponsors from further premium increases, and taxpayers from being called upon to rescue the pension insurance program.

Weaknesses in Current Funding Rules

The current defined benefit pension funding rules, which micromanage annual cash flows to the pension fund, are in need of a complete overhaul. Current rules are needlessly complex, don’t reflect economic reality, and don’t ensure that plans become well funded. Some of the pressing problems with the funding rules are described below.

 

Several failed pension plans provide cases in point for the structural defects in the current funding rules. Bethlehem Steel’s plan was 84 percent funded on a current liability basis, but turned out to be only 45 percent funded on a termination basis, with a total shortfall of $4.3 billion. Despite these funding levels, for a number of years prior to termination, Bethlehem Steel was not required to make a deficit reduction contribution, and for the three years immediately preceding termination it relied on credit balances to avoid making contributions.

 

Bethlehem Steel Termination Benefit Liability Funded Ratio 45% Unfunded Benefit Liabilities $4.3 billion

PLAN YEAR 1996 1997 1998 1999 2000 2001 2002 Current Liability Funding Ratio 78% 91% 99% 96% 86% 84% NR Was the company required to make a deficit reduction contribution? Y N N N N NR NR Was the company obligated to send out a participant notice?