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Remarks by Bradley D. Belt at the Federal Reserve Bank of Chicago's 2005 Bank Structure Conference

Remarks by

Bradley D. Belt, Executive Director

Pension Benefit Guaranty Corporation

for a Panel Discussion on Public, Private and Personal Pension Funds

at the Federal Reserve Bank ofChicago's

41st Annual Conference on Bank Structure and Competition


It is a delight to be in Chicago on non-business matters. There is a lot of intellectual firepower here, and I expect to learn a great deal. I would like to discuss some of the issues that we are dealing with in Washington, and I suspect we will have a very robust panel discussion afterwards.

I want to make three general observations. First, the broader issue we are confronting is retirement security. We have an aging population. Have we set aside enough resources to meet our future obligations and commitments? I think it is fairly clear that the answer is "no." Neither as a nation nor as individuals have we begun to tackle the looming fiscal and demographic challenges. David Walker, the head of the U.S. Government Accountability Office, talks about the fact that Social Security, Medicare, Medicaid, the Pension Benefit Guaranty Corporation, and a host of other programs have close to $50 trillion in unfunded obligations and contingent liabilities. That is an extraordinary number that defies imagination, but we have to begin to deal with it. The retirement security mechanisms in this country - Social Security, occupational pensions, and individual savings - are inadequate to provide a secure retirement for our citizens in their elder years.

The President is committed to this issue. For the first time, an administration has taken on the task of trying to strengthen the financial vitality of each element of our retirement security system. He's put forth a Social Security plan to deal with the system's $4 trillion of underfunding over the next 75 years and, over the so-called infinite horizon, the $11 trillion of underfunding. He's put forward a plan to deal with underfunding of defined benefit plans. He's put forward proposals to strengthen personal savings. We need to address all of those in a cohesive and coordinated fashion if we're to make any progress. But the bottom line is beginning to fund these obligations that we've taken on.

The second issue, and one a little closer to home for me, is private pensions, particularly defined benefit plans. Defined benefit plans are a critical element of the retirement security fabric. As has been noted, 44 million Americans participate in a defined benefit plan. If you look at those 44 millions as households with family members and dependents, defined benefit plans really matter for a significant portion of the American populace. They're also critically important given the fact that they are one of the principal mechanisms, along with Social Security, for managing longevity risk, in contrast to defined contribution plans and individual retirement savings accounts. One of the big risks that isn't easily hedged is outliving one's resources. Studies show that people systematically underestimate the amount of time that they're going to spend in retirement.

I was recently out on the west coast at a conference sponsored by the Milken Institute dealing not only with pension issues but also with a broad set of issues related to health care. There were some DNA and gene-splicing experts, and they said we are really on the cusp of a new paradigm. Within the next half century we may be living 10-20 years longer than we are now. That good news raises new questions. Have we set aside enough resources to meet our current life expectancies, let alone future gains in longevity? For example, one of the biggest financial risks facing pension plans and the PBGC is a cure for cancer. It would be great news, but it would also significantly extend life expectancy, thus increasing the cost of defined benefit promises.

The third broad point I want to make is that the PBGC's decisions are having an increasing impact on Americans' financial lives. I've already talked about the fact that what we do matters for the retirement security of, potentially, 44 million Americans. It certainly matters for the flight attendants, machinists, and pilots at United Air Lines and their counterparts at U.S. Airways. It matters for workers at steel companies like LTV, Weirton, and National, and other companies like Polaroid and Kemper Insurance. All of these companies sponsored pension plans that have terminated or are in the process of being terminated. Those employees will no longer accrue any additional retirement benefits. In many cases, because of statutory limits, they are going to see cutbacks in their benefits, which can be very substantial.

So, the decisions we make matter for participants. They also matter for the financial survivability of major U.S. companies. We have seen that not just with individual companies but also with entire industry sectors: steel, airline and, looming just over the horizon, autos. Some say PBGC's problems are yesterday's problems and are restricted to steel and Air Lines. Indeed, 70-75 percent of our claims throughout our history have come from those two industry sectors. I hope that it will be limited to those two, but I don't believe that to be the case. For instance, last year we had $31 billion of exposure to the airline industry but nearly $50 billion of exposure to the auto sector. And we have already seen that when the original equipment manufacturers, the big three, catch a cold, it's the auto part suppliers and others in the system that catch the flu. We have already had bankruptcy filings from some of these companies. We are concerned that, without changes in economic conditions, the trend will continue.

Pensions matter not only for companies in individual industry sectors but also for the capital markets as a whole. This is a little further afield from what you typically look at in terms of the banking sector, but banks are major creditors to many of these companies. You look at the debtor-in-possession lenders to United Air Lines and it's J.P. Morgan Chase and others. They all have a substantial economic stake in this. Equity investors tend to get wiped out in these situations, but bondholders are also at risk. And indeed, the decisions we are making affect the fixed income market in fairly profound ways. You may have noticed that when the administration released its proposal back in January and we announced that the PBGC was allocating $7.5 billion to long-duration fixed-income strategies, that roiled the long end of the yield curve. There is a growing demand for fixed income securities as companies start to look at more prudently managing their assets and liabilities not only through reallocation of their assets but through a variety of hedging strategies as well. They are looking for long-duration assets and there hasn't been a lot of supply to meet the expected demand, but that may be changing. France recently issued a 50-year bond. BNP Paribas introduced a new product called the Longevity Bond. And, the Treasury Department announced this week that it's considering reissuing the 30-year note. So these issues are now front-and-center, mainly for unfortunate reasons.

I want to briefly touch upon three questions that we're confronting: Where are we now? How did we get here? What do we do about this?

Where are we now? We're dealing with a defined benefit system that is in long-term structural decline. From a peak of about 112,000 defined benefit plans about 20-some years ago, today we insure fewer than 30,000 single-employer plans and a couple of thousand multiemployer plans. The percentage of the work force covered by defined benefit plans has declined fairly substantially, from more than 40 percent to less than 20 percent of the active work force. There are a lot of things going on below the surface, as well. Companies increasingly are freezing their plans. That means different things in different situations but, in many cases, participants stop accruing any further benefits. They are freezing the defined benefit plans and then offering perhaps a defined contribution plan as a supplement. Many other companies are simply closing the plan to new entrants. There also have been shifts from traditional defined benefit plans to what is known as a hybrid structure like a cash balance plan. Unfortunately, those have been thrown into legal limbo because of a court decision involving IBM.

The defined benefit system is slowly but steadily eroding and my concern is that, without any changes in law, those trends will continue and may even accelerate. We have to change the fundamental structure governing defined benefit plans if there is any hope of arresting that decline and making it legally, economically and operationally viable for a company to offer its employees some type of defined benefit plan on a going-forward basis. There are also extraordinary pressures being placed on the pension insurance program. The PBGC has a $23 billion deficit. We also announced that we were facing total system underfunding of $450 billion, about $100 billion of which is in plans sponsored by companies whose credit quality is below investment grade. That's an increase from $10 billion just two years ago. So there is a substantial amount of contingent liability out in the system that we have to be concerned about.

How did we get here? A multitude of reasons, but I would point mainly to three. First, pensions operate under a flawed set of funding rules that demonstrably do not work. We're supposed to have this comprehensive regulatory framework under the Employee Retirement Income Security Act (ERISA) that is intended to ensure that companies prudently fund their pension plans. But what have we actually seen? In the case of United Air Lines, their pension plans are underfunded by almost $10 billion. They've complied with all these ERISA rules and regulations, but they're underfunded anyway. Some of the other largest claims against the pension insurance program came from plans that were, on average, 40-50 percent funded, with hundreds of millions of dollars or billions of dollars of unfunded liability when they terminated. How can that be if we have rules in place that are designed to ensure that companies have prudently funded their plans? Obviously, the rules aren't working.

One very interesting concern with respect to the Government Sponsored Enterprises and other companies is smoothing earnings. Some executives in the corporate community may end up in jail because of that, but it's an accepted practice and part of the law with respect to pensions. We must reduce perverse incentives built into the system. Any insurance system lends itself to moral hazard. What you want to do is have a number of mechanisms put in place to minimize that moral hazard. I would argue that most of the incentives in the pension insurance program run the other way.

The next, perhaps most important and least understood, point is transparency. This whole system is a study in obfuscation with respect not only to the ERISA rules but also accounting standards dealing with pensions. Investors, participants and even regulators have far too little information to understand the risks that are inherent in the system. We need to change that. The bottom line is that sunlight is the best disinfectant and, rather than imposing onerous new regulations on plan sponsors, we need to make this whole system much more transparent. If companies want to take on more investment risk through the pension plan, that is their decision to make. But we should ensure that investors and participants understand that risk, that it is transparent, and that it is appropriately priced. The President's proposal addresses these fundamental flaws.

Now there's another element to all of this and it's cost. The bottom line is we have a $23 billion deficit. We likely will be taking on substantial additional claims in the future. Who is going to pay for those losses? Under current law, the PBGC is supposed to be self-financing. It receives no general revenues and does not have the full faith and credit backing of the United States government. It is financed by the premiums paid by the plan sponsors. Unsurprisingly, plan sponsors aren't interested in paying for the misjudgments, misfortune, mistakes, and mismanagement of their brethren, and they've resisted any significant premium increases. We've been collecting, over the last 10 years, about $1 billion in premium revenue per year on average. We've had a $30 billion swing in net position in just the last three years. Expected claims are likely to run into the billions. That's not a sustainable business model. At the end of the day we're going to have to confront the issue of "Who pays?". We need to deal with that issue now, because the last thing we want is another S&L crisis. I don't know if it's just bad karma on my part, but I was counsel to the Senate Banking Committee back in the late 1980s and early 1990s. I had the great good fortune of working on passage of FIRREA and FDICIA, creating the RTC, and issuing REFCorp and FICO bonds.* The policy of forbearance did not work then, and I don't think it's going to work here, so we need to step up to the plate and make the hard decisions now.

I appreciate your time and attention and the opportunity to be here. Thank you.

* FIRREA references the Federal Institutions Reform, Recovery and Enforcement Act of 1989. FDICIA references the Federal Deposit Insurance Corporation Improvement Act of 1991. The RTC was the Resolution Trust Corporation, created by FIRREA to address the savings and loan crisis. REFCorp bonds were bonds issued by the Resolution Funding Corporation (REFCorp) from 1989 to 1991 as part of the RTC's initial funding. FICO bonds were bonds issued by the Financing Corporation (FICO), which was established in 1987 for the sole purpose of financing a recapitalization of the Federal Savings and Loan Insurance Corporation.