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Remarks by Bradley D. Belt to the American Institute of Certified Public Accountants

Remarks by

Bradley D. Belt
Executive Director, Pension Benefit Guaranty Corporation
to the American Institute of Certified Public Accountants
Washington, DC

I want to begin my remarks today with a discussion of the Pension Benefit Guaranty Corporation-what we do, why you've been reading about us in the papers, and what we're doing to address the challenges facing the pension insurance program. I also will touch upon the role that financial accounting standards for pensions have played in leading to these challenges.

PBGC is really two businesses operating under one roof. We provide financial guaranty insurance covering 44 million workers and retirees in return for insurance premiums paid by plan sponsors, and we manage our asset base to provide life annuities to the beneficiaries of terminated pension plans. Unfortunately, we face both a clear shortfall in premiums relative to the risk posed by plan sponsors and a significant deficit between the assets we hold in trust and benefits we have promised to pay. The good news is that PBGC has the resources to continue paying benefits for several years; the bad news is that we do not have the ability under current law to meet our long-term obligations, and needed reforms grow more costly the longer we wait to implement them.

How did we get here?

The Pension Benefit Guaranty Corporation came into being following the passage of the Employee Retirement Income Security Act (ERISA) in 1974, with the purpose of providing financial guaranty insurance to participants in defined benefit pension plans sponsored by private sector employers. The expectation was that PBGC would provide the layer of protection needed to make good on guaranteed benefits that were not fully funded by plan sponsors. The funding rules enshrined in ERISA were intended to make sure that such losses were small. So optimistic were the authors of ERISA that losses could be easily shared across the sponsor population that they set the initial insurance premium at $1 per year per plan participant.

In hindsight, we now know that the basic "business model" and funding rules were flawed from inception. Although PBGC began its existence with a clean balance sheet, it was inevitable that some plan sponsors would fail with less than fully funded plans, requiring PBGC to take over the assets and liabilities of the plans - and book the difference as a net loss. But over the past three decades more than 3,600 plans have been taken over by the PBGC, and our balance sheet has grown dramatically. Today PBGC has 1.3 million beneficiaries, almost $80 billion in present-valued liabilities, and a $23 billion dollar negative net position. In fact, we have experienced a $30 billion swing in our net position over the past four years. And, the risk of further losses continues. We recently reported a record $108 billion exposure to "reasonably possible" claims, which is the amount of pension underfunding in plans sponsored by companies with less-than-investment-grade credit ratingas. Systemwide, the total funding gap necessary to settle liabilities in the private sector is more than $450 billion.

It is now apparent that the original expectation for ERISA's funding rules-that they would result in plans being fully funded across time-has gone unfulfilled. Some of this has been the result of investment choices and market fluctuations (some would like to place all the blame on the so-called "perfect storm"), but much of the problem has been the result of flaws in the structure of the funding rules themselves. Let me be clear-while a substantial majority of pension plans are underfunded, most of the funding gaps are modest in relation to the capabilities of the sponsoring companies to meet their obligations. Let me also be clear-the funding rules are broken. Companies would not be able to terminate pension plans with fewer than half the assets necessary to cover promised benefits if the rules worked. Companies would not be terminating pension plans with a $10 billion funding gap, as was the case with United Air Lines, if the rules truly required full funding of pension promises.

Simply put, the current funding rules allow, even encourage, companies to chronically underfund their pension plans, effectively borrowing on a no-cost basis from their employees; they encourage companies to avoid putting cash into pension plans when it serves other business interests (and, notwithstanding the fact that the funding gap may be widening); and they encourage companies to shift costs to workers and retirees, to other responsible plan sponsors, and possibly to taxpayers.

Reforming the System

To address these flaws, the Administration earlier this year proposed a package of reforms designed to better protect workers' pensions and substantially improve the long-term prospects of the pension insurance system. There were three key components: strengthening plan funding rules to ensure that benefit promises made to employees are properly secured; pricing premiums fairly to disincentivize risky behavior; and providing greater transparency in the system for all stakeholders-beneficiaries, sponsors, shareholders and regulators.

Apart from the legal and moral mandate to honor promises made, as the President stated last week, well-funded pension plans are essential to the long-term viability of the pension insurance system. Plan funding rules are currently based on the concept of "current liability," which properly reflects the ongoing nature of most businesses that sponsor plans but fails to account for the significant changes to projected cash flows when a sponsor is likely to terminate a pension plan. PBGC's experience shows that plans following the "letter of the law" have often terminated in a severely underfunded state. This was the case with our largest claims to date, United and Bethlehem Steel. To address these flaws, the Administration proposed to require companies to fully fund their pension plans over a reasonable period of time (seven years), to improve the measurement of assets and liabilities, to use a yield curve to discount liabilities, and to close the loopholes that have allowed companies to take long "contribution holidays."

The premium system is also overdue for reform, having remained unchanged for more than a decade despite the surge in costly plan failures. The current premium structure falls short in three ways: first, it does not adequately compensate the insurance program for the risks and costs assumed; second, it fails to provide an effective disincentive for financially risky behavior; and third, it can only be adjusted by legislation. The key is to balance the incentive structure (i.e., higher cost for higher risk) with the need to spread risk across all plan sponsors (as with any insurance system, all the insured must pay something). However, the imbalance in the current system is reflected by the fact that United paid less than $100 million in premiumsbefore saddling the insurance program with almost $7 billion in losses.

The pension system is critically short of transparency. Both ERISA and the accounting principles generally accepted in the United States (GAAP) seem designed to obfuscate reality when it comes to pensions. Pension accounting and ERISA disclosures are inadequate to allow investors, beneficiaries and regulators to make informed judgments about the health of pension plans. This lack of useful information prevents stakeholders from effectively exercising their informed self-interest and allows risk to build in the system unobserved. The principal comprehensive source of publicly available information filed by plan sponsors is generally more than two years old. The PBGC receives more timely information regarding the funded status of pension plans, but current law prohibits such information from being made publicly available. That is unacceptable. There is very little information filed in so-called 4010 reports that is inherently of a confidential business nature-the costs to the company of settling its pension liability certainly is not.

Congress is now considering legislation based on the reform framework laid out by the Administration earlier this year. The Senate recently passed its reform bill, S. 1783, by a 97-2 vote. Prospects are less certain in the House, but there appears to be some possibility that it will take up its reform bill, H.R. 2830, later this week. Both these measures contain important needed reforms, but there are also provisions that represent a step back from current law-that would perpetuate the practices that have led to the termination of more than 3,600 underfunded pension plans and the $23 billion deficit in the federal insurance program. The Administration is committed to working with the Congress in the weeks ahead to enact legislation that protects American workers' pensions. While we need to carefully balance competing stakeholder interests, as the President stated last week, the end result must be legislation that strengthens the funding rules relative to current law.

The Role of Accounting Standards

While changes to ERISA are vitally important, the critical role that pension accounting standards have played in leading us to this point must also be acknowledged. Many of the problems in the defined benefit system over the past few years are the result of a broad failure to understand the impact of a defined benefit pension plan on the corporate income statement and balance sheet. Many experts believe the accounting standards governing pensions have contributed to the problem. GAAP accounting does not consolidate the pension plan on the balance sheet, and many investors have long been accustomed to seeing the pension plan's impact only through an annual entry on the income statement. This is like looking through the wrong end of the telescope-massive liabilities that will accrue over many decades are ignored in favor of the tiny piece of the total that rolls across the income statement each year. It has been almost impossible to gain a real understanding of a pension plan's net position on an accrual, or present valued, basis.

For many years there was little reason to care. Strong investment returns through most of the 1980s and 1990s allowed pension plans to become a source of net income rather than a use of it. Think about this for a moment-we are talking about employee compensation, which is an expense. Companies have to cut checks each and every year for other forms of employee compensation-for wages, for health care, for defined contribution plans. Yet, through the alchemy of accounting standards for pensions, a cost item was magically converted to a profit center.

In addition, because the gains on equity-heavy portfolios consistently outpaced the growth in liabilities resulting from declining interest rates, sponsors were happily ignorant of the asset-liability mismatch risk they were running. In this area particularly, our accounting regime has encouraged riskier behavior by allowing plan sponsors to book expected returns on assets immediately while amortizing real volatility over time. It is only natural that, in such a regime, plan sponsors would operate with a bias towards volatile assets with higher long-term expected returns. Imagine this concept in other contexts-being able to book revenues from annual sales of 100 widgets, which is what you expected based on historical patterns, even if you actually sold just 50 widgets because of a down-turn in the economy or you were undercut by a new competitor with better products.

With the popping of the equity bubble and the drop in interest rates post-9/11, the illusion of stability vanished. As it was, investors were shocked to discover that pension plans could result in a charge to corporate income. Had they been able to see a more accurate picture of pension plans' net position on an accrual basis, the picture would have included a very large gap on many balance sheets as well. Investors are increasingly aware of the impact pension underfunding and asset-liability mismatches can have on the plan sponsor, and analysts have begun sharpening their pencils and digging into the pension accounting in search of a clearer picture. ("Turning the telescope around," if you will.)

Now, as this audience is aware, in recognition of some of the problems associated with current pension accounting, the Financial Accounting Standards Board (FASB) has voted to undertake a two-phased project to make pension information "more useful and transparent for investors, creditors, employees, and other users." The first phase would simply get the full liability on the balance sheet. The second phase would deal with how pension gains and losses flow through the income statement.

I commend FASB chairman Bob Herz and the board for undertaking this critically important initiative. It is an important complement to needed changes to ERISA. By all accounts, it will also be a contentious and controversial initiative. But the cacophony of voices calling for change is becoming deafening. The Securities and Exchange Commission, in its off-balance-sheet (OBS) report issued earlier this year, noted that "accounting for [defined benefit] pension plans deviates from the accounting required for other businesses and compensation arrangements, even when the economics are similar." The Commission's deputy chief accountant characterized the numbers derived under Statement of Financial Accounting Standards (FAS) No. 87 as "meaningless." David Zion of Credit Suisse First Boston (CSFB), who has written extensively about pension accounting issues, observes that "the current accounting results in financial statements that are misleading." And, as former SEC chairman Arthur Levitt noted in a Wall Street Journal op-ed last month, "over the past three decades, we have allowed a system of pension accounting to develop that is a shell game, misleading taxpayers and investors about the true fiscal health of ... companies-and allowing management to make promises to workers that saddle future generations with huge costs."

Where then is the controversy? Well, the principal bones of contention apparently stem from two related concerns espoused by plan sponsors and actuaries. The first is a stated desire for greater predictability, the implication being that greater transparency and using actual market-based values to measure the funded status of pensions will lead to greater unpredictability. The second is that pensions are long-term obligations and thus, the argument goes, should somehow be treated differently (not only from short-term, but also other long-term, obligations). I would like to spend a few moments addressing each of these arguments, as they arise in both the financial accounting standards and ERISA debates.

On the issue of "predictability," some sponsors argue that if they aren't able to "smooth" assets and liabilities, they will be buffeted by volatile financial statements and contribution requirements-they won't be able to plan effectively. I would like to make several observations on this issue.

Smoothing is a polite way of characterizing the masking of the underlying risks and volatility of pensions. The proposed changes to the ERISA funding rules, and similar changes to accounting standards, would not introduce risk and volatility-rather, they would expose what is already there. The volatility is wholly a function of the asset allocation and benefit decisions made by the sponsor.

There is no legitimate rationale for smoothing inputs-how assets and liabilities are measured. If there is a desire to bound the volatility of pension contributions, it can be done on the back-end. Furthermore, asset prices and interest rates from four or five years ago have no bearing on values today or in the future. This is akin to driving down the highway at high speeds looking only in the rear-view mirror-one shouldn't be surprised if one occasionally goes over a cliff or runs into a brick wall.

Of course, if predictability is the primary business objective of a sponsor, then there are mechanisms available under current law to provide it. Pensions aren't any different than other planning decisions faced daily by corporate CFOs and treasurers. The uncertainty about future equity prices and interest rates is similar to that faced by airline executives with regard to future fuel prices, by auto manufacturers with regard to the cost of commodity inputs such as steel, or by multinational companies with regard to currency fluctuations. Companies routinely make decisions to lock in prices today or to assume the risks that future prices will be more, or less, favorable.

It is also worth noting that the Administration's proposals would provide for a "smoother" contribution path than under current law for many companies. The Administration would allow companies seven years to meet their funding target. Under current law, however, companies under the deficit reduction contribution (DRC) rules could be required to fill the funding gap in as little as 3-4 years.

Finally, it is important to recognize that the current smoothing features of both the financial accounting standards and ERISA mean that investors and participants are making decisions based on misleading information. As the Commission noted in its OBS report, "the complex series of smoothing mechanisms, and the disclosures to explain them, render financial statements more difficult to understand and reduce transparency." On the ERISA side, smoothing allows widening funding gaps to be hidden from the view of participants, and it allows companies to avoid putting cash into plans when it is most needed.

The other argument advanced by some plan sponsors to justify maintaining the status quo is that pensions are long-term obligations and, thus, should be treated differently. This is used to make the case for high rate-of-return assumptions, for discounting liabilities at other than the risk-free rate, and for not fully funding plans. Again, a couple of observations come to mind.

First, accrued benefits under a pension plan are an operating expense, not a capital expense. Like wages, health care, vacation and other benefits, pension benefits are part of the operating costs of a business. For companies that sponsor defined benefit plans, pension obligations are created when the benefits are earned, notwithstanding the fact that employees must wait to receive the benefits until a later point in time during retirement. While the benefit payments are not made until some point in the future, in economic terms already accrued pension benefits represent an obligation incurred by the company for services rendered in the past.

Second, the premise that pensions are necessarily long-term obligations and that both the sponsoring company and its plans will remain ongoing is a questionable one. The fact is that there have been 160,000 standard terminations of pension plans over the past 30 years. And there have been more than 3600 terminations of underfunded pension plans, including 120 last year. Plant closures or lay-offs may also accelerate benefit obligations that were assumed to be long-term - but don't turn out to be.

We are at an inflection point with regard to defined benefit plans. Under current law, we have seen a steady erosion of the defined benefit system over the past three decades, as well as increased losses in the pension insurance program, and enormous costs being shifted to workers and potentially taxpayers. Flawed funding rules and accounting standards have contributed to the challenges facing the defined benefit system, plan sponsors, and the federal pension insurance program. The notion that maintaining the status quo will save the defined benefit system, restore the insurance program to solvency, and best protect workers and taxpayers is seriously misguided. Just as we are in the process of convergence with regard to International Accounting Standards (IAS) and GAAP, there also needs to be greater convergence between the FAS and ERISA worlds. There needs to be a better connecting of the dots between the financial statements and the funding requirements of ERISA. It is these funding requirements that ultimately dictate the future call on a company's cash flows. Accountants, actuaries, financial analysts, and policymakers need to speak a common language when talking about pension finances. We're starting down that path and it's one we need to stay on in order to best protect the interests of shareholders, plan participants, and all stakeholders in the pension system.