Presentation to the 6th Annual Conference
of the Retirement Research Consortium
by Bradley D. Belt
Executive Director, Pension Benefit Guaranty Corporation
"Strengthening Retirement Security: The Role of Defined Benefit Plans"
I appreciate the opportunity to speak here as the chief executive of the agency charged with insuring the benefits of participants in the nation's private defined benefit pension plans. The conference today is entitled "The Future of Social Security," but the real issue - and it's one that the nation needs to focus on now and in the coming years - is retirement security. While millions of people have for decades been able to rely on Social Security and employer-sponsored pension programs for income security in their retirement years, the interaction of several economic, demographic, fiscal, and regulatory factors has put the financial well-being of current and future retirees at risk. Simply put, our nation's retirement systems - Social Security, defined benefit pensions, and retirement savings accounts such as 401(k)s - are extraordinarily underfunded relative to the retirement promises and goals we have set for ourselves as a nation. This problem will worsen appreciably absent systemic reform, especially given the inexorable aging of our population.
The challenge of achieving retirement security calls for a comprehensive and coordinated solution. Not only must we strengthen Social Security and employer-sponsored pensions - both defined benefit and defined contribution plans - but we must also explore new vehicles for enhancing private saving for retirement. The objectives should be to encourage and provide a stable source of income in retirement years and to enable real wealth accumulation - heeding the President's call for an "Ownership Society."
Social Security provides a basic level of retirement income. Private savings vehicles, such as IRAs, are designed to encourage capital accumulation. Employer-based programs are well suited to contribute to fulfillment of both objectives - stable income and wealth accumulation - through traditional pensions and defined contribution plans.
However, there are significant issues with regard to all of these savings mechanisms. I don't need to belabor the fiscal challenges facing the Social Security system - that has been covered in detail by other speakers throughout this conference. There also has been at least some discussion of disturbing trends in private savings.
So, I would like to spend a few minutes talking about one of the components for which I have some responsibility - employer-sponsored pensions - before returning to the broader theme of achieving retirement security for all Americans.
Defined Benefit Plan Trends
Traditional defined benefit pension plans, based on years of service and either final salary or a specified benefit formula, at one time covered a significant portion of the workforce, providing a stable source of income to supplement Social Security. There were and still are valid reasons for employers to establish, and for employees to desire, defined benefit plans.
From the employers' perspective, plan sponsorship is a way of rewarding employees' service and loyalty to the firm and can be a powerful recruitment and retention tool. Defined benefit plans encourage workers to remain with the same employer over long periods - perhaps even the entire career for some employees - and employers can also use such incentives as early retirement benefits to help manage retirement patterns of their workforce. Qualified plans also offer significant tax advantages to sponsors - in contrast to wages, companies do not pay taxes on contributions to the pension plans.
Employees value the retirement security that defined benefit plans provide. Benefits must be offered in the form of a lifetime annuity, risk is mutualized across generations of workers, professional investment advice may result in better returns and larger benefits, and the federal government backs up the promise made by the employer.
As a result of these advantages, the number of private sector defined benefit plans grew through the 1960s and 1970s before reaching a peak of 112,000 in the mid-1980s. At that time, some 40 percent of American workers were covered by defined benefit plans. For a variety of reasons, which I will touch on shortly, there has been steady erosion in the number of defined benefit plans offered. Over the past two decades, the number of defined benefit plans has fallen by 75 percent to just over 31,000 plans today. Moreover, just 1 in 5 workers - 20 percent of the workforce - participate in private sector defined benefit plans. Notably, no new plans of significant size have been established in recent years. (The notable exception is the United Methodist Church, which in May created a traditional defined benefit plan for its 25,000 American pastors and lay employees. The plan, though, does not fall under the insurance coverage of PBGC.)
But the steady decline in the number of plans offered and workers covered doesn't tell the whole story of the threat to the defined benefit system as a source of retirement income. 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" plans. Surveys by pension consulting firms show that as many as 30 percent of their clients have instituted some form of plan freeze. PBGC is also conducting its own survey on plan freezes to obtain more comprehensive data on the phenomenon, with preliminary results due by the end of the year. Freezes are of particular concern not only because they eliminate workers' ability to earn additional pension benefits, but because they often serve as a precursor to outright plan termination, which further erodes the PBGC's premium base. There also has been a dramatic increase in the number of defined benefit plans that offer participants the option of taking a lump sum - doubling to more than 40 percent in the past decade. While lump sums may be attractive to employees, unless the monies are invested in an annuity, the guaranteed future income stream is at risk.
Challenges Facing the Defined Benefit System
Why are defined benefit plans on the endangered species list? I would highlight four principal factors that have combined to reduce employers' willingness to establish or maintain defined benefit plans for their employees: 1) demographic and workforce changes; 2) globalization and increased competition; 3) an inflexible and burdensome regulatory framework; and 4) financial market conditions, especially the period from 2000 through 2002.
As is the case with Social Security, the defined benefit system faces pressures stemming from the expected dramatic increase in the number of workers who will be retiring as the Baby Boom ages. While Social Security is moving toward a two-to-one worker to retiree ratio, the defined benefit system is in more dire straits with only one active employee for every inactive (retired or deferred vested) worker. In some companies and industry sectors, the ratio is even worse. It is difficult to envision some of these employers, especially those in declining industries, generating sufficient resources to meet the promises they have made.
Related to demographics are changing workforce patterns - in particular, the increasing mobility of today's workers. While past generations often spent their entire working lives with one employer, this is no longer the case. Employers and employees alike recognize the limitations of traditional defined benefit plans for workers who may hold many different jobs with many different companies over the course of their careers. The result is that many companies have moved away from the traditional defined benefit framework toward more portable vehicles such as 401(k)s.
The second factor is increased competition, both domestic and global. As goods and services cross borders and markets welcome new entrants, companies with high cost structures will be disadvantaged. This is true with regard to both labor and non-labor costs. Companies that traditionally provided generous pensions and health care coverage to their workers may have cost structures that make it difficult for them to compete with firms that do not provide such benefits. For example, new entrants into the airline industry, the so-called low cost carriers such as Jet Blue and Independence Air, have eschewed the traditional defined benefit formula and instead opted for defined contribution-type benefit plans. This framework minimizes labor-related costs and allows those carriers to place considerable pricing pressure on their legacy competitors. In steel, the story was old-line, integrated producers with their costly labor contracts against the high-tech mini-mills, which operated free of any "legacy" burden. And in the automobile industry, foreign carmakers are not hobbled by the liabilities that weigh down their U.S. counterparts, which have a long history of providing generous pensions to their retirees. Those promises continue to be a sizeable expense factor in competitiveness - indeed, one industry analyst last year estimated that General Motors' pension and retiree health expenses added $1,360 to the cost of each U.S.-produced vehicle, while the same cost was only $107 for Honda.
The third factor is an overly complex, costly, and inflexible legal and regulatory regime for employer-sponsored pensions, especially defined benefit plans. Much of the problem lies in Byzantine rules pertaining to the contributions companies are required to make to their pension plans. The funding rules saddle financially healthy companies with needless complexity, excessive volatility, and perverse disincentives to funding up. Financially troubled companies, on the other hand, are provided with exclusions and exemptions that allow them to forgo funding their pension promises for many years. These flaws threaten to drive healthy companies out of the system and tempt troubled companies to shift the cost of their unfunded promises to workers, other companies and, ultimately, U.S. taxpayers.
Finally, financial market conditions have played a large role in the health of pension plans, or the lack thereof. In recent years, the one-two punch of asset losses resulting from falling stock prices and increased liabilities due to declining interest rates has affected pension funding significantly. This "perfect storm" came after the prolonged stock-market bubble of the late-1990s had decreased the amount plan sponsors were required to contribute to their plans.
Challenges Facing the Pension Insurance Program
Not surprisingly, the challenges facing the defined benefit system have also had a dramatic impact on the federal insurance program backing up that system. The PBGC insures the pensions of 44 million workers and retirees. When a plan is terminated, the PBGC trustees the plan and will pay the benefits promised to participants up to the statutory maximum. However, the PBGC faces profound financial and structural challenges that threaten our ability to carry out our statutory mission of protecting workers' pensions while also ensuring that premiums paid by plan sponsors are kept as low as possible.
The PBGC is operating with a substantial deficit, which is likely to grow over time. Because the agency has no real ability to make up the gap, a number of observers have raised the specter of a taxpayer bailout. A few numbers demonstrate the scope and magnitude of the problem:
- PBGC carried an $11.2 billion deficit at the end of 2003 (which improved slightly at mid-year);
- PBGC has $85 billion in exposure to junk-bond-rated companies that are higher default risks; and
- The private defined benefit system had a $400 billion gap between assets and liabilities as of the end of 2003.
Additionally, in the near term, PBGC is facing the prospect of assuming billions of dollars in additional liabilities from the airline industry.
The problem is a pension insurance system fundamentally flawed in its design. Start with the pension funding rules, which are the root cause of the PBGC's current financial difficulties. Although they were designed to minimize volatility, current funding rules can produce long funding holidays followed by massive contribution spikes, which often occur when the economy is emerging from a recession. In fact, in 2000, sponsors of defined benefit plans made contributions of approximately $18 billion, but a year later contribution levels nearly tripled to $50 billion. This volatility provides a disincentive for companies to continue sponsoring defined benefit plans, as large fluctuations in pension costs have an adverse affect on company operations.
At the other end of the spectrum, those companies that should be contributing more to their pension plans often aren't doing so. For example, current law is supposed to require companies with highly underfunded plans to make an additional contribution, called the Deficit Reduction Contribution, to fill the gap between assets and liabilities. However, Bethlehem Steel - PBGC's largest claim to date - made no deficit reduction contribution in the six years prior to plan termination. Worse yet, the company made no contributions at all to its plan in the three years preceding termination. All the while, the company kept making promises that it clearly had no ability - and arguably no intention - to fund.
Moving on to PBGC's premium structure, we get an idea of what the agency is up against. Any other insurer would set premiums based on the risk of claims. However, PBGC's premium rate is set by Congress. Plan sponsors pay to PBGC a base premium of $19 per year for each person covered by the plan, though if the plan is significantly underfunded the sponsors may have to pay an additional 90 basis points on the amount of underfunding. While this variable-rate premium bears some relation to the amount of loss risk, it doesn't reflect the credit risk that a plan sponsor poses to the PBGC.
Many sponsors have suggested that an increase in premiums would cause them to think twice about continuing a defined benefit plan, but in some cases, the premiums that sponsors pay to insure their employees' benefits is an extraordinary bargain. Consider: United Airlines has paid just over $50 million in premiums to the PBGC since the agency's inception in 1974, yet if the company's plans terminate, the PBGC would be saddled with a claim estimated at $6.4 billion.
Finally, the pension system exhibits a disturbing lack of transparency that makes it difficult for regulators to get a clear picture of the financial status of pension plans. Nor is there any standardization in how pension information is presented. The system's opaqueness discourages accountability and market discipline, and key stakeholders are prevented from responding effectively to current problems - in effect, making important long-term policy decisions without adequate information. Worst of all, workers and retirees are often the last to know. In fact, for five years prior to plan termination, workers and retirees at Bethlehem Steel received no notice from the company that the plan was underfunded.
These three flaws with the design of the pension insurance system lead to a massive "moral hazard" problem. To be sure, any insurance system runs the risk of encouraging "bad" behavior, but the level of moral hazard plaguing the pension insurance system is staggering. Simply put, management and labor at financially troubled companies have a powerful temptation to make promises that they cannot or will not fund. The cost of wage increases is immediate, while the cost of pension increases can be deferred for up to 30 years, and shutdown benefits, which are essentially severance benefits, may never be pre-funded. In exchange for smaller wage increases today, companies often offer more generous pension benefits tomorrow, knowing that if the company fails the plan will be handed over to PBGC. Irresponsible plan sponsors face no real cost for underfunding and risky behavior, and the program creates incentives to shift risks and costs to others-namely those companies that are acting responsibly in funding their plans. At some point, these financially strong companies may exit the defined benefit system, leaving only those companies that pose the greatest risk of claims.
Has the death knell sounded for defined benefit plans and the PBGC? If we do nothing, I fear that the trend lines I noted earlier will not only continue but accelerate, and the defined benefit pension plan will be consigned to the dustbin of history. For its part, the PBGC would find itself with insufficient assets and an inadequate premium base to meet its "guarantee," resulting in calls on the American taxpayer to bail out the system. In other words, the 80 percent of the workforce that doesn't have access to defined benefit plans would pay for the benefits of the 20 percent that does. However, I do not believe these outcomes are a foregone conclusion. On the contrary, with timely intervention, I believe we can prevent the problems of today from becoming the crisis of tomorrow.
Strengthening the Pension Insurance System
To this end, the Administration last year outlined a framework for comprehensive reform of the pension insurance system. The goal is to enhance pension security for workers and retirees by improving the financial health of the voluntary defined benefit pension system. There are three primary components: rationalize and strengthen the funding rules; make premiums more reflective of the risk that plan sponsors pose to the insurance program; and enhance transparency in the system so that beneficiaries, investors, and regulators have a better understanding of the current financial condition of pension plans. In short, we must strengthen, simplify and streamline the rules governing defined benefit pension plans.
As a first step, the Administration introduced and Congress enacted legislation to replace for two years the 30-year Treasury bond rate that had been used to calculate the discount rate for liabilities with a blended corporate bond rate. Consistent with the framework proposed last year, we now need to move forward with the broader structural reforms.
One of the primary elements will be to provide more flexible funding rules for companies that pose little risk to the insurance system while strengthening the funding rules for those most likely to present claims. Contribution volatility will be reduced by allowing plan sponsors to make additional tax-deductible contributions, while also removing provisions in current law that allow sponsors of underfunded plans to avoid making contributions.
Premiums would be revised to better reflect the risks that are presented to the pension insurance program. Low-credit-risk companies with well-funded plans would pay relatively lower premiums. Companies that are a higher risk of default and/or that have significantly underfunded plans would pay much higher premiums.
There would also be 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. Plans would be required to disclose their liabilities annually, accelerate disclosure of plan information to workers, and provide funding-trend data in participant disclosures. The PBGC would be authorized to publicly release pension underfunding data that is nondisclosable under current law.
Ultimately, we need to strike a balance that reduces systemic underfunding while encouraging healthy companies to maintain their plans. Ideally, these initiatives will make defined benefit pension plans economically and regulatorily viable options - and hopefully even encourage new entrants into the defined benefit system.
Strengthening Retirement Security
As I mentioned at the outset of my remarks, the broader objective is achieving retirement security. We must set our sights on helping workers maximize financial independence so that retirement becomes a time of security and fulfillment, not scarcity and fear.
The Administration's proposal to strengthen the defined benefit system is just one aspect of a considered and comprehensive approach to achieving that objective. Where previous efforts to address weaknesses in retirement security have been piecemeal and incremental, this administration is resolved to ensure that issues are addressed holistically to keep the entire fabric of the nation's retirement system robust.
President Bush's commitment to strengthening Social Security is well known. Shortly after taking office, he convened the President's Commission to Strengthen Social Security. Importantly, he has opposed any reduction in benefits for those now in, or near, retirement, as well as any increase in the payroll tax. And he has supported allowing Social Security, in part, to become a wealth-accumulation tool. Coupled with bolstering the nation's public pension program have been proposals to foster more private retirement savings. These initiatives, along with efforts to reinforce the defined benefit system, will further enhance financial security for all Americans.
The Administration is working to ensure not only that America offers its workers the opportunity for financial independence, indeed wealth, in retirement, but that the incentive to do so is strong. As we move forward, these issues, and the work we're doing together, will be the lynchpin in a secure retirement for future generations. Thank you so much for your time, and I would be happy to answer any questions you might have.