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Backgrounder #1676 on Regulation

August 7, 2003

August 7, 2003 | Backgrounder on Regulation

Treasury Department Proposal for Defined Benefits IncludesImportant Reforms

A technical issue now being considered by Congress could jeopardize the retirement benefits of 19 percent of the American workforce. While losses to 401(k) plans and similar defined contribution pension plans have received a great deal of attention, equally serious problems face defined benefit pension plans. As a result of prolonged stock market losses and historically low interest rates, an increasing proportion of these pension plans do not have enough assets to pay full retirement benefits to present and future retirees.

Currently, 12 percent of the labor force is covered by defined benefit pension plans, while an additional 7 percent is covered by both defined benefit and defined contribution plans. Under a defined benefit plan, a worker is promised a retirement benefit based on a percentage of salary for each year worked or similar measures. While the worker does not have the direct investment risk associated with a 401(k) plan, the benefits depend on whether or not the plan is fully funded. The risk that it is not fully funded can be as great or greater than the risk from stock and bond investments, but it is usually much harder for the worker to determine how high that risk is.

A key question is whether the pension plan's level of funding is being measured properly. A July 8 proposal by the U.S. Department of the Treasury addresses both the proper way to measure pension plan funding and ways to make it easier for workers and others to determine whether their company's pension plan is at risk. It also proposes ways to prevent companies that are in financial trouble from making promises to their workers and then making the taxpayers pay for them.

The Treasury Department's plan is far superior to the discount rate provisions in the July 18 version of the Portman-Cardin bill passed by the House Ways and Means Committee--H.R.1776, named for the bill's two principal sponsors, Representatives Rob Portman (R-OH) and Benjamin L. Cardin (D-MD)--and Congress should consider incorporating Treasury's proposed reforms into the final bill.

Why an Appropriate Discount Rate Is Important

The funding of a defined benefit pension plan is measured using a "discount rate." A plan is assumed to be fully funded if the assets that it currently has can be expected to grow at a certain interest rate until the resulting level of assets then equals the total amount of pension payments that the plan promises to make in the future. For example, if a fund will owe $1,000 in 30 years and assumes that its assets will earn an average of 5 percent every year after inflation, it must have $231 today in order to be fully funded. (Invested at a 5 percent interest rate, $231 will grow to $1,000 in 30 years.)

The discount (interest) rate used to measure a plan's funding is crucial. If a plan assumes that its assets will grow at 7 percent a year instead of 5 percent, it needs only $131 today to be fully funded (rather than the $231 it would need if it used a 5 percent rate). On the other hand, if a plan uses a discount rate of only 3 percent, then it must have $412 on hand today to be fully funded.

The discount rate has no actual relationship to how much a pension plan's investments are earning. While the law requires that plans make prudent investments, these investments can change over time and are greatly affected by short-term swings in the stock, bond, and property markets. The discount rate is intended to measure whether or not the plan has sufficient assets to meet its obligations over a long period of time; thus, a defined benefit plan uses the rate for long-term government or corporate bonds instead of the rate of interest the plan is earning on its investments.

From 1987 to 2002, the law required that defined benefit pension plans use a weighted four-year average of the returns of the 30-year U.S. Treasury bond rate as their discount rate for determining funding adequacy. Under the 1987 law, plans were allowed to use any number between 90 percent and 105 percent of that rate. The spread between 90 percent and 105 percent was intended to allow the pension plan a slight amount of flexibility in its calculations. This discount rate is also used to determine lump-sum benefits for workers who want a one-time payment instead of a monthly check.

However, using this rate presents two problems. First, the Treasury Department announced in 2001 that it would stop issuing the 30-year Treasury bond. As a result, market prices for these bonds are distorted by the realization that they will no longer be issued. Second, interest rates in general are at a historic low, reaching levels not seen for almost 50 years. While economists expect them to rise gradually, pension plans argue that using today's low rate would make pension plans look far more underfunded than they actually are. Continued use of today's rate would force companies to assign pension plans literally billions of dollars that could be used more effectively to build the company.

Recognizing that the old discount rate was too low, in 2002, Congress allowed pension plans to use instead a number equal to 120 percent of the four-year average of the 30-year Treasury bond rate. However, this law expires after 2003. Some corporations have proposed that Congress substitute a longer-term corporate bond rate for the 30-year Treasury rate. Since corporate bonds do not have the full faith and credit of the United States behind them, they have higher interest rates. Using those higher interest rates would sharply reduce the amount of money that a pension plan must have on hand in order to avoid being underfunded while still protecting the funding status of the plan.

How the Treasury Department Proposal Would Affect the Discount Rate

On July 8, the Treasury Department proposed that a two-stage change in the pension plan discount rate be substituted for the current 30-year Treasury bond rate. For the next two years, the Treasury proposal would allow plans to use Congress's choice of either the 20-year or 30-year corporate bond rate. After that two-year period, companies would begin a three-year transition to using a corporate bond interest rate determined by the average age of an individual company's workforce.

Since companies with older workers will begin to pay out pension benefits sooner than companies with younger workers, the Treasury Department proposal would require companies with older workers to use a shorter-term corporate bond rate. Short-term bonds of all types have a lower annual interest rate than longer-term bonds do. This lower discount rate means that those companies would have to have proportionately more assets available to pay pension benefits. Companies with younger workers could use a longer corporate bond rate, which would allow them to have proportionately less cash and other assets available. This is an important reform that should be carefully considered.

The simple fact is that some industries and companies have workforces that are older on average than others. Since these companies will have to begin paying their workers' pension benefits sooner, the health of their pension plans is a significant factor in their ability to remain in business. If their pension plans are underfunded and the company has to make significant payments to them, that company is at a higher risk of bankruptcy than if the same company had a younger average workforce. Rather than using a uniform measure for all companies, it is much more prudent to use a discount rate that is customized to reflect a particular company's workers.

Using a customized discount rate as proposed by the Treasury Department would allow workers and investors to better understand a company's overall financial health. The customized discount rate also should allow earlier identification of problem companies so that changes can be required before they become critical.

Balancing the Interests of Workers, Companies, and Taxpayers

It is tempting to see the issue of discount rates as affecting only the amount that cash-strapped companies will have to divert to their pension plans. However, much more is at stake. Changing the discount rate to just a single long-term corporate rate might benefit companies by lowering the amount that they have to contribute to pension plans, but it also might hurt both workers and taxpayers in the long run. Workers who want to take a lump-sum pension distribution instead of monthly payments would receive less under such a system than they would under the current discount rate.

Lump-sum pension benefits are calculated by determining the total amount of pension benefits owed over a lifetime and calculating how much money invested today at the discount rate is needed to grow into the promised total amount. The higher the discount rate, the lower the amount of money that will be necessary to grow into that promised benefit, and the lower the lump sum benefit. At the same time, too low a discount rate may mean a lump-sum payment that is too high, thus further draining the plan of needed assets.

In determining an appropriate discount rate, Congress must balance the needs of both pension plans and retirees wishing to take a lump sum benefit. Similarly, if Congress only substitutes a higher uniform discount rate for the present one, taxpayers could find themselves required to pay higher taxes to make up for Pension Benefit Guarantee Corporation (PBGC) deficits. The PBGC is the federal insurance agency that takes over insolvent pension plans and pays benefits to retirees. Even though the PBGC limits the amount that it pays to each retiree, taxpayers can expect Congress to bail out the agency with additional tax money if the agency runs major deficits.

When Congress considers the appropriate discount rate, it must take into consideration the risk that an overly generous discount rate will result in more underfunded pension plans, and thus that more of those plans will be turned over to the PBGC for payment. This is not just an issue that concerns companies; taxpayers have an equal stake in its outcome.

Two Other Important Reforms

The Treasury Department proposal includes two additional reforms that would increase the information available to workers and investors and lower the potential liability to the PBGC. Even if agreement on the discount rate cannot be reached for now, Congress should swiftly consider making the following reforms:

  1. Improved Information
    All too often, the true status of a defined benefit pension plan is unknown to the affected companies' workers and investors. The Treasury Department proposal would require pension plans that are underfunded by more than $50 million to make a more timely and accurate disclosure of their assets, liabilities, and funding ratios. In addition, while phasing in the new discount rate changes, all plans would have to make an annual disclosure of their pension liabilities using the duration matched yield curve. This reform would further improve the ability of workers and investors to judge whether a pension plan is properly funded.

    Finally, pension plans would have to disclose whether they have enough assets available to pay the full amount of benefits that workers have already earned. Known as "termination basis," this method ensures that if the company files for bankruptcy and seeks to terminate its pension plan, workers are not suddenly surprised to find that the plan cannot pay the pension benefits they have already earned.

  2. Reduced Taxpayer Liability
    Companies that are in severe financial trouble often try to keep their workers happy by promising them higher pension benefits. Similarly, companies in bankruptcy sometimes seek to improve pension benefits in return for salary concessions. In both cases, these higher pension promises often get passed on to the PBGC, and thus to the taxpayers, for payment when the company seeks to terminate its pension plan. The proposed reforms would prevent severely underfunded pension plans from promising higher pension benefits or allowing lump-sum payments unless the company fully pays for those improvements by making additional contributions to its pension plan. Similar restrictions would apply to companies that file for bankruptcy.

Portman-Cardin Comes Up Short on Discount Rates

While it contains many other important pension reforms, the version of H.R. 1776 (informally known as the Portman-Cardin bill) passed on July 18 by the House Ways and Means Committee fails to address the discount rate issue adequately. Rather than including either the Treasury Department proposal or any other solution to the issue, Portman-Cardin would allow pension plans to use a long-term corporate bond rate through 2006 to determine whether a plan is fully funded.

By using the long-term corporate bond rate, Portman-Cardin fails to answer the discount rate problem, giving underfunded companies no incentive to support any further improvements in the discount rate. Extending the new rate for three years exacerbates the problem. The longer period makes it likely that when 2006 approaches, companies will seek merely to extend the date. In three years, simply extending the date will still be easier than addressing a complicated issue.

Finally, Portman-Cardin excludes both the proposed disclosure requirements and restrictions on the ability of failing companies to make pension promises that are likely to be passed on to the PBGC for payment. As a result, more workers will likely be shorted on their expected pensions because their company has passed the plan on to the PBGC for payment. Even worse, taxpayers will have to pay for recent pension increases that companies offered knowing that they lacked the assets to fund them.

Conclusion

Congress should speedily consider all of the elements contained in the Treasury Department's pension plan proposal. It should not rush to change the current pension plan discount rate from the current 30-year Treasury bond to a long-term corporate bond rate--even if it is for only a three-year period. Doing so would only provide relief to corporations without considering the interests of taxpayers. It would be too simple for future Congresses to simply extend that time period without considering the potential consequences of such a move.

If Congress cannot agree on a permanent and comprehensive change in the discount rate, it should just extend companies' current ability to use 90 percent to 120 percent of the 30-year Treasury bond rate for another two years. However, if it takes that course, Congress should at least include the additional disclosure requirements and tighten restrictions on financially unstable companies to prevent them from passing the cost of their pension promises on to the taxpayers.

David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

About the Author

David C. John Senior Research Fellow in Retirement Security and Financial Institutions
Thomas A. Roe Institute for Economic Policy Studies

Related Issues: Regulation