July 28, 2005 | WebMemo on Social Security
The House Energy and the Workforce Committee took a step toward resolving the Pension Benefit Guaranty Corporation's (PBGC) growing deficit when it approved the Pension Protection Act of 2005 (H.R.2830), introduced by Rep. John Boehner (R-OH). While that bill would improve the funding of both defined benefit pension plans and the PBGC, it still allows several serious pension funding loopholes that could undermine its reforms. The House should strengthen the bill before it is sent to the Senate.
The legislation resulted from Congress's and the Administration's understanding that the retirement security of millions of workers who are covered by defined benefit pension plans is seriously at risk because many of those plans do not have enough money to pay all of the benefits they have promised. Anyone who doubts this risk need look no further than the recent United Airlines pension disaster and a Government Accountability Office (GAO) report that details the under-funding of the 100 largest defined benefit pension plans between 1995 and 2002.
In April 2005, United Airlines defaulted on its defined benefit pension plan as part of its bankruptcy and passed its pension obligations to PBGC, a federal agency that insures such plans. PBGC was left to deal with unfunded pension promises totaling nearly $10 billion, about half of which it will pay. The other half will be borne by United's retirees, many of whom will receive lower pensions than they were promised.
While PBGC has already had to take over underfunded pension plans from two airlines and most of the steel industry, worse is yet to come. Other airlines are considering similar moves, and the auto industry is also feeling the crush of its massive pension obligations. The end result may be a massive bailout of PBGC that costs taxpayers tens of billions of dollars.
Most of PBGC's annual income, which is used to reduce the agency's deficit, comes from a $19 per worker annual insurance premium paid by covered pension plans. The Bush Administration proposes to raise premiums by $11 (equal to the amount of wage growth in the past 14 years) to $30 per worker and to index the premium to annual growth in wages. This raise would phase in over three to five years (depending on the funding status of a specific plan) starting in FY 2006 and would be the first increase since 1991. Underfunded plans would also pay an annual risk-based premium that reflects the gap between benefit promises and funding targets. The PBGC board would set the amount based on the risk of plan failure and the need to improve the agency's finances.
While the increased premiums will provide additional revenue, the bill's substantial reform of pension plan funding rules would also improve its finances. Funding rule changes would apply to both single-employer and multiemployer pension plans. The current rules are extremely complex, and plans are judged as if the employer will always be making contributions, regardless of the risk of failure. For example, Bethlehem Steel's pension plan was judged to be 84 percent funded even though it had only 45 percent of the assets needed to pay promised benefits. The PBGC was left to cover a $4.3 billion shortfall when it assumed Bethlehem's pension plans.
Revised funding rules would both provide a more accurate picture of plan funding and require companies to meet their obligations. They would also prevent a company from expanding benefit promises when its plan is severely under-funded and provide both workers and stockholders with important improved information about underfunded plans' actual financial situation. Combined with the additional premiums, the new funding rules would sharply reduce the need for a major taxpayer bailout of PBGC.
Another important reform changes the interest rate assumptions for lump sum distributions. Many plans allow workers to choose to take a large cash payment at retirement instead of regular monthly pension payments. However, because the interest rate used to calculate lump sum distributions is often too low, the lump sums were larger than appropriate and drained pension funds to the point that less was left for those retirees taking monthly benefits. The House bill largely corrects this problem by applying the current interest rate from the index used to calculate the pension plan's funding status.
The one thing that Congress should not do is to repeat the sad experience of the 1980s. Unless there is hard evidence that a specific company will recover its economic health, Congress should not casually extend the amount of time that corporations in one industry, such as the airlines, have to fund their pension plans. The Senate Finance Committee made this very mistake in its July 26 pension bill by giving airlines 14 years to pay off under-funded plans. While special exemptions may be justified on a case-by-case basis, a general exemption is likely to mean that taxpayers will have to pay more to bail out PBGC when it runs out of money. Special interest exemptions from funding requirements should require a hard mortgage on corporate assets that can be used to reduce PBGC's losses if the company enters bankruptcy.
Its most serious weakness is that it continues to allow "credit balances" that allow a company to avoid making any payments to its pension plan. A credit balance is created when a company pays more than its required minimum annual contribution. The amount in excess of that required minimum is assumed to grow using the same interest rate assumptions that the plan uses for its regular pension investments. A company can use credit balances to reduce or even eliminate its future required payments, even if the pension plan's overall level of assets has declined due to market losses. Thus, a credit balance allows a company to skip making cash payments into its pension plan even when the plan is unable to make good on its full promises because it has lost money during the year.
In fairness, the bill limits the use of credit balances to plans that are over 80 percent funded and requires plans to subtract credit balances from assets when the plan's overall funding level and PBGC premiums are calculated. However, a better approach would be to eliminate credit balances altogether, perhaps instituting a corporate tax deduction for pension payments in excess of the required minimum.
A second weakness concerns the practice of "smoothing" the interest rates used to calculate whether a pension fund has enough assets to pay all of its obligations. Under current law, pension funds may calculate their financial position using a smoothed average of interest rates over the last four years. The bill limits this to the average weighted interest rate of the last three years, with the most recent year counting 50 percent, the previous year 35 percent, and the third year 15 percent. While this is an improvement, it is it would be far better to eliminate interest rate smoothing altogether.
Finally, current law also allows pension plan operators to average the gains and losses of investments over a period of five years. This is another form of smoothing, which can seriously distort the ability of a pension plan to pay all of its benefit promises when stocks or other investments are in flux. The bill again limits smoothing to a weighted average of the least three years and further limits the declared value of the assets to a maximum of 100 percent of fair market value and a minimum of 90 percent. However, this still distorts the actual ability of a pension plan to meet its benefit promises. Instead, Congress should completely eliminate the smoothing of asset values.
Another provision of the bill will assist the millions of workers with 401(k) retirement plans who may not be receiving the most for their money because they lack easy access to investment advice.Simple financial education that covers the difference between stocks and bonds, as well as basic information about optimal asset allocation, is a good start but does not go far enough. Workers need more specific information when faced with a long list of potential investment choices, many of which look very similar. Investment advice would make it much easier for workers to choose good investments.
Unfortunately, the Employee Retirement Income Security Act (ERISA), the law that governs employer-offered retirement plans, prohibits companies that manage an employer's retirement plan or offer products included in the plan from offering any sort of investment advice. To an extent, this prohibition is wise because it prevents financial institutions from pushing high-cost investments that mainly benefit the seller. However, the provision is so broad that it also effectively prevents them from pointing out investment choices that would help a worker to meet his or her investment goals. Revising ERISA to allow objective investment advice would help workers to better manage their assets.
The bill amends ERISA to allow a "fiduciary advisor" to offer prudent and objective investment advice that is solely in the interest of retirement plan participants. Plan managers would be required to select the best advisors available and monitor their activities. The advisors would have to disclose in writing their relationships with any companies that offer products through the retirement plan as well as any fees or other compensation that they would receive. These disclosures would have to be made when the relationship is established and annually thereafter. Workers would have the ability to accept or reject any investment advice they receive.
The legislation ensures that workers will not be exploited by subjecting the advisor to strict personal liability and disclosure standards. Fiduciary advisors would be strictly limited to individuals and institutions licensed and regulated by either federal or state laws. Shady advisors would be subject to discipline and recourse through the respective federal or state financial laws, as well as a series of additional penalties and liabilities included in ERISA and other laws. This simple change will help millions of workers to get more out of their retirement investments.
The House pension legislation is an important step towards restoring solvency to the PBGC and preventing some of the losses that workers face when their pension funds are seriously under-funded. However, the bill contains serious flaws that threaten to undermine its goals, and these flaws should be corrected before the bill goes to the Senate. Taxpayers should not have to bail out companies that have over-promised and under-funded pension plans. Misguided attempts to appeal to corporations and unions will only increase the eventual cost to taxpayers.
David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies, and Rea S. Hederman, Jr., is Senior Policy Analyst in the Center for Data Analysis, at The Heritage Foundation.
 Private Pensions: Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in Funding Rules, GAO-05-294, May 2005, at /static/reportimages/99B00E3CA8884B2F4881609901FC2EC5.pdf.