solutions for the shortfalls in employer-sponsored defined-benefit...
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April 2011 Financial Innovations Lab ™ Report PROTECTING PRIVATE PENSIONS AND THE PUBLIC INTEREST Solutions for the Shortfalls in Employer-Sponsored Defined-Benefit Plans
Transcript of solutions for the shortfalls in employer-sponsored defined-benefit...
April 2011
Financial Innovations Lab™ Report
Protec ting Private Pensions and the Public interest solutions for the shortfalls in employer-sponsored defined-benefit Plans
Financial Innovations Lab™ Report
Protecting Private Pensions and the Public interestsolutions for the shortfalls in employer-sponsored defined-benefit Plans
Penny angkinand, bradley belt, and glenn Yago
April 2011
Financial Innovations Labtm Report
Financial Innovations Labs™ bring together researchers, policymakers, and business, financial, and professional practitioners to create market-based solutions to business and public policy challenges. Using real and simulated case studies, participants consider and design alternative capital structures and then apply appropriate financial technologies to them.
This Financial Innovations Lab report was prepared by Penny Angkinand, Bradley Belt and Glenn Yago.
Acknowledgments
The Milken Institute gratefully acknowledges the support of the United Food and Commercial Workers for this Financial Innovations Lab. We especially thank William McDonough and David Blitzstein for their thoughtful leadership during the Lab process. We also thank Charles Blahous for his helpful comments on the Lab report. In addition, we would like to thank our Institute colleagues Caitlin MacLean, manager of Financial Innovations Labs, editor Melissa Bauman, and executive assistant Karen Giles for their continued support.
About the Milken InstituteThe Milken Institute is an independent economic think tank whose mission is to improve the lives and economic conditions of diverse populations in the United States and around the world by helping business and public policy leaders identify and implement innovative ideas for creating broad-based prosperity. We put research to work with the goal of revitalizing regions and finding new ways to generate capital for people with original ideas.
We focus on:human capital: the talent, knowledge, and experience of people, and their value to organizations, economies, and society;financial capital: innovations that allocate financial resources efficiently, especially to those who ordinarily would not have access to them, but who can best use them to build companies, create jobs, accelerate life-saving medical research, and solve long-standing social and economic problems; andsocial capital: the bonds of society that underlie economic advancement, including schools, health care, cultural institutions, and government services.
By creating ways to spread the benefits of human, financial, and social capital to as many people as possible— by democratizing capital—we hope to contribute to prosperity and freedom in all corners of the globe.
We are nonprofit, nonpartisan, and publicly supported.
© 2011 Milken Institute
Introduction ......................................................................................................1
Part I: Defining The Problem ........................................................................5
Defining Legacy Costs and Assigning Responsibility for Their Financing ...........................6
Underfunding and the PBGC .........................................................................................7
Challenges to Overcoming Legacy Costs .........................................................................8
Funding challenges
The PBGC’s limited regulatory authority
Political and regulatory challenges
Part II: Addressing The Shortfall ............................................................10
General Principles .......................................................................................................10
Considerations for single-employer plan solutions
Minimizing moral hazard
Incentives for full funding
Specific Proposals .......................................................................................................15
Solution 1: Expand the PBGC’s authority to negotiate pension funding and termination agreements
Solution 2: Use the PBGC as a financing source (bond swap)
Solution 3: Trade pension claims
Solution 4: Consolidate 'orphan liabilities' under the PGBC
Solution 5: More equitable sharing of legacy costs
Solution 6: Allow employers/employees to negotiate benefit reductions
Solution 7: Expand the purchase of annuities to partially defease liabilities
Conclusion and Next Steps ..........................................................................................22
Appendix A (Financial Innovations Lab Participants) ................................................23
Appendix B (Examples of Market-Based Solutions)...................................................24
Endnotes..............................................................................................................27
ta b l e o f co n t e n t s
it’s impossible for the union and our signatory employers to introduce a new pension model without restructuring the burden of the existing legacy cost of the plan.— david blitzstein, united food
and commercial Workers
1
introduction
Employer-sponsored defined-benefit (DB) pension plans currently face a substantial aggregate funding shortfall, with assets in most plans insufficient to fund the benefits promised to current and future retirees. This underfunding grew worse during the Great Recession and is likely to swell further as the baby boomers leave the workforce for retirement. Addressing so-called legacy costs is essential to protecting the solvency of these plans, the retirement security of the workers they cover, and the taxpayers who could be on the hook if the federal pension insurance program is unable to cover future losses without external financial assistance.
DB pension plans have fallen out of favor with private companies. The number of these plans peaked at 114,000 in the early 1980s, providing retirement benefits to about 40 percent of U.S. workers. Over the past two decades, the number of plans has plummeted by 75 percent to just over 29,000 in 2009 (see figure 1), now covering less than 20 percent of workers. Moreover, an increasing number of the remaining plans have been frozen by the sponsor—that is, employees are no longer accruing benefits.
Source: Pension Insurance Data Book, PBGC, various years.
1FIGURE
Number of PBGC-insured defined-benefit pension plans, 1980–2009
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90
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94
1996
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Single-employer plans
(left axis)
Multi-employer plans
(right axis)
Multi-employer plans
(number)
Single-employer plans
(number)
2 Financial Innovations Lab
As Americans live longer, the cost of these plans has grown for the sponsoring companies. The increasing volatility in the financial markets has also led to greater unpredictability in the funded status of plans and the amount of contributions required. As a result, employers seeking to reduce their funding risk exposure have increasingly adopted defined-contribution (DC) plans like the 401(k), in which the employee rather than employer bears the investment risks.
In a DB system, future benefit payments are set in advance and pre-funded. Workers are typically promised monthly pension payments in the form of a life annuity after they retire in an amount usually based on an employee’s compensation and years of employment at the sponsoring company.1 A plan is fully funded if employer contributions and the earnings on those contributions (i.e., the total amount of plan assets) are sufficient to fund current and projected benefits. A plan is underfunded if the value of plan assets falls short of benefit obligations.
The actual amount of underfunding in employer-provided DB plans remains elusive. According to a recent Credit Suisse estimate2, the 354 companies in the S&P 500 with DB pension plans entered 2010 with combined funding deficits of $402 billion, producing a funding percentage of 75 percent, the lowest level in more than a decade. The deficits are even more alarming given that these plans were more than 100 percent funded at the end of 2007, according to the same study.
Of course, those estimates are for S&P 500 companies. The Pension Benefit Guaranty Corporation (PBGC) estimated in 2007, when financial markets were at their recent peak, that total underfunding in single-employer DB plans was equal to roughly $225 billion, down from a high of $452 billion in 2004. The latest available data from the PBGC shows a significant deterioration to $504 billion in 2009 and improvement in 2010 with the preliminary estimate of total underfunding at $415 billion (figure 2).
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420 452 432
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US$ billions
P = preliminary. Source: Pension Insurance Data Book, PBGC, 2009.
2FIGURE
Total underfunding in PBGC-insured single-employer plans
3Introduction
In addition to worker longevity and retiring baby boomers, several other factors have led to mounting unfunded liabilities: faulty funding rules, sub-optimal tax and premium-assessment policies, and risk management failures. The underfunding problem has been further exacerbated by the recent financial crisis, which led both to falling interest rates that raised the present value of pension liabilities and to tumbling equity prices that simultaneously reduced the value of pension assets (figure 3).
Figure 3. Key variables affecting pension funding ratios
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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Index % S&P 500 composite index (left scale)
Moody's Aa yield (right scale)
Source: Bloomberg.
3FIGURE
Key variables affecting pension funding ratios
The critically underfunded status of DB plans sponsored by financially weak companies threatens not only the solvency of sponsoring companies but also the PBGC, a government-sponsored corporation that insures existing DB plans. When an insured plan is terminated, the PBGC assumes both the plan’s assets and its obligation to pay benefits up to a statutory cap. If the plan has insufficient assets to meet these obligations, the result is deterioration in the PBGC’s net financial position. For the 2010 fiscal year, the PBGC reported that its net deficit had grown to approximately $23 billion.
The PBGC’s financial vulnerabilities in turn threaten the retirement security of some of the 44 million U.S. workers whose retirement incomes it insures. Taxpayers are also potentially on the hook if elected officials conclude that the losses in the pension insurance system are too great to be borne by plan sponsors and their workers. The PBGC, which was established as a federal corporation, is supposed to be self-financing—it does not receive any tax revenue and its obligations are explicitly not backed by the full faith and credit of the United States. However, most analysts believe Congress would provide federal financial support if the PBGC runs out of funds. (See also the section Underfunding and the PBGC.)
4 Financial Innovations Lab
For many companies, the buildup of unfunded legacy costs is a huge obstacle to their future financial viability. The size of the funding deficit and the contributions that would be required to fill the gap are so large that they may exceed the capability of the company to generate sufficient cash flow from operations or borrow at commercially reasonable rates in the debt markets to cover the required contributions and make up the funding shortfall.
To address many of these issues, the Milken Institute convened a Financial Innovations Lab in June 2010 to explore strategies for financing unfunded legacy costs while minimizing the adverse effects on employers, plan participants, the PBGC, and taxpayers. Participants included financial and institutional investors, asset managers, reinsurers, academics, actuaries, and representatives from unions, insurance companies, government, and pension funds.
To kick off the Lab, participants from the United Food and Commercial Workers (UFCW) asked key questions about how funding levels can decline so quickly and why the DB model is so susceptible to financial and regulatory crises (see the section Challenges to Overcoming Legacy Costs). Participants said the UFCW is averse to switching to defined-contribution plans due to the low-wage, part-time nature of the union’s workforce. However, the UFCW has developed a hybrid plan that combines features of both defined-benefit and defined-contribution models.
The biggest obstacle to a better, sustainable pension model is unfunded legacy costs, David Blitzstein of the UFCW said. “The reality that exists for us is that it’s impossible for the union and our signatory employers to introduce a new pension model without restructuring the burden of the existing legacy cost of the plan.”
Lab participants generally agreed that the underfunding of DB pension plans is a national problem that affects the retirement safety net and presents long-term fiscal challenges. The group further agreed that changes to federal law would be required to achieve a comprehensive solution to the shortfall. Implementation issues and the regulatory and market mechanisms required for the suggested solutions to work were also a primary focus of the Lab.
The magnitude of these legacy costs is such that creative thinking is required and difficult choices will need to be made. As Blitzstein said, even “a re-engineering of the defined-benefit system is much preferable to a chaotic system liquidation.”
While the purpose of the Lab was to identify potential solutions for resolving unfunded legacy costs, many participants stressed that requiring employers to maintain full funding after the existing financing shortfall had been resolved would have to be part of the equation. The primary focus on financing these legacy costs meant that many other important aspects of pension reform were not addressed in this Lab but could be the subject of future reports.
“A re-engineering… is much preferable to a chaotic system liquidation,” says David Blitzstein, right, with UFCW colleague William McDonough.
5
Part i: defining the Problem
Most private DB plans sponsored by companies in the S&P 500 are underfunded, as shown in figure 4. Of the 354 companies in the S&P 500 that offer DB plans, 320 saw the funded status of those plans deteriorate in 2010. Of these 354 companies, 274 firms, or 77 percent, have pension plans that are less than 80 percent funded.3 As noted above, the underfunding problem in employer-provided DB pensions overall is even greater.
With the economic and financial recovery under way, higher equity returns have led to somewhat improved corporate pension funding ratios, although the persistent low interest rate environment has continued to negatively affect funded ratios. Lab participants, however, generally agreed that even a full market recovery would be insufficient to address current pension financing shortfalls and that comprehensive reforms will be required in any event.
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Funded ratio
Underfunded Overfunded
Note: There are 354 companies in the S&P 500 with DB plans. The data are as of March 1, 2010. Source: Credit Suisse.
4FIGURE
Distribution of the funded status of the S&P 500 companies’ DB plans
6 Financial Innovations Lab
defining legacY costs and assigning resPonsibilitY for their financing
Fully understanding the scope of pension underfunding requires a conceptual separation of legacy costs from yet-to-be-accrued benefit obligations. The magnitude of legacy costs accrued to date is such that even if all future pension benefit promises were responsibly funded in advance, the pension system as a whole would still be confronted with a substantial financing shortfall. A key to designing appropriate solutions is to fairly allocate the burden of existing legacy costs while establishing rules to facilitate full funding of any future benefit accruals.
The term “legacy costs” resists precise definition. Loosely speaking, legacy costs are the already-unavoidable future costs of a pension plan—unavoidable because they are already fully accrued or because they are promised to those now in or on the verge of retirement. Accrued pension benefits are protected by law and cannot be negotiated away, but future benefits are not protected by statute. A company has the right under the Employment Retirement Income Security Act of 1974 (ERISA) to freeze benefits or terminate a plan at any time (but there may be a contractual issue if the benefits are part of a collective bargaining agreement).
Private DB plans generally are structured in one of two ways. In a multi-employer plan, workers’ pension benefits are provided by a group of employers in the same industry. A multi-employer plan is funded by employer contributions that are determined through collective bargaining agreements, and it is governed by a joint board of trustees. As a result, employers in these plans cannot easily adjust contributions based on their financial situations.
A single-employer plan, in contrast, is controlled and managed by one company. Contribution requirements for single-employer plans are established by federal law and are binding on the employer. Most existing DB plans are single-employer plans.
Because different categories of pension plans are structured differently, their paths toward solvency will also vary. For instance, while the single-employer system faces substantial deficits, the task of assigning responsibility for single- employer financing shortfalls is relatively straightforward, said Lab participant Jared Gross of PIMCO. “On the single-employer side, that’s relatively easy to do because they’re the ones who designed the plans, they’re the ones who promised the benefits, they’re the ones who invested the assets and made contributions or didn’t. … Conversely, burden-sharing makes maybe a little more sense on the multi-employer side because you can’t just sort of point the finger at one entity that was responsible for where we are today,” Gross said.
Jared Gross of PIMCO notes that the paths to solvency will vary based on the type of pension plan and how that plan is structured.
7Part I: Defining the Problem
underfunding and the Pbgc
Pension plan underfunding carries significant implications for the financial health of the pension insurance system operated by the PBGC. When a single-employer plan terminates, the PBGC assumes the assets and benefit obligations of the plan up to a statutory cap. Single-employer plans can terminate via a “distress termination” (initiated by a plan sponsor, typically in a bankruptcy proceeding) or an “involuntary termination” (initiated by the PBGC).4
In the multi-employer pension system, the bankruptcy of a plan sponsor typically means funding responsibilities are shifted to other sponsors of that plan. The PBGC may make loans to a multi-employer plan to enable it to continue benefit payments, but the path to an “insurable event” is generally more complex than with a single-employer plan.5
The PBGC faces significant risks from both types of underfunded pension plans. It finances its operations from the premiums it collects from employers and the interest, dividends, and capital gains it earns on accumulated reserves, which include assets recovered from terminated plans. Since 2002, these funding sources have been measured as insufficient to fund the PBGC’s projected benefit obligations, meaning the PBGC has accumulated a substantial deficit. In fiscal year 2010, the PBGC’s deficit was more than $21.6 billion for single-employer programs and approximately $1.4 billion for multi-employer plans (figure 5).6
With almost $80 billion in assets, the PBGC has sufficient resources to pay benefits without interruption for a number of years. However, it lacks the resources to meet all its obligation over the longer term, given that the present net value of its future obligations was approximately $102 billion (as of the 2010 fiscal year-end).7 The PBGC has the authority to borrow up to $100 million from the Treasury, but no other explicit source of funds is available to the PBGC were it to run out of money to pay pension benefits. In that instance, Congress would have to decide whether to allow retirees to lose the pension benefits covered by the PBGC or provide the PBGC with taxpayer funds to pay the benefits.8
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Source: Pension Benefit Guaranty Corporation.
5FIGURE
PBGC's net financial position by type of pension program (fiscal year)
8 Financial Innovations Lab
challenges to overcoming legacY costs
The operation of federal pension law has resulted in pension plans being substantially underfunded and the PBGC facing an unsustainable gap between its assets and its projected benefit obligations, Lab participants said. They identified inadequate funding requirements, the PBGC’s limited authority, and political factors as the main barriers to fixing the employer-provided DB pension system and securing the PBGC’s financial future.
Funding Challenges
Under the Pension Protection Act (PPA) of 2006, companies in the single-employer system are required to make a current year’s “normal plan contributions” as well as any further contribution required to amortize the plan’s current funding shortfall (with interest) over seven years. When the PPA provisions are fully phased in, the companies with the most underfunded plans will face a significant increase in required contributions.
Participants noted that many companies may be unable to generate sufficient cash flow to make the required contributions, which could force the companies into bankruptcy and lead to the plans being assumed by the PBGC. Legislation passed in June 2010—the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act—temporarily reduces sponsoring companies’ pension funding requirements if they opt for relief. But some Lab participants pointed out that this just defers the contributions ultimately required for full funding instead of eliminating them.
The PBGC’s Limited Regulatory Authority
The PBGC’s regulatory authority is limited compared to that of other financial regulators. It cannot compel companies to make additional contributions even when a plan may be substantially underfunded. It cannot modify a sponsor’s contribution requirements, even if doing so could forestall insolvency. It cannot stop a company from promising enhanced pension benefits even when the plan is already substantially underfunded (although the Pension Protection Act would restrict benefit improvements for weak plans). It cannot stop a plan sponsor from making imprudent investments that increase the risk of further deterioration. And it cannot adjust premiums even if the risk of a company defaulting on its pension obligations increases.
The PBGC’s primary negotiating leverage is limited to initiating an involuntary termination, in which the PBGC takes over the pension plan and assumes its unfunded pension obligations. As an “all or nothing” tool, however, its utility is only as good as the PBGC’s threat to initiate the termination, and it cannot be employed to surgically reduce the amount of benefit obligations for which the PBGC ultimately becomes responsible. There are other, infrequently used authorities that could at least partially address the legacy funding problem. For example, while the PBGC lacks the authority to modify statutory contribution requirements for ongoing plans, it can establish the terms of liability owed for terminated plans. This authority could provide a means for a distressed sponsor and the PBGC to agree to a “prepackaged” termination (either employer- or PBGC-initiated) on terms that would be beneficial to both parties relative to the status quo.
9Part I: Defining the Problem
The PBGC’s role also is limited for multi-employer plans; it can step in and provide financial assistance only after the plan becomes insolvent. When an employer withdraws from a multi-employer plan, the law requires that the withdrawing employer pay a penalty and that the remaining employers in the plan assume responsibility for the bankrupt employer’s obligations. With more authority, the PBGC could assist participating employers before the plan becomes insolvent.
Political and Regulatory Challenges
The following section presents several solutions that Lab participants suggested would provide more equitable outcomes than the status quo. Many of these solutions involve initiatives that could be undertaken by the PBGC itself or in cooperation with pension plan sponsors. Other options require changes to federal law to give the PBGC authority it does not currently have.
Lab participants noted that changing the PBGC’s status or creating a new role for it beyond a guaranty authority involves policy changes that Congress has so far been unwilling to adopt. Although the PBGC has some authorities that have not been fully exercised, legislative dynamics will need to change to implement many of the policy initiatives discussed during the Lab. For example, among the market-based approaches discussed were a bond swap between a sponsoring company and the PBGC, and trading pension claims in private markets. But trading pension claims is explicitly prohibited under the ERISA and the Internal Revenue Code, and the bond swap would require changes in legislative authority as well. Fully implementing these and other policy ideas from the Lab would require federal legislation.
10 Financial Innovations Lab
Part ii: addressing the shortfall
Lab participants discussed several specific proposals to address the legacy funding challenge. These proposals reflected a range of strategies, some altering the authorities of the PBGC, some tapping the creativity and resources of private markets, and some simply making implicit federal financing support even more explicit. Some options would make use of more than one of these strategies. We begin with the general principles that Lab participants used as they laid out potential solutions.
general PrinciPles
Bradley Belt, senior managing director at the Milken Institute and former executive director of the PBGC, listed six key factors for participants to keep in mind when considering reform options:
■ The rules that govern the DB system reflect in part industrial and social policy objectives that don’t necessarily lead to optimal outcomes. Unlike insurance companies, which are subject to a stringent solvency regulatory regime, DB plans function with few constraints on risk-taking (e.g., no capital reserve requirement) and can operate chronically underfunded.
■ What constitutes a “fix” to the legacy cost problem depends on stakeholders’ perspectives. What the sponsor of a pension plan may view as a fix may exacerbate the problem for beneficiaries, taxpayers, and other stakeholders, and vice versa.
■ Some concepts may have merit in terms of improving risk management, transparency, and incentives relative to the status quo, but they may not necessarily resolve legacy or unfunded costs in the DB system.
■ Some solutions cannot be implemented under current law and regulations. Consider what’s practically achievable and politically feasible for each potential solution.
■ Every plan has a different funded status and maturity structure. Every sponsor has a different covenant and risk appetite. Therefore, one-size-fits-all approaches don’t work.
■ The only real solution to the legacy cost problem is to fill the financing hole. If sponsors cannot fully fund legacy costs, then a determination as to who will must be made.
Bradley Belt, former executive director of the PBGC, lays out six general principles for evaluating pension plan solutions.
11
Considerations for Pension Plan Solutions
Lab participants generally agreed that not all solutions are appropriate to every company or every pension plan. They suggested specifically that single-employer plans undergo stress tests similar to those that assessed the health of the largest U.S. commercial banks during the recent financial crisis. The objective would be to separate healthier plans from distressed ones. This discussion divided the plans into the broad categories of “marching ahead,” “walking wounded,” and “walking dead” with the suggestion that different policy approaches be taken to each one.
■ “Marching ahead” plans are offered by healthy companies with the ability to fund their pension liabilities. The market-based strategies discussed later in this report could help transition these plans to full funding, with more rigorous funding standards applied going forward.
■ “Walking wounded” plans are not yet on the brink of termination, but it is unlikely their sponsors can afford the contributions required to fully fund their projected obligations. The general approach toward these plans would be to empower the PBGC with additional tools to mitigate its own exposure to losses while increasing the probability that a plan sponsor will stay in business.
■ “Walking dead” plans, offered by highly distressed companies that lack the resources to meet their obligations, are those that will clearly need the PBGC to take over. For these plans, the goals would be to minimize the PBGC’s losses, explicitly book any PBGC losses that are already known, and prevent these plans from imposing further costs on the system.
Participants suggested that the stress test take into account factors beyond a plan’s statutory funding ratio. This broader view would also consider the health of the sponsoring company and the macroeconomic environment. Specific factors to be monitored could include the sponsoring company’s contribution capabilities, the current funded status of its plan, the level of benefit accruals, and the allocation of assets. As participant Emily Kessler of the Society of Actuaries said, this evaluation would be done by looking comprehensively “at the sponsor as well as the plan.”
After reviewing the pension plans with the greatest unfunded liabilities (figure 6), Lab participants generally agreed that many of those employers have the ability to fully fund their plans. As Craig Rosenthal of Mercer said, “I looked at this list of the top 10 underfunded plans and … seven or eight or nine of these companies don’t cause me concern that they’re going to go out of business and not fund their pension liabilities, and some of them could probably make up the shortfall over two or three years if they wanted to ... and still not disappoint their investors.” For these plans, the policy objective should be to compel full funding under continuation of their current sponsorship, rather than PBGC trusteeship, Lab participants said.
Part II: Addressing the Shortfall
12 Financial Innovations Lab
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FordExxon
Lockheed GE IBMP�zer
Boeing
DuPont
Dow Chem.
Procter & Gamble
Raytheon
US$ billions
ChryslerGM
Note: The data are as of August 2010, except for GM and Chrysler data, which come from PBGC estimates as of early 2009.Sources: Bloomberg, the PBGC, Milken Institute.
6FIGURE
Employer plans with largest funding gaps
Minimizing Moral Hazard
Proposed solutions should be implemented in a way that minimizes moral hazard. Under current law, moral hazard is manifested whenever a company engages in imprudent pension management because there exists the potential to shift the risks of pension plan underfunding to third parties. One suggestion to limit this moral hazard is to have pension plan participants retain a portion of their benefits in the form of claims or warrants on the sponsoring companies. PBGC claims on a plan sponsor’s assets could also be assigned a higher priority than some other creditors. In that case, if the company goes bankrupt, pension plan participants (and the PBGC) would be paid before other unsecured creditors.
Another way to mitigate moral hazard in the pension insurance system would be to give the PBGC the authority to impose risk-based premiums, reflecting the funded status of the plan, the creditworthiness of the plan sponsor, and the investment risk taken with plan assets. The Pension Protection Fund in the U.K. (an entity similar to the PBGC) has such authority, and the Obama administration has proposed expanding the PBGC’s premium-setting authority. A concern with risk-based premiums, however, is that they can act counter-cyclically, i.e., financially distressed companies with significantly underfunded plans would face the prospect of higher premiums when they can least afford the additional burden. Moreover, it should be noted that while the use of risk-based premiums might help address moral hazard going forward, they would have a limited effect on the current plan funding gap.
13
One alternative is applying the principle of coinsurance to pension insurance. Plan participants would suffer some loss of benefits should a plan terminate. This would give workers an additional incentive to monitor the funding status of their pension plans. However, the effectiveness of this approach is unclear as individuals may lack the resources and economic power to assess the information and respond promptly.
The most direct way to minimize moral hazard would be to reduce pension insurance itself. With reduced pension insurance, plan participants would know in advance that they would suffer benefit losses if their pension plan is terminated while underfunded. Some Lab participants noted that insurance limitations already exist because there is a statutory cap on the amount guaranteed by the PBGC. However, most beneficiaries are not affected by the guarantee limits, so they have little incentive to negotiate for more plan funding (putting aside the question of whether they would otherwise have the ability to monitor funded status effectively or to negotiate in non-unionized plans).
Incentives for Full Funding
The general principle of reducing moral hazard can be extended further to establish specific incentives for full funding of pension plans.
Participant Jeremy Gold of Jeremy Gold Pensions offered several reasons why full funding should be the overriding goal.9 For employees, full funding means that benefits are fully protected even if their sponsoring company goes bankrupt. Full funding also limits the risk that taxpayers will face an additional financial burden from an insolvent pension insurance system.
The advantages of full funding go beyond the moral imperative to fund the pension benefits that are promised to workers, Gold said. In effect, underfunding represents a type of loan from workers to pension plan sponsors. “The trick should be to get full funding in such a way that we replace employees making bad loans to their sponsors with banks or the capital markets making good loans to those same sponsors,” Gold said.
A number of actions could incentivize sponsors to fully fund their pension plans and incentivize workers to press for full funding.
■ Sponsoring companies
1. Have the PBGC rely increasingly on premium assessments that reflect the degree of risk in a pension plan, taking into account the plan’s funding level, its investment portfolio, and its sponsors’ health, among other factors.
2. Provide a fiduciary safe harbor for sponsors that pursue investment strategies designed to limit the risk of loss (e.g, liability-driven investments).
3. Encourage rating agencies to give appropriate credit to pension plan sponsors that reduce risk in their pension financing.10
Part II: Addressing the Shortfall
14 Financial Innovations Lab
4. Issue special bonds (similar to Build America Bonds) that are subsidized by the federal government specifically for employer-provided pensions, providing sponsoring companies with a low-risk investment carrying an explicit federal subsidy in exchange for fully funding pensions and implementing strategies to minimize costs and risks.
5. Create a tradable tax credit to encourage sponsors to put money into their plans. The sponsors could later sell the tax credits to third parties.
6. Restrict dividends, equity buybacks, and supplemental executive plans for companies with underfunded pension plans, basing the severity of the restrictions on the level of underfunding. “What you might do is really just draw a hard line, and say if your plan is underfunded by $1, all these rules apply,” Gross said.
7. Provide the federal government’s guarantee on pension bonds.
■ Plan participants: Employees can be motivated to act as watchdogs to ensure full funding of their pension plans. For example, when plan funding drops below 100 percent, benefit accruals would stop until funding exceeds the threshold. The extent to which benefits are restricted would depend on the level of underfunding. This would be similar to the PPA except that the restrictions would begin immediately below the 100 percent funding level.11 As noted above, this suggestion assumes that plan participants can assess the information and influence the behavior of plan sponsors effectively.
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sPecific ProPosals
Solution 1: Expand the PBGC’s authority to negotiate pension funding and termination agreements
As mentioned, the PBGC has limited authority under current law to minimize its risk exposure. Its primary tool, initiating involuntary termination of a pension plan, is a blunt instrument. In many instances, the last thing the PBGC wants is to assume responsibility for an underfunded pension plan because the insurance program incurs losses and participants risk losing non-guaranteed benefits. But in appropriate cases the agency will initiate involuntary termination to mature an underfunded claim against a plan sponsor if it believes the company is pursuing a path that will lead to greater losses in the future. The effect of involuntary termination is powerful: A claim arises against the plan sponsor and all members of its controlled group for the full amount of underfunding calculated on a termination basis. While this authority provides a basis for the PBGC to seek additional protections from a plan sponsor, the agency’s leverage is highly contingent on the plausibility of its threat to initiate an involuntary termination.
Moreover, to the extent that a sponsor seeks to terminate an underfunded pension plan in bankruptcy, or the initiation of an involuntary termination by the PBGC forces a company into bankruptcy, the PBGC’s claim is that of an unsecured creditor—with a recovery typically amounting to just pennies on the dollar. Current law essentially leads to an all-or-nothing (or almost nothing) outcome, with no middle ground for the PBGC to negotiate the amount of required contributions or the funding deficit.
Lab participants recommended expanding the PBGC’s authority to negotiate a settlement, particularly in the case of “walking wounded” plans that are likely to be assumed eventually by the PBGC. This would permit the PBGC to negotiate with a plan sponsor well before the point of termination to arrange terms that would benefit both the plan sponsor and PBGC instead of allowing plan underfunding to mount prior to termination in bankruptcy court. “For the walking wounded, the goal here is to maybe get 80 cents on the dollar instead of 30 cents on the dollar, given that you can’t get 100 cents on the dollar,” said Brett Hammond of TIAA-CREF.
The basic idea is to create a new avenue for constraining the growth of unfunded liabilities in instances where the plan’s sponsor might otherwise be pushed into bankruptcy by current pension funding requirements. By negotiating the terms of a distress termination, the plan sponsor could be spared bankruptcy proceedings, and the PBGC could face a smaller loss than if the issue were eventually resolved in bankruptcy court.
As Lab participant Belt explained: “The PBGC could say to a financially distressed plan sponsor with a significantly underfunded pension plan, ‘We’ll agree to terminate and assume responsibility for your pension plan so you are able to avoid entering bankruptcy. In exchange, you’ve got to fill, or in some cases partially fill, the financing hole. We will use our new authority to give you different funding requirement terms than would be mandated by the PPA.’ The PBGC would also want to move up the capital structure, perhaps subordinated to all other secured debt issued by the sponsor, but ahead of other general unsecured creditors as part of a negotiated settlement.”
16 Financial Innovations Lab
Solution 2: Use the PBGC as a financing source (bond swap)
Lab participant Gold proposed a bond swap approach, which involves an exchange of bonds between a sponsoring corporation and the PBGC.12 The goal would be establishing a one-time transition period to allow an underfunded pension plan to achieve full funding, followed by a second stage in which full funding is tightly enforced.
The bond swap approach would be most appropriate for sponsors who are financially capable of achieving full funding within a defined time period. In an ideal world, the corporation would borrow from diversified lenders to bolster its underfunded pension plan, but not every corporation with pension challenges can borrow on reasonable terms through capital markets. Usually, companies with the greatest need to borrow are the least able to do so.
Gold proposed allowing a corporate sponsor to borrow through the PBGC. The corporation would issue a bond to the PBGC, and the PBGC in return would issue a bond to the corporation’s pension plan, each equal to the unfunded accrued liability of the plan. The corporation would repay the PBGC through amortization over a set period. The bond issued by the corporation would offer interest rates that reflect the funded status of the plan and the credit quality of the corporation. The interest rate spread between these two bond issuances would essentially be equal to the risk taken by the PBGC. The plan itself would become fully funded immediately, while the sponsor’s payments would effectively be spread over n years. In effect, the sponsor would be taking out a loan to achieve immediate full funding, except that this loan would be made explicitly by the PBGC rather than by the stakeholders in the plan, as is effectively the case under current law. Gold said some corporations could issue bonds not only to the PBGC but also through the capital markets, allowing tradable bonds for better pricing.
The sponsor would then be required to operate under more stringent rules to maintain full funding. As Gold pointed out, “The hard transition is from a state of substantial underfunding to one of full funding after everybody has agreed that full funding at all times meets society’s goals.” This approach would be “minimally disruptive” to the PBGC because it is already on the hook for those unfunded liabilities, he said.
Lab participants agreed that the bond swap approach was an idea worth exploring but noted that the approach has its limitations.
Going forward, full funding of pension plans should be the overriding goal, says Jeremy Gold of Jeremy Gold Pensions.
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Requirements for the bond swap to work:
■ There must be guarantees on each side of the bond-to-bond exchange. For the sponsor’s bond, for example, guarantees could be in the form of a minimum reserve requirement for the company. PBGC bonds would be guaranteed by the Treasury Department, as PBGC bonds would be unlikely to earn a AAA rating absent the explicit full faith and credit of the government.
■ Rules, taxation, and the PBGC’s authority must be clarified, and some legislative action could be required.
Limitations of the bond swap approach:
■ Like the seven-year amortization period under the PPA, a bond swap framework envisions employers making sufficient contributions to attain full funding within a defined span of time. Compared to the PPA, the bond swap approach would offer less flexibility in whether employers meet full funding requirements within this period, and less latitude in pension management after full funding has been reached. As a result, it is only an option for employers that are financially capable of meeting the full funding standard within the time specified.
■ Bond swaps are suitable primarily for large corporations because many small employers don’t have access to the public debt markets. This approach would be of limited value to union locals, nonprofit organizations, and any critically underfunded pension plan.
■ The bond swap approach is likely to work best when sponsoring companies have small unfunded pension obligations relative to their assets.
■ The effectiveness of this approach would depend on a return to some semblance of normalcy in the corporate bond market, participants noted.
Specific Proposals
18 Financial Innovations Lab
Solution 3: Trade pension claims
Lab participants discussed the possibility of using private capital markets to fill the unfunded legacy cost gap. “There may be another organization besides the PBGC which would give you a better deal now, so why not just open it up to the market where you can determine who’s able and who’s willing to take on that kind of arrangement? It doesn’t have to be the PBGC,” Karyn Williams of Wilshire Associates said.
Trading pension claims could let companies transfer legacy liabilities from their balance sheets to someone other than the PBGC. Currently, if a company wants to terminate its pension plan, the only way to do it without PBGC trusteeship is through a standard termination. In this process, a company is required to purchase annuities from the safest AAA-rated annuity providers to satisfy its pension obligations. However, “there is a huge cost to do that,” Belt said, “and essentially you are forcing a company operating with sub-investment-grade credit to buy a AAA cost solution. It’s a huge gap.”
With only this costly option now available, some companies choose to keep the risk on their balance sheets and try to manage it themselves. As participants noted, many companies are simply gambling: They may pay 100 cents on the dollar on promised pension benefits if they regain financial strength, or they may pay, for example, 30 cents on the dollar if they go bankrupt.
Trading pension claims could create a middle ground between costly annuities on one hand and relying on a sub-investment-grade sponsor to continue operating the pension plan on the other. If another entity that is a safer credit risk than the original plan sponsor—even if it is not a AAA-rated annuity provider—can operate the pension plan, both the PBGC and workers’ retirement security benefit.
Though trading pension claims arguably would require changing existing law, Lab participants agreed this market-based approach would likely be less expensive than the status quo. Trading pension claims in the private capital markets would allow private investors to determine reasonable prices for pension claims, and the risks for a business or investor would be small because the pension claims are guaranteed by the PBGC.
Lab participants recognized the potential political resistance to this concept, particularly in a post-recession environment in which the risk-assessment practices of financial institutions are receiving far more public scrutiny. Extra steps would be required to address any perception that this approach would make either worker pension benefits or the pension insurance system as a whole less secure.
The concept of trading pension claims is discussed in detail by Dumas and Syz (2007). Other defeasance structures explored by Berner and Peskin (2006) and other market-based solutions such as issuing the PPA compliance bonds proposed by the American Academy of Actuaries are summarized in Appendix B.
Karyn Williams sees the private capital markets as a potential solution to unfunded legacy costs without burdening the PBGC.
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Solution 4: Consolidate 'orphan liabilities' under the PGBC
Another concept discussed by Lab participants was to recognize certain unavoidable losses as “sunk costs” faced by the PBGC. The idea is to recognize at the earliest possible moment any costs the PBGC is unlikely to escape.
This idea is particularly relevant to multi-employer plans because their likely costs are not currently accounted for on the PBGC’s balance sheet. For single-employer plans, the PBGC books both previous and probable terminations in determining its net financial position.
When a participating employer in a multi-employer plan goes bankrupt, the remaining employers in the plan are required to fulfill the bankrupt employer’s obligations. Because these other employers are the first line of defense, the mounting levels of unfunded liabilities do not appear on the PBGC’s balance sheet. There was a sense among some Lab participants that this bookkeeping method understates the likely future toll on the PBGC and that these “orphan liabilities” should be explicitly recognized. Senator Robert Casey (D-Pennsylvania) introduced a similar concept in the unsuccessful Create Jobs and Save Benefits Act of 2010.
Booking orphan liabilities on the balance sheet of the PBGC would explicitly concede that federal resources would be required to meet financing shortfalls in multi-employer plans. This would reduce the burden on the remaining employers, and some participants argued that it might reduce the PBGC’s long-term exposure as well. Some participants said this approach would worsen the PBGC’s balance sheet only on paper. As Gross explained, “From PBGC’s perspective, the cost is fairly explicit, which is you’re taking a non-balance-sheet liability many years in the future and explicitly rolling it up onto the balance sheet today. So PBGC’s balance sheet would take a big hit under this scenario. I mean economically it hasn’t really changed their position, but from an accounting standpoint it certainly would.”
Other Lab participants noted that elements of this proposal would need to be clarified. If the proposal resulted in the PBGC taking on new obligations relative to current law, the result would be a significant deterioration in the PBGC’s financial position. Others noted that the Casey bill went further than simply shifting guaranteed benefits to the PBGC; it mandated that the PBGC pay benefits that are now beyond the statutory limits. If the Casey proposal were law, the PBGC would clearly take a significant new hit to its finances.
Moreover, booking “orphan liabilities” with the PBGC raises the question of what the process would be for financing them. Under current law, the PBGC provides financial assistance to an insolvent multi-employer plan, but it doesn’t typically become a trustee; establishing actual PBGC trusteeship would be a substantial change from current mechanisms. Others asked whether this solution would be made available to all multi-employer plans with orphan liabilities or only those plans projected to be insolvent.
Specific Proposals
20 Financial Innovations Lab
Solution 5: More equitable sharing of legacy costs
Lab participant Kessler noted that some pension plans face difficulties largely because of the changing nature of the industries that they serve. For example, deregulating the airline industry in the late 1970s allowed airlines to compete freely and lowered the costs of tickets, so perhaps passengers should be paying a share of the airline industry's legacy costs. Start-up airlines have been more competitive because they lacked the legacy costs of their established rivals. “That legacy cost is essentially part of the cost of the industry,” Kessler said, adding that any potential solutions should recognize that and avoid spreading the costs to others in the pension sponsor community or to taxpayers. One method would be assessing a tax on purchases of that particular product or service, the proceeds of which would go toward addressing funding pension shortfalls in that particular industry.
Solution 6: Allow employers/employees to negotiate benefit reductions
One approach to helping a company reduce unfunded obligations would be allowing sponsoring employers to negotiate benefit reductions with plan participants and even retirees, with the goal of swapping future annuitized benefits for a near-term lump sum that is worth somewhat less in terms of present value. Though the lump sum’s value may be less than the pension stream they gave up, workers would have the certainty of cash in hand at a time when their employer’s future is less certain. An employer “could go to employees and say, ‘We’re in trouble, and God knows if I’m going to be able to pay this to you someday. I’ll trade you 80 cents on the dollar today fixed for a roll of the dice tomorrow, ’ ” Kessler said. “That might be one way of lowering your liability is by getting participants to agree to take a haircut themselves.”
Among the issues with this approach:
■ This option would provide an incentive for worker participation only if the offered benefits exceed those guaranteed by the PBGC. Otherwise, workers will take their chances with their pension plan or the PBGC and reject the lesser lump sum. In many cases, the PBGC’s maximum is indeed lower than the benefits the employer has promised, especially in multi-employer plans, suggesting this tactic might be more effective for multi-employer plans.
■ Some Lab participants noted that the partial-benefit payment could be substantially less expensive to employers than purchasing an annuity from an insurance company, especially if participants are willing to accept cash at a discount rate that is higher than an annuity insurance rate.
■ Some at the Lab were concerned that this approach might benefit plan sponsors more than participants. Another concern was that individuals, who do not always make optimal retirement decisions, may be more likely to select a lump sum even if it is less beneficial in the long run than an annuity.13
“One way of lowering your liability is by getting participants to agree to take a haircut themselves,”says Emily Kessler of the Society of Actuaries.
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Solution 7: Expand the purchase of annuities to partially defease liabilities
Lab participants discussed the private insurance industry as a potential financial conduit for resolving legacy costs, similar to buy-out, buy-in pension schemes in the United Kingdom. One way to implement this approach is to have the sponsoring company purchase annuities for the unfunded portion of the plan’s pension liabilities, transferring the risks to a third party (e.g. an insurance company). Some participants believed annuity purchases should be a core component of any long-term solution because they offer the prospect of pension liabilities being managed by insurance companies, which are subject to a stricter regulatory scheme than are current plan sponsors and are thus required to carry less risk. Some Lab participants said insurers would generally manage and hedge pension liabilities better than individual sponsoring companies do. Some participants even suggested the PBGC should play an active role in helping sponsoring companies buy annuities.
Though annuity purchases may be part of the long-term solution, limitations to this approach exist. First, turning to annuity providers does not by itself resolve the funding gap problem because sponsors would still need sufficient funding to buy the annuities. Though the purchase would permit the sponsor to shift financing risks to a third party, the sponsor would still have to contribute substantially more funding to the pension plan than current law requires. Also, annuity purchases are not the only means of shifting financing risks to a more financially stable third party, as discussed in the prior section on trading pension claims.
Participant Blitzstein wondered whether moving pension liabilities from a troubled plan to a troubled financial industry was jumping from the frying pan into the fire. “I think that was viable pre-2008,” he said. “I would have some serious concerns about shifting assets to another troubled sector of the financial industry, and I personally don’t think we have yet seen the next shoe to drop in the financial community.” Another concern at the Lab was that annuities are not covered by the PBGC, so the only protection for these transferred pension obligations would be the health of the insurer.
Specific Proposals
22 Financial Innovations Lab
conclusion and next stePs This Financial Innovations Lab explored many innovative approaches to managing and restructuring the legacy costs of employer-provided defined-benefit plans. Many of these strategies would require significant changes to federal law and regulation.
The discussion produced general agreement on the following principles:
■ To ensure adequate pension funding going forward, comprehensive reforms will be required. Though full financial market recovery would somewhat reduce projected funding shortfalls, it will by itself be insufficient to ensure adequate funding.
■ One-size-fits-all approaches are unlikely to be fruitful. Clear thinking on pension funding policy will likely require drawing distinctions between “marching ahead,” “walking wounded,” and “walking dead” plans, each of which warrants different policy approaches.
■ Current law is not flexible enough when it comes to the disposition of underfunded pension plans, specifically by permitting no middle ground between full annuitization of pension benefits and trusteeship by the PBGC. Workers, employers, and the PBGC could all benefit from the latitude to pursue outcomes in between these extremes.
■ Many potentially useful strategies involve the PBGC partnering with employers to tap into the creativity and resources available in private financial markets. Even these private market solutions, however, require legislative changes to establish or clarify the PBGC’s authority.
■ Lab participants generally agreed that the PBGC’s existing authorities were inadequate to fully protect the interests of workers and the pension insurance system, and that new negotiating authority and legal tools were warranted.
■ The consensus was that full funding should be the eventual goal of pension policy, though the attainability of this standard varies greatly within the pension sponsor community.
■ Pension funding incentives should be restructured to reduce moral hazard and to incentivize full funding where possible.
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a P P e n d i x aFinancial Innovations Lab Participants
George Jamgochian Managing Director, Institutional Sales, Principal Global Investors LLC
Emily Kessler Senior Fellow, Society of Actuaries
Michael L. Klowden President and CEO, Milken Institute
David Lee Vice President, Strategic Income Security Services
Daniel J. Lucey Institutional Portfolio Specialist, Ryan Labs Inc.
Caitlin MacLean Manager of Financial Innovations Labs, Milken Institute
William T. McDonough Executive Vice President, United Food and Commercial Workers International Union
Laurin Moore Director of U.S. Tax-Exempt Asset Services, BNY Mellon Asset Servicing
Michael Moran Vice President, Goldman Sachs & Co.
Win Neuger Chairman and CEO, PineBridge Investments
Craig Rosenthal Partner, Mercer
(Affiliations at time of Lab)
Penny Angkinand Senior Research Analyst, Milken Institute
Rob N. Aronchick Associate, Capital Markets, Coventry
Bradley D. Belt Chairman and CEO, Palisades Capital Management LLC
David S. Blitzstein Special Assistant for Multiemployer Funds, United Food and Commercial Workers International Union
Peter Brady Senior Economist, Investment Company Institute
Maxine Dotseth First Vice President, BNY Mellon Asset Servicing
Allan R. Emkin Managing Director, Pension Consulting Alliance Inc.
Jeremy Gold Proprietor, Jeremy Gold Pensions
Jared B. Gross Senior Vice President, PIMCO
Brett Hammond Chief Investment Strategist, TIAA-CREF
Robert Hiltonsmith Policy Analyst, Demos
Mindy Silverstein Director, Strategic Partnerships, Milken Institute
Barry Slevin President, Slevin & Hart P.C.
Anne B. Walsh Senior Managing Director, Guggenheim
Fred Weinberger Managing Director, BlackRock
Karyn Williams, Managing Director, Wilshire Associates
Glenn Yago Executive Director, Financial Research, Milken Institute
Appendix
Financial Innovations Lab
e n d n ot e s
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Securitizing unfunded liabilities through the PBGC
Proposed by: Jeremy Gold, “Never Again: A Transition to a Secure Private Pension System,” Journal of Portfolio Management, Fall 2005, 92-97.
Highlights: This approach is designed to bring private capital market principles and discipline into a pension system.
Mechanism: The sponsoring company issues private placement bonds to the PBGC. The plan receives bonds issued by the PBGC, each in an amount equal to the initial unfunded accrued liabilities. The sponsor’s bond can be flexibly designed to increase its attractiveness. The price and interest rate of the PBGC bonds, which would be introduced to the capital markets, would be adjusted for a company’s credit rating. Note that the sponsor pays a higher rate than the PBGC and that this rate would reflect the funded status of the plan and the creditworthiness of the sponsor.
How this approach overcomes underfunded pension plans: A bond-to-bond exchange will provide full funding. The approach aims to drive sponsors to borrow in the capital markets in order to fund their plans fully.
Conditions for the strategy to work: It needs guarantors of the bonds. The PBGC can assume responsibility in the case of sponsor default.
Advantages: Benefits include transparency and a one-time- only credit analysis.
Obstacles to success: Barriers include the slow recovery in the capital markets and the difficulty of estimating the bond’s valuation.
Trading pension claims
Proposed by: Bernard Dumas and Juerg Syz, “Why Not Trade Pension Claims?” Financial Analysts Journal, 63(1), 46-54, 2007.
Highlights: This proposal is based on a financial structure similar to that of a collateralized debt obligation (CDO). Just as loans or mortgages are pooled and tranched in traditional CDOs, pension claims could be pooled and tranched in a collateralized pension claim obligation (CPCO).
Mechanism: This approach allows pension beneficiaries to trade their claim to pension benefits for a CPCO if they suspect they will never collect the full face value of their claim or are uncomfortable with the specific risk of the plan sponsor. Through this method, the CPCO accumulates claims on many companies, becoming naturally diversified.
How this approach overcomes underfunded pension plans: With a posted market price for pension claims for everyone to see, companies would have incentive to fully fund their plans.
Conditions for the strategy to work: Constructing pools of pension claims would require a high level of claim standardization. Another crucial condition for a successful CPCO scheme would be a large volume of trading in the pension-claim pools.
Advantages: This approach will create a market for pension liabilities that would improve transparency. The sponsoring companies would be made fully aware of the market value of their individual claims, which would now reflect default risk and underfunding, so sponsors would face pressure to maintain funding close to 100 percent.
Obstacles to success: Financial market participants might not be willing to trade a CPCO. The pension claim pools would carry longevity risk. Another obstacle is the adverse selection problem (e.g. beneficiaries would be better informed about their own longevity risks than the CPCO managers would be, so people in poor health might select the higher payout offered by a weaker tranche). Also, trading pension claims is prohibited under current law.
Risks: The companies might oppose CPCOs to avoid increased transparency and the associated necessary contribution. Another risk is the suggestion that trading pension claims be initiated by the beneficiaries rather than by the company.
a P P e n d i x bExamples of Market-Based Solutions
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Defeasance strategy
Proposed by: Richard Berner and Michael Peskin, “Defeasing Legacy Costs,” Journal of Applied Corporate Finance, 18(1), 104-107, 2006.
Highlights: This approach allows the sponsoring companies to exchange their legacy pension debt for another liability with more attractive terms.
Mechanism: The strategy involves an exchange or swap of promissory notes between the PBGC and a plan sponsor. The PBGC would grant a troubled plan sponsor a long-term mortgage (an amortizing note) on favorable terms to cover its unfunded pension liability. In exchange, the sponsor gives the PBGC a priority claim on its assets and agrees to service the note until the legacy costs are extinguished. One restriction is that the unfunded liability is not allowed to grow beyond the current level.
How this approach overcomes underfunded pension plans: An exchange of promissory notes would separate the legacy costs a sponsoring company accrued in the past from the plan’s future operations.
Conditions for the strategy to work: The approach should be applied only to sponsoring companies with a reasonable chance of survival. Weak sponsoring companies will exit the system and transfer the legacy debts to the PBGC and, ultimately, taxpayers.
Advantages: The transparency gained by separating the past from future liabilities will give better insight into sponsors’ balance sheets, reducing the moral hazard in the DB pension system that resulted from the PBGC guarantees.
Obstacles to success: 1) The PBGC may lack authority to exchange notes with plan sponsors. 2) Existing bondholders will object to a new creditor having a superior position prior to bankruptcy, which may break existing covenants in the company’s outstanding debt. 3) If the sponsor is not profitable, it cannot use a tax deduction to help fund its plan.
Risks: While the swap may impose restrictions on the company’s behavior as a sponsor, those covenants do not assure that management will work to restore its overall financial health.
PPA Compliance Bonds
Proposed by: American Academy of Actuaries
Highlights: In 2003 General Motors issued $18 billion in bonds and used the proceeds to fully fund its pension plans. The approach borrows this concept by encouraging DB plan sponsors to issue Pension Protection Act compliance bonds.
Mechanism: The plan sponsors issue bonds into the marketplace and contribute the proceeds to their pension plans. These special PPA compliance bonds would be guaranteed by the federal government. The participating sponsors would agree to various “good behaviors.”
How this approach overcomes underfunded pension plans: The sponsors would borrow the amounts necessary to fully fund their plans. Depending on the structure of the bond issues, the sponsor’s cash funding requirements would spread over 20 to 30 years.
Advantages: This approach avoids the potential financial burden on the PBGC over the next several decades.
Obstacles to success: The bond market is illiquid, which makes it less attractive to investors. The government guarantee may increase the demand for bonds. However, requiring a government guarantee may result in some resistance to this approach because the unfunded pension liabilities of a bankrupt company are dumped directly on the U.S. government and because taxpayers would bear the cost if the government had to pay bond guarantees.
Risks and issues to be considered: 1) The sponsors would need encouragement to participate. 2) It is important to control the flow of new debt into the market to avoid a significant impact on interest rates. 3) A financial vehicle similar to bond debt needs to be developed for smaller entities and nonprofits (presumably through financial institutions that act as pass-through agents. 4) It must be assured that the government’s bond guarantee is not significantly greater than the guarantee already provided by the PBGC.
Appendix
27
1. In many plans, benefits can also be received as a lump sum of an amount that is also a function of employee compensation and tenure.
2. David Zion and Amit Varshney, “Pension Headwinds: Low Interest Rates & Weak Stock Market Are Bad News for Pension Plans,” Credit Suisse, September 21, 2010. The data are based on actual amounts for companies as of the end of June 2010.
3. There are other studies that provide estimates of the funded status of the S&P companies’ DB plans. See, for example, Michael A. Moran and Abby Joseph Cohen, “Accounting policy update: Recent pension palpitations linked to declining interest rates,” Goldman Sachs Global Markets Institute, July 12, 2010.
4. A DB pension plan can also be terminated under a “standard termination,” in which a company agrees to pay all accrued benefits to participants.
5. To understand key differences between the PBGC’s insurance for single-employer and multi-employer pension plans, read GAO-10-708T, “Private Pensions: Long-standing Challenges Remain for Multiemployer Pension Plans,” United States Government Accountability Office, May 27, 2010. http://www.gao.gov/products/GAO-10-708T (accessed February 17, 2011).
6. The smaller figure for multi-employer plans reflects in large part the different nature of PBGC multi-employer pension insurance and should not necessarily be interpreted to mean the multi-employer system is in qualitatively superior health.
7. Joshua Gotbaum, director, Pension Benefit Guaranty Corporation, statement to the Committee on Health, Education, Labor, and Pensions of the United States Senate, December 1, 2010.
8. For additional reading, see various GAO studies on
the PBGC’s insurance programs (available at http://www.gao.gov/highrisk/risks/insurance/pension_benefit.php; accessed February 17, 2011), and Zvi Bodie, “Less is Less: Straight Talk about Government Pension Insurance,” The Milken Institute Review, first quarter, 2005.
9. His presentation was based on an article by Lawrence N. Bader, “Pension Deficits: An Unnecessary Evil,” Analysts Journal 60 (May/June 2004), pp. 15-21.
10. For additional explanation and analysis of this issue, see “Funny Money: The Increasing Irrelevance of Pensions Earnings,” Oliver Wyman Financial Services and Mercer, August 2010.
11. According to the PPA, plans with a funding ratio of less than 80 percent are prohibited from making amendments that increase benefits. For plans with ratios between 60 percent and 80 percent, lump sums and certain “accelerated benefits” are restricted to the lesser of (i) 50 percent of the full amount or (ii) the PBGC maximum guaranteed benefit. For plans with a funding ratio below 60 percent, all future benefit accruals must be frozen, and the plan cannot provide a shutdown benefit or any other unpredictable event benefit.
12. Based on Gold’s article, “Never again: A transition to a secure private pension system,” Journal of Portfolio Management, Fall 2005, pp. 92-97. http://www.soa.org/library/monographs/retirement-systems/the-future-of-pension-plan-funding-and-disclosure-monograph/2005/december/M-RS05-1_gold-paper.pdf (accessed February 17, 2011).
13. See, for example, the 2001 study by John T. Warner and Saul Pleeter, “The Personal Discount Rate: Evidence from Military Downsizing Programs,” The American Economic Review. 91(1): 33-53.
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