The Actuary Magazine December 2004 - Defined Benefit Funding Reform: Do Not Throw The Baby Out With The Bath Water
Defined Benefit Funding Reform: Do Not Throw The Baby Out With The Bath Water
By Ken Steiner
Some believe the proposed plan to aid the voluntary defined benefit system could actually create more harm than good, eventually leading to the collapse of the system.
On September 14, 2004, U.S. Rep. John Boehner, chairman of the House Education and the Workforce Committee, released a statement calling for reform of the defined benefit system. According to the Rep. Boehner, "Federal rules governing defined benefit plans are badly outdated and comprehensive reform is necessary." While many benefit professionals would agree with this statement, there is concern that significant changes to the current rules could destroy the already fragile voluntary defined benefit system in the United States. While reform is indeed necessary, the focus of the reform should be on those plans that present the greatest risk.
As usual, in a call for broad reform, there are multiple interests at stake. In the case of pension reform, the principal stakeholders include plan participants, employers, the Pension Benefit Guaranty Corporation (PBGC) and possibly even the taxpayers. Successful private pension plan reform will have to safeguard plan participants? earned benefits and the integrity of the PBGC, while still allowing employers to design and maintain plans that are consistent with their business objectives. This is a tall order. But serving one set of interests at the expense of another would ultimately fail the defined benefit plan system and its participants. Why? Because one thing is clear—plan sponsors that are forced to choose between achieving key business goals and sponsoring a defined benefit plan are very likely to terminate or freeze these plans.
The number of defined benefit plans in the United States has declined significantly over the past 20 years. If Congress overlooks the interests of plan sponsors in its reform, we?re likely to witness further erosion of an already weakened defined benefit system, and America's workers would be the ultimate losers.
Where To Focus
Under current law, the PBGC pays claims only if two conditions are met: 1) the sponsor?s plan terminates with insufficient assets; and 2) the sponsor is bankrupt or has insufficient corporate assets to cover the pension–funding shortfall. It is important to note that temporarily lacking sufficient plan assets to pay all earned benefits does not necessarily pose a threat to participants? benefits. If a company in sound financial condition terminates its plan, it simply pays all accumulated benefits out of its corporate assets.
Ninety percent of companies whose pension plans had to be taken over by the PBGC had junk bond credit ratings for the entire 10–year period before termination, according to the PBGC. So, in developing rules to protect participants in the event of plan termination, it makes sense to focus reform efforts primarily on the under–funded plans of unhealthy companies (i.e., those with below investment grade credit ratings). There is no reason to penalize healthy companies who are fully able to meet their benefit obligations (either through plan or company assets). For healthy companies, the current rules are arguably operating well and are sufficient to protect the interests of the PBGC and plan participants. While minor changes in the rules applicable to pension plans sponsored by healthy companies may be desirable (such as increased maximum deductible limits or relaxed reversion penalties), we do not appear to need significant changes for these plans for the system to work as intended.
The current funding rules (which apply to plans sponsored by both healthy and unhealthy companies) try to achieve a balance between funding plans on a long–term, "ongoing" basis and funding them on a plan termination basis. Actuaries are permitted to use long–term assumptions for determining certain plan liabilities. But if plan assets fall below specified levels of "current liabilities" that are designed to approximate plan termination liability, other rules kick in. While it makes sense to assume a long–term funding horizon for a healthy company, a company with an increased risk of imminent insolvency should be held to different standards. Therefore, we should subject plans sponsored by unhealthy companies to different rules that recognize the increased plan termination risk. The following information outlines changes that could reduce the risks posed by unhealthy companies without penalizing healthy companies.
Funding Changes for Unhealthy Companies
Using PBGC assumptions, almost all of the plans taken over by the PBGC had funded ratios of less than 75 percent at termination and more than half of the plans had funded ratios less than 50 percent, according to the 2003 PBGC Pension Data Book. Clearly, current funding rules applicable to unhealthy companies are not adequately protecting the interests of plan participants and the PBGC. While some strengthening of the rules may be appropriate for all plans, reforms should focus primarily on reducing the risks posed by unhealthy plans sponsored by unhealthy companies. Even for these companies, however, there should be significant smoothing of minimum funding requirements, so contributions remain reasonable from one year to the next and unhealthy companies are not forced into bankruptcy by their pension plans. Changes to current funding rules for under–funded plans sponsored by unhealthy companies designed to improve a plan?s funded status in the event of plan termination could include: ignoring prior credit balances, using plan termination type assumptions rather than ongoing plan assumptions, requiring faster amortization of charge bases and restricting plan investments.
Since plan sponsors are legally required to subsidize lump sums and the PBGC generally does not pay out lump sums after a plan terminates, there is often a "run on the bank" situation before such terminations, which increases the PBGC's eventual liability. To remedy this situation, funding reform could include restrictions on lump sum payments from under–funded plans of unhealthy companies. Other benefit restrictions should also be considered for under–funded plans of unhealthy companies, such as reduced future benefit accruals for plans with declining funded ratios. Since unfunded plant shutdown benefits pose too great a risk to the PBGC, it also makes sense that the PBGC stop insuring those benefits.
Participant Notice Requirements
While current law requires plan sponsors to furnish notices regarding funded status to plan participants under certain circumstances, most participants in under–funded plans sponsored by unhealthy companies have no idea what benefit(s) they would actually receive upon plan termination. The administration has proposed providing participants with more up–to–date information about plan assets and current liabilities, but this additional disclosure would only provide an average plan funded status that can be misleading. Benefits that fall into higher Employee Retirement Income Security Act (ERISA) priority categories may be completely protected, while other benefits may not be protected at all. It makes sense to require unhealthy plan sponsors to disclose more relevant participant–specific information.
There is no question that pension reform is necessary. If all airline industry plans listed by the PBGC as possible terminations actually terminated, PBGC premiums would probably have to triple for the agency to remain financially viable without federal subsidies. Increasing PBGC premiums by such a degree would penalize healthy and unhealthy companies alike, and would probably prompt healthy companies to rethink the viability of their plans. As more companies decided to terminate their plans, the PBGC?s need for revenue would increase while the number of defined benefit plan participants would decrease, thus hastening the defined benefit plan death spiral.
To protect the interests of employers, workers and the PBGC, we need to spare healthy plan sponsors from new regulatory burdens, reserving new funding and disclosure remedies for those plan sponsors that are sick. Imposing higher PBGC premiums on everyone to make up for the failure of some plan sponsors to meet their benefit promises would give healthy plan sponsors another good reason to withdraw from the defined benefit system altogether. Companies in good financial shape that are fully able to make good on their pension promises should be encouraged to keep doing what they're already doing right.
Ken Steiner is the resource actuary in the United States for Watson Wyatt Worldwide. He can be contacted at:Ken.Steiner@ Watson Wyatt.com
The views presented in this article are those of the author and do not represent the views of his employer.