PBGC

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PBGC
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what PBGC does

• insures participants of defined benefit plans
  against loss of pensions
• when sponsor goes bankrupt, PBGC fills in the
  gapsPBGC will cover any losses subject to
• limit per month (as of 2005)
• 3,801.14 at age 65
• 1,710.51 at age 55
• five year phase in
• only source of funds is premium income and claim
  against sponsor (trivial)
• PBGC has no authority to
• increase premiums congress
• modify insurance contract congress
• oversee the operation of pension plans IRS, DoL

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Events leading to the establishment of pension
insurance

• failure of Studebaker in 1963,
• 6900 employees lost 85 percent or more of their
  pension benefits

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The rationale for ERISA

• insufficient information on the part of the
  employee to
• judge probability of bankruptcy for sponsor
• determine if plan is being adequately funded
• shifts role of assuring the quality of pensions
  to the federal government

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premium system

• a) started at 1 per participant
• b) now 19/participant, with variable rate premium
  of 9/1000 underfunding,

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Why are losses so persistent in federal pension
insurance

• 1. insurance program flawed
• 2. private insurance company woulda) first
  assess risk exposure from insurance contract and
  determine insurance premiums to charge the plan
  sponsors for the costb) if losses exceeded
  expectation, it would modify the terms of h
  insurance

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Adverse selection

• tendency for those with the highest probability
  of loss to purchase insurance and those with the
  least risk of loss to opt out of the insurance
  pool
• occurs when insurance premiums are not risk
  relateda) high risk firms will buy more
  insurance since it is underpricedb) low risk
  firms will try to leave the system

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adverse selection continued

• as a result, average riskiness of the pool
  increases, the premiums must be increased, and
  upward spiral results
• this is evidenced by the trend from defined
  benefit to defined contribution plans

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causes relevant to adverse selection

• premiums have been set too low for high-risk
  sponsors
• concentration of defined benefit plans in
  declining sector of the economy means than many
  participant plans have shorter life expectancies
  and entail higher risk than n the average us firm
• only fully funded defined benefit plans can leave
  the system all of those leaving system had a low
  risk of making a claim against PBGC

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solutions to adverse selection

• a) risk based premiums
• b) compulsory participation
• (1) require every firm to maintain a defined
  benefit plan (2) exit fee to those that switch
  from defined benefit to defined contribution

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Morale Hazard

• existence of insurance weakens the incentives to
  avoid loss
• a) participants in pension plans have weaker
  incentive and are willing to go to fewer lengths
  to see that their employers fully fund the
  pension promises
• b) labor negotiations will focus on benefits, not
  funding
• c) employees will be indifferent as to the
  riskiness of the pension investments

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Morale Hazard

• as sponsor of insured pension plans approach
  bankruptcy, insurance encourages them to offer
  increase in compensation in the from of insure
  pension benefit rather than in wages
• (TWA increased pension benefit by more than 100
  million in lieu of wages while in bankruptcy)

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partial solutions to moral hazard

• a) monitoring keeping tabs on the finances of
  sponsors gives early warning and opportunity to
  limit losses
• b) regulation control ability of insured to
  increase risk after insurance is provided
• c) coinsurance(1) on employees incur real
  losses when their pension plans terminate as a
  result of the difference between their pay at
  termination and their pay at retirement
  (2) creditors of sponsors )the more pbgc receives
  from the bankrupt firm, the less the other
  creditors receive)

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what causes PBGC's losses

• A. law permits sponsors to underfund their
  pension plans
• 1. amortizing pension debta) allows flat benefit
  plans to remain continually underfunded
• 2. deterioration before terminationa) funding
  waiversb) changes in actuarial
  assumptionsc) Shutdown benefits

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what causes PBGC's losses

• B. composition of plan assets
• not immunized against interest rate changes
• C. premiums are not sufficiently related to risk
• D. lags occur in policy adjustment

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Methodology for Considering Long-Term Claims

• No single underfunding number or range of
  numberseven the reasonably possible estimateis
  sufficient to evaluate PBGCs expo-sure and
  expected claims over the next ten years.
• There is too much uncertainty about the future,
  both with respect to the performance of the
  econ-omy and the performance of the companies
  that sponsor insured pension plans.
• PBGC uses a stochastic modelthe Pension
  Insurance Modeling System (PIMS)to evaluate its
  exposure and expected claims.

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• PIMS portrays future underfunding under current
  funding rules as a function of a variety of
  economic parameters.
• The model recognizes that all compa-nies have
  some chance of bankruptcy and that these
  probabilities can change significantly over time.
• The model also recognizes the uncertainty in key
  economic parameters (particularly interest rates
  and stock returns).
• The model simulates the flows of claims that
  could develop under thousands of combinations of
  economic parameters and bankruptcy rates.

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• Under the model, median claims over the next ten
  years will be about 650 million per year
  (expressed in todays dollars)
• that is, half of the scenarios show claims above
  650 million per year, and half below.
• The mean level of claims (that is, the average
  claim) is much higher, more than 1,050 million
  per year.
• The mean is higher because there is a chance
  under some scenarios that claims could reach very
  high levels.

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• For example, under the model, there is a ten
  percent chance that claims could exceed 2.6
  billion per year.
• PIMS projects PBGCs potential financial position
  by combining simulated claims with simulated
  premiums, expenses, and investment returns.
• The mean outcome is an 11.6 billion surplus in
  2010 (in present value terms).
• However, the model also shows the potential for
  significant downside outcomes.

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• In particular, there is nearly a 20 percent
  chance that the agency could return to a deficit
  in the next ten years and a ten percent chance
  that the deficit could exceed 12.0 billion in
  2010 (in present value terms).
• These outcomes are most likely if the economy
  performs poorly, in which case PBGC may
  experi-ence large claims amounts and investment
  losses.
• PBGC is continuing to analyze the best way to
  manage and reduce the risk of insolvency.