Lecture 4: Funding DB Pension Plans

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Lecture 4 Funding DB Pension Plans

• Tuesday, September 4, 2007

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By the end of this lecture, you should be able to

• List types of funding arrangements
• Describe plan termination rules
• Explain the role of the PBGC
• Discuss what happens when a plan is underfunded
• Discuss potential distortions that arise as a
  result of pension accounting rules

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First, A Question to Discuss

• How might you best achieve the goal of providing
  workers and retirees with protection against
  losing their pension in the event that their
  employer goes bankrupt?
• What would an ideal policy look like?

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IMPORTANT NOTE

• Some of the details of funding requirements in
  these slides have changed as a result of the
  passage of the Pension Protection Act, signed
  into law just last year.
• Slides at the end of this lecture will provide
  updates to the rules

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Overview of Pension Funding

• Prior to ERISA (1974), a firm could pay benefits
  as they came due
• If firm went bankrupt, workers could lose their
  entire pension (Studebaker)
• Since 1974, ERISA requires that all qualified
  plans must advance fund the benefits obligations
• Assets must be held by a funding agency, which is
  a trust or an insurance company
• Plan must purchase insurance from the Pension
  Benefit Guarantee Corporation (PBGC)

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Funding Agency

• Trusts are the primary method of funding
  qualified plans
• Legal agreement with three parties
• Grantor of the trust (employer)
• The trustee (fiduciary)
• The beneficiaries (employees / plan participants)
• Alternative is an insurance contract
• Complex array of arrangements is available

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The Basic Idea of Funding

• Conceptually, the concept is straightforward
• Calculate NPV of the pension plans liabilities
• Estimate annual future benefit payments
• Benefit rules, earnings growth, job turnover,
  mortality
• Compute NPV using a discount rate
• Calculate value of the plan assets
• Compare the two measures to determine if plan is
  adequately funded
• In practice, this is a complex and confusing area
  

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The Complexity of Pension Funding

• Pension funding rules are extremely complex for
  several reasons
• Liabilities computed on an accrual basis and
  require numerous assumptions about the future
• There are multiple measures / definitions of
  pension plan liabilities
• Accounting rules and ERISA (PBGC) funding rules
  can be quite different (and IRS tax treatment can
  differ from both!)
• Different interest rates
• Use different liability measures

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Measuring Liabilities Examples

• Current liability
• Represents an estimate of the benefits earned to
  date, assuming the plans sponsor remains in
  business and the plan is continued
• Termination liability
• Estimate of cost of terminating a pension
  buying a group annuity from an insurer to cover
  the obligations
• Accrued liability
• Similar to current liability, but larger because
  it includes additional items.
• Ex Considers future wage growth in calculating
  future benefits. (Current liability freezes
  wages)

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Discount Rate

• Choice of the discount rate has a HUGE effect on
  the size of existing liabilities
• Ex PV of 1000 in 30 years
• R .07 NPV 131.37
• R .06 NPV 174.11 (32 higher!)
• PBGC uses discount rate based on corporate bond
  yields to calculate the current liability for
  determining whether plan is fully funded
• PBGC uses a different interest rate to calculate
  the termination liability (based on confidential
  survey of insurers)
• Accounting rules are different still

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Note on Discount Rate

• Historically, PBGC required that plans use a rate
  based on the 30 year Treasury bond, but with
  flexibility
• Allowed to be within 90 - 120 of 30 year rate
• Could use a smoothed average of past 4 years
• What happens when interest rates are declining?
• US Treasury stopped issuing 30 year bonds in 2001
  ? now permitted to use corporate rates
• These are higher ? makes liabilities look smaller
  

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The PBGC

• The Pension Benefit Guarantee Corporation was
  established by ERISA in 1974
• Collects insurance premiums from employers that
  sponsor insured pensions
• 19 per worker or retiree 9 for every 1000 of
  unfunded vested benefits
• Insures benefits (up to a max) in case employer
  goes bankrupt
• Currently pays benefits (up to a guaranteed
  maximum) to about 460k retirees in over 3000
  plans that have been terminated

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PBGC (ERISA) Funding Requirements

• Goal is to require firm to contribute enough to
  cover benefits earned during the year plus
  interest on existing obligations
• Changes in liability arising from changes in
  assumptions, discount rates and asset values are
  spread over multiple years
• Must keep assets gt 90 of liabilities
• Full funding limit Upper limit on funding
• To avoid using as a tax shelter
• May have contributed to under funding problem

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What if a Plan is Underfunded?

• If underfunded, then firm must make Deficit
  Reduction Contributions (DRC)
• Firm is given approx. 3 to 7 years to bring plan
  funding ratio back up to 90 or better
• Precise schedule depends in part on the degree of
  underfunding
• Policy Goal avoid underfunded plans becoming a
  liability of the government (via the PBGC)

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Past 5 Years The Perfect Storm

• Substantial drops in stock market
• ? plan assets decreased
• Interest rates declined
• ? plan liabilities increased
• ?RESULT massive pension underfunding!
• June 2005 DB pensions in the U.S. were
  collectively under funded by 354 billion
• ? Hear PBGC Director discuss the problems
• http//www.npr.org/templates/story/story.php?stor
  yId3877446

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First Legislative Response

• April 10, 2004 Pension Funding Equity Act
• Temporarily replaced interest rate on 30 year
  treasuries with long term investment grade
  corporate bonds
• Lets steelmakers and airlines cut their deficit
  reduction contribution by 80 in 2004 (and by 60
  in 2005).
• Saves affected industries billions of dollars
  in funding liabilities

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Concerns About Pension Funding Equity Act

• Special provisions for airlines and steel
  companies would increase the funding problem for
  the very plans that are currently most at risk.
• Reminiscent of SL crisis of the 1980s
• Special provisions to help them out in the short
  run led to longer run problems

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Plan Termination

• A requirement for plan qualification is that plan
  is intended to be permanent
• Plan can be terminated by employer unless
  prohibited by collective bargaining agreements or
  other employment contracts
• 100 vesting at termination
• Excess plan assets can be returned to employer
  through an asset-reversion termination, but these
  are subject to a penalty
• 50 of reversion amount, reduced to 20 if
• There is a replacement plan
• Benefits to participants are increased by 20 of
  reversion
• Employer is in bankruptcy

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Termination Problem

• Current liability of the pension is NOT the
  same as its termination liability
• Termination liability is what it would cost the
  PBGC to buy group annuity contracts in private
  market to make guaranteed payments
• Termination liability tends to accrue more
  quickly than current liability
• RESULT A plan can be funded, but if PBGC takes
  it over, it may find the assets woefully
  inadequate to cover termination benefit
  obligations ? PBGC is on the hook

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Is Termination Problem Real?

• Ex Bethlehem Steel pension plan reported that
  it was 84 funded
• Upon termination, assets were equal to only 45
  if its termination liability
• Ex US Airways pilot plan reported that it was
  94 funded
• Upon termination, assets were equal to only 35
  of its termination liability

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Who Bears the Cost of a Terminated Underfunded
Pension?

• The PBGC
• Now experiencing significant underfunding
• Plan beneficiaries
• Article on United Airlines
• What is expected benefit of United Pilot before
  bankruptcy?
• What is PBGC max benefit at age 60 (required
  retirement age for pilots?)

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PBGC Financial Situation

• Under current law, the PBGC is only liable to
  extent that it has resources to pay, but
  political reality is that there is implied
  federal guarantee
• Existing PBGC revenue structure inadequate to
  finance PBGC liability exposure
• 23 billion shortfall as of fiscal year end 2004
• Assets 40 billion Liabilities 63 billion
• Not a short-term liquidity problem
• United Airlines / US Airways bring total to over
  30 b.
• CBO projects addl 48 billion over next 10 years
• To fund this through premium increases alone
  would require five-fold increase in premiums

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Top Five PBGC Claims (1975-2005)
Most recent losses (UAL and US Air) are 1st and
3rd largest in PBGC history.
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Three Flaws of the PBGC Design

• Poor Risk Adjustment ? bad incentives
• Failure to Ensure Adequate Funding
• Lack of Information

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Poor Risk Adjustment

• Financially weak companies can create unfunded
  liabilities and pass costs to PBGC if they fail
• Examples
• Can increase benefits as long as funding ratio gt
  60 ? distressed firms can substitute pension
  promises for wages
• Firms increase asset risk because benefit from
  upside gains, but have implicit put option on the
  downside
• PBGC does not adjust premiums for risk
• Ex United Airlines paid only 75 million in
  premiums from 1994 2005, despite junk bond
  status and massive pension under funding (now a
  6 billion claim)

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Inadequate Funding Mechanisms

• Employers can game the system
• Tremendous discretion in how liabilities
  calculated
• Using high interest rates without risk adjustment
• Measure of under-funding used to calculate
  required contributions bears no systematic
  relation to the actual cost of plan termination
• Asset values are smoothed
• Funding rules do not consider plan termination
  risk
• Over 90 of largest 41 claims had junk bond
  status for 10 years
• Ex Bethlehem Steel was considered 84 funded on
  current liability basis. But upon termination,
  it had assets to cover only 45 percent of
  liabilities.

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Inadequate Information

• In rational model with full information, workers
  will be receive compensation to reflect
  likelihood of benefit default
• But when PBGC receives complete information (Form
  5500), it is typically 2.5 years old
• Inadequate information provided to plan
  participants and investors
• Participants receive notice only if plan under
  funding is extreme
• Information insufficient to capture true market
  cost of under funding

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Ex Bethlehem Steel (terminated 2003)
Termination Benefit Liability Funded Ratio
45 Unfunded Benefit Liabilities Approximately
4 billion
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Possible Policy Options

• Infuse taxpayer money (bail-out)
• Raise fixed rate premium
• Raise under funding premium
• Vary premium based on credit risk
• Vary premium with investment allocation
• Tighten funding rules
• Raise maximum pension funding limits
• Raise PBGC priority during bankruptcy
• Limit the PBGC guarantee
• Privatize the role of the PBGC

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Pension Protection Act of 2006

• Stricter funding requirements
• Now must have assets 100 of liabilities
• Plans at risk of termination must also fund for
  choices that might increase liabilities
• Restrictions on use of credit balances
• Loophole
• Airline relief provisions allow 17 years to
  fund the plans and at a higher discount rate!

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Pension Protection Act of 2006

• Heavily underfunded plans restricted from
  increasing benefits
• Eliminates exception to rule requiring payments
  of variable premium for underfunding
• Reduces use of smoothing techniques

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Net Results of PPA 2006

• Improved the situation
• But did not solve the underlying problem
• Silver lining the bill also contained some
  improvements to 401(k) landscape, that may prove
  more important going forward
• More to come on this point