Lecture 4: Funding DB Pension Plans

Tuesday, September 4, 2007

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

List types of funding arrangementsDescribe plan termination rulesExplain the role of the PBGCDiscuss what happens when a plan is underfundedDiscuss potential distortions that arise as a result of pension accounting rules

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?

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 …

Overview of Pension FundingPrior 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 companyPlan must purchase insurance from the Pension Benefit Guarantee Corporation (PBGC)

Funding AgencyTrusts 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 contractComplex array of arrangements is available

The Basic Idea of FundingConceptually, the concept is straightforward:

Calculate NPV of the pension plan’s 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 …

The Complexity of Pension FundingPension 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 liabilitiesAccounting 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

Measuring Liabilities: ExamplesCurrent liability

Represents an estimate of the benefits earned to date, assuming the plans sponsor remains in business and the plan is continued

Termination liabilityEstimate of cost of terminating a pension & buying a group annuity from an insurer to cover the obligations

Accrued liabilitySimilar to current liability, but larger because it includes additional items.

• Ex: Considers future wage growth in calculating future benefits. (Current liability “freezes” wages)

Discount RateChoice 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 fundedPBGC uses a different interest rate to calculate the termination liability (based on confidential survey of insurers)Accounting rules are different still

Note on Discount RateHistorically, 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 rateCould 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

The PBGCThe 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

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 yearsMust keep assets >= 90% of liabilities

“Full funding limit”: Upper limit on fundingTo avoid using as a tax shelterMay have contributed to under funding problem

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)

Past 5 Years: “The Perfect Storm”Substantial drops in stock market

plan assets decreasedInterest rates declined

plan liabilities increasedRESULT: massive pension underfunding!

June 2005: DB pensions in the U.S. were collectively under funded by $354 billion

Hear PBGC Director discuss the problemshttp://www.npr.org/templates/story/story.php?storyId=3877446

First Legislative ResponseApril 10, 2004: Pension Funding Equity Act

Temporarily replaced interest rate on 30 year treasuries with long term investment grade corporate bondsLets 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

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 S&L “crisis” of the 1980s

Special provisions to help them out in the short run led to longer run problems

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 contracts100% 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

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 paymentsTermination 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

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

Who Bears the Cost of a Terminated Underfunded Pension?

The PBGCNow experiencing significant underfunding

Plan beneficiariesArticle 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?)

PBGC Financial SituationUnder current law, the PBGC is only liable to extent that it has resources to pay, but political reality is that there is implied federal guaranteeExisting 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 add’l $48 billion over next 10 yearsTo fund this through premium increases alone would require five-fold increase in premiums

Top Five PBGC Claims (1975-2005)

Company Year PBGC Claims

UAL (United) 2005 $6.4 billion

Bethl. Steel 2003 $3.7 billion

US Airways 2004 - 2005 $2.1 billion

LTV Steel 2002 – 2004 $2.0 billion

National Steel

2003 – 2004 $1.2 billion

Most recent losses (UAL and US Air) are 1st and 3rd largest in PBGC history.

Three Flaws of the PBGC Design

1. Poor Risk Adjustment bad incentives

2. Failure to Ensure Adequate Funding

3. Lack of Information

Poor Risk AdjustmentFinancially weak companies can create unfunded liabilities and pass costs to PBGC if they failExamples:

Can increase benefits as long as funding ratio > 60% distressed firms can substitute pension promises for wagesFirms increase asset risk because benefit from upside gains, but have implicit put option on the downside

PBGC does not adjust premiums for riskEx: 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)

Inadequate Funding MechanismsEmployers 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 terminationAsset values are smoothedFunding 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.

Inadequate InformationIn rational model with full information, workers will be receive compensation to reflect likelihood of benefit defaultBut when PBGC receives complete information (Form 5500), it is typically 2.5 years oldInadequate 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

Ex: Bethlehem Steel (terminated 2003)

1996 1997 1998 1999 2000 2001 2002

Funding ratio 78%

91%

99%

96%

86% 84% NR

Required to make DRC?

Yes No No No No NR NR

Required to notify participants

Yes Yes No No No No No

Debt Rating B+ B+ BB- BB- B+ D N/aTermination Benefit Liability Funded Ratio = 45%Unfunded Benefit Liabilities = Approximately $4 billion

Possible Policy OptionsInfuse taxpayer money (bail-out)Raise fixed rate premiumRaise under funding premiumVary premium based on credit riskVary premium with investment allocationTighten funding rulesRaise maximum pension funding limitsRaise PBGC priority during bankruptcyLimit the PBGC guaranteePrivatize the role of the PBGC

Pension Protection Act of 2006

Stricter funding requirementsNow must have assets = 100% of liabilitiesPlans “at risk” of termination must also fund for choices that might increase liabilitiesRestrictions on use of “credit balances”

Loophole …“Airline relief” provisions allow 17 years to fund the plans and at a higher discount rate!

Pension Protection Act of 2006

Heavily underfunded plans restricted from increasing benefitsEliminates exception to rule requiring payments of variable premium for underfundingReduces use of “smoothing” techniques

Net Results of PPA 2006

Improved the situationBut 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 …