oversight

Private Pensions: Changing Funding Rules and Enhancing Incentives Can Improve Plan Funding

Published by the Government Accountability Office on 2003-10-29.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                              United States General Accounting Office

GAO                           Testimony
                              Before the Committee on Education and
                              the Workforce, House of Representatives


For Release on Delivery
Expected at 10:30 a.m. EST
Wednesday, October 29, 2003   PRIVATE PENSIONS
                              Changing Funding Rules
                              and Enhancing Incentives
                              Can Improve Plan Funding
                              Statement of Barbara D. Bovbjerg, Director,
                              Education, Workforce, and Income Security Issues




GAO-04-176T 

                                                October 29, 2003


                                                PRIVATE PENSIONS

                                                Changing Funding Rules and Enhancing
Highlights of GAO-04-176T, a report to the      Incentives Can Improve Plan Funding
Committee on Education and the
Workforce, House of Representatives




Over the last few years, the total              Recent terminations of severely underfunded pension plans suggest that
underfunding in the defined-benefit             current funding rules do not provide adequate mechanisms for maintaining
pension system has deteriorated to              adequate funding of pension plans. Funding inadequacies place the
the point where the Pension                     retirement security of millions of American workers and retirees, along with
Benefit Guaranty Corporation                    PBGC, at risk. While external factors, such as falling stock prices, low
(PBGC), the federal agency
responsible for protecting private
                                                interest rates, and slow economic growth, have contributed to widespread
sector defined benefit plan                     pension underfunding, the defined-benefit system also faces structural
benefits, estimates that total plan             problems that extend beyond cyclical economic conditions. Stagnant growth
underfunding grew to more than                  of the defined-benefit system, along with several large recent terminations of
$400 billion as of December 31,                 underfunded pension plans, has left PBGC in a precarious financial
2002, and still exceeded $350                   condition as the insurer of pension benefits.
billion as of September 4, 2003.
PBGC itself faced an estimated $8.8             There are two general approaches to funding reform that may improve the
billion accumulated deficit as of               funding of defined-benefit pension plans. The first approach would change
August 31, 2003. Deficiencies in                the funding requirements directly. These measures could address reforms to
current funding and related                     the use of termination liability instead of current liability, additional funding
regulations have contributed to
several large plans recently
                                                requirements, and lump-sum distributions. The second, more indirect
terminating with severely                       approach would seek to improve plan funding by providing better incentives
underfunded pension plans.                      for sponsors to keep their plans better funded. Options in this category could
                                                include requirements broadening the disclosure of plan investments and
This testimony provides GAO’s                   termination liability information to plan participants and their
observations on a variety of                    representatives. These reforms, as part of a comprehensive package, could
regulatory and legislative reforms              increase the likelihood that workers and retirees receive promised benefits,
that aim to improve plan funding                while not creating an undue regulatory or financial burden on sponsors.
and better protect the benefits of
millions of American workers and                Recent unfavorable economic conditions have contributed to widespread
retirees while minimizing the
burden to plan sponsors of
                                                underfunding and conspired to place well-meaning plan sponsors in
maintaining defined-benefit plans.              difficult positions. Although comprehensive reform should include
                                                improving plan funding as the key vehicle to stabilize the long-term
                                                health of the defined-benefit system, Congress may seek to balance
                                                improvements in funding and accountability against the short-term needs
                                                of some sponsors who may have difficulty making plan contributions.

                                                Figure 2: Total Underfunding in PBGC-Insured Single-Employer Plans, 1980-2003

                                                Dollars in billions
                                                400


                                                350


                                                300


                                                250


                                                200


                                                150


www.gao.gov/cgi-bin/getrpt?GAO-04-176T.         100


                                                 50

To view the full product, including the scope     0
and methodology, click on the link above.             1980   1981     1982   1983   1984   1985   1986   1987   1988   1989   1990   1991   1992   1993   1994   1995   1996   1997   1998   1999   2000   2001   2002   2003

For more information, contact Barbard D.        Source: PBGC.


Bovbjerg at (202) 512-7215 or                   Note: Figure for 2003 is an estimate, as of September 4, 2003.
bovbjergb@gao.gov..
Mr. Chairman and Members of the Committee:

I am pleased to be here today to discuss improving the funding of single-
employer defined-benefit plans.1 As all of you are aware, this is a crucial
issue threatening the retirement security of millions of America’s workers
and retirees. Underfunded plans sponsored by weak or bankrupt
employers have drained the financial resources of the Pension Benefit
Guaranty Corporation (PBGC), the backstop federal agency that insures
the benefits promised by these plan. PBGC’s single-employer insurance
program currently faces an estimated deficit of $8.8 billion as of August 31,
2003, following the largest 1-year loss in the agency’s history. This deficit
could likely increase during the next few years, with PBGC estimating that
by the end of fiscal year 2003, total underfunding in financially troubled
firms could exceed $80 billion.2 We believe that an appropriate
comprehensive policy response can stabilize the funding of these pension
plans, thereby protecting workers’ benefits for the foreseeable future.
Reforming the rules that regulate how sponsors fund their pension plans is
an essential part of this response. I hope my testimony will help clarify
some of the key issues as the Congress and the relevant agencies choose
how to respond to these serious financial challenges. As you requested, I
will discuss some options to improve the funding status of defined-benefit
plans.




1
 A defined-benefit plan promises a benefit that is generally based on an employee’s salary
and years of service. The employer is responsible for funding the benefit, investing and
managing plan assets, and bearing the investment risk. In contrast, under a defined
contribution plan, benefits are based on the contributions to and investment returns on
individual accounts, and the employee bears the investment risk. There are two federal
insurance programs for defined-benefit plans: one for single-employer plans and another
for multiemployer plans. Our work was limited to the PBGC program to insure the benefits
promised by single-employer defined-benefit pension plans. Single-employer plans provide
benefits to employees of one firm or, if plan terms are not collectively bargained,
employees of several unrelated firms.
2
 According to PBGC, for example, companies whose credit quality is below investment
grade sponsor a number of plans. PBGC classified such plans as reasonably possible
terminations if the sponsors’ financial condition and other factors did not indicate that
termination of their plans was likely as of year-end. See PBGC 2002 Annual Report, p. 41.
The independent accountants that audited PBGC’s financial statement reported that PBGC
needs to improve its controls over the identification and measurement of estimated
liabilities for probable and reasonably possible plan terminations. According to an official,
PBGC has implemented new procedures focused on improving these controls. See Audit of
the Pension Benefit Guaranty Corporation’s Fiscal Year 2002 and 2001 Financial
Statements in PBGC Office of Inspector General Audit Report, 2003-3/23168-2
(Washington, D.C.: Jan. 30, 2003).



Page 1                                                                        GAO-04-176T
To identify the types of reform that may improve funding for defined-
benefit (DB) pension plans, we reviewed proposals for reforming the
single-employer program made by the Department of the Treasury, PBGC,
and pension professionals. We also discussed with PBGC officials, and
examined annual reports and other available information related to the
funding and termination of three pension plans: the Anchor Glass
Container Corporation Service Retirement Plan, the Pension Plan of
Bethlehem Steel Corporation and Subsidiary Companies, and the Polaroid
Pension Plan. We selected these plans because they represented the
largest losses to PBGC in their respective industries in fiscal year 2002.
PBGC estimates that, collectively, the plans represented over $4 billion in
losses to the program at plan termination. At the request of this
committee, we will release a report at the end of this month on the
financial condition of the PBGC single-employer pension program and
related issues of pension plan reform.

To summarize my responses, there are two general approaches to funding
reform that may improve the funding of defined-benefit pension plans. The
first approach would change the funding requirements directly. These
measures could encompass reforms to the use of current and termination
liability in plan funding calculations,3 additional funding requirements,
credit balances, unfunded benefits or benefit increases, and lump-sum
distributions. The second, more indirect approach would seek to improve
plan funding by providing better incentives for sponsors to keep their
plans better funded. Options in this category could include requirements
broadening the disclosure of plan investments and termination liability
information to plan participants and their representatives, the
restructuring of PBGC’s variable-rate premium to incorporate risk factors
other than the level of underfunding, and making modifications to certain
guaranteed benefits that could decrease losses incurred from underfunded
plans. Reforms adopted to directly change the funding requirements or
improve plan funding through providing incentives for sponsors are not
mutually exclusive, and several variations exist within each reform option.
These reforms, taken separately or in coordination, could increase the
likelihood of plans receiving adequate funding to ensure that workers and
retirees receive promised benefits.




3
 A plan’s termination liability measures the value of accrued benefits using assumptions
appropriate for a terminating plan, while its current liability measures the value of accrued
benefits using assumptions specified in applicable laws and regulations.



Page 2                                                                         GAO-04-176T
             Before enactment of the Employee Retirement and Income Security Act
Background   (ERISA) of 1974, few rules governed the funding of defined-benefit
             pension plans, and participants had no guarantees that they would receive
             the benefits promised. When Studebaker’s pension plan failed in the 1960s,
             for example, many plan participants lost their pensions.4 Such experiences
             prompted the passage of ERISA to better protect the retirement savings of
             Americans covered by private pension plans. Along with other changes,
             ERISA established PBGC to pay the pension benefits of participants,
             subject to certain limits, in the event that an employer could not.5 ERISA
             also required PBGC to encourage the continuation and maintenance of
             voluntary private pension plans and to maintain premiums set by the
             corporation at the lowest level consistent with carrying out its
             obligations.6

             Under ERISA, the termination of a single-employer defined-benefit plan
             results in an insurance claim with the single-employer program if the plan
             has insufficient assets to pay all benefits accrued under the plan up to the
             date of plan termination.7 PBGC finances the unfunded liabilities of
             terminated plans partially through premiums paid by plan sponsors.
             Currently, plan sponsors pay a flat-rate premium of $19 per participant per
             year; in addition, some pay a variable-rate premium, which was added in


             4
              The company and the union agreed to terminate the plan along the lines set out in the
             collective bargaining agreement: retirees and retirement-eligible employees over age 60
             received full pensions, and vested employees under age 60 received a lump-sum payment
             worth about 15 percent of the value of their pensions. Employees whose benefit accruals
             had not vested, including all employees under age 40, received nothing. James A. Wooten,
             “The Most Glorious Story of Failure in Business:’ The Studebaker–Packard Corporation
             and the Origins of ERISA.” Buffalo Law Review, vol. 49 (Buffalo, NY: 2001): 731.
             5
              Some defined-benefit plans are not covered by PBGC insurance; for example, plans
             sponsored by professional service employers, such as physicians and lawyers, with 25 or
             fewer employees.
             6
             See section 4002(a) of P.L. 93-406, Sept. 2, 1974.
             7
              The termination of a fully funded defined-benefit pension plan is termed a standard
             termination. Plan sponsors may terminate fully funded plans by purchasing a group annuity
             contract from an insurance company under which the insurance company agrees to pay all
             accrued benefits or by paying lump-sum benefits to participants if permissible. Terminating
             an underfunded plan is termed a distress termination if the plan sponsor requests the
             termination or an involuntary termination if PBGC initiates the termination. PBGC may
             institute proceedings to terminate a plan if, among other things, the plan will be unable to
             pay benefits when due or the possible long-run loss to PBGC with respect to the plan may
             reasonably be expected to increase unreasonably if the plan is not terminated. See 29
             U.S.C. 1342(a). PBGC may pay only a portion of the claim because ERISA places limits on
             PBGC’s benefit guarantee.



             Page 3                                                                       GAO-04-176T
1987 to provide an incentive for sponsors to better fund their plans. The
variable-rate premium, which started at $6 for each $1,000 of unfunded
vested benefits, was initially capped at $34 per participant. The variable
rate was increased to $9 for each $1,000 of unfunded vested benefits
starting in 1991, and the cap on variable-rate premiums was removed
starting in 1996.

Following the enactment of ERISA, however, concerns were raised about
the potential losses that PBGC might face from the termination of
underfunded plans. To protect PBGC, ERISA was amended in 1986 to
require that plan sponsors meet certain additional conditions before
terminating an underfunded plan. For example, sponsors could voluntarily
terminate their underfunded plans only if they were bankrupt or generally
unable to pay their debts without the termination.

The single-employer program has had an accumulated deficit—that is,
program assets have been less than the present value of benefits and other
liabilities—for much of its existence. (See fig. 1.) In fiscal year 1996, the
program had its first accumulated surplus, and by fiscal year 2000, the
accumulated surplus had increased to about $10 billion, in 2002 dollars.
However, the program’s finances reversed direction in 2001, and at the end
of fiscal year 2002, its accumulated deficit was about $3.6 billion. PBGC
estimates that this deficit grew to $8.8 billion by August 31, 2003, its largest
deficit in the program’s history both in real and nominal terms. From less
than $50 billion as of December 31, 2000, the total underfunding in single-
employer plans grew to more than $400 billion as of December 31, 2002,
and still exceeds $350 billion according to recent estimates by PBGC. (See
fig 2.) Despite the program’s large deficit, according to a PBGC analysis,
the single-employer program was estimated to have enough assets to pay
benefits through 2019, given the program’s conditions and PBGC
assumptions as of the end of fiscal year 2002.8 However, losses since that
time may have shortened the period over which the program will be able
to cover promised benefits. In July of this year, because of serious risks to




8
 The estimate assumes: (1) a rate of return on all PBGC assets of 5.8 percent and a discount
rate on future benefits of 5.67 percent; (2) no premium income and no future claims beyond
all plans with terminations that were deemed “probable” as of September 30, 2002; (3)
administrative expenses of $225 million in fiscal year 2003, $229 million per year for fiscal
years 2004-2014, and $0 thereafter; (4) mid-year termination for “probables”; and (5) that
PBGC does not assume control of “probable” assets and future benefits until the date of
plan termination.



Page 4                                                                        GAO-04-176T
                                                the single-employer program’s viability, we placed the PBGC on our high-
                                                risk list.9

Figure 1: Assets, Liabilities, and Net Position of the Single-Employer Pension Insurance Program, Fiscal Years 1976-2002

2002 Dollars in billions
30


25


20


15


10


  5


  0


 -5


-10
       1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

                                                         Assets

                                                         Liabilities

                                                         Net position
Source: PBGC annual reports.

                                                Note: Amounts for 1986 do not include plans subsequently returned to a reorganized LTV
                                                Corporation. We adjusted PBGC data using the Consumer Price Index for All Urban Consumers: All
                                                Items.




                                                9
                                                See U.S. General Accounting Office, Pension Benefit Guaranty Corporation Single-
                                                Employer Insurance Program: Long-Term Vulnerabilities Warrant “High Risk”
                                                Designation, GAO-03-1050SP (Washington, D.C.: July 23, 2003).



                                                Page 5                                                                          GAO-04-176T
Figure 2: Total Underfunding in PBGC-Insured Single-Employer Plans, 1980 - 2003
Dollars in billions
400


350


300


250


200


150


100


 50


  0
      1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: PBGC.

                                          Note: 2003 figure is an estimate, as of September 4, 2003.


                                          For the most part, liabilities of the single-employer pension insurance
                                          program are comprised of the present value of insured participant
                                          benefits. PBGC calculates present values using interest rate factors that,
                                          along with a specified mortality table, reflect annuity prices, net of
                                          administrative expenses, obtained from surveys of insurance companies
                                          conducted by the American Council of Life Insurers.10 In addition to the
                                          estimated total liabilities of underfunded plans that have actually
                                          terminated, PBGC includes in program liabilities the estimated unfunded
                                          liabilities of underfunded plans that it believes will probably terminate in
                                          the near future.11 PBGC may classify an underfunded plan as a probable
                                          termination when, among other things, the plan’s sponsor is in liquidation
                                          under federal or state bankruptcy laws.




                                          10
                                           In 2002, PBGC used an interest rate factor of 5.70 percent for benefit payments through
                                          2027 and a factor of 4.75 percent for benefit payments in the remaining years.
                                          11
                                           Under Statement of Financial Accounting Standard Number 5, loss contingencies are
                                          classified as probable if the future event or events are likely to occur.



                                          Page 6                                                                      GAO-04-176T
Several Factors Have    As we reported to this committee in September of this year,12 several
Contributed to PBGC’s   factors have contributed to PBGC’s and plans’ current financial
Current Financial       difficulties. The financial condition of the single-employer pension
                        insurance program returned to an accumulated deficit in 2002 largely due
Difficulties            to the termination, or expected termination, of several severely
                        underfunded pension plans. In 1992, we reported that many factors
                        contributed to the degree plans were underfunded at termination,
                        including the payment at termination of additional benefits, such as
                        subsidized early retirement benefits, which have been promised to plan
                        participants if plants or companies ceased operations.13 These factors
                        likely contributed to the degree that plans terminated in 2002 were
                        underfunded. Factors that increased the severity of the plans’ unfunded
                        liability in 2002 were the recent sharp decline in the stock market and a
                        general decline in interest rates.

                        In many cases, sponsors did not make the contributions necessary to
                        adequately fund the plans before they were terminated. For example,
                        according to annual reports (Annual Return/Report of Employee Benefit
                        Plan, Form 5500) submitted by Bethlehem Steel Corporation, in the 7 years
                        from 1992 to 1999, the Bethlehem Steel pension plan went from 86 percent
                        funded to 97 percent funded. (See fig. 3.) From 1999 to plan termination in
                        December 2002, however, plan funding fell to 45 percent as assets
                        decreased and liabilities increased, and sponsor contributions were not
                        sufficient to offset the changes. According to a survey,14 the Bethlehem
                        Steel defined-benefit plan had about 73 percent of its assets (about $4.3
                        billion of $6.1 billion) invested in domestic and foreign stocks on
                        September 30, 2000. One year later, assets had decreased $1.5 billion, or
                        25 percent, and when the plan was terminated in December 2002, its assets
                        had been reduced another 23 percent to about $3.5 billion—far less than
                        needed to finance an estimated $7.2 billion in PBGC-guaranteed
                        liabilities.15 Surveys of plan investments by Greenwich Associates


                        12
                         See U.S. General Accounting Office, Pension Benefit Guaranty Corporation: Single-
                        Employer Pension Insurance Program Faces Significant Long-Term Risks, GAO-03-873T
                        (Washington, D.C.: Sept. 4, 2003).
                        13
                         See U.S. General Accounting Office, Pension Plans: Hidden Liabilities Increase Claims
                        Against Government Insurance Programs, GAO/HRD-93-7 (Washington, D.C.: Dec. 30,
                        1992).
                        14
                         Pensions & Investments, vol. 29, Issue 2 (Chicago: Jan. 22, 2001).
                        15
                          According to the survey, the Bethlehem Steel Corporation’s pension plan made benefit
                        payments of $587 million between Sept. 30, 2000, and Sept. 30, 2001. Pensions and
                        Investments, www.pionline.com/pension/pension.cfm (downloaded on June 13, 2003).


                        Page 7                                                                     GAO-04-176T
indicated that defined-benefit plans in general had about 62.8 percent of
their assets invested in U.S. and international stocks in 1999.16

Figure 3: Assets, Liabilities, and Funded Status of the Bethlehem Steel Corporation
Pension Plan, 1992-2002

Dollars in billions                                                                             Percent
8.0                                                                                                 120


7.0
                                                                                                    100

6.0

                                                                                                     80
5.0


4.0                                                                                                  60


3.0
                                                                                                     40

2.0

                                                                                                     20
1.0


     0                                                                                                0
         1992     1993       1994    1995    1996   1997   1998    1999    2000     2001     2002

            Assets

            Current liabilities

            Funded percentage
Source: Annual Form 5500 reports and PBGC.

Note: Assets and liabilities for 1992 through 2001 are as of the beginning of the plan year. During that
period, the interest rate Bethlehem Steel used to value current liabilities decreased from 9.26 percent
to 6.21 percent. Assets and liabilities for 2002 are PBGC estimates at termination in December 2002.
Termination liabilities were valued using a rate of 5 percent.


These recent events and their consequences for PBGC’s finances have
occurred in the context of the long-term stagnation of the defined-benefit
system. The number of PBGC-insured plans has decreased steadily from
approximately 110,000 in 1987 to around 30,000 in 2002.17 While the
number of total participants in PBGC-insured single-employer plans has
grown approximately 25 percent since 1980, participation has declined as


16
 2002 U.S. Investment Management Study, Greenwich Associates, Greenwich, Conn.
17
  In contrast, defined-contribution plans have grown significantly over a similar period—
from 462,000 plans in 1985 to 674,000 plans in 1998.



Page 8                                                                                 GAO-04-176T
                        a percentage of the private sector labor force. Further, the percentage of
                        participants who are active workers has declined from 78 percent in 1980
                        to 53 percent in 2000. Manufacturing, a sector with virtually no job growth
                        in the last half-century, accounted for almost half of PBGC’s single-
                        employer program participants in 2001, suggesting that the program needs
                        to rely on other sectors for any growth in premium income. Unless
                        something reverses these trends, PBGC may have a shrinking plan and
                        participant base to support the program in the future as well as the
                        likelihood of a participant base concentrated in certain, potentially more
                        vulnerable industries.


Minimum Funding Rules   Internal Revenue Code (IRC) minimum funding rules, which are designed
Did Not Prevent Plans   to ensure plan sponsors adequately fund their plans, did not have the
from Being Severely     desired effect for the terminated plans that were added to the single-
                        employer program in 2002. The amount of contributions required under
Underfunded             IRC minimum funding rules is generally the amount needed to fund
                        benefits earned during that year plus that year’s portion of other liabilities
                        that are amortized over a period of years.18 Also, the rules require the
                        sponsor to make an additional contribution if the plan is underfunded to
                        the extent defined in the law. Under the additional funding requirement
                        rule, a single-employer plan sponsored by an employer with more than
                        100 employees in defined-benefit plans is subject to a deficit reduction
                        contribution for a plan year if the value of plan assets is less than
                         90 percent of its current liability. However, a plan is not subject to the
                        deficit reduction contribution if the value of plan assets (1) is at least
                        80 percent of current liability and (2) was at least 90 percent of current
                        liability for each of the 2 immediately preceding years or each of the
                        second and third immediately preceding years. To determine whether the
                        additional funding rule applies to a plan, the IRC requires sponsors to
                        calculate current liability using the highest interest rate allowable for the
                        plan year.19

                        In 1987, the minimum funding rules incorporated by ERISA in the IRC
                        were amended to require that plan sponsors calculate each plan’s current



                        18
                          Minimum funding rules permit certain plan liabilities, such as past service liabilities, to be
                        amortized over specified time periods. See 26 U.S.C. 412(b)(2)(B). Past service liabilities
                        occur when benefits are granted for service before the plan was set up or when benefit
                        increases after the set up date are made retroactive.
                        19
                         See 26 U.S.C. 412(l)(9)(C).



                        Page 9                                                                           GAO-04-176T
liability, using a discount rate based on the 30-year Treasury bond rate,
and to use that calculation to assess the plan’s funding level.20 If plans are
funded below certain thresholds as defined in the IRC, employers are to
determine minimum contribution amounts on the basis of those
assessments. Employers must make additional contributions to the plan if
it is underfunded to extent defined in the law.21 If a plan is fully funded as
defined in the law, employers are precluded from making additional tax-
deductible contributions to the plan. In 2002, the Congress acted to
provide temporary relief to DB plan sponsors by raising the top of the
permissible range of the mandatory interest rate.22 As discussed in a report
we issued earlier this year,23 concerns that the 30-year Treasury bond rate
no longer resulted in reasonable current liability calculations has led both




20
  Under the IRC, current liability means all liabilities to employees and their beneficiaries
under the plan. See 26 U.S.C. 412(l)(7)(A). In calculating current liabilities, the IRC requires
plans to use an interest rate from within a permissible range of rates. See 26 U.S.C.
412(b)(5)(B). In 1987, the permissible range was not more than 10 percent above, and not
more than 10 percent below, the weighted average of the rates of interest on 30-year
Treasury bond securities during the 4-year period ending on the last day before the
beginning of the plan year. The top of the permissible range was gradually reduced by 1
percent per year beginning with the 1995 plan year to not more than 5 percent above the
weighted average rate effective for plan years beginning in 1999. The weighted average rate
is calculated as the average yield over 48 months with rates for the most recent 12 months
weighted by 4, the second most recent 12 months weighted by 3, the third most recent 12
months weighted by 2, and the fourth weighted by 1.
21
  Under the additional funding requirement rule, a single-employer plan sponsored by an
employer with more than 100 employees in defined-benefit plans is subject to a deficit
reduction contribution for a plan year if the value of plan assets is less than 90 percent of
its current liability. However, a plan is not subject to the deficit reduction contribution if
the value of plan assets (1) is at least 80 percent of current liability and (2) was at least 90
percent of current liability for each of the 2 immediately preceding years or each of the
second and third immediately preceding years. To determine whether the additional
funding rule applies to a plan, the IRC requires sponsors to calculate current liability using
the highest interest rate allowable for the plan year. See 26 U.S.C. 412(l)(9)(C).
22
  The top of the permissible range of the 30-year Treasury rate for determining a plan’s
current liability was temporarily increased to 20 percent above the weighted average rate
for 2002 and 2003. This temporary measure expires at the end of 2003.
23
 See U.S. General Accounting Office, Private Pensions: Process Needed to Monitor the
Mandated Interest Rate for Pension Calculations, GAO-03-313 (Washington, D.C.: Feb. 27,
2003).



Page 10                                                                           GAO-04-176T
Congress and the administration to propose alternative rates for these
calculations.24

While minimum-funding rules may encourage sponsors to better fund their
plans, plans can earn funding credits, which can be used to offset
minimum funding contributions in later years, by contributing more than
required according to minimum funding rules. Therefore, sponsors of
underfunded plans may avoid or reduce minimum funding contributions to
the extent their plan has a credit balance in the account, referred to as the
funding standard account, used by plans to track minimum funding
contributions.25

Additionally, the rules require sponsors to assess plan funding using
current liabilities, which a PBGC analysis indicates have been typically
less than termination liabilities.26 A plan’s termination liability measures
the value of accrued benefits using assumptions appropriate for a
terminating plan, while its current liability measures the value of accrued
benefits using assumptions specified in applicable laws and regulations.
Current and termination liabilities differ because the assumptions used to
calculate them differ. Interest rates are a key assumption in calculating the
present value of future pension benefits: while all sponsors calculate
current liabilities using a rate based on the 30-year Treasury bond rate,
ERISA requires sponsors of some underfunded plans to report plan
termination liability information to PBGC. These sponsors calculate
termination liability using a rate published by PBGC, based on surveys of




24
  Recently, the U.S. House of Representatives passed the Pension Funding Equity Act (H.R.
3108), which replaces the 30-year Treasury rate with a blend of corporate bond index rates
for 2 years through 2005. In July of 2003, the Department of the Treasury unveiled The
Administration Proposal to Improve the Accuracy and Transparency of Pension
Information. The proposal’s stated purpose is to improve the accuracy of the pension
liability discount rate, increase the transparency of pension plan information, and
strengthen safeguards against pension underfunding.
25
 See 26 U.S.C. 412(b).
26
 For the analysis, PBGC used termination liabilities reported to it under 29 C.F.R. sec 4010.



Page 11                                                                       GAO-04-176T
insurance companies performed by the American Council of Life
Insurers.27

Other aspects of minimum funding rules may limit their ability to affect the
funding of certain plans as their sponsors approach bankruptcy. According
to its annual reports, for example, Bethlehem Steel contributed about $3.0
billion to its pension plan for plan years 1986 through 1996. According to
the reports, the plan had a credit balance of over $800 million at the end of
plan year 1996. Starting in 1997, Bethlehem Steel reduced its contributions
to the plan and, according to annual reports, contributed only about $71.3
million for plan years 1997 through 2001. The plan’s 2001 actuarial report
indicates that Bethlehem Steel’s minimum required contribution for the
plan year ending December 31, 2001, would have been $270 million in the
absence of a credit balance; however, the opening credit balance in the
plan’s funding standard account as of January 1, 2001, was $711 million.
Therefore, Bethlehem Steel was not required to make any contributions
during the year.

Other IRC funding rules may have prevented some sponsors from making
contributions to plans that in 2002 were terminated at a loss to the single-
employer program. For example, on January 1, 2000, the Polaroid pension
plan’s assets were about $1.3 billion compared to accrued liabilities of
about $1.1 billion—the plan was more than 100 percent funded. The plan’s
actuarial report for that year indicates that the plan sponsor was
precluded by IRC funding rules from making a tax-deductible contribution
to the plan.28 In July 2002, PBGC terminated the Polaroid pension plan, and
the single-employer program assumed responsibility for $321.8 million in
unfunded PBGC-guaranteed liabilities for the plan. The plan was about 67
percent funded, with assets of about $657 million to pay estimated PBGC-
guaranteed liabilities of about $979 million.




27
  Sponsors are required to provide PBGC with termination liability information if, among
other things, the aggregate unfunded vested benefits at the time of the preceding plan year
of plans maintained by the contributing sponsor and the members of its controlled group
exceed $50 million, disregarding plans with no unfunded benefits. See 29 U.S.C. 1310(b).
Among the information to be provided to PBGC is the value of benefit liabilities determined
using the assumptions applicable to the valuation of benefits to be paid as annuities in
trusteed plans terminating at the end of the plan year. See 29 C.F.R. 4010.8(d)(2).
28
  See 26 U.S.C. 404(a)(1) and 26 U.S.C. 412(c)(7). The sponsor might have been able to
make a contribution to the plan had it selected a lower interest rate for valuing current
liabilities. Polaroid used the highest interest rate permitted by law for its calculations.



Page 12                                                                          GAO-04-176T
                            Several types of reforms might be considered to improve the funding of
Strengthening Plan          defined-benefit pension plans. Some options for reform would directly
Funding Rules Can           address funding requirements and related rules. Funding rules could be
                            revised to require increased minimum contributions to underfunded plans
Help Sponsors               and to allow additional contributions to fully funded plans. This approach
Maintain Well-Funded        would improve plan funding over time and improve the security of
                            workers’ benefits, while limiting the losses PBGC would incur when a plan
Plans                       is terminated. Such a change would require some sponsors to allocate
                            additional resources to their pension plans, which may cause the plan
                            sponsor of an underfunded plan to provide less generous wages or
                            benefits than would otherwise be provided. Also, such funding rule
                            changes could take years to have a meaningful effect on PBGC’s financial
                            condition. As examples of such funding rule revisions, the IRC could be
                            amended to:

                       •	   Base Additional Funding Requirement and Maximum Tax-
                            Deductible Contributions on Plan Termination Liabilities, Rather
                            than Current Liabilities. Since plan termination liabilities typically
                            exceed current liabilities, such a change regarding deficit reduction
                            contributions would likely improve plan funding and, therefore, reduce
                            potential claims against PBGC. One potential problem with this approach
                            is the difficulty plan sponsors would have in determining the appropriate
                            interest rate to use in valuing termination liabilities. As we reported,
                            selecting an appropriate interest rate for termination liability calculations
                            is difficult because little information exists on which to base the
                            selection.29

                       •	   Change Requirements For Making Additional Funding
                            Contributions. IRC requires sponsors to make additional contributions
                            under two circumstances: (1) if the value of plan assets is less than 80
                            percent of its current liability or (2) if the value of plan assets is less than
                            90 percent of its current liability, depending on plan funding levels for the
                            previous 3 years. Raising the threshold would require more sponsors of
                            underfunded plans to make the additional contributions.

                       •	   Limit the Use of Credit Balances by Severely Underfunded Plans to
                            Avoid Additional Contributions. For sponsors who make contributions
                            in any given year that exceed the minimum required contribution, the
                            excess plus interest is credited against future required contributions.
                            Limiting the use of credit balances to offset contribution requirements


                            29
                             GAO-03-313.



                            Page 13                                                             GAO-04-176T
     might also prevent sponsors of significantly underfunded plans from
     avoiding cash contributions. For example, in the absence of a credit
     balance, Bethlehem Steel would have been due to pay at least $270 million
     to its pension plan for the plan year ending December 31, 2001; however,
     because it showed a credit balance of $711 million as of January 1, 2001,
     Bethlehem was not required to make any cash contributions for that year.
     Limitations might also be applied based on the plan sponsor’s financial
     condition. For example, sponsors with poor cash flow or low credit ratings
     could be restricted from using their credit balances to reduce their
     contributions.

•	   Limit Lump-Sum Distributions by Plans That Are Significantly
     Underfunded. Defined-benefit pension plans may offer participants the
     option of receiving their benefit in a lump-sum payment. Allowing
     participants to take lump-sum distributions from severely underfunded
     plans, especially those sponsored by financially weak companies, allows
     the first participants who request a distribution to drain plan assets, which
     might result in the remaining participants receiving reduced payments
     from PBGC if the plan terminates.30 A “tiered system” may be set up
     whereby a plan that does not meet a certain funding ratio threshold might
     be prohibited from allowing highly compensated employees from taking
     benefits as lump sums; below a lower funding ratio threshold, lump-sum
     withdrawals for all employees might be prohibited. However, the payment
     of lump sums by underfunded plans may not directly increase losses to the
     single employer program because lump sums reduce plan liabilities as well
     as plan assets.

•	   Raise the Level of Tax-Deductible Contributions. IRC and ERISA
     restrict tax-deductible contributions to prevent plan sponsors from
     contributing more to their plan than is necessary to cover accrued future
     benefits.31 This can prevent employers from making plan contributions
     during periods of strong profitability. Raising these limitations might result




     30
      The administration’s proposal would require companies with below investment grade
     credit ratings whose plans are less than 50 percent funded on a termination basis to
     immediately fully fund or secure any new benefit improvements, benefit accruals, or lump
     sums.
     31
      Employers are generally subject to an excise tax for failure to make required
     contributions or for making contributions in excess of the greater of the maximum
     deductible amount or the ERISA full-funding limit.



     Page 14                                                                    GAO-04-176T
     in pension plans being better funded, decreasing the likelihood that they
     will be underfunded should they terminate.32

•	   Expand Restrictions on Unfunded Benefit Increases. Currently, plan
     sponsors must meet certain conditions before increasing the benefits of
     plans that are less than 60 percent funded.33 Increasing this threshold, or
     restricting benefit increases or accruals when plans reach the threshold,
     could decrease the losses incurred by PBGC from underfunded plans. One
     disadvantage is that it could result in lower pension benefits for affected
     workers. In addition, plan sponsors have said that the disadvantage of
     such changes is that they would limit an employer’s flexibility with regard
     to setting compensation, making it more difficult to respond to labor
     market developments. For example, a plan sponsor might prefer to offer
     participants increased pension payments or shutdown benefits instead of
     offering increased wages because pension benefits can be deferred—
     providing time for the plan sponsor to improve its financial condition—
     while wage increases have an immediate effect on the plan sponsor’s
     financial condition.

•	   Improve Funding of Shutdown Benefits. Shutdown benefits provide
     significant early retirement benefit subsidies or other benefits offered to
     participants affected by a plant closing or a permanent layoff. Such
     benefits are primarily found in the pension plans of large unionized
     companies in the auto, steel, and tire industries. In general, shutdown
     benefits cannot be adequately funded before a shutdown occurs. Rules
     could mandate accelerated funding of shutdown benefits after they go into
     effect. However, if a plant shutdown coincides with the bankruptcy of a
     company and the termination of the pension plan, it may be impossible for
     the bankrupt sponsor to fund these benefits.

     In addition to funding rules, plan sponsors need an accurate funding
     “target” that provides enough funding to pay promised current and future
     benefits while not leading sponsors to “overfund” their pension plans,


     32
       For example, one way to do this would be to allow deductions within a corridor of up to
     130 percent of current liabilities. Gebhardtsbauer, Ron. American Academy of Actuaries
     testimony before the Subcommittee on Employer-Employee Relations, House Committee
     on Education and the Workforce, Hearing on Strengthening Pension Security: Examining
     the Health and Future of Defined-benefit Pension Plans. (Washington, D.C.: June 4, 2003),
     9.
     33
      IRC provides generally that a plan less than 60 percent funded on a current liability basis
     may not increase benefits without either immediately funding the increase or providing
     security. See 26 U.S.C. 401(a)(29).



     Page 15                                                                       GAO-04-176T
                         siphoning resources from other productive firm specific activities. The
                         interest rate sponsors use to determine plan liabilities can affect this target
                         and, therefore, plan funding. In 1987, when the 30-year Treasury bond rate
                         was adopted for use in certain pension calculations, the Congress intended
                         that the interest rate used for current liability calculations would, within
                         certain parameters, reflect the price an insurance company would charge
                         to take responsibility for the plan’s pension payments. However, selecting
                         a replacement rate that will provide an accurate funding target may be
                         difficult because little information exists on which to base the selection.34
                         In taking action to replace the 30-year Treasury bond rate, it is important
                         to consider the impact that any change may have on funding. If Congress
                         mandates the use of a rate that is “too high,” plans are more likely to
                         appear better funded, but minimum and maximum employer contributions
                         would decrease, possibly increasing the likelihood of plan underfunding.
                         In addition, some plans would reach full-funding limitations and avoid
                         having to pay variable-rate premiums, and PBGC would receive less
                         revenue. Conversely, a rate that is “too low” would make plans appear
                         worse funded, with more plans likely to increase contributions and
                         possibly pay variable-rate premiums. Thus, it may well be prudent for
                         Congress to make any provision replacing the 30-year Treasury bond rate
                         temporary to facilitate more comprehensive funding reform to take shape.


                         In addition to direct changes to the funding rules, other reforms may result
Other Reforms Might      in improved plan funding by improving incentives for sponsors to maintain
Enhance Sponsor          proper funding in their plans. These measures may prevent plans from
                         terminating with severely underfunded balances, thus better protecting
Incentives to Maintain   workers, retirees, and PBGC. For example, improving the availability of
Plan Funding             information to plan participants and others about plan investments,
                         termination funding status, and PBGC guarantees may give plan sponsors
                         additional incentives to better fund their plans, making participants better
                         able to plan for their retirement. The restructuring of PBGC’s premium


                         34
                           Other than a survey conducted for PBGC, no mechanism exists to collect information on
                         actual group annuity purchase rates. Compared to other alternatives, the PBGC interest
                         rate factors may have the most direct connection to the group annuity market, but PBGC
                         factors are less transparent than market-determined alternatives. Long-term market rates
                         may track changes in group annuity rates over time, but their proximity to group annuity
                         rates is uncertain. For example, an interest rate based on a long-term market rate, such as
                         corporate bond indexes, may need to be adjusted downward to better reflect the level of
                         group annuity purchase rates. However, as we stated in our report earlier this year,
                         establishing a process for regulatory adjustments to any rate selected may make it more
                         suitable for pension plan liability calculations. See GAO-03-313.



                         Page 16                                                                       GAO-04-176T
     rates could also provide an incentive for plan sponsors to better fund their
     plans. It is also possible that basing changes to premium rates on the
     degree of risk posed by different plans may encourage financially healthy
     companies to remain in or enter the defined-benefit system while
     discouraging riskier plan sponsors. Moreover, it may be appropriate to
     consider modifying certain benefit guarantees that could decrease losses
     incurred by PBGC from underfunded plans. ERISA could be amended to:

•	   Require Greater Disclosure of Information on Plan Investments.
     Some information on the allocation of plan investments among asset
     classes—such as equity or fixed income—may be available from Form
     5500s prepared by plan sponsors, but that information is not readily
     accessible to participants and beneficiaries. Additionally, some plan
     investments may be made through common and collective trusts, master
     trusts, and registered investment companies, and asset allocation
     information for these investments might need to be obtained from Form
     5500s prepared by those entities or from their prospectuses. As such,
     improving the availability of plan asset allocation information to
     participants may give plan sponsors an incentive to increase funding of
     underfunded plans or limit riskier investments. Moreover, only
     participants in plans below a certain funding threshold receive annual
     notices regarding the funding status of their plans, and the information
     plans must currently provide does not reflect how the plan’s assets are
     invested. One way to enhance notices provided to participants could be to
     include information on how much of plan assets are invested in the
     sponsor’s own securities.35 This would be of concern because should the
     sponsor become bankrupt, the value of the securities could be expected to
     drop significantly, reducing plan funding. Although this information is
     currently provided in the plan’s Form 5500, it is not readily accessible to
     participants. Additionally, if the defined-benefit plan has a floor-offset
     arrangement and its benefits are contingent on the investment
     performance of a defined-contribution plan, then information provided to
     participants could also disclose how much of that defined-contribution
     plan’s assets are invested in the sponsor’s own securities.

•	   Require Greater Disclosure of Plan Termination Funding Status.
     Under current law, sponsors are required to report a plan’s current liability
     for funding purposes, which often can be lower than termination liability.


     35
      Although ERISA permits plan sponsors to invest plan assets in employer stock, defined-
     benefit plans may not acquire any qualified employer security or real property if
     immediately after the acquisition the aggregate fair market value of such assets exceeds 10
     percent of the fair market value of the plan’s total assets.



     Page 17                                                                      GAO-04-176T
     In addition, only participants in plans below a certain funding threshold
     receive annual notices of the funding status of their plans.36 As a result,
     many plan participants, including participants of the Bethlehem Steel
     pension plan, did not receive such notifications in the years immediately
     preceding the termination of their plans. Expanding the circumstances
     under which sponsors must notify participants of plan underfunding might
     give sponsors an additional incentive to increase plan funding and would
     enable more participants to better plan their retirement. Under the
     Administration’s proposal, all sponsors would be required to disclose the
     value of pension plan assets on a termination basis in their annual
     reporting. The Administration proposes that all companies disclose the
     value of their defined-benefit pension plan assets and liabilities on both a
     current liability and termination liability basis in their Summary Annual
     Report (SAR).37

•	   Increase or Restructure Variable-Rate Premium. PBGC charges plan
     sponsors a variable-rate premium based on the plan’s level of
     underfunding, premiums, with sponsors paying $9 per $1,000 of unfunded
     liability. However, the recent terminations of Bethlehem Steel, Anchor
     Glass, and Polaroid, plans that paid no variable-rate premiums shortly
     before terminating with large underfunded balances, suggest that the
     current structure of the variable-rate premium does not provide a strong
     enough incentive to improve plan funding or is too easily avoidable. The
     rate could be adjusted so that plans with less adequate funding pay a
     higher rate. In addition, premium rates could be restructured based on the
     degree of risk posed by different plans, which could be assessed by
     considering the financial strength and prospects of the plan’s sponsor, the
     risk of the plan’s investment portfolio, participant demographics, and the
     plan’s benefit structure—including plans that have lump-sum,38 shutdown




     36
      The ERISA requirement that plan sponsors notify participants and beneficiaries of the
     plan’s funding status and limits on the PBGC guarantee currently goes into effect when
     plans are required to pay variable-rate premiums and meet certain other requirements. See
     29 U.S.C. 1311 and 29 C.F.R. 4011.3.
     37
      Participants and individuals receiving benefits from their plan must receive a Summary
     Annual Report (SAR) from their plan’s administrator each year. The SAR summarizes the
     plan’s financial status based on information that the plan administrator provides to the
     Department of Labor on its annual Form 5500. This document must generally be provided
     no later than nine months after the close of the plan year.
     38
      For example, a plan that allows a lump-sum option—as is often found in a cash-balance
     and other hybrid plan—may pose a different level of risk to PBGC than a plan that does
     not.



     Page 18                                                                     GAO-04-176T
     benefit, and floor-offset provisions.39 One advantage of a rate increase or
     restructuring is that it might improve accountability by providing for a
     more direct relationship between the amount of premium paid and the risk
     of underfunding. A disadvantage is that it could further burden already
     struggling plan sponsors at a time when they can least afford it, or it could
     reduce plan assets, increasing the likelihood that underfunded plans will
     terminate. A program with premiums that are more risk-based could also
     be more challenging for PBGC to administer.

•	   Phase-in the Guarantee of Shutdown Benefits. PBGC is concerned
     about its exposure to the level of shutdown benefits, or benefit increases
     that are unfunded at termination.40 PBGC could phase-in the guarantee of
     such benefits. Similar to benefit increases prior to termination, the agency
     could perhaps guarantee an additional 20 percent of shutdown benefits
     each year after the benefits are offered, with full benefits (up to PBGC
     limits) guaranteed only after 5 years. Phasing in guarantees from the date
     of the applicable shutdown could decrease the losses incurred by PBGC
     from underfunded plans.41 A phase-in might cause workers to put pressure
     on sponsors to fund these benefits or benefit increases, or demand
     alternative forms of compensation. Modifying these benefits would reduce
     the early retirement benefits for participants who are in plans with such
     provisions and are affected by a plant closing or a permanent layoff.
     Dislocated workers, particularly in manufacturing, may suffer additional
     losses from lengthy periods of unemployment or from finding
     reemployment only at much lower wages.




     39
      Under the floor-offset arrangement, the benefit computed under the final pay formula is
     “offset” by the benefit amount that the account of another plan, such as an Employee Stock
     Ownership Plan, could provide.
     40
       PBGC guarantees benefits up to certain limits. PBGC may pay only a portion of the claim
     because ERISA places limits on the PBGC benefit guarantee. For example, PBGC generally
     does not guarantee annual benefits above a certain amount, currently about $44,000 per
     participant at age 65. Additionally, benefit increases in the 5 years immediately preceding
     plan termination are not fully guaranteed, though PBGC will pay a portion of these
     increases. The guarantee does not generally include supplemental benefits, such as the
     temporary benefits that some plans pay to participants from the time they retire until they
     are eligible for Social Security benefits.
     41
       Currently, some measures exist to limit the losses incurred by PBGC from certain
     terminated plans. PBGC is responsible for only a portion of all benefit increases that the
     sponsor adds in the 5 years leading up to termination.



     Page 19                                                                        GAO-04-176T
               Widespread underfunding in the defined-benefit pension system
Conclusion 
   potentially threatens the retirement security of millions of American
               workers. The termination of severely underfunded plans can significantly
               reduce the benefits promised to workers and retirees. It also threatens the
               solvency of PBGC’s single-employer insurance program, with, in the worse
               case, Congress facing the choice of a bailout or of letting affected workers
               and retirees lose the pension benefits they depend on. While the pension
               system does not face an immediate crisis, these serious financial
               challenges suggest that meaningful, if perhaps difficult, comprehensive
               action needs to be taken. Such action would be aimed towards the
               improvement of the long-term funding status of plans and the
               accountability of plan sponsors, especially those that represent a clear risk
               to PBGC, plan participants, and their beneficiaries.

               Undoubtedly, unfavorable economic conditions have contributed to
               widespread underfunding and conspired to place well-meaning sponsors
               in very difficult positions to maintain their plans’ funding. Although
               comprehensive reform should include improving plan funding as the key
               vehicle to stabilize and enhance the long-term health of the defined-benefit
               system, Congress may seek to balance improvements in funding and
               accountability against the short-term needs of some sponsors who may
               have difficulty making contributions to their plans. Relief measures should
               be carefully targeted to those sponsors that may need it most urgently,
               with some provision for this aid to eventually lead to improved plan
               funding. In crafting this reform, the Congress should be wary of temporary
               rule changes directed exclusively to short-term problems that could
               increase the risk that plans terminate in even worse financial straits than
               they suffer today.

               It is important to keep in mind that the factors contributing to the
               deterioration of pension plan funding go beyond the effects of the recent
               economic downturn. The defined-benefit system has shown signs of
               stagnation for the past 2 decades, with a steady decline in the number of
               plans and a decreasing proportion of working participants. PBGC’s
               participant base may also be concentrated in more vulnerable industries.
               Concerns about PBGC’s long-run financial viability, and not just the recent
               alarming jump in its accumulated deficit, prompted us to put the single-
               employer program on our high-risk list. While it is unlikely that any rules
               can guarantee that all plans are fully funded at all times, nor should that be
               their goal, regulations should strive to maintain the overall health of the
               system and prevent poor economic conditions from creating a general
               funding crisis.



               Page 20                                                          GAO-04-176T
           In addition to the administration’s current proposal, the Treasury
           Department, Labor Department, and PBGC are considering reforms that
           seek to address many of these issues and include elements of the options
           that I have identified in my testimony, such as increased transparency for
           plan participants. The private defined-benefit pension system is at a
           crossroads, facing a threat of continued financial erosion and decline.
           However, we also have the opportunity and the challenge to broadly move
           the system back to a solid, stable financial footing that will provide needed
           retirement benefits to workers and retirees for decades to come.

           Mr. Chairman, this concludes my statement. I would be happy to respond
           to any questions that you or other members of the Committee may have.

           For information regarding this testimony, please contact Barbara D.
           Bovbjerg, Director, Education, Workforce, and Income Security Issues, on
           (202) 512-7215 or Charles A. Jeszeck on (202) 512-7036. Individuals who
           made key contributions to this testimony are Mark M. Glickman,
           Jeremy Citro, Daniel F. Alspaugh, and John M. Schaefer.




(130334)
           Page 21                                                          GAO-04-176T
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