Background

Before enactment of the Employee Retirement and Income Security Act  (ERISA) of 1974, few rules governed the funding of defined benefit  pension plans, and participants in these plans had no guarantees they  would receive the benefits promised. When Studebaker’s pension plan  failed in the 1960s, for example, many plan participants lost their  pensions. 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. 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.
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. 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 is limited to certain benefits, including so-called  “shut-down benefits,”—significant subsidized early retirement benefits  that are triggered by layoffs or plant closings that occur before plan  termination. 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.
Following 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. (See app I.) For example, sponsors  could voluntarily terminate their underfunded plans only if they were  bankrupt or generally unable to pay their debts without the termination.
Concerns about PBGC finances also resulted in efforts to strengthen the  minimum funding rules incorporated by ERISA in the Internal Revenue  Code (IRC). In 1987, for example, the IRC was amended to require that  plan sponsors calculate each plan’s current liability, and make additional  contributions to the plan if it is underfunded to the extent defined in the  law. As discussed in a report, we issued earlier this year, concerns that  the 30-year Treasury bond rate no longer resulted in reasonable current  liability calculations has led both the Congress and the Administration to  propose alternative rates for these calculations.
Despite the 1987 amendments to ERISA, concerns about PBGC’s financial  condition persisted. In 1990, as part of our effort to call attention to high- risk areas in the federal government, we noted that weaknesses in the  single-employer insurance program’s financial condition threatened  PBGC’s long-term viability. We stated that minimum funding rules still  did not ensure that plan sponsors would contribute enough for terminating  plans to have sufficient assets to cover all promised benefits. In 1992, we  also reported that PBGC had weaknesses in its internal controls and  financial systems that placed the entire agency, and not just the single- employer program, at risk. Three years later, we reported that legislation  enacted in 1994 had strengthened PBGC’s program weaknesses and that  we believed improvements had been significant enough for us to remove  the agency’s high-risk designation. Since that time, we have continued to  monitor PBGC’s financial condition and internal controls. For example, in  1998, we reported that adverse economic conditions could threaten  PBGC’s financial condition despite recent improvements; in 2000, we  reported that contracting weaknesses at PBGC, if uncorrected, could  result in PBGC paying too much for required services; and this year, we  reported that weaknesses in the PBGC budgeting process limited its  control over administrative expenses.
PBGC receives no direct federal tax dollars to support the single-employer  pension insurance program. The program receives the assets of terminated  underfunded plans and any of the sponsor’s assets that PBGC recovers  during bankruptcy proceedings. PBGC finances the unfunded liabilities of  terminated plans with (1) premiums paid by plan sponsors and (2) income  earned from the investment of program assets.
Initially, plan sponsors paid only a flat-rate premium of $1 per participant  per year; however, the flat rate has been increased over the years and is  currently $19 per participant per year. To provide an incentive for  sponsors to better fund their plans, a variable-rate premium was added in  1987. 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. After increasing sharply in the 1980s, flat-rate  premium income declined from $753 million in 1993 to $654 million in  2002, in constant 2002 dollars. (See fig. 1.) Income from the variable-rate  premium fluctuated widely over that period.
The slight decline in flat-rate premium revenue over the last decade, in real  dollars, indicates that the increase in insured participants has not been  sufficient to offset the effects of inflation over the period. Essentially,  while the number of participants has grown since 1980, growth has been  sluggish. Additionally, after increasing during the early 1980s, the number  of insured single-employer plans has decreased dramatically since 1986.  (See fig. 2.)
The decline in variable-rate premiums in 2002 may be due to a number of  factors. For example, all else equal, an increase in the rate used to  determine the present value of benefits reduces the degree to which  reports indicate plans are underfunded, which reduces variable-rate  premium payments. The Job Creation and Worker Assistance Act of 2002  increased the statutory interest rate for variable-rate premium calculations  from 85 percent to 100 percent of the interest rate on 30-year U.S. Treasury  securities for plan years beginning after December 31, 2001, and before  January 1, 2004.
Investment income is also a large source of funds for the single-employer  insurance program. The law requires PBGC to invest a portion of the funds  generated by flat-rate premiums in obligations issued or guaranteed by the  United States, but gives PBGC greater flexibility in the investment of other  assets. For example, PBGC may invest funds recovered from terminated  plans and plan sponsors in equities, real estate, or other securities and  funds from variable-rate premiums in government or private fixed-income  securities. According to PBGC, however, by policy, it invests all premium  income in Treasury securities. As a result of the law and investment  policies, the majority of the single-employer program’s assets are invested  in U.S. government securities. (See fig. 3.)
Since 1990, except for 3 years, PBGC has achieved a positive return on the  investments of single-employer program assets. (See fig 4.) According to  PBGC, over the last 10 years, the total return on these investments has  averaged about 10 percent.
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. 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. 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.
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. 5.) In fiscal year 1996, the  program had its first accumulated surplus, and by fiscal year 2000, the  accumulated surplus had increased to almost $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 $5.7 billion by July 31, 2003. Despite this  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. Losses since that time may have shortened the period over  which the program will be able to cover promised benefits.

	Termination of Severely Underfunded Plans Was Primary Factor in Financial Decline of Single- Employer Program

The financial condition of the single-employer pension insurance program  returned to an accumulated deficit in 2002 largely due 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.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. The current minimum  funding rules and variable-rate premiums were not effective at preventing  those plans from being severely underfunded at termination.

		PBGC Assumed Responsibility for Several Severely Underfunded Plans in 2002

Total estimated losses in the single-employer program due to the actual or  probable termination of underfunded plans increased from $705 million in  fiscal year 2001 to $9.3 billion in fiscal year 2002, in 2002 dollars. In  addition to $3.0 billion in losses from the unfunded liabilities of terminated  plans, the $9.3 billion included $6.3 billion in losses from the unfunded  liabilities of plans that were expected to terminate in the near future.  Some of the terminations considered probable at the end of fiscal year  2002 have already occurred. For example, in December 2002, PBGC  involuntarily terminated an underfunded Bethlehem Steel Corporation  pension plan, which resulted in the single-employer program assuming  responsibility for about $7.2 billion in PBGC-guaranteed liabilities, about  $3.7 billion of which was not funded at termination.
Much of the program’s losses resulted from the termination of  underfunded plans sponsored by failing steel companies. PBGC estimates  that in 2002, underfunded steel company pension plans accounted for 80  percent of the $9.3 billion in program losses for the year. The three largest  losses in the single-employer program’s history resulted from the  termination of underfunded plans sponsored by failing steel companies:  Bethlehem Steel, LTV Steel, and National Steel. All three plans were either  completed terminations or listed as probable terminations for 2002. Giant  vertically integrated steel companies, such as Bethlehem Steel, have faced  extreme economic difficulty for decades, and efforts to salvage their  defined-benefit plans have largely proved unsuccessful. According to  PBGC’s executive director, underfunded steel company pension plans  have accounted for 58 percent of PBGC single-employer losses since 1975.

		Plan Unfunded Liabilities Were Increased by Stock Market and Interest Rate Declines

The termination of underfunded plans in 2002 occurred after a sharp  decline in the stock market had reduced plan asset values and a general  decline in interest rates had increased plan liability values, and the  sponsors did not make the contributions necessary to adequately fund the  plans before they were terminated. The combined effect of these factors  was a sharp increase in the unfunded liabilities of the terminating plans.  According to annual reports (Annual Return/Report of Employee Benefit  Plan, Form 5500) submitted by Bethlehem Steel Corporation, for example,  in the 7 years from 1992 to 1999, the Bethlehem Steel pension plan went  from 86 percent funded to 97 percent funded. (See fig. 6.) 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.
A decline in the stock market, which began in 2000, was a major cause of  the decline in plan asset values, and the associated increase in the degree  that plans were underfunded at termination. For example, while total  returns for stocks in the Standard and Poor’s 500 index (S&P 500)  exceeded 20 percent for each year from 1995 through 1999, they were  negative starting in 2000, with negative returns reaching 22.1 percent in  2002. (See fig. 7.) Surveys of plan investments by Greenwich Associates  indicated that defined-benefit plans in general had about 62.8 percent of  their assets invested in U.S. and international stocks in 1999.
A stock market decline as severe as the one experienced from 2000  through 2002 can have a devastating effect on the funding of plans that had  invested heavily in stocks. For example, according to a survey, 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. Over that same general period, stocks in the S&P 500 had a  negative return of 38 percent.
In addition to the possible effect of the stock market’s decline, a drop in  interest rates likely had a negative effect on plan funding levels by  increasing plan termination costs. Lower interest rates increase plan  termination liabilities by increasing the present value of future benefit  payments, which in turn increases the purchase price of group annuity  contracts used to terminate defined-benefit pension plans. For example, a  PBGC analysis indicates that a drop in interest rates of 1 percentage point,  from 6 percent to 5 percent, increased the termination liabilities of the  Bethlehem Steel pension plan by about 9 percent, which indicates the cost  of terminating the plan through the purchase of a group annuity contract  would also have increased.
Relevant interest rates may have declined 3 percentage points or more  since 1990. For example, interest rates on long-term high-quality  corporate bonds approached 10 percent at the start of the 1990s, but were  below 7 percent at the end of 2002. (See fig. 8.)

		Minimum Funding Rules and Variable-Rate Premiums Did Not Prevent Plans from Being Severely Underfunded

IRC minimum funding rules and ERISA variable rate premiums, which are  designed to ensure plan sponsors adequately fund their plans, did not have  the desired effect for the terminated plans that were added to the single- employer program in 2002. The amount of contributions required under  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. Also, the rules require the  sponsor to make an additional contribution if the plan is underfunded to  the extent defined in the law. However, plan funding is measured using  current liabilities, which a PBGC analysis indicates have been typically  less than termination liabilities. Additionally, 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.
While minimum funding rules may encourage sponsors to better fund their  plans, the rules require sponsors to assess plan funding using current  liabilities, which a PBGC analysis indicates have been typically less than  termination liabilities. Current and termination liabilities differ because  the assumptions used to calculate them differ. For example, some plan  participants may retire earlier if a plan is terminated than they would if the  plan continues operations, and lowering the assumed retirement age  generally increases plan liabilities, especially if early retirement benefits  are subsidized. With respect to two of the terminated underfunded pension  plans that we examine, for example, a PBGC analysis indicates:
The retirement age assumption for the Anchor Glass pension plan on an  ongoing plan basis was 65 for separated-vested participants. However, the  retirement age assumption appropriate for those participants on a  termination basis was 58—a decrease of 7 years. According to PBGC,  changing retirement age assumptions for all participants, including  separated-vested participants, resulted in a net increase in plan liabilities  of about 4.6 percent.
The retirement age assumption for the Bethlehem Steel pension plan on an  ongoing plan basis was 62 for those active participants eligible for  unreduced benefits after 30 years of service. On the other hand, the  retirement age assumption for them on a plan termination basis was 55 –  the earliest retirement age. According to PBGC, decreasing the assumed  retirement age from 62 to 55 approximately doubled the liability for those  participants.
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 the IRC funding rules from making a tax-deductible  contribution to the plan. 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.
Another ERISA provision, concerning the payment of variable-rate  premiums, is also designed to encourage employers to better fund their  plans. As with minimum funding rules, the variable-rate premium did not  provide sufficient incentives for the plan sponsors that we reviewed to  make the contributions necessary to adequately fund their plans. None of  the three underfunded plans that we reviewed, which became losses to the  single-employer program in 2002 and 2003, paid a variable-rate premium in  the 2001 plan year. Plans are exempt from the variable-rate premium if  they are at the full-funding limit in the year preceding the premium  payment year, in this case 2000, after applying any contributions and credit  balances in the funding standard account. Each of these four plans met  this criterion.

	PBGC Faces Long- Term Financial Risks from a Potential Imbalance of Assets and Liabilities

Two primary risks threaten the long-term financial viability of the single- employer program. The greater risk concerns the program’s liabilities:  large losses, due to bankrupt firms with severely underfunded pension  plans, could continue or accelerate. This could occur if returns on  investment remain poor, interest rates stay low, and economic problems  persist. More troubling for liabilities is the possibility that structural  weaknesses in industries with large underfunded plans, including those  greatly affected by increasing global competition, combined with the  general shift toward defined-contribution pension plans, could jeopardize  the long-term viability of the defined-benefit system. On the asset side,  PBGC also faces the risk that it may not receive sufficient revenue from  premium payments and investments to offset the losses experienced by  the single-employer program in 2002 or that this program may experience  in the future. This could happen if program participation falls or if PBGC  earns a return on its assets below the rate it uses to value its liabilities.

		Several Factors Affect the Degree to Which Plans Are Underfunded and the Likelihood That Plan Sponsors Will Go Bankrupt

Plan terminations affect the single-employer program’s financial condition  because PBGC takes responsibility for paying benefits to participants of  underfunded terminated plans. Several factors would increase the  likelihood that sponsoring firms will go bankrupt, and therefore will need  to terminate their pension plans, and the likelihood that those plans will be  underfunded at termination. Among these are poor investment returns,  low interest rates, and continued weakness in the national economy and  or specific sectors. Particularly troubling may be structural weaknesses in  certain industries with large underfunded defined-benefit plans.
Poor investment returns from a decline in the stock market can affect the  funding of pension plans. To the extent that pension plans invest in stocks,  the decline in the stock market will increase the chance that plans will be  underfunded should they terminate. A Greenwich Associates survey of  defined-benefit plan investments indicates that 59.4 percent of plan assets  were invested in stocks in 2002. Clearly, the future direction of the stock  market is very difficult to forecast. From the end of 1999 through the end  of 2002, total cumulative returns in the stock market, as measured by the  S&P 500, were negative 37.6 percent. In 2003, the S&P 500 has partially  recovered those losses, with total returns (from a lower starting point) of  14.7 percent through the end of September. From January 1975, the  beginning of the first year following the passage of ERISA, through  September 2003, the average annual compounded nominal return on the  S&P 500 equaled 13.5 percent.
A decline in asset values can be particularly problematic for plans if  interest rates remain low or fall, which raises plan liabilities, all else equal.  The highest allowable discount rate for calculating current plan liabilities,  based on the 30-year U.S. Treasury bond rate, has been no higher than 7.1  percent since April, 1998, lower than any previous point during the 1990s.Falling interest rates raise the price of group annuities that a terminating  plan must purchase to cover its promised benefits and increase the  likelihood that a terminating plan will not have sufficient assets to make  such a purchase. An increase in liabilities due to falling interest rates also  means that companies may be required under the minimum funding rules  to increase contributions to their plans. This can create financial strain  and increase the chances of the firm going bankrupt, thus increasing the  risk that PBGC will have to take over an underfunded plan.
Economic weakness can also lead to greater underfunding of plans and to  a greater risk that underfunded plans will terminate. For many firms, slow  or declining economic growth causes revenues to decline, which makes  contributions to pension plans more difficult. Economic sluggishness also  raises the likelihood that firms sponsoring pension plans will go bankrupt.  Three of the last five annual increases in bankruptcies coincided with  recessions, and the record economic expansion of the 1990s is associated  with a substantial decline in bankruptcies. Annual plan terminations  resulting in losses to the single-employer program rose from 83 in 1989 to  175 in 1991, and, after declining to 65 in 2000, the number reached 93 in  2001.
Weakness in certain industries, particularly the airline and automotive  industries, may threaten the viability of the single-employer program.  Because PBGC has already absorbed most of the pension plans of steel  companies, it is the airline industry, with $26 billion of total pension  underfunding, and the automotive sector, with over $60 billion in  underfunding, that currently represent PBGC’s greatest future financial  risks. In recent years, profit pressures within the U.S. airline industry have  been amplified by severe price competition, recession, terrorism, the war  in Iraq, and the outbreak of Severe Acute Respiratory Syndrome (SARS),  creating recent bankruptcies and uncertainty for the future financial  health of the industry. As one pension expert noted, a potentially  exacerbating risk in weak industries is the cumulative effect of  bankruptcy; if a critical mass of firms go bankrupt and terminate their  underfunded pension plans, others, in order to remain competitive, may  also declare bankruptcy to avoid the cost of funding their plans.
Because the financial condition of both firms and their pension plans can  eventually affect PBGC’s financial condition, PBGC tries to determine how  many firms are at risk of terminating their pension plans and the total  amount of unfunded vested benefits. According to PBGC’s fiscal year 2002  estimates, the agency is at potential risk of taking over $35 billion in  unfunded vested benefits from plans that are sponsored by financially  weak companies and could terminate. Almost one-third of these  unfunded benefits, about $11.4 billion, are in the airline industry.  Additionally, PBGC estimates that it could become responsible for over  $15 billion in shutdown benefits in PBGC-insured plans.
PBGC uses a model called the Pension Insurance Modeling System (PIMS)  to simulate the flow of claims to the single-employer program and to  project its potential financial condition over a 10-year period. This model  produces a very wide range of possible outcomes for PBGC’s future net  financial position.

		Revenue from Premiums and Investments May Not Offset Program’s Current Deficit or Possible Future Losses

To be viable in the long term, the single-employer program must receive  sufficient income from premiums and investments to offset losses due to  terminating underfunded plans. A number of factors could cause the  program’s revenues to fall short of this goal or decline outright. For  example, fixed-rate premiums would decline if the number of participants  covered by the program decreases, which may happen if plans leave the  system and are not replaced. Additionally, the program’s financial  condition would deteriorate to the extent investment returns fall below  the assumed interest rate used to value liabilities.
Annual PBGC income from premiums and investments averaged $1.3  billion from 1976 to 2002, in 2002 dollars, and $2 billion since 1988, when  variable-rate premiums were introduced. Since 1988, investment income  has on average equaled premium income, but has varied more than  premium income, including 3 years in which investment income fell below  zero. (See fig. 9.) In 2001, total premium and investment was negative and  in 2002 equaled approximately $1 billion.
Premium revenue for PBGC would likely decline if the total number of  plans and participants terminating their defined-benefit plans exceeded  the new plans and participants joining the system. This decline in  participation would mean a decline in PBGC’s flat-rate premiums. If more  plans become underfunded, this could possibly raise the revenue PBGC  receives from variable-rate premiums, but would also be likely to raise the  overall risk of plans terminating with unfunded liabilities. Premium  income, in 2002 dollars, has fallen every year since 1996, even though the  Congress lifted the cap on variable-rate premiums in that year.
The decline in the number of plans PBGC insures may cast doubt on its  ability to increase premium income in the future. The number of PBGC- insured plans has decreased steadily from approximately 110,000 in 1987  to around 30,000 in 2002. While the number of total participants in  PBGC-insured single-employer plans has grown approximately 25 percent  since 1980, 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. (See fig 10.) In addition, a growing percentage of  plans have recently become hybrid plans, such as cash-balance plans that  incorporate characteristics of both defined-contribution and defined- benefit plans. Hybrid plans are more likely than traditional defined-benefit  plans to offer participants the option of taking benefits as a lump-sum  distribution. If the proliferation of hybrid plans increases the number of  participants taking lump sums instead of retirement annuities, over time  this would reduce the number of plan participants, thus potentially  reducing PBGC’s flat-rate premium revenue. Unless something reverses  these trends, PBGC may have a shrinking plan and participant base to  support the program in the future and that base may be concentrated in  certain, potentially more vulnerable industries.
Even more problematic than the possibility of falling premium income  may be that PBGC’s premium structure does not reflect many of the risks  that affect the probability that a plan will terminate and impose a loss on  PBGC. While PBGC charges plan sponsors a variable-rate premium based  on the plan’s level of underfunding, premiums do not consider other  relevant risk factors, such as the economic strength of the sponsor, plan  asset investment strategies, the plan’s benefit structure, or the plans  demographic profile. Because these affect the risk of PBGC having to take  over an underfunded pension plan, it is possible that PBGC’s premiums  will not adequately and equitably protect the agency against future losses.  The recent terminations of Bethlehem Steel, Anchor Glass, and Polaroid,  plans that paid no variable-rate premiums shortly before terminating with  large underfunded balances, lend some evidence to this possibility.  Sponsors also pay flat-rate premiums in addition to variable-rate  premiums, but these reflect only the number of plan participants and not  other risk factors that affect PBGC’s potential exposure to losses. Full- funding limitations may exacerbate the risk of underfunded terminations  by preventing firms from contributing to their plans during strong  economic times when asset values are high and firms are in the best  financial position to make contributions.
It may also be difficult for PBGC to diversify its pool of insured plans  among strong and weak sponsors and plans. In addition to facing firm- specific risk that an individual underfunded plan may terminate, PBGC  faces market risk that a poor economy may lead to widespread  underfunded terminations during the same period, which potentially could  cause very large losses for PBGC. Similarly, PBGC may face risk from  insuring plans concentrated in vulnerable industries that may suffer  bankruptcies over a short time period, as has happened recently in the  steel and airline industries. One study estimates that the overall premiums  collected by PBGC amount to about 50 percent of what a private insurer  would charge because its premiums do not account for this market risk.
The net financial position of the single-employer program also depends  heavily on the long-term rate of return that PBGC achieves from the  investment of the program’s assets. All else equal, PBGC’s net financial  condition would improve if its total net return on invested assets exceeded  the discount rate it used to value its liabilities. For example, between 1993  and 2000 the financial position of the single-employer program benefited  from higher rates of return on its invested assets and its financial  condition improved. However, if the rate of return on assets falls below  the discount rate, PBGC’s finances would worsen, all else equal. As of  September 30, 2002, PBGC had approximately 65 percent of its single- employer program investments in U.S. government securities and  approximately 30 percent in equities. The high percentage of assets  invested in Treasury securities, which typically earn low yields because  they are considered to be relatively “risk-free” assets, may limit the total  return on PBGC’s portfolio. Additionally, PBGC bases its discount rate on  surveys of insurance company group annuity prices, and because PBGC  invests differently than do insurance companies, we might expect some  divergence between the discount rate and PBGC’s rate of return on assets.  PBGC’s return on total invested funds was 2.1 percent for the year ending  September 30, 2002, and 5.8 percent for the 5-year period ending on that  date. For fiscal year 2002, PBGC used an annual discount rate of 5.70  percent to determine the present value of future benefit payments through  2027 and a rate of 4.75 percent for payments made in the remaining years.
The magnitude and uncertainty of these long-term financial risks pose  particular challenges for the PBGC’s single-employer insurance program  and potentially for the federal budget. In 1990, we began a special effort to  review and report on the federal program areas we considered high risk  because they were especially vulnerable to waste, fraud, abuse, and  mismanagement. In the past, we considered PBGC to be on our high-risk  list because of concerns about the program’s viability and about  management deficiencies that hindered that agency’s ability to effectively  assess and monitor its financial condition. The current challenges to  PBGC’s single-employer insurance program concern immediate as well as  long-term financial difficulties, which are more structural weaknesses  rather than operational or internal control deficiencies. Nevertheless,  because of serious risks to the program’s viability, we have placed the  PBGC single-employer insurance program on our high-risk list.

	Several Reforms Might Reduce The Risks To The Program’s Financial Viability

Although some pension professionals have suggested a “wait and see”  approach, betting that brighter economic conditions improving PBGC’s  future financial condition are imminent, agency officials and other pension  professionals have suggested taking a more prudent, proactive approach,  identifying a variety of options that could address the challenges facing  PBGC’s single-employer program. In our view, several types of reforms  might be considered to reduce the risks to the single-employer program’s  long-term financial viability. These reforms could be made to strengthen funding rules applicable to poorly funded plans; modify program guarantees;  improve the availability of information about plan investments,  termination funding, and program guarantees.
Several variations exist within these options and each has advantages and  disadvantages. In any event, any changes adopted to address the challenge  facing PBGC should provide a means to hold sponsors accountable for  adequately funding their plans, provide plan sponsors with incentives to  increase plan funding, and improve the transparency of the plan’s financial  information.

		Strengthening Plan Funding Rules Might Reduce Program Risks

Funding rules could be strengthened to increase minimum contributions  to underfunded plans and to allow additional contributions to fully funded  plans. This approach would improve plan funding over time, while  limiting the losses PBGC would incur when a plan is terminated. However,  even if funding rules were to be strengthened immediately, it could take  years for the change to have a meaningful effect on PBGC’s financial  condition. In addition, 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. 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 would likely improve plan funding and therefore  reduce potential claims against PBGC. One problem with this approach is  the difficulty plan sponsors would have 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.
Raise threshold for additional funding requirement. The 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. 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  might also prevent sponsors of significantly underfunded plans from  avoiding contributions. Such 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. 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. 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. The 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. Raising these limitations might result in pension plans being  better funded, decreasing the likelihood that they will be underfunded  should they terminate.
Modifying Program  Guarantee Would Decrease  PBGC from underfunded plans. This approach could preserve plan assets  Plan Underfunding  Modifying certain guaranteed benefits could decrease losses incurred by  by preventing additional losses that PBGC would incur when a plan is  terminated. However, participants would lose benefits provided by some  plan sponsors. ERISA could be amended to:
Phase-in the guarantee of shutdown benefits. PBGC is concerned  about its exposure to the level of shutdown benefits that it guarantees.  Shutdown benefits provide additional benefits, such as significant early  retirement benefit subsidies 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. Phasing in guarantees from the date of the applicable  shutdown could decrease the losses incurred by PBGC from underfunded  plans. However, 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.
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. Increasing this threshold, or  restricting benefit increases when plans reach the threshold, could  decrease the losses incurred by PBGC from underfunded plans. 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.

		Restructuring The Program’s Premium Structure Might Improve Its Financial Viability

PBGC’s premium rates could be increased or restructured to improve  PBGC’s financial condition. Changing premiums could increase PBGC’s  revenue or provide an incentive for plan sponsors to better fund their  plans. However, premium changes that are not based on the degree of risk  posed by different plans may force financially healthy companies out of  the defined-benefit system and discourage other plan sponsors from  entering the system. Various actions could be taken to reduce guaranteed  benefits. ERISA could be amended to:
Increase or restructure variable-rate premium. The current variable- rate premium of $9 per $1,000 of unfunded liability could be increased.  The rate could also be adjusted so that plans with less adequate funding  pay a higher rate. Premium rates could also 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, shutdown  benefit, and floor-offset provisions. 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.
Increase fixed-rate premium. The current fixed rate of $19 per  participant annually could be increased. Since the inception of PBGC, this  rate has been raised four times, most recently in 1991 when it was raised  from $16 to $19. Such increases generally raise premium income for  PBGC, but the current fixed-rate premium has not reflected the changes in  inflation since 1991. By indexing the rate to the consumer price index,  changes to the premium would be consistent with inflation. However, any  increases in the fixed-rate premium would affect all plans regardless of the  adequacy of their funding.

		Increasing Transparency of Plan Information Might Encourage Sponsors to Better Fund Plans, Reducing Program Risks

Improving the availability of 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. ERISA could  be amended to:
Disclose information on plan investments. While some asset  allocation information is reported by plans in form 5500 filings with the  IRS, some plan investments may be made through common and collective  trusts, master trusts, and registered investment companies, which make it  difficult or impossible for participants and others to determine the asset  classes–such as equity or fixed-income investments–for many plan  investments. Improving the availability of plan asset allocation information  may give plan sponsors an incentive to increase funding of underfunded  plans or limit risky investments. Information provided to participants  could also disclose how much of plan assets are invested in the sponsor’s  own securities. This would be of concern because should the sponsor  becomes 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.
Disclose 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. In addition, only participants  in plans below a certain funding threshold receive annual notices of the  funding status of their plans. 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.
Disclose benefit guarantees to additional participants. As with the  disclosure of plan funding status, only participants of plans below the  funding threshold receive notices on the level of program guarantees  should their plan terminate. Termination of a severely underfunded plan  can significantly reduce the benefits participants receive. For example, 59- year old pilots were expecting annual benefits of $110,000 per year on  average when the US Airways plan was terminated in 2003, while the  maximum PBGC-guaranteed benefit at age 60 is $28,600 per year.Expanding the circumstances under which plan sponsors must notify  participants of PBGC guarantees may enable more participants to better  plan for their retirement.

	Conclusion

The current financial challenges facing PBGC and the array of policy  options to address those challenges are more appropriately viewed within  the context of the agency’s overall mission. In 1974, ERISA placed three  important charges on PBGC: first, protect the pension benefits so essential  to the retirement security of hard working Americans; second, minimize  the pension insurance premiums and other costs of carrying out the  agency’s obligations; and finally, foster the health of the private defined- benefit pension plan system. While addressing one or even two of these  goals would be a challenge, it is a far more formidable endeavor to fulfill  all three. In any event, any changes adopted to address the challenges  facing PBGC should provide plan sponsors with incentives to increase  plan funding, improve the transparency of the plan’s financial information,  and provide a means to hold sponsors accountable for funding their plans  adequately. Ultimately, however, for any insurance program, including the  single-employer pension insurance program, to be self-financing, there  must be a balance between premiums and the program’s exposure to  losses.
A variety of options are available to the Congress and PBGC to address the  short-term vulnerabilities of the single-employer insurance program.  Congress will have to weigh carefully the strengths and weaknesses of  each option as it crafts the appropriate policy response. However, to  understand the program’s structural problems, it helps to understand how  much the world has changed since the enactment of ERISA. In 1974, the  long-term decline that our nation’s private defined-benefit pension system  has experienced since that time might have been difficult for some to  envision. Although there has been some absolute growth in the system  since 1980, active workers have comprised a declining percentage of  program participants, and defined-benefit plan coverage has declined as a  percentage of the national private labor force. The causes of this long-term  decline are many and complex and have turned out to be more systemic,  more structural in nature, and far more powerful than the resources and  bully pulpit that PBGC can bring to bear.
This trend has had important implications for the nature and the  magnitude of the risk that PBGC must insure. Since 1987, as employers,  both large and small, have exited the system, newer firms have generally  chosen other vehicles to help their employees provide for their retirement  security. This has left PBGC with a risk pool of employers that is  concentrated in sectors of the economy, such as air transportation and  automobiles, which have become increasingly vulnerable. As of 2002,  almost half of all defined-benefit plan participants were covered by plans  offered by firms in manufacturing industries. The secular decline and  competitive turmoil already experienced in industries like steel and air  transportation could well extend to the other remaining strongholds of  defined-benefit plans in the future, weakening the system even further.
Thus, the long-term financial health of PBGC and its ability to protect  workers’ pensions is inextricably bound to this underlying change in the  nature of the risk that it insures, and implicitly to the prospective health of  the defined-benefit system. Options that serve to revitalize the defined  benefit system could stabilize PBGC’s financial situation, although such  options may be effective only over the long term. The more immediate  challenge, however, is the fundamental consideration of the manner in  which the federal government protects the defined-benefit pensions of  workers in this increasingly risky environment. We look forward to  working with the Congress on this crucial subject.
Mr. Chairman, members of the committee, that concludes my statement.  I’d be happy to answer any questions you may have.

Appendix I: Key Legislative Changes That Affect the Single-Employer Insurance Program

As part of the Employee Retirement and Income Security Act (ERISA) of  1974, the Congress established the Pension Benefit Guaranty Corporation  (PBGC) to administer the federal insurance program. Since 1974, the  Congress has amended ERISA to improve the financial condition of the  insurance program and the funding of single-employer plans (see table 1).

Summary:
Why GAO Did This Study

More than 34 million workers and retirees in 30,000 single-employer defined benefit pension plans rely on a federal insurance program managed by the Pension Benefit Guaranty Corporation (PBGC) to protect their pension benefits, and the program's long-term financial viability is in doubt. Over the last decade, the program swung from a $3.6 billion accumulated deficit (liabilities exceeded assets), to a $10.1 billion accumulated surplus, and back to a $3.6 billion accumulated deficit, in 2002 dollars. Furthermore, despite a record $9 billion in estimated losses to the program in 2002, additional severe losses may be on the horizon. PBGC estimates that financially weak companies sponsor plans with $35 billion in unfunded benefits, which ultimately might become losses to the program. This testimony provides GAO's observations on the factors that contributed to recent changes in the single-employer pension insurance program's financial condition, risks to the program's long-term financial viability, and changes to the program that might be considered to reduce those risks.

What GAO Found

The single-employer pension insurance program returned to an accumulated deficit in 2002 largely due to the termination, or expected termination, of several severely underfunded pension plans. Factors that contributed to the severity of plans' underfunded condition included a sharp stock market decline, which reduced plan assets, and an interest rate decline, which increased plan termination costs. For example, PBGC estimates losses to the program from terminating the Bethlehem Steel pension plan, which was nearly fully funded in 1999 based on reports to IRS, at $3.7 billion when it was terminated in 2002. The plan's assets had decreased by over $2.5 billion, while its liabilities had increased by about $1.4 billion since 1999. The single-employer program faces two primary risks to its long-term financial viability. First, the losses experienced in 2002 could continue or accelerate if, for example, structural problems in particular industries result in additional bankruptcies. Second, revenue from premiums and investments might be inadequate to offset program losses experienced to date or those that occur in the future. Revenue from premiums might fall, for example, if the number of program participants decreases. Because of these risks, we recently placed the single-employer insurance program on our high-risk list of agencies with significant vulnerabilities to the federal government. While there is not an immediate crisis, there is a serious problem threatening the retirement security of millions of American workers and retirees. Several reforms might reduce the risks to the program's longterm financial viability. Such changes include: strengthening funding rules applicable to poorly funded plans, modifying program guarantees, restructuring premiums, and improving the availability of information about plan investments, termination funding, and program guarantees. Any changes adopted to address the challenge facing PBGC should provide a means to hold plan sponsors accountable for adequately funding their plans, provide plan sponsors with incentives to increase plan funding, and improve the transparency of plan information.