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88–593—PDF 2003

S. HRG. 108–71

FUNDING CHALLENGE: KEEPING DEFINED BENEFIT

PENSION PLANS AFLOAT

HEARING

BEFORE THE

COMMITTEE ON FINANCE

UNITED STATES SENATE

ONE HUNDRED EIGHTH CONGRESS

FIRST SESSION

MARCH 11, 2003

(

Printed for the use of the Committee on Finance

COMMITTEE ON FINANCE

CHARLES E. GRASSLEY, Iowa, Chairman

ORRIN G. HATCH, Utah

DON NICKLES, Oklahoma

TRENT LOTT, Mississippi

OLYMPIA J. SNOWE, Maine

JON KYL, Arizona

CRAIG THOMAS, Wyoming

RICK SANTORUM, Pennsylvania

BILL FRIST, Tennessee

GORDON SMITH, Oregon

JIM BUNNING, Kentucky

MAX BAUCUS, Montana

JOHN D. ROCKEFELLER IV, West Virginia

TOM DASCHLE, South Dakota

JOHN BREAUX, Louisiana

KENT CONRAD, North Dakota

BOB GRAHAM, Florida

JAMES M. JEFFORDS (I), Vermont

JEFF BINGAMAN, New Mexico

JOHN F. KERRY, Massachusetts

BLANCHE L. LINCOLN, Arkansas

KOLAN DAVIS, Staff Director and Chief Counsel

JEFF FORBES, Democratic Staff Director

(II)

(III)

C O N T E N T S

OPENING STATEMENTS

Page

Grassley, Hon. Charles E., a U.S. Senator from Iowa, chairman, Committee

on Finance ............................................................................................................ 1

Baucus, Hon. Max, a U.S. Senator from Montana ................................................ 3

PUBLIC WITNESSES

Kandarian, Steven, executive director, Pension Benefit Guaranty Corporation,

Washington, DC ................................................................................................... 5

O’Flinn, Christopher W., vice president, Corporate Human Resources, AT&T,

representative of the ERISA Industry Committee, Bedminster, NJ ............... 17

Schuler, Capt. Mark, U.S. Airways, Barrington, New Hampshire, accompanied by Captain Pete McGuirk, U.S. Airways ............................................... 19

Eickelberg, Henry, staff vice president, General Dynamics, representative

of the American Benefits Council, Falls Church, VA ........................................ 21

Gebhardtsbauer, Ron, senior pension actuary, the American Academy of Actuaries, Washington, DC ......................................................................................... 23

ALPHABETICAL LISTING AND APPENDIX MATERIAL

Baucus, Hon. Max:

Opening statement ........................................................................................... 3

Eickelberg, Henry:

Testimony .......................................................................................................... 21

Prepared statement .......................................................................................... 37

Gebhardtsbauer, Ron:

Testimony .......................................................................................................... 23

Prepared statement .......................................................................................... 45

Grassley, Hon. Charles E.:

Opening statement ........................................................................................... 1

Kandarian, Steven:

Testimony .......................................................................................................... 5

Prepared statement .......................................................................................... 55

Responses to questions from Senator Grassley .............................................. 63

O’Flinn, Christopher W.:

Testimony .......................................................................................................... 17

Prepared statement .......................................................................................... 67

Rockefeller, Hon. John D.:

Prepared statement .......................................................................................... 83

Schuler, Capt. Mark:

Testimony .......................................................................................................... 19

Prepared statement .......................................................................................... 84

COMMUNICATIONS

AARP ........................................................................................................................ 87

Hinze, Jay ................................................................................................................. 91

Peskin, Michael ........................................................................................................ 92

Ryan Labs Inc. ......................................................................................................... 126

Gold, Jeremy ............................................................................................................ 142

(1)

FUNDING CHALLENGE: KEEPING DEFINED

BENEFIT PENSION PLANS AFLOAT

TUESDAY, MARCH 11, 2003

U.S. SENATE,

COMMITTEE ON FINANCE,

Washington, DC.

The hearing was convened, pursuant to notice, at 10:08 a.m., in

room 215, Dirksen Senate Office Building, Hon. Charles E. Grassley (chairman of the committee) presiding.

Also present: Senators Baucus, Rockefeller, and Bingaman.

OPENING STATEMENT OF HON. CHARLES E. GRASSLEY, A U.S.

SENATOR FROM IOWA, CHAIRMAN, COMMITTEE ON FINANCE

The CHAIRMAN. Good morning. I welcome everybody who is here

to the committee hearing. This hearing is on defined benefit pension plans and the rules that we use to fund them. This is our first

pension hearing for this Congress.

Before I proceed, I welcome our witnesses from the administration and from plan sponsor communities. I am sorry that the

Treasury Department was not able to be with us today, and I look

forward to hearing from the person who was going to represent the

Department, Mr. Fisher, at the earliest convenience.

I would remind Mr. Fisher and anybody else with the administration that is up for Senate confirmation, that we regularly ask

committee nominees three questions, of which the third one is, ‘‘Do

you agree, without reservation, to respond to any reasonable summons to appear and testify before any duly constituted committee

of the Congress, if you are confirmed?’’ Mr. Fisher was confirmed,

he was invited here, and he is not here.

I would also like to note that Captain Schuler was the only witness who provided his testimony, not only on time, but early.

Maybe the rules of the committee on when testimony is supposed

to be submitted does not mean much to anybody, but it means an

awful lot to Senator Baucus and me. We would appreciate it if you

would get your testimony in according to the rules of the committee.

We are here today to discuss what is the proper measure to value

liabilities of pension plans. The statutory rate is the 30-year Treasury rate, but in October, 2001 the Treasury Department discontinued issuing these bonds, at the same time interest rates on the

bond was at a 40-year low. While the Treasury Department is still

calculating the yield on 30-year Treasury bonds, the number is becoming more and more soft.

2

In the Economic Stimulus Bill of 2002, Congress granted interest

rate relief to plans for 2002 and 2003. We are quickly running out

of 2003, obviously, and plans are running out of relief.

This is not to say that plans are fully funded. While some are

well funded, others are not. The newspapers are full of stories

about underfunded plans too often.

In the past 3 years, the Pension Benefit Guaranty Corporation

has taken over the pension plans of almost the entire U.S. steel industry. The PBGC already is holding the pension plans of many

airlines, when earlier this month the Bankruptcy Court advised

that they could take over the U.S. Airway Pilots plan.

The unfunded liability remaining in airline pension plans is a

staggering $18 billion. The PBGC is currently $3.6 billion in deficit.

Some critics argue that the agency is swimming in money. If they

take over what is left of the steel industry pension plans and the

pension debt of the rest of the airlines, they obviously will not be

swimming.

Alternatively, others would argue that the PBGC is barely treading water now, and urgently needs a life preserver. In the past, I

have been a critic of the PBGC, but this agency is the backstop to

failed funding promises in our defined benefit pension plan system.

What happens to this tiny agency is critical to millions of American retirees whose pension benefits were not there for them when

they were ready to retire. Therefore, I hope none of our witnesses

will make light of the mission of this agency.

Balancing the need to have fully funded pension plans for all

Americans, while the need to encouraging defined benefit pensions

is always high on Congress’ list.

There are activists who, for whatever reason, do not believe that

defined benefit pensions are best for Americans. Now, as you know,

there are others who simply disapprove of one type of defined benefit arrangement, such as hybrid plans. But a pension is a wonderful social tool because it provides every retiree with the option for

a lifetime payout of their benefit.

Nowadays, a minority of workers have a pension. In 1987, there

were well over 111,000 defined benefit pensions in this Nation.

Today, just 15 years later, there are barely 30,000 plans remaining.

This decline in the number of defined benefit pension plans is bad

for Americans.

The 401(k) account is not required to pay out in an annuity form,

and I have often thought that one serious illness in a worker can

have their entire retirement savings wiped out.

If workers have no defined benefit pension plans and they wipe

out their 401(k) savings, then of course they only have Social Security to depend upon. The long-term outlook for Social Security is

for long-term deficits beginning once the baby boomers start to retire, so we ought to be looking at ways to encourage sponsorship

of defined benefit pension plans.

Funding rules that are too harsh will not encourage defined benefit pension plans, but funding rules should not allow sponsors to

manipulate the system and make pension promises that they cannot deliver on, or foist those promises on the PBGC and on those

solvent employers who pay premiums into that system. This does

3

1For more information on this subject, see also, ‘‘Present Law and Background Relating To

Employer-Sponsored Defined Benefit Plans and the Financial Position of the Pension Benefit

Guaranty Corporation (‘PBGC’),’’ Joint Committee on Taxation Staff Report (JCX–16–03), March

10, 2003.

not provide the protection necessary for workers to have faith in

their respective plans.

So please bear in mind with us that this is all a balancing act.

We must encourage employers to keep these plans, but not at the

expense of workers and their faith in the defined benefit pension

plan system.1

Senator Baucus?

OPENING STATEMENT OF HON. MAX BAUCUS, A U.S. SENATOR

FROM MONTANA

Senator BAUCUS. Thank you very much, Mr. Chairman. I am also

a bit concerned that one of the principal witnesses that we had

asked to come to testify before us, Mr. Peter Fisher, at the last

minute declined.

Mr. Chairman, if this committee and this Congress is going to do

its work, it has to have the advice and the views of administration

officials, particularly on a topic like this. I think both the Treasury

Department and Department of Labor have very serious concerns

with, and are deeply involved with, pension issues.

I think it is almost an affront to this Congress and to the committee for the administration to, at the end, just pull out. I do not

know the reasons. We were given no reasons.

This committee understands that witnesses sometimes have to

reschedule because of scheduling conflicts. That appears not to be

the case this time. In fact, there was no reason given whatsoever.

One can only surmise that perhaps Mr. Fisher was asked not to

testify. My guess is, it was not his decision, it was somebody in the

White House, because of a fear that some members of this committee may ask some questions about various issues, debt limit

issues, for example, or budget issues, deficit issues, that might be

a little bit embarrassing to the administration.

Well, my answer to that is, if that is the reason for not testifying,

is to recall Harry Truman’s dictum: if you cannot stand the heat,

you just get out of the kitchen.

I mean, those of us who run for these offices and seek the public

trust have an obligation to stand up and answer questions that are

asked of us in public service. Mr. Fisher did, under oath, say that

he would appear if reasonably asked to appear. Well, apparently he

seems not to be honoring that oath.

Now, my guess is that it is not Mr. Fisher’s call, that, again,

somebody in the White House told Mr. Fisher not to come, and it

is unfortunate, to say the least.

I might say, Mr. Chairman, this is a practice we cannot let continue. I do not know what the solution is. I can think of many different solutions. I do not know which one is the best to deal with

this problem, but we cannot let this continue.

I know I speak for you when I say we will find a reasonable way

that encourages Treasury officials, when reasonably asked, to come

and testify before us, as is the case today, and particularly when

we are dealing with pension issues.

4

The CHAIRMAN. I fully associate myself with your remarks, and

only claim in this particular case that I found out so late last night,

that I did not feel I could do much about it.

Senator BAUCUS. Which often is the case. That is not against

you, it is just what they often do.

The CHAIRMAN. I will try to stay on top of that so that we have

full cooperation of the administration.

Senator BAUCUS. Thank you, Mr. Chairman.

The CHAIRMAN. If I were not a Republican, it would not be so

embarrassing, but it is embarrassing.

Senator BAUCUS. Well, it is embarrassing to the committee.

The CHAIRMAN. Yes, it is.

Senator BAUCUS. I mean, it should be an embarrassment to Mr.

Fisher, and it should be an embarrassment to the administration,

frankly.

Mr. Chairman, today’s hearing is focused on the difficult balances associated with funding defined benefit pension plans. I must

say, these issues are similar to the issues surrounding the Social

Security system.

That is, we need to make sure that the funding is in the system

so Social Security recipients are not denied their benefits, so the

benefits promised for the future are the benefits paid in the future.

At the same time, we should not require unwarranted excess

payments to be made into the system. We need to ensure that companies and workers have money today to make investments today.

Enron, WorldCom, and other similar meltdowns illustrate in very

graphic terms the risks associated with defined contribution plans

such as 401(k)s, and especially with the even higher risks of 401(k)

plans that are not carefully diversified.

However, the focus on 401(k) plans has put defined benefit plans

in the spotlight again. While a worker in a defined benefit plan

may not get the upside potential of a 401(k) plan in a bull market,

they also should not have to be afraid of the bear market, that is,

a weak economy.

Our funding rules, along with the insurance guarantee through

the Pension Benefit Guaranty Corporation, are designed to ensure

that no one in a defined benefit plan will ever be hit with an empty

nest egg. The worker may not get everything she was expecting at

retirement, but she should not be left penniless, either.

The PBGC’s insurance program should provide this guarantee,

but the PBGC’s guarantees are only as good as the assets that are

backing them. That means if the plans are not adequately funded

at the same time, the PBGC is not strong, then the guarantees

given to the workers are eroded.

As a result, workers get less than they were promised and other

companies find themselves paying higher premiums to make up the

shortfall of the PBGC funds. Everything is relative, as we will hear

from our witnesses today.

A guarantee of $20,000 a year to live on after retirement may

sound pretty good, that is, unless you earned $100,000 during your

decades of work. A company that has worked hard to fully fund its

pension plan could also pay a price if others are not so prudent or

so lucky, so they drive the cost of premiums up for everyone.

5

Funding defined benefit plans is a careful balancing act. First, if

we allow too little money to be contributed, then workers run the

risk of losing some of the benefits they have come to rely on. On

the other hand, require too much money to be contributed, and

companies will not even offer the plans because of the costs.

Third, if you require that money be contributed when a company

is already struggling financially, you risk pushing the company

over the cliff into bankruptcy.

Clearly, there are no easy answers. I thank you, Mr. Chairman,

for holding this hearing. You convened it as a result of the crisis

in the airline industry, an industry where companies are still reeling from the combination of the terrorist attack on September 11th

and the weak economy.

Nonetheless, responding to funding issues on a piecemeal basis

and industry-by-industry basis, I believe, does not work. Providing

relief to one industry without dealing with the bigger picture of our

funding structure itself could well start a long line of dominoes.

The airline industry is not the only industry struggling in this

economy. Quite frankly, it is hard to give relief to one industry

without giving relief to all. But, at the same time, the more companies that are allowed to postpone funding their plans results in

more workers who are placed at risk.

We need to find the right balance between risk and reward if the

defined benefit system is to stay strong and vital. It may take some

time to find that balance, but I believe it will be time well spent.

Thank you, Mr. Chairman.

The CHAIRMAN. Thank you, Senator Baucus.

I have a statement for Senator Santorum that will be put in the

record, without objection. The record will be left open for the rest

of the day for other Senators that want to submit statements or

questions for answer in writing.

I can say to the present witness, as well as the next panel of witnesses, that if you get questions in writing, we would appreciate a

response in 2 weeks.

[The prepared statement of Senator Santorum appears in the appendix.]

The CHAIRMAN. I now go to Mr. Kandarian, who is the executive

director of the PBGC here in Washington, DC. Would you proceed

in your statement? Your long statement will be put in the record.

Thank you. Proceed with your summation.

STATEMENT OF STEVEN KANDARIAN, EXECUTIVE DIRECTOR,

PENSION BENEFIT GUARANTY CORPORATION (PBGC), WASHINGTON, DC

Mr. KANDARIAN. Mr. Chairman, Senator Baucus, good morning.

I am Steve Kandarian, executive director of the Pension Benefit

Guaranty Corporation. I want to thank you for holding this timely

hearing.

Last year, PBGC’s single employer insurance program went from

a surplus of $7.7 billion to a deficit of $3.6 billion. The $11.3 billion

loss is five times larger than any previous loss in the program’s 28-

year history.

6

In addition, we estimate that total pension underfunding of single employer plans now exceeds $300 billion, by far the largest

shortfall ever recorded.

While the PBGC is a Federal Government corporation, it receives

no taxpayer revenues and is not backed by the full faith and credit

of the U.S. Government.

When PBGC takes over underfunded pension plans, it is premium payers, other companies that sponsor defined benefit plans,

who bear the cost. Financially healthy companies with well-funded

pension plans end up subsidizing financially weak companies with

chronically underfunded plans.

If this subsidy becomes too great, strong companies may choose

to leave the system, subjecting the insurance program to adverse

selection.

During the recession of the early 1990’s, PBGC experienced what

was then the largest claims in its history, $600 million for Eastern

Airlines and $800 million for Pan Am.

Those claims pale next to our recent losses, $1.3 billion for National Steel, $1.9 billion for LTV Steel, and $3.7 billion for Bethlehem Steel. Claims for fiscal year 2002 exceed the sum of all

claims since the agency’s inception in 1974.

Recent pension claims have skyrocketed, while PBGC premiums

have remained flat, at about $800 million a year. It would take

about 12 years of premiums to cover the claims for fiscal year 2002

alone.

But raising premiums high enough to cover the size of losses now

being incurred could prove counterproductive, driving financially

strong companies out of the defined benefit system.

The worst may not be over. In plans sponsored by companies

with below investment-grade credit ratings, our exposure to pension underfunding has more than tripled, from $11 billion to $35

billion. About half of this $35 billion is in the troubled steel and

airline industries.

The current $3.6 billion deficit is the largest in our history. Nevertheless, it does not create an immediate liquidity problem for the

agency. We will be able to continue paying benefits for a number

of years.

Some have argued that because PBGC is not in any immediate

danger of running out of cash, there is no need to address the issue

of pension underfunding. This view is misguided.

Congress heard the same argument in 1987, and again in 1994,

when it strengthened pension security. Without those reforms,

workers in the pension insurance program would be in even worse

shape today.

Mr. Chairman, we believe there are three options for dealing

with the challenges facing the defined benefit system. First, we

could do nothing and hope the system will self-correct. This approach risks putting off today’s problems to the next generation.

Second, Congress can enact a large, across-the-board premium

increase, a change that seems unfair to companies with well-funded

plans that are already subsidizing the system. Third, we could look

at how to get underfunded pension plans adequately funded over

a reasonable period of time.

7

The PBGC and the Departments of Labor, Treasury, and Commerce are looking at the pension funding rules. Under current

rules, funding is not high enough for the plans of companies with

the greatest risk of termination. The funding rules do not require

many of these companies to make annual cash contributions to

their plans.

In addition, benefits can be increased with little new funding,

even if the plan is only 60 percent funded. Moreover, in certain industries, including steel, PBGC is exposed to liability for shut-down

benefits that were never funded by the employer, and for which no

specific premium was charged.

Another concern is the need for better disclosure. The value of

plan assets and liabilities is not transparent to workers, retirees,

investors, and creditors. The most current information regarding

funded status of plans is available to PBGC, but not the public.

A final concern is the financial integrity of the pension insurance

program. One issue is whether a more risk-based premium structure would be preferable to the current system. In general, however, well-funded plans represent a better solution for participants

and the pension insurance program than any premium changes we

could make.

It is important to note that the existence of the pension insurance program creates the risk of moral hazard. Financially troubled

companies are tempted to defer the funding of their pension obligations and pass the cost of underfunded plans to responsible companies that have adequately funded their plans.

We should make sure that the incentives in the system are

changed to prevent this from happening. We are working to find

ways to improve pension security for workers and retirees by putting the voluntary defined benefit system on a sound financial footing.

Defined benefit plans are an important source of retirement income for workers. PBGC insurance protects those benefits, but

there are limits to the guarantee. To prevent workers from suffering significant benefit cut-backs when their plans are terminated, we must ensure that companies adequately fund their plans.

Thank you, Mr. Chairman, for inviting me to testify this morning. I will be happy to answer your questions.

[The prepared statement of Mr. Kandarian appears in the appendix.]

The CHAIRMAN. Thank you. We will have five-minute rounds.

The PBGC now has this large deficit, as you pointed out. Can

you still pay benefits, and for how long can you continue to pay

benefits?

Mr. KANDARIAN. Senator, we can pay benefits for a number of

years to come. It is difficult to say exactly how many years. The

reason is, it is a moving target. So depending upon what happens,

for example, this year, that number could change pretty dramatically either up or down.

What I mean by that, is not only the number of claims that come

in, but also the size of those claims. One of the biggest concerns

to us is the airline industry, which you noted has significant underfunding today and is in distress. When pension payments must be

made is also important. So, for example, when we terminate a penVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 88593.000 SFINANC2 PsN: SFINANC2
8

sion plan, we get these assets today. We have that cash on hand

today. On the one hand, the pension promises may already be running for retirees, but they are a number of years away for people

who are young workers.

So, depending upon how young your workforce is or not, the

number of years is unclear. But the important factor, I think, to

take into account, is that some day this agency will run out of

money if the size of these underfunded plans that have been coming to us recently continues, given current premium levels.

The CHAIRMAN. If Congress were to adopt, as some have asked

Congress to do, the corporate bond rate as a replacement for the

30-year treasuries, what effect would that have on plan funding

and on, particularly, the premium income of your agency?

Mr. KANDARIAN. If Congress simply adopted the long-term aggregate corporate bond rate with no other changes to the current funding system that would reduce the level of funding to these plans.

But it could now adopt the long-term corporate bond rate and make

some adjustments. For example, it could take out some of the

smoothing factors. It could change some of the funding rules. It

could make other adjustments to the program that could offset the

reduction in funding that would result from using a corporate bond

rate which is a higher interest rate than the Treasury rate, which

of course is the lowest interest rate, the risk-free rate.

The CHAIRMAN. Companies have told those of us in Congress,

and publicized it well themselves, that funding rules do not allow

them to make large enough pension contributions in good economic

times. Do you think that the current funding rules are responsible

for limiting pension contributions?

Mr. KANDARIAN. Well, for some companies it may be, but for

most companies, based upon a survey we did covering the late

1990’s, that is not the case. The survey that we conducted for the

years 1996, 1998, and 2000, during the good years of the stock

market when companies were making large profits and perhaps

had more access to capital to fund their plans, found that only

about 20 percent of the companies in that period of time that have

100 participants or more actually went up to the maximum funding

limits that are in the law currently. So, only 20 percent really were

maxxed out, according to the survey that we did.

However, I do not think we should foreclose that possibility. It

is something we are studying. We should certainly look at providing more flexibility and finding ways to enable companies to

fund during the good years and not be in a bind during the lean

years in terms of making up for the shortfall.

The CHAIRMAN. I think you have suggested, have you not, stronger funding rules for companies with chronically underfunded plans.

Can those companies, in your judgment, afford to make greater

plan contributions, because they also tend to be companies that are

cash starved?

Mr. KANDARIAN. There are certainly trade-offs, as you point out.

I think that we can look at transition rules to give companies some

period of time to plan for the future. And if you put a goalpost

some number of years out there for companies to see and know

what they are striving toward, they can make plans. They can adVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00012 Fmt 6633 Sfmt 6633 88593.000 SFINANC2 PsN: SFINANC2
9

just their pension promises going forward to be able to fund the

promises they have already made.

So sometimes companies, especially where there are collective

bargaining agreements involved, continue to make ever-larger pension promises and have great difficulty funding even the ones they

have already made.

The CHAIRMAN. Could you give us your judgment how come so

many plans go so underfunded so quickly?

Mr. KANDARIAN. There are a number of factors, but probably the

most important ones relate to how liabilities are calculated and the

way plans invest their assets.

Liabilities are calculated based upon interest rates. It is different

for both funding purposes and termination purposes, but, still, it is

interest rates. The lower the interest rate, the higher the liability,

just like a bond.

So as interest rates have come down in the last few years, those

liabilities have grown dramatically. At the same time, the assets

that most companies have invested in with their pension trust are

oftentimes 50 percent or more in the stock market.

Those assets have come down at the same time the liabilities

have gone up, and the mismatch of assets and liabilities has resulted in the volatility you have seen in the last few years.

The CHAIRMAN. Thank you.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman.

The question is, where is, sort of, the cliff? That is, there are

fewer plans, but the workforce apparently covered by the plans has

increased. Is that correct? There are fewer defined benefit plans

over time, but the number of people covered has increased.

Mr. KANDARIAN. The number of people covered may be up slightly. It is pretty flat, I think, as a way of characterizing it, largely

because most of the plans terminated were small plans, under 100

participants.

Senator BAUCUS. Have you explored ways to try to reinvigorate

participation in defined benefit plans?

Mr. KANDARIAN. We have. I think, for the larger, more mature

companies, most of them have not dropped their plans, at least not

voluntarily. Some have because of inability to afford those plans,

and oftentimes through the bankruptcy process.

The smaller companies have chosen to exit the system when they

had the ability to do so, meaning they had plans that were wellfunded, you could buy annuities in the private market, and they

exited the system and oftentimes offered defined contribution

plans.

I think smaller companies, in particular, are concerned about the

cost of the system, the paperwork involved, a number of these factors. We did propose some legislation which was passed in the

House the last year or two, but was not ultimately adopted by Congress due to issues of germaneness.

Senator BAUCUS. But what is to prevent the trend from continuing? That is, fewer companies participating. You mentioned

smaller ones dropping out. What is to prevent that from continuing?

10

Mr. KANDARIAN. In terms of small companies, or large, or across

the board?

Senator BAUCUS. Across the board, but I suppose mostly smaller

dropping out, as you were saying.

Mr. KANDARIAN. Well, some of the proposals we put forward, I

think, could be helpful in making the system less onerous for the

small companies. As to the larger companies, I think it really gets

to the issue of whether employees and workers, highly value these

pension promises.

I think, in the late 1990’s, when the stock market was in a bubble, people looked to their 401(k)s or just their simple direct investments in the stock market, and valued those kinds of approaches

to retirement more than traditional pension plans. That may be reversing today, as people have seen the consequences of that.

Senator BAUCUS. Any evidence of reversal? There is no evidence

of reversal.

Mr. KANDARIAN. Only anecdotal. We have no studies we have

done or anything that I can point to that would scientifically suggest that things are swinging back. But it would not surprise me

if workers would tell their companies or managements of these

companies that, ‘‘We value these benefits. We would like these benefits. Please retain them, or please institute them.’’

Senator BAUCUS. When do you reach the point where you have

kind of lost the cushion? That is, where there are so many plans

dropped, that you do not have the assets. Where is that point?

Mr. KANDARIAN. There are probably a couple of factors. One is

simply the size of claims we take into the agency. I think that the

key there, Senator, is that the premium structure has been relatively flat for about a decade, so the number of dollars we take

into the agency has been level for about 10 years.

The size of the claims in this economic slump now, is growing

fairly dramatically from the previous slump in the early 1990’s. It

is because these plans are getting larger, they are more generous,

there are more retirees, there are more people in the plans in these

large companies.

If the level of funding in those plans does not change, then a 50

percent underfunded plan today results in a much larger claim to

us than a 50 percent underfunded claim in 1991, which is what I

was trying to point to in my oral testimony. The size of those

claims against the agency have gone from the hundreds of millions

to the billions, but the premiums are flat.

Now, I do not think going to premiums, in the first instance, is

the right way to approach a fix. The right way to approach a fix

is to get those funded ratios up so plans come into us when they

do in economic slumps 10 or 20 percent underfunded, not 50, 60,

or 70 percent underfunded. That is the correct way, I believe, to fix

the system.

Senator BAUCUS. But how can you assure that, that they come

in at the lower percent underfunded?

Mr. KANDARIAN. You would have to address the funding rules

that exist today. That is something that our task force is working

on currently.

Senator BAUCUS. When do you think you will have an answer,

a proposal?

11

Mr. KANDARIAN. I do not have a specific date, but I can assure

you, we are working very hard to pull together a proposal to

present.

Senator BAUCUS. Can you give us a rough estimate? Is it going

to take a year? Ten years?

Mr. KANDARIAN. I hope it occurs in the next number of months,

but certainly not years.

Senator BAUCUS. Good. So we can look forward to hearing from

you in, what, 6 months, to be fair? Is that fair?

Mr. KANDARIAN. I think some of this will result from both our

work with the administration and timing in terms of when the administration rolls out different economic packages for consideration.

Senator BAUCUS. What did we learn from the LTV matter, avoiding a strong word? You know, there were a lot of pay-outs there.

Mr. KANDARIAN. There were. The company did have a highly underfunded plan. It was only about 50 percent funded. It was a company that went through very difficult times in the 1980’s. It tried

to terminate its plans back then. We restored those plans and

eventually took them back in a decade later.

I think it goes to the same issue we have been talking about,

which is making sure that pension promises that are made are

pension promises that are funded and kept. If these firms do end

up liquidating, we hope that the level of underfunding, again, is

much lower, that is, that the plans are much better funded when

they come into the agency.

We can certainly handle 10 or 20 percent underfunding, but 50,

60, 70 percent underfunding of very large pension plans will overwhelm the system at some point.

Senator BAUCUS. My time is up, Mr. Chairman.

The CHAIRMAN. Thank you. I am going to submit questions for

answer in writing. If you have got any more questions, just go

ahead now.

Senator BAUCUS. Just a couple more. That is, if you could separate the short-term relief, say some of the airlines ask you for

short-term relief compared with longer term, what is in the category of short-term and what is in the category of long-term here?

Mr. KANDARIAN. I think the key on that issue really relates to

this 30-year Treasury replacement issue. What I hope we do not do

is select a rate that is intended to provide funding relief. It should

be the best measure of those liabilities to provide transparency, to

provide an accurate measure of these liabilities.

Now, if funding relief is considered desirable in the near term for

considerations of where we are in the economy, that should be addressed separately on some transitional basis.

But, again, putting the goal post out there some number of

years—not too far out—to get these plans better funded, but let us

not use the replacement for Treasuries as a way to provide shortterm funding relief, because all we will do is lock in the underfunding that ultimately will come back and haunt us in years to

come.

Senator BAUCUS. Long term?

Mr. KANDARIAN. Long term, we have to tighten up the funding

rules.

12

Senator BAUCUS. Are you going to come up with separate recommendations for short term and long term?

Mr. KANDARIAN. Yes. Yes, we will. Again, it is the Departments

of Treasury, Labor, Commerce, PBGC, and others within the administration who are working on this task force to address these

issues.

Senator BAUCUS. And we will get those recommendations in the

timeframe that we discussed?

Mr. KANDARIAN. Yes. Yes.

Senator BAUCUS. This hearing was called basically because of

U.S. Air. Senator Santorum, inspector. What should we do with

U.S. Airways? Say, short term. What is the short-term solution for

U.S. Airways?

Mr. KANDARIAN. We were asked at the agency to consider doing

something that is referred to as ‘‘restoration funding,’’ taking in the

pension plans of U.S. Airways and then giving them right back to

the company with a different funding schedule, essentially providing 30 years to fund the unfunded amounts that exist today as

opposed to what current law provides, which is closer to 5, 6, or

7 years.

We rejected that on legal grounds, saying the act did not provide

that power to us, that it was the power of Congress to set the funding rules, not the agency’s Executive Director, essentially, which

was what was being requested.

The second thing we said was that we would not support a

change of law to provide that power to the agency to make those

kinds of calls. My concern there was that you then start dealing

with the situations on a case-by-case basis. I would be concerned

about a slippery slope in providing this kind of relief in one case,

like U.S. Airways, without providing it to other airlines who have

similar problems of their own, or other industries that have problems right now.

So I think any sort of relief that may be desirable should be considered on a much grander scale and scheme, not on a case-by-case

basis made by the agency itself.

Senator BAUCUS. Where is that grander scheme, or under what

grander scheme? How could you define it? Are you talking about

a different forum? Are you talking about a different proposal? What

do you mean?

Mr. KANDARIAN. Yes. I think that the approach that Congress

has taken, and was supported by the administration, was setting

up the ATSB to provide loan guarantees to the airline industry,

and grants, in some cases. That kind of relief has been provided

to U.S. Airways.

Senator BAUCUS. And so you prefer that route to a PBGC fix?

Mr. KANDARIAN. I think that is the better public policy approach

when you consider, if society thinks there should be some relief,

then society is paying for it through the Federal Government, the

taxpayer revenues.

On the other hand, if you say, let us give specific companies relief on a case-by-case basis through PBGC, you are directing the

cost of that, potentially, to the rate payers in the defined benefit

world, which is a segment of society. I think that is a less supportable approach.

13

Senator BAUCUS. So your answer would be the same with respect

to any industry request for relief from PBGC.

Mr. KANDARIAN. Yes. Yes. And I think one of the charts we

showed earlier, the pie chart, indicates the size of the cross subsidy

going on in the system today. I think that is just too large.

Senator BAUCUS. Could you explain that chart again, please?

Mr. KANDARIAN. Sure. This chart shows the claims against the

insurance system since inception, since 1974. So of all the claims

that came into the insurance system, what percent was steel? The

answer is 58 percent. Airlines, 13 percent. That does not include

the currently bankrupt airlines that we are aware of. In all, those

are 29 percent.

Now, steel represents less than 3 percent of the workforce that

we insured at its peak in 1974. Today, it is less than 2 percent.

Yet, the claims are approximately 58 percent. Airlines represent

less than 2 percent of workers but the claims represent about 13

percent. We are talking about today’s airline claims, again, before

the more recent bankruptcies.

So, while there are going to be cross-subsidies in the system, I

am not saying we should not have some of that. The question is,

to what extent can the system support that kind of

disproportionality and still be viewed as a fair system, and be

viewed by strong companies as a system they want to be a part of?

Senator BAUCUS. So how do we deal with that cross-subsidy, and

that magnitude of cross-subsidy? Is that magnitude going to, in

your judgment, continue, all things being equal, or do you suggest

some changes to minimize or to reduce that cross-subsidy?

Mr. KANDARIAN. There is not much we can do, obviously, retrospectively. But prospectively, if we get these plans better funded,

again, up to much higher levels of funding, so if there is a termination—and we are certainly here for that purpose—they are not

coming in 50, 60, 70 percent underfunded, as many of these did.

Senator BAUCUS. And that would require what?

Mr. KANDARIAN. Legislative changes to the funding rules.

Senator BAUCUS. Right. To someone who is kind of uninitiated in

this subject, what would the statutes provide?

Mr. KANDARIAN. Senator, if I could just defer on that one. Those

are a number of things we are considering and studying within the

administration, and as of now we do not have a plan that we can

put forward. I am trying to be careful not to put forward something

that, at this point in time, really is not a completed package that

has been agreed to.

Senator BAUCUS. Right. Even though it is not complete, what direction might it tend toward?

Mr. KANDARIAN. It would result in companies better funding

these plans through looking at the promises they have made, making sure they fund those promises over some reasonably short period of time, especially before they start making much larger promises in the future.

Senator BAUCUS. Well, Mr. Kandarian, I want to thank you very

much for participating and for helping this committee very much

in trying to find a solution. Thank you.

The CHAIRMAN. The Chair recognizes the Senator from West Virginia for questioning.

14

Senator ROCKEFELLER. Thank you very much, Mr. Chairman. I

apologize for coming in late, but I was in Commerce trying to help

Iowa and Montana maintain essential air service and airport development authority.

Senator BAUCUS. Good for you.

The CHAIRMAN. More airplanes in and out of Waterloo, Iowa,

then.

Senator ROCKEFELLER. That was the point at which I broke down

and started crying. [Laughter.] I am not going to say anything

about Billings.

Senator BAUCUS. I was going to say, if you cried over Waterloo,

what did you do over Cutbank? [Laughter.]

Senator ROCKEFELLER. Mr. Kandarian, I apologize for coming

late. I know that of the $13.3 billion deficit—I mean, I can remember when PBGC, back in the 1980’s, was just one of the most flush,

wonderful agencies to consider. Now I think you are dealing with,

what a $13.7 billion deficit?

Mr. KANDARIAN. We have a $3.6 billion deficit, but we had a loss

of $11.4 billion, approximately, in one year.

Senator ROCKEFELLER. Yes. So this is a 2-year process. About 7.5

of that comes from the steel industry, am I right?

Mr. KANDARIAN. That is about right.

Senator ROCKEFELLER. Yes. I assume that Senator Baucus was

questioning you about that also. I want to be very specific on

Wheeling-Pittsburgh Steel, because they are in the process, as you

know, of trying to recover from bankruptcy, and they have not

given up on that.

There are all kinds of things that are going on right now which

could affect both them and Wierton Steel, but Wheeling-Pittsburgh

is the subject of the moment.

I have to say that the executives of that company, including a

couple of Senators who represent that State, were really startled

to learn from the newspapers last week that, despite the very clear

ongoing efforts of that company to stay afloat and make good on

pension benefits that they had promised their workers, that the

PBGC would be coming in and involuntarily terminating their pension plan. That was devastating news for many of the workers and

retirees, and it was extremely surprising to me, and, of course, totally unknown, which is usually not a good idea.

Now, it is my understanding also that PBGC made the decision

to terminate the plan last week in order to avoid any possibility of

becoming liable for shutdown benefits, and I want you to talk about

that in a minute.

I understand your desire to minimize your losses. You are, after

all, in deficit. I cannot support a decision that unnecessarily punishes the workers that you, as far as I understand it, are meant

to protect. That is what you are chartered for. Although you have

acted within your legal authority, I cannot argue that, this may not

have been a very constructive way to proceed.

Can you tell me why the PBGC did not make a good faith effort

to work with the company’s executives in order to protect the workers’ benefits as they stood just last week instead of precipitously

terminating the plan?

15

Mr. KANDARIAN. Yes, Senator. The issue is shut-down benefits,

and the question is whether they should be guaranteed by this

agency. My view is they should not. The law is silent. ERISA is silent on the issue.

For much of this agency’s history, it has moved to terminate

plans before shutdown benefits sprang forward. The way the system works is based upon a regulation issued in 1975, and some

have questioned whether it is a good regulation.

The regulation says, essentially, if the plan terminates prior to

shutdown occurring, legally, there are no shutdown benefits guaranteed by the agency. If, instead, the company shuts down a facility or the entire company, shutdown benefits are guaranteed if the

plan terminates afterwards. So, it is a timing issue.

So in the first instance, let me say why we cannot go and telegraph our actions, because companies can then turn around and

shut down prior to our taking the action to avoid the liability.

In fact, that happened in the case of Bethlehem Steel. I was criticized for the first instance when I took this kind of action with RTI,

Republic Technologies, International, a steel company which we

terminated in June of 2002.

We gave no notice. We simply published in the papers. We called

the company, we called the union the day we took the action, and

were criticized for doing what you just said.

In the case of Bethlehem, we gave 2 days’ notice. The day in between the notice and the day we took legal action, they shut down

the facility, costing millions of dollars to the agency. So, that is the

issue of why we do not telegraph ahead of time.

Now, the greater issue is, should these be guaranteed benefits?

The reason I think they should not be guaranteed benefits, is because, unlike other benefits that we guarantee which are underfunded, these are not unfunded. No money goes aside for these benefits.

Senator ROCKEFELLER. Can I ask, then—and I understand your

explanation because I understand your program—is it, therefore,

now the policy of PBGC to involuntary terminate pensions in order

to minimize your own potential liability?

Mr. KANDARIAN. Under the act, we are required to look at involuntarily terminating pension plans based upon an unreasonable increase in long-run loss to the agency.

So, I looked at the case of Wheeling-Pittsburgh. We studied that

company for some time. We hired outside consultants to try to help

us understand whether this company could survive without additional access to capital markets and loans.

The company has been in bankruptcy since November of 2000,

over 2 years. It sought a loan from the Emergency Steel Guaranty

Loan Board. That loan request was rejected.

Once that loan request was rejected, our belief was that there

was little chance the company could afford this pension plan, and

that we would get the plan eventually in any case.

I should note that this is probably the only instance in our history where we have actually taken in defined benefit pension plans

and had significant liabilities from the same company twice; it occurred back in the middle 1980’s.

16

So in this case, the underfunding, without the shut-down, was around $65 million. The shutdown benefits would have added well

over $300 million on top of the $65 million.

Based upon the law, based upon ERISA, that is an unreasonable

increase in long-run loss based upon our analysis, using both people within the agency and using experts from the steel industry

outside.

Senator ROCKEFELLER. All right. Mr. Chairman, I am finished,

but I will just close with a comment.

Wheeling-Pittsburgh is considering a number of options. You

came to the conclusion that they had been turned down by the loan

board, and therefore that was it for them.

They do not think of it that way. They are not proceeding that

way. Their banks and their creditors are not reacting in that way.

But you made that decision for them, which hurts them, I would

assume, with their creditors and their bankers.

So, this is part of the conundrum I think we find ourselves in.

You made a decision based upon what you understood, but you did

not, perhaps, understand that they have not yet given up by any

means.

Mr. KANDARIAN. Mr. Chairman, might I respond to the comment?

The CHAIRMAN. Yes.

Mr. KANDARIAN. We did try to take that into consideration, Senator. We were aware that they might be going back to the Emergency Steel Loan Guaranty Board for another go at the loan.

We are happy to talk to the company about our actions and work

with them at this point in time, but if we had waited to do that

and they did not get the loan, or chose for some reason not to go

forward and simply shut down, that liability would have sprung

forward.

So we have sort of put our mark on the ground in terms of the

timing of our action. That timing can be negotiated to a different

date. That timing can be considered and discussed with the company, and I am happy to do that.

But if I did not put the mark on the ground now and they shut

down because the loan was not granted—and by the way, it takes

us about four or 5 days, as a legal matter, to declare our involuntary termination because of newspaper ads and all the rest, and

the company can shut down, as we noted in the case of Bethlehem,

in 24 hours, a group, a facility, or an entire company, in fact, if

they are planning for it.

So, we have to consider all these factors, which we did. They are

difficult decisions. They weren’t done in a vacuum. They weren’t

done without consideration of all the factors that you discussed. Regrettably, the law is set up in a way that forces us to take this kind

of action. I wish it did not, but it does, and that is what I am working under.

Senator ROCKEFELLER. Good. So a change in the law would not

be unwelcome to you?

Mr. KANDARIAN. No.

Senator ROCKEFELLER. Thank you, Mr. Chairman.

Mr. KANDARIAN. I wish that the law was not the way it was.

The CHAIRMAN. Before you go, could you give us some sort of aggregate value of the shut-down benefits in the system?

17

Mr. KANDARIAN. We think it is in excess of $15 billion. To give

you some perspective, our entire assets are about $25 billion, and

liabilities today are about $29 billion. Shutdown benefits are in

steel, auto, tire and rubber, and a little bit in aerospace.

The CHAIRMAN. If they are owed by the company, are these nondischargeable in bankruptcy?

Mr. KANDARIAN. To the company, you are saying?

The CHAIRMAN. Yes.

Mr. KANDARIAN. To the company, there would be a claim against

the company’s assets, but typically in bankruptcy, there is nothing

left over. So we end up taking on these plans, and if a shutdown

occurred, again, before we took the plan in, it would be the liability

of this Federal Government corporation.

The CHAIRMAN. I was speaking specifically about Chapter 11

type cases, not Chapter 7.

Mr. KANDARIAN. Right. In terms of, can they extinguish those liabilities unilaterally in bankruptcy?

The CHAIRMAN. Yes. Then, if so, are they dischargeable?

Mr. KANDARIAN. I believe they are not, but let me get back to you

for the record.

The CHAIRMAN. All right. Then you can give an answer in writing, or I will wait for you to consult.

Mr. KANDARIAN. I will get back to you for the record on that one,

Senator.

The CHAIRMAN. All right. That is good.

We thank you very much for coming here as an expert witness

in this area, and for the work that you do.

I would call the next panel. I would like all four of you to come

right now. You do not have to wait until I call you.

The first one is Christopher W. O’Flinn, vice president, Corporate

Human Resources, AT&T, and he will be representing the ERISA

Industry Committee; Mark Schuler, Captain, U.S. Airways, from

Barrington, New Hampshire; Henry Eickelberg, staff vice president, General Dynamics, representing the American Benefits Council; and Ron Gebhardtsbauer, the American Academy of Actuaries,

Washington, DC.

We will start with you, Mr. O’Flinn. Then we will go the Captain,

then Mr. Eickelberg, then Mr. Gebhardtsbauer before we ask questions.

You do not have to ask for your complete statement to be put in

the record. We will do that. We would ask you to summarize in the

5 minutes that have been allotted.

First, you, Mr. O’Flinn.

STATEMENT OF CHRISTOPHER W. O’FLINN, VICE PRESIDENT,

CORPORATE HUMAN RESOURCES, AT&T, BEDMINSTER, NEW

JERSEY, CHAIRMAN OF THE ERISA INDUSTRY COMMITTEE

Mr. O’FLINN. Thank you, Mr. Chairman and members of the

committee. Thank you for the opportunity to present the views of

the ERISA Industry Committee on the funding of defined benefit

plans.

ERIC, as we are known, has a unique interest in the funding

rules for defined benefit plans, because about 95 percent of our

18

membership actually sponsor defined benefit programs, as well as

other substantial benefit programs, like 401(k) and health plans.

ERIC is pleased to testify today because it is critical that the

issue of the proper discount rate to use in determining current

funding obligations of defined benefit plans be addressed quickly

and in the appropriate way.

If we leave only one message with the committee today, it should

be that the continued absence of a permanent and appropriate discount rate in the law is tremendously damaging to the employer

sponsors of defined benefit plans, to their shareholders, and to

their employees.

The damage will adversely affect the ability of these firms to contribute to the economic recovery, to maintain their defined benefit

plans, and to enhance employment opportunities.

Let me give you some examples of the damage I am referring to.

Today, investment analysts are starting to notice the absence of a

permanent appropriate discount rate in the law for Federal minimum funding rules and are advising investors, in writing, to avoid

the stock of companies with major defined benefit programs.

Another example. Corporate finance departments are developing

cash flow needs today for 2004, and they are looking at an artificially low discount rate for determining minimum pension funding

under the Federal law, beginning in 2004.

Consequently, they are beginning to look for ways to raise the

cash demanded by the rules. They are reevaluating their defined

benefit plans, they are looking at the level of their workforce in

2004 and today, and equally important, they are looking at other

cash needs, like capital investment, on which to trim back all in

order to raise capital needed to wake the pension contribution.

Their analysis for all of these alternatives for raising the cash

will need to be complete, and their decisions made, by this summer

at the latest.

Mr. Chairman, Senator Baucus, members of the committee, this

provision in the law concerning the interest rates the Chairman

talked about in his opening remarks must be fixed, we believe, immediately, and in the appropriate way or the damaging momentum

that is already under way will be too great for any legislation to

completely stop.

ERIC has a proposed solution in this area. Echoing the remarks

of the Chairman and Senator Baucus in the opening statements, it

is intended to balance the needs of everyone who is concerned in

this area.

We have already, we believe, a very comprehensive program for

funding of defined benefit programs. We have minimum funding

standards. The Grassley-Baucus amendments of 2001 have raised

the deductibility of pension contributions, which was a very important step, we believe, in encouraging employers to make more than

the minimum contribution.

In addition, as the committee members know, we have an accelerated funding rule, a snapshot test, which is intended to take a

snapshot of the funding status of the plan in order to determine if

funding should be accelerated.

19

The snapshot looks at the plan assets to determine where they

are with respect to the plan’s obligations, and it is the assumptions

used in taking the snapshot that is the focus of our discussion.

As the Chairman pointed out again in his opening remarks, the

key assumption is the interest rate assumption, which in the statute today is the defunct 30-year bond rate, currently at an historic

low relative to other rates.

ERIC’s proposal is to keep the statutory funding arrangements

in place, including the protection of the overview of the enrolled actuary, and including the snapshot test. But we strongly urge that

the interest rate be changed to reflect the long-term investments

which pension plans typically make in the fixed income area.

We also favor changing the mortality assumptions to reflect the

fact that people are living longer, again, balancing the interests

around this key determination.

Our goal is that those employers who voluntarily make a pension

promise to their employees should be required to take prudent action to fund that promise, but without excessive special funding requirements caused by historical aberrations which can delay our

economic recovery, diminish employment, and diminish the rewards for employment.

Thank you, Mr. Chairman, for the opportunity to address the

committee.

The CHAIRMAN. Thank you, Mr. O’Flinn.

[The prepared statement of Mr. O’Flinn appears in the appendix.]

The CHAIRMAN. Captain Schuler? Before I forget, please tell your

mother hello for me.

Capt. SCHULER. I certainly will. She also says hello to you, too,

Senator.

STATEMENT OF MARK SCHULER, CAPTAIN, U.S. AIRWAYS,

BARRINGTON, NEW HAMPSHIRE, ACCOMPANIED BY PETE

McGUIRK, CAPTAIN, U.S. AIRWAYS, MEMBER OF THE RETIREMENT AND INSURANCE COMMITTEE OF U.S. AIRWAYS’ AIRLINE PILOTS ASSOCIATION

Capt. SCHULER. I am Captain Mark Schuler of U.S. Airways. Accompanying me, right behind me here, is Capital Pete McGuirk,

also of U.S. Airways, and a member of the Retirement and Insurance Committee of the U.S. Airways’ Airline Pilots Association.

I appreciate the invitation of Chairman Grassley and this committee to discuss the effects of terminating the pilots’ pension plan

on my behalf and my colleagues of U.S. Airways.

As members of the committee are aware, U.S. Airways is currently operating in Chapter 11 of the bankruptcy code and plan to

emerge from bankruptcy on March 31, 2003. The company has petitioned the ATSB for approval of a $900 million, 7-year loan guarantee to secure exit financing.

ATSB approval of the loan guarantee and additional debtor-inpossession financing is contingent, in part, upon successful resolution of the pilots’ pension issue.

On January 31 of this year, U.S. Airways announced its intention to terminate the Pilots Pension plan, effective March 31, 2003.

20

Although the company met its minimum legal funding requirements, the drop in the stock market and the low interest rates created a Pilots Pension funding deficit of $575 million in 2004, $333

million in 2005. The bankruptcy court of Virginia approved this

termination in a decision on March 1.

The company’s decision to terminate the plan followed significant

restructuring of labor agreements at U.S. Airways in two rounds of

negotiations. In each round of these negotiations, the pilots took

the lead among labor groups and agreed to a 33 percent pay cut

and significant reduction in work rules.

The company and the pilot group also agreed to a revised and reduced retirement plan. All of these concessions together will save

U.S. Airways $645 million annually, reducing the cost of employing

a pilot at the company by nearly 46 percent.

Downsizing the airline also resulted in many pilots moving from

captain to first officer positions, generating a significant loss of

pay. However, the most painful effect of the restructuring was the

furlough of several thousand employees, including 1,827 pilots.

After unprecedented contract concessions and furloughs, the pilot

group now faces termination of the pension we had planned on for

our entire careers. Assumption of the plan by the PBGC presents

U.S. Airways pilots with an enormous loss of pension benefits.

The formula for calculating the benefits includes variables such

as the pilot’s age, time of employment, and projected earnings,

which depend on one’s seniority position. Therefore, it is difficult

to capture a single profile as illustrative of the group.

However, all pilots retire at age 60. This has an effect of reducing the PBGC maximum payment. In my own case, the PBGC benefit at age 60 represents a 67 percent reduction in my retirement

benefits, compared with the revised retirement plan reached

through a collective bargaining agreement between the union and

the company in December of 2002.

That agreement required amortizing the pension deficit to a 30-

year term instead of the current 7-year timeframe. The PBGC declined to approve this restoration funding.

With the announcement to terminate pilots’ pensions, the company proposed a defined contribution plan to supplement the PBGC

guarantee. This plan provides retirement benefits below those of

the agreement reached in December of 2002.

It requires an investment return of 8 percent to reach the plan

targets and is funded only going forward until a pilot retires at age

60. If a plan similar to this is created, many pilots lose the potential benefit of this supplement to the PBGC guarantee.

First Officer Charles Couch, who is 58, must retire in 2 years,

and will realize a 56 percent loss in retirement benefits with the

PBGC maximum payment. This monthly maximum payment for

First Officer Couch will be $2,382 per month, down from $5,409.

Assuming a replacement plan is created requiring an 8 percent

return and the funding for that plan begins April 1, 2003, he will

have only 2 years to earn any additional pension benefits.

Captain Mike Fairley was a veteran of Eastern Airlines and the

Trump Shuttle. He will shortly be 60 years old and will receive a

PBGC payment from the Eastern plan, which was terminated

21

when the company went out of business. The Trump Shuttle was

acquired by U.S. Airways in 2000.

Assuming the PBGC will provide a payment from both the Eastern and the U.S. Airways plan, Captain Fairley’s benefits are reduced from an anticipated benefit of $5,880 to $3,760 per month.

If dual payments are not allowed, the benefit is further reduced to $2,910 monthly. In either case, Captain Fairley retires in June

of 2003 and has virtually no opportunity to accumulate increased

pension fund earnings.

When I joined U.S. Airways in 1985, I was fulfilling a lifelong

dream to fly for a major carrier. Pilots plan their careers with a

single carrier, because moving laterally to another company is not

possible. A move requires starting again at the bottom of a seniority list, and a pilot’s seniority determines crew assignment and potential earnings.

As I mentioned earlier, pilots are required by law to retire at age

60. We must undergo semi-annual flight physicals and risk the loss

of our license and profession from medical disqualification.

We spend our careers committed to the safety of our passengers

and look forward to the pensions earned under the provisions of

our contract. Now we face the loss of that earned pension and

major losses in our retirement benefit. Without an opportunity to

plan earlier for this change in our retirement plan, many will face

a significant loss of retirement security.

The agreement reached between ALPA and the company in December of 2002, reducing the existing pension plan, would significantly mitigate the loss of pay and benefits facing the pilot group.

This change is possible under the provisions of S. 119, which

would permit restoration funding by amortizing the funding requirements over a period of 30 years. This would be a win for both

the pilot group and the company. This solution would also avoid

the need for the PBGC to take over another distressed plan.

I would like to thank the committee for this opportunity to testify today, and for your consideration of the situation faced by U.S.

Airways’ pilots.

Mr. Chairman, if the committee has any questions, I will do my

best to answer them. If there are any difficult questions, I would

like to defer to my colleague, Captain McGuirk, who has a great

deal of experience in dealing with this complicated subject.

The CHAIRMAN. I thank you, Captain Schuler. When we get to

questions, that will be permitted.

[The prepared statement of Captain Schuler appears in the appendix.]

The CHAIRMAN. Mr. Eickelberg?

STATEMENT OF HENRY EICKELBERG, STAFF VICE PRESIDENT, GENERAL DYNAMICS, REPRESENTATIVE OF THE

AMERICAN BENEFITS COUNCIL, FALLS CHURCH, VA

Mr. EICKELBERG. Thank you, Mr. Chairman, Senator Baucus. I

appreciate the opportunity to talk before you today. My name is

Henry Eickelberg. I am the staff vice president of Benefit Programs

at General Dynamics Corporation here in Falls Church, Virginia.

We are a major defense and aerospace company and we employ

48,000 employees here in the United States.

22

I am appearing before you today on behalf of the American Benefits Council, where General Dynamics is a member, and I personally serve on their board of directors.

The American Benefits Council is a public policy organization,

representing principally Fortune 500 companies and other organizations that either sponsor directly or provide services to retirement and health plans, covering more than 100 million Americans.

Like you, the council and its member companies are very concerned about the health of the voluntary employer-sponsored defined benefit programs. It is no secret that defined benefit plan

sponsorship has declined for many years, and it is the position of

the council that, without immediate, comprehensive, and permanent interest rate relief, this trend will only accelerate.

Mr. Chairman, Senator Baucus, the council applauds you for

your leadership on the 2001 tax bill that made many improvements

in the defined benefit system, and we particularly appreciate the

temporary interest rate relief.

But that relief is set to expire at the end of this year unless Congress can enact a permanent and comprehensive change. We believe that that change must take place this spring in order to provide certainty to employer sponsors.

The financial ramifications of the low 30-year bond rates have

led increasing numbers of employers to either freeze their defined

benefit plans or to terminating them.

In addition, we believe that it is in Congress’ best interests to

look at the way that pension plans are funded. It makes no sense

that companies are prohibited from making certain contributions to

their plans at the very time when the economy is doing well and

they have the money, yet during an economic downturn, as we are

experiencing now, they are frequently required to make large infusions of cash into their pension plans.

The common-sense approach would be to allow employers to

more generously fund their plans in times of economic strength,

and thereby better weather economic downturns.

Tied up in the discussion of the current state of plan funding, is

the financial condition of the Pension Benefit Guaranty Corporation. The council takes this matter very seriously.

I want to underscore that it has been the council’s position, in

representing companies like General Dynamics with well-funded

plans, to be at the forefront of past Congressional efforts promoting

strong funding that insures that the weakest plans would not be

able to terminate and impose their liabilities on the rest of PBGC

premium payors such as General Dynamics, or, in the alternative,

the Federal Government.

Simply stated, the American Benefits Council has no incentive to

trivialize any of the problems at the PBGC because it is our member companies who inevitably will be called to pay higher premium

costs in the event of default by sponsors of underfunded plans.

We believe the best way to ensure the agency’s financial integrity

for the long term is to strengthen the commitment of employers

that sponsor defined benefit plans. Mr. Chairman, pension plans do

not go broke. It is employers that go broke.

In conclusion, the council feels strongly that we must ensure that

defined benefit plans remain a viable choice for employers so that

23

companies can select the benefit plan design most suited to their

needs and the wishes of their workforce. Without prompt action by

Congress, however, we fear that these plans will increasingly disappear from the American pension landscape.

I thank you for the opportunity to appear before you today, and

I would be pleased to answer any of your questions.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. Eickelberg appears in the appendix.]

The CHAIRMAN. Now we go to Mr. Gebhardtsbauer.

STATEMENT OF RON GEBHARDTSBAUER, THE AMERICAN

ACADEMY OF ACTUARIES, WASHINGTON, DC

Mr. GEBHARDTSBAUER. Thank you, Chairman Grassley, Ranking

Member Baucus. Good morning, and thank you for inviting us to

testify on keeping defined benefit pension plans afloat.

My name is Ron Gebhardtsbauer, and I am the senior pension

actuary for the American Academy of Actuaries. The Academy is

the professional organization for all actuaries in the United States.

My written statement provides more details on this subject, so

that I can focus on the most important issues for this hearing,

namely a need for a quick fix to the pension discount rate.

As you pointed out earlier, defined benefit plans are beneficial to

employees, employers, and the Nation. However, many employers

are considering freezing or terminating their plans because the

temporary fix to the discount rate expires at the end of this year.

There are many major financial decisions being made today that

depend on what next year’s pension contribution will be. For example, bankruptcy judges are being forced to decide today whether

employers before them can afford their pension plan.

The courts may decide that the employer cannot afford the pension, and later find out the rules have been fixed and that the employer could have afforded the plan. Bad decisions can come from

this. Thus, a permanent fix is desperately needed, and needed very

soon.

So what should the discount rate be? The Academy’s Pension

Practice Council believes that a high-quality corporate bond rate—

that is the blue line on my chart—or an annuity pricing rate—that

is the green line on the chart—either one of them would be appropriate.

In addition, the chart shows the highest permissible discount

rate allowed by the law in the past. That is the brown line, the

smoother line. That is the highest interest rate we are allowed to

use right now.

You will note that that highest permissible rate that we have

been using in the past has actually been very close to the corporate

bond rate, the blue line. In fact, it has been above the annuity rate.

In fact, when the interest rates fell recently, Congress fixed this

temporarily last year by putting that permissible rate back up

where the corporate bond rate is.

There are reasons to choose the corporate bond rate. For instance, the SEC and the financial accounting standards require it

for financial statements. In addition, if a terminating pension plan

is funded to the amount that this corporate bond number would

24

create, it generally does not need help from the PBGC because, if

there is a shortfall, it is small and the employers have typically

made a contribution in order to avoid going to the PBGC.

However, if the employer does not make the contribution, PBGC

will generally not experience an economic loss because PBGC does

not always guarantee the full benefit and they do not buy annuities

either.

As I mentioned, another acceptable rate is the discount rate used

for pricing annuities, again, the green line. It could increase costs

by another 6 percent or 8 percent or so over what high-quality corporate bonds would create.

But employers do not want to contribute more than they need to.

What is that amount? Well, they self-insure, just like the PBGC,

so they can invest in stocks and earn a higher rate of return on

average, and avoid paying for the higher expenses, the risk margins, and profits of insurance companies.

There are many other ideas for keeping defined benefit plans

afloat described in our written testimony. One very important idea

would be to allow employers to contribute in the good years.

Many people have asked why certain employers did not contribute in the 1990’s. The answer is, some were not allowed to

make a deductible contribution. In fact, if the employer had made

a contribution to their pension plan, they would have been penalized with an excise tax.

The pension funding limit should allow a pension plan to create

a margin over current liability. It works when interest rates are

high, but it does not work when interest rate are low, particularly

for plans that are retiree heavy, and hourly plans which cannot advance-fund their benefit increases.

In summary, being forced to contribute when you can least afford

it and being kept from contributing when you can afford it is unreasonable and difficult on the PBGC, employers, and participants.

We believe that fixing the discount rates soon and allowing contributions above current liability would resolve these two major

issues.

We at the Academy thank you for holding this hearing and for

inviting us to speak. Thank you.

The CHAIRMAN. Thank you.

[The prepared statement of Mr. Gebhardtsbauer appears in the

appendix.]

The CHAIRMAN. We will take five-minute rounds.

I am going to start with a question for Mr. O’Flinn and Mr.

Eickelberg. Mr. Kandarian testified that only a few companies had

their pension contributions limited by current funding rules.

During the boom of the 1990’s, how many of your members contributed the maximum allowed by the rules? Was it government

contractors who had costs plus expenses, such as AT&T and General Dynamics, or were they the steel, airline, and similar companies hurt by the current rules?

Mr. O’FLINN. Mr. Chairman, I cannot be completely responsive to

your question now, but I can be partially responsive. I recall Director Kandarian’s testimony was that 20 percent of the population

were limited. I think that is a substantial number of people to be

limited, 20 percent of the pension universe.

25

The maximum limitations in terms of the impact on ERIC, members all of which sponsor defined benefit plans, I do not have. However, they are among the most well-funded plans in the United

States. AT&T, in particular, is still in an over-funded position, despite being in a competitive environment for about 19 years. But,

Mr. Chairman, we will get that information for you.

The CHAIRMAN. Mr. Eickelberg?

Mr. EICKELBERG. Yes. Mr. Chairman, I do not have an answer

in terms of the splits that you asked for. In our own particular situation at General Dynamics, we would have been subject to an excise tax and potentially criminal penalties for making contributions

to our plans.

In a defense contracting situation, there is a further set of rules

which limits the amount that is reimbursable on government contracts. So, even though the IRS rules may require a contribution,

the required contribution by the IRS would not be an allowable expense and would be paid out of the pockets of the shareholders of

the corporation.

We have been very conservatively funded and really looked at

our plan from a stewardship standpoint, and we are in a position

where we were fully funded.

The CHAIRMAN. Mr. O’Flinn, your organization has been quoted

as saying that the PBGC probably will not have a problem until

it runs out of money. Now, that is kind of an irresponsible position.

Should we wait until there is a crisis before we protect the finances

of the only backstop to the defined benefit pension system, which

is PBGC?

Mr. O’FLINN. Absolutely not, Mr. Chairman. We did not suggest

that our position was anything other than that the PBGC should

be strong and robust financially. We are mindful, however, of the

balancing needs that both you and Senator Baucus referred to earlier. The PBGC can pay its benefits today and for many years; they

are not in crisis.

The issues are as Director Kandarian outlined them. Our organization would be very pleased to work with Director Kandarian, as

we did with his predecessors in 1987 and in the early 1990’s when

we raised concerns over funding and premium rates.

The CHAIRMAN. I would follow up with a question to you, as well

as to Mr. Eickelberg. Given that Mr. Kandarian testified that it

would take 12 long years worth of premium income to make up for

the claims paid out in 2002 and that under funding is at a record

$300 billion, is it appropriate for Congress to grant much relief beyond easing interest rate requirements that were enacted in last

year’s stimulus bill? Mr. O’Flinn, then Mr. Eickelberg.

Mr. O’FLINN. Mr. Chairman, any stimulus that the Congress

could see fit to employ to increase contributions to pension plans,

I think, would be a good idea, consistent with sound actuarial funding based on good and logical interest rate assumptions and mortality assumptions.

Mr. EICKELBERG. Mr. Chairman, it would be our position that

the current PBGC rates, both for the fixed and the variable premiums, are at this time appropriate. We believe that the PBGC’s

position is serious and warrants close monitoring.

26

We do not believe that it would be in the best interests of public

policy, for either our members or the employees that are covered

by these plans, to increase the cost of maintaining these programs.

It would only have the effect of forcing further employers to terminate or freeze these benefits.

In terms of longer help that would be available to sponsors, I

think it is important to unscramble the current tax law which prohibits contributions when a company is doing well financially. The

stock market goes up, your investments in the plan go up, and the

actuary says you cannot put any money in the plan.

The stock market goes down because businesses are not doing

very well, and the actuary says, besides you having more bills than

you thought you were going to have, you have got another one to

deal with. So that type of an alignment would be very welcome

support. Thank you, Mr. Chairman.

The CHAIRMAN. Thank you.

Senator Baucus?

Senator BAUCUS. Thank you, Mr. Chairman. I would like any of

you that want, to take a stab at this. Mr. Kandarian basically said,

do not raise rates, or do not give a bail-out. Do not give assistance

now to U.S. Airways alone, or that industry alone, because that is

too piecemeal and it would need a longer term solution.

He said, therefore, use the current financing arrangements we

have today, namely, the Airline Transportation Stabilization Board.

If I understood him correctly, that is basically what he said.

Your response, anybody?

Mr. EICKELBERG. Yes. I would say that that is an appropriate reflection of his comments. I think that the American Benefits Council would also echo that. There have been a number of large plans

that have been hoisted onto the PBGC where financial concessions

were not made to the participants.

I think the executive director of the PBGC was simply stating

that, to the extent that in public policy and in good judgment that

type of relief is necessary, it should take place outside of the payment structure that is provided under the PBGC, because otherwise member companies such as General Dynamics and AT&T are

simply going to be responsible for paying that.

Senator BAUCUS. Yes. I will get to Captain Schuler’s colleague in

just a minute, but I want to get to other witnesses, first.

Mr. O’Flinn, do you have a response?

Mr. O’FLINN. Yes, Senator Baucus. I basically agree with Director Kandarian’s view of the law and understand his reluctance to

make special arrangements. We do note, however, that Director

Kandarian would be one of the few creditors who was unable to

‘‘work out’’ arrangements with a debtor if the law were to remain

the same.

It might be possible that, given the number of creditors that

might be coming his way, that this would be worthwhile looking

into. That is to say, some legislation in this area would be worth

examining.

Senator BAUCUS. Mr. Gebhardtsbauer?

Mr. GEBHARDTSBAUER. The Academy actually has not addressed

this particular issue, so I cannot say what the academy would say.

Senator BAUCUS. Your personal view.

27

Mr. GEBHARDTSBAUER. As a practicing actuary and someone who

has been in the business for a while, I guess I can see the concern,

that if you modify the rules just for one organization, that it is difficult on the competitors.

Just as one organization lowers payroll, then the others end up

having to do it. If one reduces pension costs, then the others will

want to be able to do that, too, in order to be able to continue to

compete.

Senator BAUCUS. So you tend to sympathize with his main view,

that is, let us not change the payback rate for one company or one

industry alone?

Mr. GEBHARDTSBAUER. I think that is correct. I think he had a

lot of really good points in that area, about how it is not as good

to do it just with one organization, but maybe if you had to do

something quick, maybe for an industry, but the best thing is to

be able to have a set of rules that apply everywhere.

Senator BAUCUS. Captain Schuler, your colleague wants to say

something. Why do you not come to the table, sir. Sit down and

state your name, please.

Captain McGuirk. My name is Captain Pete McGuirk, U.S. Airways. I wanted to respond to the issue of U.S. Airways. I have a

fundamental problem with any kind of a system that has absolutely no accommodation for merit.

I think, when you look at the situation of U.S. Airways and the

airlines in general, you have to look at, first off, what has happened to the airlines in particular as a result of 9/11, and perhaps

at U.S. Airways specifically because of the impact of the closing of

Reagan National Airport, which is one of the major hubs of U.S.

Airways, and the impact that that has had on the financial results.

I attended the hearing on Senate bill 119 back in January. During that testimony, I heard that the PBGC did not believe that

they were specifically authorized to accommodate restoration funding for any plan.

But, under repeated questioning by the panel, I never heard that

there was any inability to grant restoration funding, that it was

not specifically prohibited either.

I would submit that the inability to judge on merit, considering

the dramatic reductions in costs that the pilots at U.S. Airways

have undergone as a result of the two restructuring agreements—

the second restructuring agreement made major concessions in the

pension benefits, essentially freezing the pensions for any pilot that

had more than 21 years of service, reducing by more than half for

any other pilot remaining on the payroll.

So, going forward, the increased liabilities of the plan were dramatically reduced. I believe that we are a perfect candidate for

judgment by some kind of a standard, perhaps similar to what the

ATSB has done, to determine whether or not this airline should be

granted restoration funding.

Not doing so has a terrible business result, both for the PBGC

and the pilots of U.S. Airways whose benefits are dramatically reduced. The PBGC has a liability of half a billion dollars, which they

now are contemplating undertaking, starting on the 1st of April.

Senator BAUCUS. My time has expired, so thank you very much,

sir.

28

The CHAIRMAN. Thank you, Senator Baucus.

Senator Bingaman?

Senator BINGAMAN. Thank you very much, Mr. Chairman. I

apologize for not being here for all of the testimony, but I did see

some of it on the television.

Let me ask, in addition to this suggestion here Mr. Eickelberg,

you make the suggestion about allowing contributions in good

years.

Are there some other things that could be done by the Congress

to make it more attractive for employers to provide defined benefit

plans? It has been many years since anybody has established a defined benefit plan, as I understand it.

I mean, the trend is all against defined benefit plans. Everyone

is shifting from defined benefit to defined contribution, and many

are dropping that. So are there other things in addition to this allowing contributions in good years that you think might reverse

that trend, or are the economic pressures to reduce wages and benefits so great that there is no way to swim against that tide?

Mr. EICKELBERG. No. I think that one of the major factors in the

decrease in defined benefit plans—well, there are really two of

them. I would say the first of them is the desire by employees, and

the understandability of a defined contribution. You can look at a

bank account and you can judge how much money you have got.

A defined benefit plan is a promise to pay money on a monthly

basis at some time in the future. It is not as tangible.

I can tell you, on behalf of the members of the American Benefits

Council, that all of us slug through a lot of rules in order to comply

and keep our plan in legal compliance.

If you look at the cost to deliver a benefit to an employee, the

401(k) plan is the cheapest benefit. It is easy. You can hire somebody to handle it. It is very hard to goof it up. For the defined benefit plan, there are so many trip wires that exist in the law today.

General Dynamics has a lot of people. We have got very competent professionals and a lot of lawyers, and they can slug

through those rules. A smaller company, 500 people out in the Midwest, they are just not going to do that. Their company lawyer is

not going to advise them to create a defined benefit plan. They are

just not going to do it.

Senator BINGAMAN. Do you think it is possible to eliminate or

streamline those rules and avoid—I mean, some of those rules are

put there to avoid some abuses preferential treatment for top executives and that sort of thing.

Mr. EICKELBERG. Right.

Senator BINGAMAN. Do you think that you can deal with those

problems in a reasonable way without having all the rules?

Mr. EICKELBERG. I do. I think, as a matter of fact, the rules that

are in place on discrimination were actually placed in the law because small employers, doctor’s offices, would have coverage for the

doctor and not for the nurses.

At General Dynamics, we do not have qualified plans that cover

our senior executives and nobody else. We have plans that cover

probably 98 percent of our entire workforce. We are very happy

with those plans, and all of the employees there count on those

plans, in addition to a 401(k) plan, and Social Security.

29

Yes, I do honestly believe, if you took complexity out of the system and you added flexibility for contributions, that employers

would contribute because it is the type of program where it is a

benefit to their employees.

Senator BINGAMAN. Yes. Did you have a point of view on that?

Mr. GEBHARDTSBAUER. Thank you very much, Senator Bingaman. Yes. There was a hearing last year, in fact, on how can we

encourage companies to have defined benefit plans. In our testimony, we pointed out that a lot of companies are moving to the

401(k) idea and it has a lot fewer rules.

So not only is it the issue of rules, the defined benefit plans have

a lot more complex rules, but the playing field is not level, not only

on the rules, but also there are some things you cannot do in the

defined benefit world.

For instance, you cannot have pre-tax employee contributions go

into the defined benefit plan. You can do it on the 401(k) side, but

you cannot do it on the defined benefit side.

Another example, is it is difficult to do matches in the defined

benefit plan, but you can do them on the defined contribution side.

So, it is an unlevel playing field. Employers would like to have sort

of a level playing field so they can decide what is best for them,

and in fact best for their employees, too.

But sometimes you weigh them and the rules are just a lot heavier on the defined benefit side, so you go with the 401(k) side. Employees liked that idea back in the late 1990’s, I think, because

they figured they could get their 20 percent returns and do better

than anybody else. But now I find a lot of people coming to me saying, where do I invest my money? In fact, I think employers are

hearing that, too.

They are finding that employees really want companies to keep

their defined benefit plans. So it is not only an issue of, how can

we get more defined benefit plans, but also maintaining the defined

benefit plans that we still have.

Mr. EICKELBERG. And if I may add, Senator, it is about risk. You

have got to create an environment where the employer is willing

to take the risk. Right now, what we have got is a situation where

that risk has shifted to the employee, both for two things. First, the

rate of return, and also mortality. People are getting older.

I think Chairman Greenspan testified in front of the Aging Committee, and he mentioned that a lot of people were dying with large

sums of money. That is because, in retirement, they are very conservative about what they spend because they are not sure how

long they are going to live and what their expenses are going to

be. Defined benefit plans are a terrific answer for that.

The CHAIRMAN. Thank you, Senator Bingaman.

I have a follow-up to a question that Senator Bingaman asked,

and I would like to ask Mr. Eickelberg. If hybrid defined benefit

plans are prohibited by statute or regulation, what impact will that

have on defined benefit plan sponsorship?

Mr. EICKELBERG. Well, Mr. Chairman, I think if that is the

choice, then the choice becomes a traditional defined benefit plan

or no benefit plan. As Mr. Gebhardtsbauer said, I think the idea

is to introduce flexibility and responsibility into the system, not a

weakening of choices.

30

The CHAIRMAN. Thank you.

Mr. Gebhardtsbauer, should plans not have to fund shut-down

benefits, because if they do not have to be funded, why should the

PBGC have to pay for them?

Mr. GEBHARDTSBAUER. Currently, it is difficult to fund in advance for shut-down benefits. If it is something where the whole

company could shut down, you cannot fund for it and you end up

getting what we call gains every year because the company did not

shut down.

So if you have lots of years in which you are always shooting for

something that is too big, the rules make it difficult on the actuary

to fund that. So, the laws actually make it difficult right now to

fund for shut-down benefits.

If you are a big company with lots of little facilities where shutdowns can occur in one little facility or another, you can actually

fund for that. But if it is the whole company, it is very difficult to

fund for that.

So I think we should consider ways in which employers could

start having more margins in their pension plans. That goes back

to this idea again. Right now, the interest rates are so low that you

cannot put more money into the pension plan beyond 100 percent

of your current liabilities.

So if you could put this money in, that would reduce the risks

that we were talking about earlier, too. Maybe employers have not

put money in their plans in the past more than they had to, but

I think now they have learned about risk, just like individuals, and

that they need to have these margins.

Margins could help fund for shut-down benefits. But another possibility is, if you cannot fund for shut-down benefits, then it is awkward then for PBGC to have to guarantee those shut-down benefits.

Also, in addition, they cannot charge premiums for shut-down

benefits right now, so that is also a concern for them. So, you can

understand their concern. In addition, if companies that do have

lots of shut-down benefits, in effect, treat it as a no-cost item, then

since PBGC is insuring everybody, then the costs are spread and

it is spread to companies that do not have shut-down benefits.

The CHAIRMAN. All right. Also, a question of you. This is from

your testimony, that plans would be better off if Congress eased

the funding rules. The Academy has done a lot of research in this

area. But has it not been PBGC’s experience—and I would say certainly it has been in the case of steel—that easing the funding

rules for chronically underfunded plans has not resulted in improvement of overall funding?

Mr. GEBHARDTSBAUER. Actually, our testimony, on pages 11 and

12, talks about tightening the rules, and particularly for the plans

that you were talking about that are more likely to be underfunded, hourly plans or bargained plans.

For instance, right now, every 3 years they can improve benefits,

and then they fund for them after that. That is not something that

is their fault, it is something that is in the law.

You cannot fund in advance for a benefit improvement until the

benefit improvement actually occurs, and then the law actually alVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00034 Fmt 6633 Sfmt 6633 88593.000 SFINANC2 PsN: SFINANC2
31

lows you to fund for it for the next 30 years, which we at the Academy feel is too many years to be funding for these benefits.

In fact, an example, is when you improve benefits for retirees,

those benefits go up and they are probably going to be paid out

over the next 10 years, but the company gets to fund for it over

the next 30 years. So, in effect, a retiree increase actually de-funds

the pension plan. In fact, you will see in our testimony several

ideas that we have talked about where we could strengthen these

rules.

You are right. Just allowing companies to put more in does not

solve all the problems because there are companies out there that

will not do it automatically because they are allowed. So, you need

to encourage them.

We have another section in the report, if I have a few minutes,

that shows that there is some encouragement already in the law.

Right now, if you are funded under 125 percent of current liability,

you cannot move money to the health plan. If you are under 110

percent, you cannot pay the full lump sum to the top 25 employees.

If you are under 100 percent, you can actually get hit by an accounting rule so that there is a hit to equity, so a lot of companies

try to avoid that by putting a lot of money—I think IBM and

Ford—into the plan.

But then there was the question of whether they could even deduct it. So, there is lots of pain when your pension plan has less

assets. So I think employers now are going to want to use this idea

to put more money in. But I think not only do you need encouragement, but on some plans that are historically under funded, like

the hourly plans, I think those rules definitely need to be strengthened in a mandatory way.

The CHAIRMAN. Captain Schuler, I know during the last time you

had negotiations, that your union and management negotiated both

wages and benefits. Do you have any idea why there was not a negotiation for fully funding pensions rather than higher wage increases in the package?

Captain Schuler. I think I would defer to Captain McGuirk for

that question.

The CHAIRMAN. All right.

Captain McGuirk. The wage increases that we got recently—and

this is not my particular area of expertise. I was not even a member of U.S. Airways back when the contract was negotiated. The

pay raises were given via a parity mechanism that was written into

the contract. I think in the more recent agreements there were, in

fact, provisions in there for strengthening the funding of the pilot

plan.

The CHAIRMAN. All right. Senator Baucus?

Senator BAUCUS. Mr. Gebhardtsbauer, in looking at a couple of

questions, one on your chart.

Mr. GEBHARDTSBAUER. Yes, sir.

Senator BAUCUS. The lines tend to bunch up.

Mr. GEBHARDTSBAUER. Right. They are all pretty close, especially

from this distance.

Senator BAUCUS. Yes. Then at the end they diverge a little. Explain that.

32

Mr. GEBHARDTSBAUER. Oh, right. In the past, the Treasury rates,

the corporate bond rates, and the annuity pricing rate were all

much closer.

Senator BAUCUS. Yes. Around 10 percent in 2001.

Mr. GEBHARDTSBAUER. Right. In the year 2000, the Treasury

rates fell. In fact, all interest rates fell, but Treasury rates fell dramatically lower, for a couple of reasons. Back in 1999, it was because we thought we were going to have a surplus, so the markets

reacted to that.

More recently, now the deficits are here, it is because there is a

flight to safety. People are getting out of stocks and going into the

very safe investments of Treasury bonds. So the interest rates on

Treasury bonds are unusually low right now.

The reason why they parted, is because insurance companies,

when they get money from you for the annuity, they invest in corporate bonds, they do not invest in Treasuries, generally. They invest in corporate bonds and mortgages, and they take out a little

bit for risks and expenses. So, that is why the annuity rate is a

little lower than the corporate bond rate.

Senator BAUCUS. Right. I guess my question is, since we are

going to move away from 30-year Treasuries into something else—

I do not know what it is—when I saw the wider gap there, I wondered if that was any clue to what we should move toward.

You suggested, I guess, corporate bonds. Is that correct? The blue

line?

Mr. GEBHARDTSBAUER. In fact, if you actually look, the law actually said you could use 110 percent of the Treasury rate, and then

it moved to 105 percent of the Treasury rate. So if you actually look

at the line that we are allowed to use, the brown line.

Senator BAUCUS. Right.

Mr. GEBHARDTSBAUER. Actuaries are allowed to use that interest

rate up to the brown line. You will notice that the brown line is

very close to the blue line. So, historically we have been allowed

to use interest rates up to the corporate bond rate. It was calculated based on the Treasury rate.

But then, a few years ago, the Treasury rate was so low, that

even if you took 105 percent of it, or 100 percent of it, you still

ended up with an interest rate that was actually not only below

corporate bonds, it was also below annuities. In fact, at one point

it was even below Treasuries, because the Treasury spiked up at

one point.

Senator BAUCUS. But you suggest, as I recall, that the solution

is to raise discount rates, and also, I guess, increase the caps on

the amounts that can be contributed or deducted. Is that correct?

Mr. GEBHARDTSBAUER. That is correct. For instance, Ford and

IBM put a big contribution into their pension plan this year, and

it was actually because the accounting rules had a positive effect

for the PBGC.

Senator BAUCUS. But why would you want to increase the discount rate, which has the effect of lowering the contribution?

Mr. GEBHARDTSBAUER. We at the Academy believe that if the law

is not fixed right now—for instance, I looked at the newspaper

today, and Treasury rates are like 4.6 percent, I think, something

33

like that. Very low. So if we continue to use the rule the way it

is now, as you can see, it went very low.

Then Congress did the temporary fix to put it back up around

the corporate bond range. But if it reverts back, then a lot of employers are going to say they cannot afford their pension plan.

In addition, I think they are going to see that it is very difficult

for Congress to fix the rule when it gets broken. I think, if Congress does fix it when it is broken, that will give employers the

faith that Congress is watching and fixing the rules.

It makes sense that Congress wants employers out there to be

able to choose between defined benefit and defined contribution

plans, choose the one that is right for them, and that they are

going to keep the rules working.

Senator BAUCUS. Well, Congress did increase the amount that

could be deducted fairly recently.

Mr. GEBHARDTSBAUER. Right. That 2-year fix is on the chart. You

will notice, the brown number went up to the blue line.

Senator BAUCUS. Oh, yes. Right. There it is.

Mr. GEBHARDTSBAUER. And that actually put it back up into the

corporate range, but it actually falls back down to below even the

annuity rates.

Senator BAUCUS. Does anyone disagree with Mr.

Gebhardtsbauer’s general premise?

Mr. EICKELBERG. No. I would echo his sentiments on behalf of

the American Benefits Council. The lower the interest rate, the

more the liability, even though the liability goes out into the future

60 years.

When you value it for the contribution determination in any particular calendar year, the lower that interest rate, the more the liability, and therefore the more cost you have. We would not have

had this hearing 3 years ago. Yesterday was the 3-year anniversary

high on the Nasdaq.

At that time, we had a lot more money in our pension plan and

I had a lot more hair on my head. This is the kind of relief that

employers need, and it will show the faith that the Congress has

got in these programs.

Senator BAUCUS. As I understand it, GAO did a study that raised

some questions, that is, some down sides of using the corporate

rate. That is, questions of transparency and potential manipulation.

Mr. EICKELBERG. Right. I went through their report which was

issued, I believe, last week. They did not advocate a particular interest rate, but they did say that there were certain factors that

they would like to see in that interest rate.

One of those, is the inability to manipulate the interest rate. The

other was, as Ron has said, that the interest rate reflect the cost

of an annuity purchase.

The way that we got started down the road, was we started with

an interest rate off the Treasuries, then added a premium on it or

a corridor to mimic the cost of the annuity purchase. But now with

the Treasuries having dropped, as Ron’s chart shows so aptly, it

has dropped way below that now.

34

Senator BAUCUS. But you think there are ways then to accommodate those concerns? I guess you agree that those concerns are legitimate?

Mr. EICKELBERG. Yes, I do.

Senator BAUCUS. And that there are ways to accommodate them?

Mr. EICKELBERG. Yes, I do.

Senator BAUCUS. All right. I am finished, Mr. Chairman.

The CHAIRMAN. Thank you.

Does Senator Bingaman want to participate in a second round?

Senator BINGAMAN. Yes, Mr. Chairman. Let me just ask a couple

of questions.

Mr. O’Flinn, your testimony also talks about this need to replaced this 30-year Treasury rate, and indicates that unless something is done so that that can change by the end of the second

quarter, I think as you put it, ‘‘action by the end of the second

quarter, after which planning for 2004 becomes critical, is vital.

Delay means damage to plans and their participants, damage to

companies, damage to companies’ ability to fuel economic recovery.’’

So your view is, we need to act. We need to legislate right away

on this issue.

Mr. O’FLINN. That is correct, Senator. Of course, the interest rate

we are talking about is not the interest rate for the normal funding. It is only the interest rate for the snapshot test to determine

if accelerated funding is necessary. So, it is not a wholesale revision of funding.

It is basically correcting a special test intended to accelerate

funding. Although there is a temporary fix in place now, thanks to

this committee, it expires at the end of this year.

But you read my point exactly right, Senator Bingaman. We cannot wait until the end of this year to fix it, because folks who are

very interested in what that rate is, including corporate finance

people and including the investment community, are acting now

basically on the worst assumption.

Senator BINGAMAN. What is the administration’s view on this

proposal that you all are making here for us to go ahead and legislate on this?

Mr. O’FLINN. We have received a lot of very favorable support

from the professionals in the benefits community, including the actuarial community. But I am not aware that we have heard officially from the administration yet.

Senator BINGAMAN. Have any of you had any discussion with

anyone in the administration about this?

Mr. O’FLINN. Yes we have.

Senator BINGAMAN. Mr. Chairman, I hope we are able to do

something on this issue. It sounds like something that would be a

high priority.

The CHAIRMAN. Yes. We expressed, Senator Baucus and I did,

earlier, about not having somebody here from the administration,

as we thought Deputy Secretary Fisher was going to come and testify. We also reminded administration people of the promise, if they

go through the confirmation process, to appear when called upon

for testimony.

35

So I know you were speaking about product more than process,

but I think hearing from the administration is very important in

this regard as well.

Senator BINGAMAN. Thank you very much, Mr. Chairman.

The CHAIRMAN. All right. Senator Baucus said he did not have

more questions. I think there will be some I will submit for answer

in writing. We thank all of you for participating, and the hearing

is adjourned.

[The questions appear in the appendix.]

[Whereupon, at 11:59 a.m. the hearing was concluded.]

(37)

A P P E N D I X

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

PREPARED STATEMENT OF HENRY EICKELBERG

Chairman Grassley, Ranking Member Baucus, I thank you for the opportunity to

appear before you today on this critically important topic. I am Henry Eickelberg,

Staff Vice President for Benefit Programs for the General Dynamics Corporation.

General Dynamics is a major defense and aerospace company employing over 48,000

people within the United States.

I am appearing today on behalf of the American Benefits Council, where General

Dynamics serves on the board of directors. The American Benefits Council (Council)

is a public policy organization representing principally Fortune 500 companies and

other organizations that assist employers of all sizes in providing benefits to employees. Collectively, the Council’s members either sponsor directly or provide services to retirement and health plans covering more than 100 million Americans.

Like you, Mr. Chairman, the Council and its member companies are very concerned and troubled by the health of the voluntary, employer-sponsored defined benefit pension system. The largest problem for employer-sponsored defined benefit

plans is the required use of an obsolete interest rate for pension funding, pension

premium and lump sum distribution calculations. Use of this obsolete benchmark—

the rate on 30-year Treasury bonds—artificially inflates the plan’s liabilities and required contributions, threatening employers’ ability to continue their commitment to

defined benefit programs for their employees. The effects of this interest rate anomaly are exacerbated by the current economic and stock market downturn, which has

dramatically reduced plan asset levels, wiping out five years of asset gains in many

cases. Employer sponsors of defined benefit plans also confront plan funding rules

that aggravate the negative effects of economic slumps without allowing the development of financial cushions in good times, continued resistance by some to hybrid

pension plans, and the prospect of counter-productive changes in pension accounting

rules.

Fortunately, Congress can address many of these issues in a positive manner that

will enable employers to provide financially sound pension programs. Our testimony

details the current threats and opportunities below. After providing some background on the defined benefit system and the current state of pension funding, we

discuss the need for pension funding reform and offer our views on the financial position of the PBGC. We then offer our recommendations for replacement of the 30-

year Treasury bond, discuss the need to make certain 2001 pension reforms permanent and urge enactment of certain defined benefit reforms previously put forward

by Chairman Grassley and Senator Baucus. We close with discussion of the recent

regulatory efforts regarding hybrid plans and the potential threat posed by an

emerging re-evaluation of pension accounting principles.

The Council commends the Committee for examining these issues, and we look

forward to working with all Committee members in the weeks and months ahead

to ensure that defined benefit plans remain a viable retirement plan design for employers.

Background on Defined Benefit Plans

Mr. Chairman, today’s examination of our private-sector defined benefit pension

system is urgently needed. While this system helps millions of Americans achieve

retirement income security, it is a system in which fewer and fewer employers participate. The total number of defined benefit plans has decreased from a high of

170,000 in 1985 to 56,405 in 1998 (the most recent year for which official Department of Labor statistics exist), and most analysts believe there are fewer than

38

1The decline in sponsorship of defined benefit plans is in stark contrast to the increase in

sponsorship of defined contribution plans, such as 401(k)s. According to the same official Department of Labor statistics, the number of defined contribution plans has increased from 462,000

in 1985 to 661,000 in 1997. 2 Employee preference for account-based and more portable benefits has been a prime factor

in the development of hybrid defined benefit plans, which are discussed below.

50,000 plans in the U.S. today.1 There has been a corresponding decline in the percentage of American workers with a defined benefit plan as their primary retirement plan from 38 percent in 1980 to 21 percent in 1997. Looking at the decline

in defined benefit plans over just the past several years makes this unfortunate

downward trend all the more stark. The Pension Benefit Guaranty Corporation

(PBGC) reports that it insured 39,882 defined benefit plans in 1999 but only about

33,000 plans in 2002. This is a decrease of over six thousand defined benefit plans

in just three years. These numbers reflect the unfortunate reality that today’s environment is so challenging that more and more employers are concluding that they

must freeze or terminate their pension programs.

These numbers are particularly sobering because defined benefit plans offer a

number of features that are effective in meeting employee needs—benefits are funded by the employer (and do not typically depend upon employees making their own

contributions to the plan), employers bear the investment risk in ensuring that

earned benefits are paid, benefits are guaranteed by the federal government through

the PBGC, and benefits are offered in the form of a life annuity assuring that participants and their spouses will not outlive this benefit. The stock market conditions

of recent years (and the corresponding decline in many individuals’ 401 (k) balances)

have once again demonstrated to many the important role that defined benefit plans

can play in an overall retirement strategy.

So, with these advantages for employees, a logical question is what has led to the

decline of the defined benefit system? We see several factors that have played a role.

First, we see a less than friendly statutory and regulatory environment for defined

benefit plans and the companies that sponsor them. Throughout the 1980’s and

early 1990’s, frequent changes were made to the statutes and regulations governing

defined benefit pensions, often in the name of promoting pension ‘‘fairness.’’ The primary driver behind these changes was a desire to eliminate potential abuses attributed to small employer pension plans. And yet, these rules were applied to across

the board to employers of every size. The result was that defined benefit pension

plans became increasingly expensive and complicated to administer. Additionally,

plan design flexibility, which is so important to large employers, was impaired. During this same period Congress repeatedly reduced the benefits that could be earned

and paid from defined benefit plans in the name of increasing federal tax revenues,

thus significantly reducing the utility of these voluntary plans to senior management and other key decision-makers.

The current tax laws also saddles defined benefit plan sponsors with significant—

and often unpredictable and untimely—financial commitments. Many companies

have found the cost of maintaining a defined benefit plan more difficult in light of

intense business competition from domestic and international competitors, many of

whom do not offer defined benefit plans to their employees and so do not have the

corresponding pension expense. In addition, employees have not tended to place

great value on defined benefit pension benefits offered by employers, preferring

‘‘shorter-horizon’’ and more visible benefits such as 401(k) and other defined contribution plans, stock option or stock purchase programs, health insurance and cafeteria plans. So ironically, while defined benefit plans have been complicated for employers to administer and expensive for them to maintain, they have not resulted

in a significant increase in employee satisfaction, which is one of the core reasons

for an employer to offer a benefit program in the first place.2

The State of Defined Benefit Pension Plan Funding

Mr. Chairman, we are all aware that defined benefit plan funding is a serious

concern today. At General Dynamics nearly every one of our 48,000 U.S. employees

is covered by a defined benefit pension plan. While recent market conditions have

eroded our pension plans’ funded levels, we anticipate that in one of our major pension plans no contribution is needed and in our other major pension plan any shortterm cash contributions will be de minimis to our overall financial performance.

It is important, I believe, to state an otherwise obvious fact. Over the short-term,

a pension plan’s funding level can fluctuate widely. Thus, looking at a pension plan’s

funding level at a specific point in time is a very misleading indicator of the pension

plan’s ultimate ability to pay out participant benefits (whether accrued or anticipatory). In such an analysis, the only relevant factor is and will always be the unVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00042 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
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4Table 11.2, EBRI Databook on Employee Benefits, 1997, 4th Edition, The Employee Benefits

Research Institute, Washington, D.C. 5Schieber, Sylvester J. 1996. ‘‘Proposals for Retirement Policy Reform: Ensuring Our Workers’

Retirement Security.’’ Testimony before the Senate Labor and Human Resources Committee

Aging Subcommittee, Washington, D.C.

derlying financial strength of the employer sponsor. Simply put, pension plans do

not go broke; employers do. An extremely poorly funded pension plan in the hands

of a capable and profitable company sponsor, by law, cannot become the financial

responsibility of the PBGC. The employer sponsor must manage any pension liability just as it manages any other business liability. Thus, it is the inability of the

employer sponsor to continue to make cash contributions to an existing pension plan

(often as a result of financial problems in its core business) that is the direct and

proximate cause of any negative financial ramifications employees and retirees experience flowing from a PBGC distressed termination.

To put it another way, it is not the pension plan that can’t pay its bills, it is the

insolvent employer sponsor. Corporations, such as General Dynamics, routinely

enter into long-term business contracts, often creating as part of these contracts, liabilities far in excess of those created by a pension plan. Corporations must manage

these liabilities to survive. But, the principal difference between the financial obligations assumed by a corporation under a business contract and those it would assume under a defined benefit plan is the much greater clarity and predictability in

a business contract, of the employer’s ultimate financial obligations, and particularly, any cashflow requirements. In the opinion of the Council, until Congress is

prepared to adjust federal law to provide rational and flexible cash-flow requirements in funding pension plans, employer sponsors will continue to remove them

from their benefit programs. The predictability and flexibility of the cash-flow requirements is one of the great attributes driving the explosion of 401(k) and other

defined contribution plans. The same attribute is needed in the defined benefit pension area.

The Council believes that the swing from the abundant funding levels of the

1990s to the present state of increasing deficits for many plans is due in large measure to the counterproductive pension funding rules adopted by Congress. Over the

nearly 30 years since the enactment of the Employee Retirement Income Security

Act (ERISA), the Congress has alternated between strengthening the pension plan

system and limiting the revenue loss from tax-deductible pension contributions. Beginning in 1986, Congress limited the ability of companies to make nondeductible

contributions and lowered the maximum deductible contribution. In 1997 and after,

some relief was provided, but the overall result is that our laws and regulations

strongly encourage employers to keep their plans as near as possible to the minimum funding level instead of providing a healthy financial cushion above that

level. By 1995, only 18 percent of plans had a funded ratio of assets over accrued

liabilities of 150 percent or more as compared with 45 percent in 1990.4

The result has been that companies sponsoring defined benefit plans have experienced a dramatic shift in funding. During much of the 1990s, the popular press regularly reported on the pension funding holidays experienced by a number of large

employers as if these ‘‘holidays’’ presented employers with a financial windfall at the

expense of employees. Yet what was never reported was the simply fact that these

contribution holidays were most often not a matter of employer choice; rather the

internal revenue code imposed heavy tax penalties on employers that made additional contributions during a contribution holiday. Many suspected that plans experiencing these policy-induced funding holidays would eventually confront a harsh reality when funding levels declined. That has proven to be very true. As one observer

presciently noted in 1996:

These contribution holidays created by OBRA 87 ultimately may prove to be

a narcotic that will signal the death knell for some defined benefit plans. It is

one thing for a company to see its annual contributions to its pension program

rising by a couple of percentage points from a starting contribution level of 5

or 6 percent of payroll over a decade as its work force ages. It is quite another

to have the contribution rate jump from nothing for several years to 7 or 8 percent of payroll. . .With such precipitous changes in plan funding requirements, some sponsors will not continue to support their plans.5

The Council believes that it is time for this Committee and the Congress as a

whole to reexamine the rules for plan funding. It makes absolutely no sense that

companies were not able to provide a strong financial cushion in times of economic

plenty, and it is counterproductive to the overall economic health of this country

that companies that are struggling to put scarce capital to productive use in the current downturn are being saddled with exorbitant required pension contributions.

40

The common sense approach would be to alter the pension funding rules so that employers can fund their plans in times of economic strength and weather economic

downturns without imposition of extreme funding requirements.

Tied up in discussions of the current state of plan funding is the financial condition of the Pension Benefit Guaranty Corporation. As you know, Mr. Chairman, the

PBGC’s 2002 Annual Report showed the agency in a deficit position for the first

time since 1995. In urging caution and prudence in responding to the PBGC’s current situation, I want to underscore that the Council has always predominantly represented companies with very well-funded plans. For example, our membership does

not include any companies in the steel industry. As an organization representing

premium payers who support the PBGC system, the Council has been at the forefront of past Congressional efforts promoting strong funding standards that ensure

that the weakest plans would not be able to terminate their plans and impose their

liabilities on the rest of the PBGC premium payers. Simply stated, the Council has

no incentive to trivialize any problems at the PBGC that will come back to haunt

us if other companies are not able to keep their promises to their retirees.

Thus, while the deficit revealed in the 2002 annual report is certainly to be considered very seriously, it does not necessarily indicate an urgent threat to the

PBGC’s viability. Indeed, the PBGC operated in a deficit position throughout much

of its history. Nor does the shift from surplus to deficit over the course of one year

suggest the need to change our pension funding or premium rules in order to safeguard the health of the PBGC. In particular, the Council is unlikely to support any

proposal that would unwisely penalize prudent and proven plan asset allocation

strategies or firms undergoing financial stress. We note that, as the agency stated

in its report, the insurance program’s total assets are in excess of $25 billion and

it should be able to meet current and expected obligations for years to come.

Certainly if the financial position of the agency continues to decline in forthcoming years, the Council would join with policymakers and all other stakeholder

groups to re-examine the PBGC’s financing structure and ensure that a disturbing

situation does not become a crisis. The financial condition of the PBGC should, of

course, be monitored closely. At this point in time, we believe the best way to ensure

the agency’s financial position is to keep as many employers as possible committed

to the defined benefit system. The urgently needed policy changes we are advocating

today will help achieve this aim and ensure that the PBGC continues to receive a

steady stream of premium income from defined benefit plan sponsors.

Pension Interest Rate Reform

Clearly the action most urgently needed to improve the health of the defined benefit system and stem the increasing number of defined benefit plan terminations is

for Congress to enact a permanent replacement for the 30-year Treasury bond rate

currently used for pension calculations.

Under current law, employers that sponsor defined benefit pension plans are required to use 30-year Treasury bond rates for a wide variety of pension calculations.

Yet the Treasury Department’s buy-back program and subsequent discontinuation

of the 30-year bond has driven rates on these bonds to a level significantly below

other conservative long-term bond rates. The result has been an artificial inflation

in pension liabilities, often by more than 20 percent. As a result of these inflated

liabilities, employers confront inflated required pension contributions and inflated

variable premium payments to the PBGC. Due to the nature of the pension funding

rules, where required contributions do not increase proportionally with increases in

liabilities and decreases in funding levels, a number of employers face dramatic increases in their pension funding obligations.

The low 30-year Treasury bond rates have the same inflationary effect on lump

sum payments from defined benefit plans that they have on the funding and premium obligations. In other words, the low 30-year bond rates have produced artificially inflated lump sum payments to departing employees. While these inflated

lump sums may appear to redound to the benefit of the affected employees, the reality is that the drain of cash from plans as a result of these artificially inflated

payments jeopardizes the financial position of the plan. Artificially inflated lump

sums also deter employees from taking their benefit in an annuity form of payment,

with the protections such form offers against spousal poverty and outliving one’s financial resources. The cold reality is that departing employees are taking a benefit

payment which is far greater than what the plan had been expected to pay. This

forces the employer sponsor to make higher cash contributions thus driving up the

plan’s cost. The higher the cost of the plan, the greater the visibility within the company’s internal budget environment and the greater the pressure to justify the

plan’s cost/benefit to the company as a whole.

41

The financial ramifications of the low 30-year bond rates have led increasing numbers of employers to freeze their defined benefit plans. Such freezes result in no additional pension accruals for current workers and no defined benefit program whatsoever for new hires.

Congress included short-term relief from inflated funding and premium requirements in the Job Creation and Worker Assistance Act of 2002. The Council wishes

to thank you, Mr. Chairman, and Senator Baucus for your leadership in providing

assistance, which gave employers some short-term but quite meaningful relief. As

you know, however, this relief was not comprehensive in nature and expires at the

end of this year. It is therefore imperative for Congress to enact permanent and

comprehensive pension interest rate reform as soon as possible. This effort must involve selection of a substitute long-term interest rate for use by pension plans in

lieu of the 30-year Treasury bond rate. Recently, in letters submitted to you, Mr.

Chairman, and Ranking Member Baucus, the Council outlined a set of principles

that should guide legislative reform of the 30-year Treasury bond interest rate for

pension calculations. The key principles are as follows: • Adopt a Comprehensive Solution. It is imperative that permanent interest

rate reform revise the rate for all pension calculations required by the Internal

Revenue Code (Code) and ERISA that are currently dependent on the 30-year

Treasury bond rate. This comprehensive replacement of the 30-year Treasury

bond would affect not only pension funding and premium calculations but also

calculations affecting the valuation of lump sums and maximum benefits payable from defined benefit pension plans. • Use a Consistent Rate. It is important that the same new benchmark be used

for all of the Code and ERISA pension calculations currently dependent on the

30-year Treasury bond. Use of differing interest rates for different pension calculations (particularly for funding and lump sum purposes) could create severe

financial instability in plans. • Select a Benchmark that Tracks the Return on a Conservatively Invested Portfolio. We recommend that the new benchmark track the returns

expected on a pension plan portfolio conservatively invested in long-term corporate bonds. Such a benchmark is one that the PBGC could meet or exceed

through its own investing in the event that it assumes the liabilities of the pension plan. • Use a Blend of Corporate Bond Indices as the New Benchmark. The

most effective way to track the return of a portfolio conservatively invested in

corporate bonds is to select an actual corporate bond index as the replacement

for the 30-year Treasury bond rate. To avoid dependence on a single bond index

and to replicate the breadth of the long-term corporate bond market, we recommend that the substitute for the 30-year rate be a blend of several different

leading corporate bond indices (giving the Treasury Department flexibility to

modify the specific component indices if necessary).

• Use the New Rate for Lump Sums but Provide a Transition Period. As

noted above, the current law requirement to use the very low 30-year Treasury

bond rate to value lump sums artificially and substantially inflates the value

of these payments. This inflationary effect has contributed to the large number

of pension plan participants who take their benefits in lump sum rather than

annuity form. (The low 30-year Treasury bond rates have no inflationary effect

on the value of plan annuities.) This artificial encouragement of lump sums—

and artificial discouragement of annuities—is unsound retirement policy. Participants should be encouraged to select the plan distribution option that works

best for them and their families and should not be given an artificial economic

incentive to choose one over the other. That being said, the switch to the new

interest rate should be phased in so that lump sum values are not changed precipitously for participants on the verge of retirement.

• Preserve the Existing Interest Rate Averaging and Corridors. Given the

urgency of enacting a replacement benchmark for the 30-year Treasury bond,

we recommend that the existing interest rate averaging mechanisms and corridors generally be maintained. Such an approach—in which the new blended

corporate bond index is plugged into the existing statutory structure as a replacement for the 30-year bond rate—is the simplest approach and will facilitate prompt enactment of permanent reform.

We cannot over-emphasize the urgency of enacting this permanent, comprehensive reform nor the degree to which achieving this reform is related to stemming

the decline in defined benefit plans. Action is needed by late spring in order to convince employers currently struggling with the difficult decision of whether to freeze

or terminate their plan that help is on the way. Uncertainty about what the future

required interest rate will be is also contributing to stock market instability as comVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00045 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
42

6The cash balance design combines features of a traditional defined benefit pension with those

of a defined contribution plan such as a 401(k), hence the term ‘‘hybrid.’’ In a traditional defined

benefit plan, an individual’s pension is generally determined by a formula incorporating the employee’s years of service and pay near retirement. The benefit in this traditional pension is expressed in the form of a lifetime annuity (stream of income) beginning at normal retirement age,

which is typically 65. In a cash balance plan, an individual’s pension is generally determined

by an annual benefit credit (typically a percentage of pay) and an annual interest credit (an

annual rate of interest that is specified by the plan). These benefit and interest credits are expressed as additions to an individual’s cash balance account. These accounts grow over time as

the benefit and interest credits accumulate and compound. Benefits in a cash balance plan are

ultimately paid out in the form of a lifetime annuity or a lump sum.

panies cannot accurately predict their future pension liabilities and costs. The Council is committed to working with Congress and with groups from across the ideological spectrum to enact the permanent, comprehensive pension interest rate reform

so necessary for defined benefit plans to remain viable.

Making the 2001 Pension Reforms Permanent

The Council is very gratified that in recent years Congress has recognized disturbing trends in defined benefit plan sponsorship and has begun to establish a

more supportive policy environment for defined benefit pensions. Mr. Chairman and

Ranking Member Baucus, you led these efforts with the Retirement Security and

Savings Act of 2001 (S. 742 in the 107th Congress), which was ultimately enacted

as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. This legislation contained a number of very positive changes to the rules governing defined

benefit plans. Correcting a series of past revenue-driven restrictions enacted by Congress, the Grassley/Baucus legislation repealed an artificially low cap on pension

funding that had complicated pension budgeting and financing. It also increased the

benefits that can be earned under—and paid from—qualified defined benefit pension

plans so that these plans remain an attractive vehicle for employers to sponsor in

our voluntary pension system. The Grassley/Baucus legislation also simplified a

number of the most complex rules applicable to defined benefit plans, making these

plans somewhat easier to administer, particularly in the context of mergers and acquisitions.

However, these pension changes included in the 2001 tax law need to be made

permanent. This step will encourage and support defined benefit pension plans.

Sound pension policy depends upon truly long-range planning and budgeting, for

both employees and employers, and this is difficult to achieve given that all of the

recent positive reforms are scheduled to evaporate come 2011. Consistency and

supportiveness have too often been lacking in our nation’s policy toward defined

benefit pension plans, but by making the 2001 pension changes permanent, Congress can realize these goals and help to restore the health of our nation’s defined

benefit system.

Unfinished Pension Reforms from the Pension Reform Legislation

Additional changes to our pension laws that would aid defined benefit pensions

were contained in the Grassley/Baucus pension legislation but were not enacted as

part of the final 2001 tax law due to application of the Byrd Rule. Mr. Chairman,

you and Ranking Member Baucus included these reforms in the National Employee

Savings and Trust Equity Guaranty Act that was passed unanimously by this Committee last July. These reforms would make defined benefit plans a more attractive

vehicle for small employers through pension insurance premium relief and simplified reporting. They would create fairness for defined benefit plan sponsors by allowing the PBGC to pay interest on premium overpayments. Finally, they would

help to simplify and rationalize defined benefit plan administration through a number of regulatory reforms. We encourage you to enact these important remaining

items from the Grassley/Baucus pension legislation this year in order to take another important step to support and encourage defined benefit pensions.

Hybrid Plan Clarification

One notable bright spot in the defined benefit plan landscape in recent years has

been the development of what are known as hybrid defined benefit plans, the most

common variety of which is the cash balance plan.6 These plans have proven popular with employees and employers alike. While they offer the benefits of a traditional defined benefit plan (employer funding and risk-bearing, federal guarantees,

the option of annuity benefits), they do so in an individual account form that is more

easily understood and therefore more easily integrated into the employee’s overall

retirement planning. Cash balance plans also offer the benefit of portability since

benefits can be rolled over to an employee’s next workplace retirement plan or to

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7 Congress devoted significant attention to conversions from traditional defined benefit plans

to cash balance plans during the 106th and 107th Congresses. It was understandably concerned

about the information employees received regarding these conversions and how certain, discrete

groups of workers were affected by the change in plan design. These concerns led to enactment

of an expanded notice requirement as part of the 2001 tax law, which will ensure that all employees receive the information they need to understand these conversions and the effect on

their pension benefits.

an Individual Retirement Account. In addition, they offer a more even accrual pattern than traditional defined benefit plans (where significant benefit accruals are

dependent on long service, producing disappointing results for employees who

switch jobs several times during their careers). The bottom line is that the transparency, portability and level accruals of cash balance plans often make these hybrid defined benefit plans a better fit for the retirement needs of today’s mobile

workforce than the traditional defined benefit pension.7 In addition, unlike defined

contribution 401(k) plans, these hybrid plans do help support the PBGC system

through regular premium payments.

Unfortunately, the rules applicable to defined benefit plans have not been updated

to reflect the development and adoption of hybrid pension plans, leaving a number

of pressing compliance issues regarding hybrid plans unresolved. In recent months,

the relevant regulatory agencies, led by the Treasury Department, have begun administrative actions to address these unresolved issues.

We salute the agencies for their focus in this critical area and for their commitment to resolving these complex but vitally important issues. Notwithstanding the

controversy associated with some of these hybrid plan issues, we urge Congress and

the members of this Committee to allow the pending regulatory processes to continue. Hybrid plans are a source of real vitality in our defined benefit system today

and have proven themselves to be the most effective way to deliver defined benefit

plan advantages and protections in a way that meets the needs of today’s mobile

employees. We must arrive at a legal regime that encourages these plans through

rules that acknowledge their unique features.

The Next Generation of Pension Reform

With the enactment of the many positive Grassley/Baucus pension reforms as part

of the 2001 tax law, the Council has spent a good deal of time over the past year

developing additional recommendations to further strengthen and expand the employer-sponsored retirement system. A number of these recommendations focus on

ways to revitalize our defined benefit system and many of the defined benefit reforms I have already discussed today top our list of recommendations. Thus, we believe achieving permanent and comprehensive pension interest rate reform, making

the 2001 pension reforms permanent, enacting the unfinished Grassley/Baucus pension changes, and allowing the regulatory process regarding hybrid plans to continue are the most important steps Congress can take to improve the health of our

defined benefit system.

Yet there are other reforms that the Council believes would help strengthen defined benefit pensions. Let me share a few with you today. • First, the Council believes Congress should help to make defined benefit pension plans a more useful mechanism for the financing of retiree medical coverage. Pension benefits are often used to meet health costs in retirement and

we believe certain tax changes would help employees do this more efficiently.

At many companies today, employees are asked to bear a share of the cost of

retiree medical coverage. Yet if these employees are receiving a pension benefit

and wish to pay their retiree medical premium with these funds, the position

of the Internal Revenue Service appears to be that these workers must pay tax

on the pension benefit and then pay the premium with after-tax dollars. We recommend that Congress allow employees to direct the appropriate portion of

these pension payments to pay retiree medical premiums on a pre-tax basis (as

active employees may do with salary to pay health premiums). This will allow

employees to pay these premiums with pre-tax dollars, helping to alleviate one

of the primary financial pressures faced by many older Americans. • Second, the Council believes that a legislative solution is necessary to address

the growing administrative burdens attributable to ‘‘lost participants’’, i.e., participants with relatively small benefits who cannot be located by plans. The cost

for plans of maintaining records of these benefits and searching for the participants is significant, and a solution needs to be found. The Council believes that

one option to explore is a material expansion of PBGC’s missing participant program to apply to plans that have not terminated. • Third, the Council recommends further simplification of the many complex rules

governing defined benefit plans, many of which achieve little from a policy perVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00047 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
44

8What follows are several examples of defined benefit plan complexity in need of reform and

simplification. Today when a defined benefit plan obtains from a participant a waiver of the

qualified pre-retirement survivor annuity (QPSA) (with spousal consent) and the participant is

younger than 35 years old, the plan must seek another waiver from the same participant (again

with spousal consent) after he or she has attained age 35. Another example of needed reform

is legislation to further facilitate the use of new technology in plan administration. This use reduces costs and improves accuracy, thereby clearly improving administrative efficiency. A final

example is legislation that reduces unnecessary burdens on the many defined benefit plans that

use base pay (or rate of pay) in their benefit formula. Current law requires such plans to perform complex testing not otherwise necessary. The Council would be pleased to share with interested members of the Committee our other recommended regulatory simplifications in the defined benefit area. 9 In 1985, FASB adopted Statement of Financial Accounting Standards No. 87 (SFAS 87),

which requires plan sponsors to allocate the cost of future retirement obligations over the working lifetime of employees in a reasonable manner. The purpose of SFAS 87 is to recognize the

long-term nature of the pension plan, reduce short-term volatility in the annual expense, promote consistency over time and recognize the compensation cost of a pension over the employee’s

service. SFAS 87 requires plan sponsors to make a reasonable current estimate of pension costs.

These are estimates because the actual pension payments may not be incurred for decades into

the future because employees may work for 20 or 30 years into the future and then receive payments over an additional 20 or 30 years. In the process of making this valuation, pension asset

investment performance is taken into account by using an estimate of the expected earnings.

SFAS 87 does not require a specific expected rate of return to be used, but plan sponsors can

determine a reasonable estimate in part based on historical performance and the plans investment philosophy. This estimate represents the expected long-term rate of return on the portfolio,

i.e., it is not meant to be the expected return for the current year. Differences between the expected rate of return and the actual returns are then spread over average future service, and

other techniques to smooth volatility are also employed.

spective but can make pension plan administration both more complicated and

more costly.8

The Council hopes to work with you Chairman Grassley and Ranking Member

Baucus, and with other leaders in Congress to see these additional defined benefit

reforms included in upcoming pension reform legislation.

Pension Accounting

Before closing, we would like to raise one emerging issue that could have profound

consequences for the U. S. defined benefit pension system. That issue involves the

accounting treatment of pension income and expense on company financial statements. The current rules governing pension accounting have been criticized by some

and are under review by the International Accounting Standards Board (IASB) and

the Financial Accounting Standards Board (FASB).

In particular, these critics attack the amortizing of pension asset gains and losses

over time and advocate for immediate recognition of asset and liability experience.

The Council is concerned that changes to the current accounting rules for pensions

may present a serious threat to the employer-sponsored defined benefit pension system. Under the current accounting standard for determining pension cost, reported

expenses or income does not track with the actual experience during the particular

year. Rather, expenses are allocated in a method designed to track the long-term

nature of the pension obligation and income is estimated using expected long-term

returns.9 Critics claim that the use of smoothing techniques for expenses and an expected rate of return on assets unfairly reports pension income (or a lowered pension expense) at a time when asset values have actually declined. They recommend

that companies adopt a ‘mark-to-market’ approach in which the full fluctuation in

the value of the pension expense or income is reflected each year. Yet such an approach would create significant fluctuations in the value of pension expense and

produce extreme and unnecessary volatility in the reporting of annual net income.

The IASB has initiated a project that, tentatively, would prohibit the use of

smoothing techniques for pension accounting purposes, and the FASB is undertaking a review of SFAS 87 and its ‘perceived deficiencies.’ In addition, FASB plans

to work closely with the IASB to harmonize accounting regimes.

There have been significant international repercussions from pursuit of the ‘markto-market’ approach. The accounting standard-setting body in the United Kingdom

adopted Financial Reporting Standard 17 (FRS 17), which utilizes such an approach. Under FRS 17, projected benefit liabilities and the plan’s assets are entered

directly on the company’s balance sheet. All annual changes to assets and liabilities

are immediately recognized in the income statement. All U.K. companies were to

comply by June 2003, but recently the compliance deadline was extended. In a recent survey by the National Association of Pension Funds, a British trade group,

75 percent of British pension funds responded that they are considering terminating

their pension plans. Some employers have already begun terminating their plans

45

10Klieber, Eric. J. ‘‘Pension Valuation Needs More Disclosure, Not A New Formula,’’ Contingencies, September/October 2002, pp. 33–36.

and transferring their liabilities to insurance companies and others have just frozen

the plans by not offering new accruals. FRS 17 is significant not only because it provides a glimpse of the likely effect on American pension plan sponsorship of adoption of a ‘mark-to-market,’ but because the former head of the U.K. accounting

standards body responsible for FRS 17 is now chair of the IASB.

Sponsors of defined benefit pension plans understand that pensions are a longterm commitment. While a company can terminate a pension plan at any time, the

operation of an ongoing pension plan is made with a long-term perspective in mind.

Because of the long-term nature of a pension plan and because of the accounting

requirement to place a current value on pension obligations that occur far into the

future, the valuation determination must take into consideration the investment

performance of assets over an extended period of time. As there is no reason to assign different rates of performance to different periods of time, the use of an average

or smoothed asset return assumption is appropriate. Moreover, the use of such a

smoothed expected rate of return enables orderly planning and somewhat predictable costs for the employer.

The use of an average expected rate of return does not mean that actual investment returns are ignored; full recognition of differences in the expected and actual

experience is only delayed. Current expected rates of return reflect all possible outcomes, including the bull markets of the 1990s, and also take into account regular

downturns in asset prices. Similarly, the rates of return used for pension plans in

the 1990s did not then reflect the huge returns pension assets were actually earning

at that time.

Shifting to an approach that immediately recognizes asset gains and losses would

dramatically increase the variability of pension expense and produce significant new

volatility in annual corporate income levels. As a result, plan sponsors may respond

by shifting pension assets out of equities and into bonds. Such a move would result

in the plan sponsor experiencing higher costs for maintaining the plan in the longterm because they would no longer be reaping the benefit of an equity premium in

the asset returns. Even worse, many plan sponsors may react by terminating their

plans because they simply cannot accept having corporate income levels subject to

unpredictable and uncontrollable shifts in the value of pension assets.

Moreover, it is not clear how investors would gain from a ‘mark-to-market’ approach. Over the long-term, pension plan costs are generally a small part of total

compensation, and the ‘mark-to-market’ approach does not reflect the long-term nature of the pension commitment. As one commentator noted, ‘‘the fact that a DB

pension plan can be terminated and its assets and liabilities liquidated is no reason

to value those assets and liabilities as if the plan were about to terminate. The logical extension would be that since the company could sell or liquidate every one of

its components, all components should be valued at their sale or scrap value.’’10

Markets and financial analysts have enough savvy and experience with SFAS 87 to

enable reasonably accurate company valuations.

Conclusion

Mr. Chairman and Ranking Member Baucus, I want to thank you once again for

calling this hearing on what the Council believes to be one of the most important

components of our nation’s retirement system and for examining some of the most

important retirement policy questions we as a nation face today. The Council feels

strongly that we must ensure that both traditional and hybrid defined benefit plans

remain viable choices for employers so that companies can select the pension plan

design most suited to the needs and wishes of their workforce. Defined benefit plans

offer unique advantages for employees, but without prompt action by Congress we

fear these plans will increasingly disappear from the American pension landscape.

Thank you very much for the opportunity to appear today and I would be pleased

to answer whatever questions you and the members of the Committee may have.

PREPARED STATEMENT OF RON GEBHARDTSBAUER

The American Academy of Actuaries is the public policy organization for actuaries

of all specialties within the United States. In addition to setting qualification standards and standards of actuarial practice, a major purpose of the Academy is to act

as the public information organization for the profession. The Academy is nonpartisan and assists the public policy process through the presentation of clear, objective analysis. The Academy regularly prepares testimony for Congress, provides

46

1See my earlier testimony on the benefits of Defined Benefit plans at the June 20, 2002 hearing of the Ways and Means Subcommittee on Oversight on ‘‘Retirement Security and Defined

Benefit Pension Plans’’ at http://www.actuary.org/pdf/pension/testimony—20june02.pdf 2See our paper, ‘‘The Impact of Inordinately Low 30-Year Treasury Rates on Defined Benefit

Plans,’’ which can be found at http://www.actuary.org/pdf/pension/treasurybonds—071101.pdf

information to federal elected officials and congressional staff, comments on proposed federal regulations, and works closely with state officials on issues related to

insurance.

Chairman Grassley, Ranking Member Baucus, and distinguished committee members, good morning and thank you for inviting me to testify on ‘‘The Funding Challenge: Keeping Defined Benefit Pension Plans Afloat’’. My name is Ron

Gebhardtsbauer, and I am the Senior Pension Fellow at the American Academy of

Actuaries. The Academy is the non-partisan public policy organization for actuaries

of all specialties in the United States.

My written statement covers five important issues for this hearing, namely:

(1) Problems of the current funding rules and the need for a quick permanent

fix,

(2) Alternatives for discounting liabilities,

(3) Concerns with current lump sum rules,

(4) PBGC issues, and

(5) Allowing greater contributions in good years.

Background and Problem: Defined Benefit plans are beneficial to employees,

employers, and the nation.1 However, as you know, a problem in pension funding

rules arose in 1998 due to Treasury bond rates becoming inordinately low. As pointed out in our 2001 paper on this subject,2 the rules dramatically increased minimum

pension contributions (to levels much higher than Congress ever intended), at a

time when employers could least afford them.

Temporary Fix: Fortunately, Congress acted quickly in March of 2002 to remedy

this problem by allowing employers to use a higher discount rate in 2002 and 2003

for determining their pension liabilities and PBGC premiums. However, the pension

rules revert back to the inordinately low discount rates in 2004. Meanwhile, major

financial decisions are being made today, which depend on what next year’s pension

contribution will be. In addition, bankruptcy judges are being forced to decide today

whether employers can afford their pension plans in 2004. Courts may decide the

employer cannot afford its pension plan, and later find out that the rule was fixed

and the employer could have afforded the pension plan. Bad decisions can come

from bad information. Thus, a permanent fix is desperately needed for the funding

rules very quickly. Delaying the fix will continue the bad decisions being made in

courts and on trading floors today.

Selecting an appropriate target: The first step to resolving this issue—and

perhaps the most challenging—is to select an appropriate target. Any interest rate

alternative should be judged based on the results it produces relative to this target.

An appropriate target should:

• Produce contributions that will adequately address participant and PBGC security concerns without forcing ongoing companies to put more assets into their

pension plans than needed,

• Avoid discouraging the formation of defined benefit plans because of overwhelming or unpredictable funding requirements,

• Avoid funding requirements that unnecessarily divert funds that could otherwise go to increasing other benefits and wages, retaining employees, or keeping

the company from financial distress, and

• Result in appropriate premiums to support the pension risk assumed by the

PBGC without increasing the PBGC’s surplus to unnecessary levels.

Annuities and/or Lump Sum Values: Congress may have intended the interest

rate used in current liability calculations to reflect a plan sponsor’s cost of plan termination—the actual cost of annuities and lump sums. In OBRA ’87 (the Omnibus

Budget Reconciliation Act of 1987), Congress specified that the interest rate used

should be ‘‘consistent with the assumptions which reflect the purchase rates which

would be used by insurance companies to satisfy the liabilities under the plan.’’ IRC

section 412(b)(5)(B)(iii)(II). Note that the law uses the word ‘‘liabilities,’’ and not

‘‘annuities.’’ Thus, we are not sure why the IRS ignored the cost of lump sums in

Notice 90–11. Lump sum amounts can be larger than annuity prices due to interestrate requirements in IRC section 417(e). Our paper recommended that Notice 90–

11 be revised to specify that benefit liabilities equal the lump sum amounts for participants expected to elect lump sums. Without this modification, plans can be underfunded when, as now, lump sums are greater than the value of the annuity using

the current liability discount rate.

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3 ‘‘Alternatives to the 30-year Treasury Rate’’ at www.actuary.org/pdf/pension/rate—

17july02.pdf 4See a complete list on page 13 of our paper entitled, ‘‘Alternatives to the 30-year Treasury

Rate’’ at http://www.actuary.org/pdf/pension/rate—17july02.pdf . We recommend that the discount rate be changed for every calculation of current liability (both the RPA94 version and the

OBRA87 version) so that there is only one current liability number. There is no reason to have

two versions. 5Why did Treasury rates fall so much compared to corporate bond rates? In August 1998, the

CBO’s Economic and Budget Outlook (ftp://ftp.cbo.gov/8xx/doc828/e&bO898.pdf) suggested that,

for the first time in 30 years, the U.S. unified budget would show a surplus; and, in fact, that

the surplus would continue forever. In other words the US started reducing its Treasury debt

instead of increasing it. The law of supply and demand suggests that with reduced supply (and

continued demand), prices will go up. Treasury bond prices did go up and their interest rates

dropped. In fact, they dropped faster than corporate bond rates, and that has continued since

then. This has continued, even as surpluses have turned to deficits, probably due to increased

Continued

It appears that, at the very least, Congress believed that interest rates inherent

in annuity purchase prices and lump sums would be within the range specified by

the new law for determining current liability (a 10 percent corridor on either side

of a four-year average of 30-year Treasury rates). In fact, we note that the highest

permissible discount rate by law has consistently been quite close to corporate bond

rates, and above annuity discount rates. In 1999, when the highest pennissible discount rate fell below the corporate bond rate, Congress fixed it temporarily by putting it back up with corporate bond rates.

Alternatives: An Academy paper in 2002 provided three alternative discount

rates for fixing this problem,3 and they are set forth on the accompanying graph.

They are: • The pension plan’s expected long-term rate of return (orange line) • A high-quality long-term Corporate bond rate of return (blue line) • Discount rates used in pricing annuities (green line)

The Academy’s Pension Practice Council suggests that a smoothed average of either the bond or the annuity pricing rate would be appropriate for discounting liabilities for underfunded plans. The next 4 sections discuss these rates and the

long-term Treasury rate (red line).

Expected Long-Term Rate of Return (Orange Line): ERISA (the Employee Retirement Income Security Act) has allowed the Enrolled Actuary since

1974 to choose a reasonable interest rate (taking into account reasonable expectations) for pension funding calculations. As you can see from the first chart,

actuaries have chosen a long-term rate averaging around 8 percent for at least

the last 15 years.

In the mid-1980’s, PBGC noted that the funding rules, taken as a whole, were

still allowing pension plans to be underfunded. The biggest problem was in the

amortization periods (not the interest rates). The rules allowed pension plans

to improve benefits frequently and pay for them over the next 30 years (even

though retiree increases could be paid out faster than 30 years). Thus, benefit

improvement could defund underfunded pension plans. Consequently, OBRA’87

changed the rules to not only shorten the funding periods for underfunded

plans, but also to require a separate discount rate for the calculation based on

the 30-year Treasury rate. The rules specified that the pension liabilities for

this calculation (known as Current Liabilities or CL) be determined using a discount rate no larger than 110 percent of the 30-year Treasury rate, averaged

over the prior 4 years (the brown line in the chart). As you can see, it was close

to Corporate Bond rates and, in fact, was actually larger than the interest rates

used by the average actuary at the time. You can also see that Treasury rates,

annuity pricing rates, corporate bond rates, and the maximum allowable rate

were closer back then.

Treasury Rates (Red Line): Why was the 30-year Treasury rate chosen?

Among other reasons, the Treasury rate was easy to obtain, had durations similar to pension plans, and wasn’t subject to manipulation (or, at least, that was

the perception at that time). In addition, the rate was acceptable to employers

for funding purposes because the law allowed use of 110 percent of the Treasury

rate (which allowed a rate near corporate bond rates), and it was smoothed (by

using a four-year average of the rate) so it would not cause excessively volatile

contributions and was predictable in advance.

Today, the Treasury rate is used for detennining pension funding amounts,

PBGC variable premiums, lump sum amounts, and many other pension items.4

Unfortunately, the Treasury rates have fallen much more than corporate bond

rates, annuity rates, and expected long-term rates.5 For example, from 1983

48

demand caused by investors turning from stocks and corporate bonds to the safety of Treasury

bonds, and because of decreased supply in the wake of the government’s decision in 2002 to stop

issuing 30-year bonds. 6For purposes of these calculations, we assume that the plan is invested 60 percent in equities

and 40 percent in bonds, and would yield approximately 200 basis points over corporate bond

rates, and that the plan’s duration is a typical duration of 12 (i.e., decreasing the interest rate

by 1 percent would increase liabilities by 1.01 raised to the twelfth power or 12 percent). The

50 percent comes from (1 + 8.1 percent ¥ 4.7 percent)¥12 ¥ 1 = 50 percent. 7 Even though pension contributions for underfunded plans are determined using 105 percent

of Treasury rates (except for 2002 and 2003), the lump sums are determined using 100 percent

of Treasury rates, which affects contributions. 8Of course, pension plans are not invested solely in Treasury bonds. They are invested in equities and corporate bonds, with the expectation that they will earn a larger return over the

long term. (Ibbotson data from the past 76 years shows that over any 20-year period, stocks

have performed better than bonds.) Of course, that is not a guarantee, so employers have taken

on a risk that the future may not be like the past. 9 In fact, the highest permissible discount rate in the law has consistently beets quite close

to this corporate bond rate. In 1999, when the permitted rate fell, Congress fixed it by putting

it back up near the corporate bond rates. 10This assumes that expected returns would be around 2 percent greater than corporate bond

returns. The 27 percent comes from 1.02¥12 - 1 = 27 percent. See the second prior footnote

for further details.

through 1997 Treasury rates were less than 100 basis points below corporate

bond rates (except for 1986), but by the year 2000 they were 200 basis points

below. In addition, we now know that Treasuries can be manipulated by the private sector and by the government. A major investment banking firm manipulated prices in August of 1991 and the Treasury showed it could manipulate

prices in November of 2001, when it said it would stop issuing 30-year Treasuries. (By comparison, a Composite Corporate Bond rate would be much more

difficult to manipulate. In fact, if corporate bond rates ever were manipulated,

annuity prices would presumably be affected in the same way, and the resulting

rates would still be appropriate.)

As we noted above, using the Treasury rate increases costs dramatically.

Many employers based their decisions to have a pension plan on long-term expectations. If today’s low Treasury rates are used to determine liabilities, they

increase costs by about 50 percent over using long-term expectations.6 This is

what causes the dramatically higher lump sums and pension contributions.7 In

effect it says, this is what the contribution should be if the pension plan is invested solely in Treasury bonds.8 The next section discusses the cost assuming

the pension plan is invested solely in corporate bonds.

Long-Term High-Quality Corporate Bond Rates (Blue Line): Pension liabilities for the plan sponsor’s financial statements are generally discounted

using current Long-Term High-Quality Corporate Bond rates due to the requirement in FAS87 (Financial Accounting Standard #87) paragraph 44 and statements by the Securities and Exchange Commission.9 If assets equal this liability, then benefits can be paid by the cash flows from bond coupons and maturity

values of an immunized bond portfolio. This means that an employer could

hedge its interest rate risk (i.e., it doesn’t matter if interest rates change, the

liabilities could still be matched by the bond cash flows).

If this discount rate is used, liabilities will be around 27 percent higher than

if expected returns are used.10 Thus, using this rate (in comparison to the expected return) improves benefit security for participants and means the pension

plan is less likely to need trusteeship by the PBGC. A plan that is funded to

this amount generally does not require the PBGC because, if additional

amounts are needed, they are small, and employers have typically made the additional contributions in order to avoid distress terminations (which can be very

complex and entail benefit cuts to employees). Even if this plan does qualify for

a distress termination, the PBGC will generally not experience an economic loss

because PBGC does not guarantee the full benefit, and it does not buy annuities. The PBGC, like employers, self-insures (i.e., doesn’t buy annuities) in

order to reap higher returns and avoid the larger expenses, risk margins and

profit loadings of the insurance company.

Discount Rates used in Pricing Annuities (Green Line): The discount

rates used in pricing annuities are very similar to the corporate bond rates, because when someone buys an annuity, the insurance company invests the

money in corporate bonds (often with lower credit ratings of A and Baa, in order

to reap the credit risk premium), private placements, and mortgages. A study

for the Society of Actuaries by Victor Modugno suggested that these discount

rates could be approximated by Bloomberg’s A3 option adjusted corporate bond

49

11The 6 percent comes from (1 + 50bp)¥12 - 1 = 6 percent. 12The GAO (General Accounting Office) report, ‘‘Process Needed to Monitor the Mandated Interest Rate for Pension Calculations’’ is at http://www.gao.gov/new.items/d03313.pdf 13 A yield curve has the advantage of pricing liabilities more like the financial markets would

(lower discount rates for short duration liabilities). When the yield curve is steep, it would increase the liabilities of hourly plans with large retiree populations. However, we note that a

more precise calculation might also use a blue-collar mortality table for the hourly plan, which

could offset the effects of using the complex yield curve. 14See the reasons suggested on page 12 of our paper on alternatives located at http://

www.actuary.org/pdf/pension/rate—17july02.pdf

index minus 70 basis points (for the insurance company expenses, risk margins,

and profits). The adjustment is less than 70 basis points if one uses the High

Quality Composite rate suggested by ERIC (the ERISA Industry Committee).

Using an annuity discount rate could increase costs by about one-third over expected returns (or about 6 percent over high-quality corporate rates).11 A plan

with assets equal to this liability amount would be able to buy annuities for everyone, and thus would be less likely to require the help of the PBGC. On the

other hand, employers contend that they are self-insuring (like the PBGC) so

that they can earn a risk premium from stocks and avoid paying for the higher

insurance company expenses, risk margins, and profits.

Dynamic Process for Setting Discount Assumption: Determining insurance

company prices is not an easy or exact science, and no one index will work forever

without adjustment. Discount rates vary between insurance companies, and over

time companies change their pricing methods, so it is difficult to fix a formula in

law that is appropriate for all time. Our 2002 paper and a recent GAO report 12 both

suggest that if Congress desires such a rate, it should allow for a dynamic process

to set it. For example, if Congress carefully defines the rate in law to be the discount rate used in pricing the average annuity, a committee with annuity pricing

actuaries, pension actuaries, investment professionals, and government actuaries

could set the discount rate.

Alternatively, our paper also suggested that Congress could define the discount

carefully in law and allow the plan’s Enrolled Actuary to determine it. Either of

these methods could also be used to seta high-quality long-term corporate bond rate.

Smoothing: As in our paper, we suggest policy-makers investigate reducing the

4-year smoothing rule for discount rates in IRC §412(b)(5)(B)(ii)(I) to something less,

for example, 2year smoothing (e.g., the average of the monthly rate on the valuation

date and the prior valuation date). Otherwise, if interest rates go back up quickly

(as they did in the late 1970s and early 1980s), then plans would have to use a discount rate lower than Treasury rates to determine their contributions. (In other

words, employers would have to increase their contributions even though the plans

would have enough funds to buy annuities to cover all plan liabilities.) The Academy’s Pension Practice Council believes that this suggestion would still produce

funding requirements that are reasonably predictable in advance and have enough

smoothing to satisfy sponsor concerns. However, we are concerned that this issue

would slow down passage of this bill; further study is indicated. For example, it

could take time for regulations to be proposed and finalized, and employers need

to know now what the discount rate will be for 2004.

Yield Curves and Hedging: Some actuaries suggest using a current yield curve

(i.e., using different rates for different periods in the future, not just one average

long-term rate) so that volatility can be hedged by investing in certain asset classes.

On the other hand, many other actuaries are concerned about the volatility that

could ensue if a plan sponsor did not want to change its investment philosophy

away from stocks. Thus, they prefer using a smoothed average rate. Therefore, our

paper suggested that Congress not mandate a yield curve,13 but rather allow for it.

The IRC could accommodate both if plan sponsors could elect to use the then-current corporate bond yield curve. It will be interesting to see how many plans elect

to use the yield curve. We do not expect that it would be many (at least initially).

The use of a yield curve (which could have 30 or more rates) will take time to propose in regulations and finalize, and add complexity to an already very complex set

of minimum funding rules (and it might not change the results appreciably, especially when the yield curve is flat). Clearly, it would be too complex for lump sum

calculations,14 and Congress might want to exempt small plans from the calculations or create simplified alternatives, such as one rate for actives and one rate for

retirees.

Changing the discount rate and mortality table at the same time. It is

widely understood that minimum funding calculations will soon be required to reflect an updated mortality table, which would further increase the required funding

for pension plans. It makes sense to make any change in interest rates effective at

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15 Changing from the 83GAM to the most recent mortality table RP2000 has the same affect

as lowering the discount rate by up to 0.5 percent for males, 0 percent for females (because their

mortality rates didn’t improve), and 0.25 percent for unisex rates (if 50/50). Thus, changing the

mortality table also justifies increasing the discount rate. 16For example, retirees of Polaroid are suing their former employer for paying the mandated,

subsidized lump sums to recent retirees, because they are defunding the plan. This means the

retirees will have their benefits cut down to the guaranteed benefit by PBGC.

the same time the mortality table is changed for funding, so that calculation methods only need to be revised once. In addition, since the change in the discount rate

and the mortality table change the liability calculations in the opposite direction,

they will offset the effects of each other.15

Retroactivity: Permitting a change in interest rates retroactively to 2001 could

help some employers immediately by retroactively reducing the contributions that

would have been required in that year and allowing the reduction in contribution

to increase the credit balance. This increase in the credit balance could then be used

to reduce the current-year minimum contribution, which could reduce the current

severity of cash flow problems affecting employment, compensation, and other benefit issues (and it would increase government tax revenues). However, the retroactivity provision should be optional, so that employers do not have to incur the cost

of revising past actuarial valuations or have to change their budgeting of contributions—or lose the deduction for contributions made in good faith on the basis then

in effect.

Pension Calculations Affected: As in our paper, we encourage Congress to

change the interest rate for every calculation of Current Liability. Replacing the reference to the 30-year Treasury rate in all of the RPA94 and OBRA87 calculations

listed on page 13 of our ‘‘Alternatives’’ paper would increase consistency and simplicity. The use of multiple interest rates and multiple liability numbers are confusing to actuaries, employers, participants, and other interested parties in the general public, such as investors.

Changing the current liability interest rate would not affect certain other calculations, which policy-makers may wish to also consider, including:

• Lump sums under IRC section 417(e), maximum lump sums under section 415,

and automatic lump sums under $5,000 under section 411(a)(11), which all use

the 30-year Treasury rate;

• The projection of employee contributions under IRC section 411(c), which uses

120 percent of the federal mid-term applicable rate.

Lump Sums: There are reasons for using one corporate bond rate or annuity

price (not a complex yield curve) in every place where the 30-year Treasury rate is

currently used. For example:

• Simplicity—Only one rate is used, instead of the multitude of rates now used.

• Spousal benefits—The use of Treasury rates for determining lump sums makes

the lump sum option more valuable than the Qualified Joint and Survivor Annuity. This conflicts with the original intent of ERISA—to encourage pensions

to surviving spouses.

• Public Policy—The current rules mandating the Treasury rate make it impossible for plans to provide an actuarially equivalent lump sum. Thus, the economic decision to take a lump sum is not a neutral one. The worker can take

the lump sum and buy a larger annuity with it (which they rarely do). Thus,

the rules encourage workers to take lump sums, which may be viewed negatively from a public policy perspective, because more retirees will spend down

their lump sum too quickly and end up falling on government assistance (Supplemental Security Income and Medicaid).

• Plan Funding—Each lump sum in an underfunded plan defunds the plan (i.e.,

the funding ratio is decreased), particularly if it is subsidized by the unusually

low Treasury rate. In addition, plans will tend to be less well funded, because

Notice 90–11 prohibits the subsidy from being included in the current liability

calculation. This is not only a concern for participants,16 but also for the PBGC.

• Increased Costs Beyond Amounts Intended—Plan sponsors have to contribute

more funds to the plan because the low Treasury rate made lump sums larger

(not because the employer decided to increase lump sums). Thus, the plan is

more expensive than the employer originally intended.

• Obstruction of Bargaining Process—Due to the expense of paying larger lump

sums, plan sponsors are less likely to make plan improvements suggested by

workers at the next bargaining period. Thus, requiring the Treasury rate ignores the collective bargaining process and discriminates against participants

that don’t take lump sums. If employees were permitted to decide where the

funds should go, staff in labor organizations have told us that bargainers would

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17 Unless all interest rates go up dramatically in the next 3 years. 18 Every year participants get one year closer to their Normal Retirement Date (NRD), which

means their lump sum increases by one year’s interest rate (unless they are already beyond

their NRD, in which case the lump sum can decrease). 19 Another idea might be to freeze the lump sum dollar amount on the amendment date (using

the accrued benefit on that date), so that the lump sum amount would not decrease, unless the

old rules would have decreased it (e.g., due to the Treasury rate going up or due to the participant being beyond the NRA, or in the case where a large early retirement subsidy is in the

lump sum). However, this could be a little more complex to calculate than the 3-year phasein idea. 20This $31.5 billion amount includes the $6 billion in assets front probable plans in PBGC’s

FY 2002 annual report (such as Bethlehem Steel), because PBGC includes such liabilities in the

report.

probably use the funds to improve the benefit formula for all workers, instead

of just for those workers who take lump sums.

Changing to a higher interest rate can reduce a worker’s lump sum, so a transition rule may be helpful. For example, ERIC and ABC suggest phasing in the interest rate change over 3 years. Their phase-in could limit the increase in the interest

rate to about 0.5 percent per year.17 We note that Treasury rates have increased

in the past, so this would not be the first time that lump sum interest rates have

increased. The Treasury rate went up in the 1990’s by more than 1 percent three

times (i.e., 1994, 1996, and 1999). Furthermore, with this transition, a worker’s

lump sum may not go down. It may still grow because each year a worker gets additional service, pay increases, and their age gets closer to the Normal Retirement

Age (NRA).18 19

In addition, we suggest Congress simplify the incredibly complex calculations

caused by §415(b)(2)(E) for maximum lump sums. One simple alternative suggested

by ASPA (the American Society of Pension Actuaries) would be to use just one interest rate. Our paper suggested that it could be somewhere in the 5 percent to 8 percent range. The Academy has also suggested to the Treasury Department in the

past that the rules could be greatly simplified by deleting the words ‘‘or the rate

specified in the plan’’ in §415(b)(2)(E), so that the maximum lump sum would be

the same in all plans (and the discount rate used above and below the Normal Retirement Age would be the same).

PBGC’s Financial Status: Another item that policymakers need to consider

whenever the funding rules are modified is the effect of the changes on the PBGC.

The Academy’s Pension Practice Council believes that increasing the discount rate

to a corporate bond rate or annuity pricing rate helps the PBGC in the short term,

because fewer plans will have to be trusteed by the PBGC (due to plan sponsors

not being able to afford the artificially large contributions). It may also help PBGC

in the long term, if it keeps more Defined Benefit plans around to pay premiums

to the PBGC. By fixing the discount rate, Congress signals to employers its intention to keep Defined Benefit plans as a viable option for employer retirement programs. However, that statement comes with a caveat. Since increasing the interest

rate reduces minimum contributions, there may be a need to review the funding and

premium rules in the near future, particularly if PBGC takes on some more major

losses over the next couple years in this current economic downturn.

Due to the triple whammy of plummeting stock prices, lower interest rates, and more bankruptcies, the PBGC has gone from a surplus of $10 billion just two years

ago to a $3.6 billion deficit. However, the dollar amount of the deficit is not as relevant as the funding ratio, which is 90 percent. Each time the PBGC takes over

a pension plan, it also takes over the plan assets. PBGC’s assets are now over $31.5

billion 20 while its annual outgo is expected be around $3 billion. Thus, the PBGC

will not have problems fulfilling its primary mission for a number of years to pay

guaranteed benefits on time.

However, this discussion so far has only taken into account PBGC’s past terminations. PBGC’s financial status is intimately linked with how the airline industry

fares over the next several years. The pension underfunding at several weak airlines

exceeds $10 billion. In fact, PBGC’s 2002 Annual Report forecasts that future claims

could be twice the average of past claims—a clear signal that they may want to double premiums and/or tightening funding rules.

Risk-related PBGC Premiums: Recently, the PBGC floated the idea of charging

higher premiums (or strengthening the funding rules) for plans that present more

risk to them (e.g., plans with high levels of equities and plans sponsored by weak

companies). These rules might be helpful to strong employers so that they would

not have to subsidize weak employers. However, employer groups have not asked

for these fixes, possibly because almost all plans have over 50 percent of their assets

in equities. And many employers are wary of the second idea because they could

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21For example, charge a larger premium rate (on just the benefit increase) that is risk related,

require faster funding (fund benefit increases faster than 30 years; FAS already requires employers to expense benefit increases over a much shorter period, and the Deficit Reduction Contribution rules already do that when the funding ratio is under 80 percent or 90 percent continually), or prohibit the benefit increases unless liens are provided as in §401(a)(29)—and just increase the 60 percent threshold to 70 percent or 80 percent. 22Some of these ideas might apply to both single and multi-employer plans, so the suggestions

may also be applicable to both. In fact, having different rules for these hourly plans can set

up arbitrage opportunities that some plan sponsors have tried to exploit. (Multi-employer plans

need not pay variable premiums or Deficit Reduction Contributions.) Some of the reasons for

the difference in the rules may be that the Multi-employer guarantees are smaller than those

for Single employer plans, the PBGC multi-employer fund has a surplus, and it is more difficult

for Multi-employer plans to change their funding in the middle of a bargaining period.

someday have lower credit ratings. In addition, implementing these risk-related premiums would raise many complex issues (in an area that is already overly complex).

For example, the government might have to assign credit ratings to employers and

that could lead to audits for misleading the PBGC’s analysts. The PBGC would have

to assign risk levels to stocks and bonds (and some bonds present more volatility

and/or mismatch risk than certain stocks). Plan sponsors might seek ways to temporarily avoid the riskier investments on the measurement date, and if those rules

were tightened it could hurt the markets when pension plans started selling equities.

Other Reforms: Other fixes could be:

(1) To make it more difficult for weak companies to increase benefits.21

(2) To address the cost of shutdown benefits (or to not guarantee them).

(3) To get contributions into the plans earlier. The PBGC tells us that pension

plans frequently do not contribute in their last year when the PBGC takes over

the plan. Thus, requiring sponsors of underfunded plans to make contributions

by year end (or very soon thereafter) could help the PBGC. Employers might

be amenable to this rule if quarterlies were eliminated. This could also enable

quicker reporting of pension plan financial information, which would also be

valuable to the PBGC and the markets, and be a step in the cause for greater

clarity and transparency.

(4) To suspend the use of the credit balance when plans are very underfunded.

(5) To improve PBGC’s standing in bankruptcy courts.

(6) To increase disclosure.

Hourly/bargained plans 22 are more likely to be underfunded than salaried plans,

because:

(1) They are amended frequently to update benefit levels for inflation. These

amendments can be funded over 30 years (even though the increased retiree

benefits can be paid out much faster). If plans are very underfunded, they have

to amortize benefit increases over 3 to 5 years by means of the deficit reduction

contribution. One compromise might be to smooth out these rules so that there

is not such a large cliff between them. Congress might consider reducing the

30-year period (FAS already requires companies to expense benefit increases

over a much shorter period).

(2) When assets exceed current liability, the plan sponsor can’t make a deductible contribution. (See below for a suggested fix.)

(3) They are more likely to be in industries that have large legacy costs payable to large retiree populations (in comparison to smaller workforces).

(4) They can experience large asset losses, and may find it difficult to amortize them over a small workforce, even if assets cover their retiree liability. Immunization of the retiree liability in underfunded plans could be discussed, but

Congress would need to be careful about removing the flexibility plan sponsors

currently have to invest pension assets in the way that best fits their plan and

the everchanging economic conditions.

These are all very complex ideas and have far reaching implications for the pension world, so they should not be implemented until after major discussion and

analysis.

Allowing Contributions in Good Years: An Academy task force has already

met with the PBGC on simplifying funding rules. One fix that the Academy task

force proposes would have helped companies that were not allowed to make deductible contributions to their pension plans in the late 1990s and now must make sizable contributions under deficit reduction contribution rules.

The paper recommends that employers be allowed to make a deductible contribution to their pension plans, even if assets are above 100 percent of current liability

(CL). Currently, their contribution would also be subject to an excise tax. When inVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00056 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
53

terest rates were higher, the full funding limit allowed a pension plan to have a

margin above Current Liability (see second chart). That margin is also needed when

interest rates are low, particularly for plans that are retiree-heavy and hourly plans,

which can’t easily advance fund their benefit increases. Congress could allow a contribution up to (for example) 130 percent of current liability minus assets. Alternatively, the definition of the Full Funding Limit could have (for example) 130 percent of current liability as a minimum.

We also note that there are strong incentives for companies to contribute more,

and companies have learned a lot lately about the risks inherent in pension plan

funding. Recent drops in the market have provided a good reason for employers to

increase their funding margins and build a ‘‘cushion’’ to protect against adverse experience. Thus, companies may be more willing to contribute more than necessary

in the future to avoid falling below certain key thresholds, if the law allows them

a deduction (or at least doesn’t penalize them with an excise tax for making nondeductible contributions). For example, if assets fall below the Accumulated Benefit

Obligation, accounting rules may force a major hit to the company’s net worth. If

assets fall below the liability for vested benefits, companies must pay an additional

premium to the Pension Benefit Guaranty Corporation (PBGC). If assets fall below

90 percent of current liability, contributions can increase dramatically.

A list of the penalties follows. If policymakers want to increase the incentives for

funding, then a threshold for one of the penalties could be increased (e.g., the

threshold for security).

We believe many employers will contribute enough to reach a key threshold margin in order to avoid these problems.

Being forced to fund when the plan sponsor cannot afford it and being precluded

from funding when the plan sponsor can afford it is unreasonable, self-defeating,

and difficult on the PBGC. We hope Congress will consider making this fix, which

does not cause problems (because it is voluntary), except for reducing tax revenues.

However, we don’t believe that the revenue loss will be as large as might be expected because it may not be used heavily in the near future, and to the extent that

it is used, it will reduce contributions in the future.

We at the American Academy of Actuaries hope that a permanent fix to the 30-

year Treasury rate can be enacted quickly. In addition, we are also very interested

in working with Congress and the PBGC to consider funding ideas further. Thank

you for holding this hearing and inviting us to speak before you today.

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55

PREPARED STATEMENT OF STEVEN A. KANDARIAN

Mr. Chairman, Ranking Member Baucus, and Members of the Committee:

Good morning. I am Steven A. Kandarian, Executive Director of the Pension Benefit Guaranty Corporation (PBGC). I want to thank you for holding this hearing and

for the interest you have in the retirement security of America’s workers.

This hearing is especially timely. During FY 2002 PBGC’s single-employer insurance program went from a surplus of $7.7 billion to a deficit of $3.6 billion—a loss

of $11.3 billion in just one year. This loss is more than five times larger than any

previous one-year loss in the agency’s 28-year history. In addition, we estimate that

the total underfunding in the single-employer defined benefit system now exceeds

$300 billion, the largest number ever recorded. I appreciate the opportunity to appear before you today to speak about these important issues.

STATE OF THE PBGC

PBGC was created as a federal corporation by the Employee Retirement Income

Security Act of 1974 (ERISA). PBGC protects the pensions of nearly 44 million

workers and retirees in more than 32,000 private defined benefit pension plans.

PBGC’s Board of Directors consists of the Secretary of Labor, who is the chair, and

the Secretaries of the Treasury and Commerce.

PBGC insures pension benefits worth $1.5 trillion and is responsible for paying

current and future benefits to 783,000 people in over 3,000 terminated defined benefit plans. As a result of the recent terminations of several very large plans, PBGC

will be responsible for paying benefits to nearly 1 million people in FY 2003. Similarly, benefit payments that exceeded $1.5 billion dollars in FY 2002 will rise to

nearly $2.5 billion in FY 2003.

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NO FULL FAITH AND CREDIT: NO FEDERAL TAX DOLLARS

While PBGC is a government corporation under ERISA, it is not backed by the

full faith and credit of the federal government. Moreover, PBGC receives no federal

tax dollars. Instead, PBGC is funded by four sources: the insurance premiums paid

to PBGC by defined benefit pension sponsors, the assets of pension plans that PBGC

has trusteed, recoveries in bankruptcy from former plan sponsors (generally only

cents on the dollar), and earnings on invested assets.

When PBGC takes over pension plans that are underfunded by billions of dollars,

it is the premium payers—employers that sponsor defined benefit plans—who bear

the cost. Financially healthy companies with well-funded pension plans end up subsidizing financially weak companies with chronically underfunded pension plans. As

a result, over time, strong companies with well-funded plans may elect to leave the

system. This potential for ‘‘adverse selection’’ could pose a real problem for the insurance program.

HEALTH OF PBGC’S PROGRAMS

PBGC operates two financially independent insurance programs, the larger singleemployer program and a smaller program for multiemployer plans (i.e., plans set

up between a union and two or more employers). The multiemployer program has

been in surplus since 1980. The single-employer program, however, was in deficit

for 21 years from 1974 until 1995.

For six years, from 1996 until 2001, the single-employer program was in surplus,

reaching a surplus of almost $10 billion in FY 2000. The surplus grew substantially

during these years because of PBGC’s investment gains during the stock market

boom and because the PBGC did not have to trustee any plans with large amounts

of underfunding.

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During FY 2001 and FY 2002, however, PBGC’s surplus rapidly deteriorated and

has now disappeared altogether, leaving PBGC with a deficit of $3.6 billion. Our

deficit was caused by the failure of a significant number of large companies with

highly underfunded plans. These include the plans of the retailers Bradlees, Caldor,

Grand Union, and Payless Cashways; steelmakers including LTV, Acme, Empire,

Geneva, and RTI; other manufacturers such as Singer, Polaroid, Harvard Industries, and Durango; and Trans World Airlines. Mr. Chairman, pension claims for

2002 alone were greater than the total claims for all previous years combined. At

current premium levels, it would take about 12 years of premiums to cover just the

claims from 2002.

In December 2002, PBGC terminated the plans of two other major steel companies with extremely large underfunding: National Steel and Bethlehem Steel, both

of which are included in the $3.6 billion deficit figure. In addition, in our most recent annual report, PBGC reported exposure to additional claims totaling $35 billion, which we categorize as ‘‘reasonably possible.’’ Of this $35 billion, about half

represents underfunding in airline and steel plans.

Over the longer term, exposure and expected claims are more difficult to quantify.

However, we expect that our deficit may increase dramatically.

Large plan terminations with low funding levels drove PBGC into deficit, and additional large claims may increase that deficit. However, the current $3.6 billion dollar deficit, even though it is the largest in history, does not create an immediate

liquidity problem for PBGC—we will be able to continue paying benefits for a number of years. But with $29 billion in benefit liabilities and only $25 billion in assets,

we should not wait to put the insurance program on a sound financial basis. We

should not pass off the cost of today’s problems to future generations.

Recently, some have argued that, because PBGC is not in any immediate danger

of running out of cash, there is no need to address the issue of pension underfunding. We believe this view is misguided.

Mr. Chairman, Congress heard the same argument in 1987 and again in 1994

when Congress strengthened pension security for workers. Without those reforms,

workers and the PBGC would be in even worse shape today.

STATE OF THE DEFINED BENEFIT PENSION SYSTEM

Defined benefit plans are. an important source of retirement income security for

rank-and-file American workers. The defined benefit system is not in crisis, but

there are structural problems that need to be addressed.

As you know, Mr. Chairman, our pension system is voluntary. In recent years,

many employers have chosen not to adopt defined benefit plans, and other employers have chosen to terminate their existing defined benefit plans. Since 1986, 97,000

plans with 7 million participants have terminated. In 95,000 of these terminations

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the plans had enough assets to purchase annuities in the private sector to cover all

benefits earned by workers and retirees. The remaining 1,800 were PBGC terminations where companies with underfunded plans shifted their unfunded pension liabilities to the insurance program, resulting in benefit reductions for some participants since ERISA doesn’t guarantee all employer-promised pension benefits.

Of the 32,000 defined benefit plans that remain ongoing, many are in our oldest,

most mature industries. These industries face growing benefit costs due to an increasing number of retired workers, a problem compounded by increased competition.

At the same time, equity investments have suffered a large decline and pension

liabilities have ballooned due to falling interest rates. As a result, underfunding in

private sector defined benefit plans is now estimated to exceed a record $300 billion.

Last year over 270 corporations reported to PBGC that they had pension plan

underfunding greater than $50 million. This is more than three times the number

of corporations that have reported to PBGC in any year in the past. In addition,

about 150 major US corporations are now in bankruptcy, many of which have defined benefit plans.

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During the last economic downturn in the early 1990s, the pension insurance program absorbed what were then the largest claims in its history—$600 million in

underfunding for the Eastern Airlines plans and $800 million for the Pan American

Airlines plans. Those claims seem modest in comparison to the plans we have taken

in lately: $1.3 billion for National Steel, $1.9 billion for LTV Steel and $3.7 billion

for Bethlehem Steel. Underfunding in some of the troubled airlines may be larger

still.

With pension promises growing and with the percentage of plan underfunding remaining in the same range for a decade or more, the dollar amount of pension

underfunding has skyrocketed. Meanwhile, PBGC’s premium collections have remained flat at roughly $800 million a year. Raising premiums enough to cover

losses of the size the PBGC endured in 2002 could prove counterproductive, driving

the financially healthy companies out of the defined benefit system.

CHALLENGES FACING THE DEFINED BENEFIT SYSTEM

There are a number of challenges facing the defined benefit system, including the

following:

The current funding rules are inadequate to ensure sufficient pension contributions for those plans that are chronically underfunded. To our knowledge, none of

the defined benefit pension plans responsible for the $300 billion in underfunding

is in violation of law. Companies with hugely underfunded plans have followed the

funding requirements of ERISA and the Internal Revenue Code.

When PBGC trustees these underfunded plans, participants often complain that

‘‘there ought to be a law’’ requiring companies to fund their plans. Mr. Chairman,

there is a law, but it is inadequate to fully protect the pensions of America’s workers

when their plans terminate. The funding targets are simply not high enough for the

plans of companies at the greatest risk of termination. Allowing companies to compute contribution requirements based on asset and liability numbers that are averages of prior years can further defer funding. Finally, nothing in the funding rules

requires companies with underfunded pensions to make annual cash contributions

to the plan.

Another trend impacting the defined benefit system is increased in competitive

pressures that have led companies to look at their entire cost structure. During the

1990’s, some workers did not place a high value on their defined benefit plans, and

the costs to plan sponsors have been volatile. As of result, many companies are increasingly unable to afford or unwilling to maintain defined benefit plans and are

moving to 401 (k) and other defined contribution arrangements.

In addition, demographic trends have made defined benefit plans more expensive.

With workers retiring earlier and living longer, plans must pay annuities for far

longer. Today, the average life expectancy of the 65year old male has grown to 16.1

years, and the average age of retirement has dropped to 62. As a result, the number

of years of retirement has increased from 11.5 in 1950 to 18.1 today, an additional

seven years of retirement which must be funded.

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Another problem is that the current disclosure rules do not require timely data

that would help participants and shareholders understand the funding status of

plans and the consequence of pension underfunding. The current value of plan assets and liabilities is not transparent to workers, retirees, investors, or creditors.

Timely, accurate data would allow the capital markets to inject some discipline into

the system and allow participants to protect their interests.

Congress added new requirements in 1994 providing more timely data to PBGC

and expanding disclosure to participants in certain limited circumstances, but our

experience tells us those disclosures are not adequate. The information provided to

PBGC is confidential, so its impact is limited. And the notices to participants do not

provide sufficient funding information to inform workers of the consequences of plan

termination. Workers in many of the plans we trustee are surprised when we have

to tell them their plans are underfunded. They are also surprised to find that

PBGC’s guarantee does not cover certain benefits, including early retirement benefits not yet fully earned.

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PROBLEMS IN THE STEEL AND AIRLINE INDUSTRIES

In addition to the issues affecting the defined benefit system as a whole, there

are also challenges facing specific economic sectors, including steel and airlines.

PBGC is watching these two industries closely because they have accounted for

some 70 percent of the claims against PBGC but fewer than 5 percent of insured

participants. Steel, with less than 3 percent of participants, has accounted for 58

percent of PBGC’s claims, and the airlines, with about 2 percent of participants,

have constituted 13 percent of claims.

Airline pension plans currently have about $18 billion in underfunding. Almost

all carriers are losing money today. Two major carriers are currently in bankruptcy—US Airways and United Airlines—and several others are financially troubled.

To reduce its pension cots, US Airways asked PBGC (late in 2002) to terminate

the company’s pension plans, immediately restore those plans, and provide 30 years

to fund them. PBGC does not have the legal authority to terminate and restore the

US Airways plans. Moreover, we do not believe it would have been wise to grant

the request even if we had the legal authority to do so.

We understand the financial difficulties many companies are facing and we are

sympathetic to those workers who would suffer significant cutbacks if their plans

were terminated. However, relaxing the funding rules for plans of companies in financial distress would set a dangerous precedent for the pension insurance program

and put further at risk the integrity of the overall defined benefit system.

Furthermore, providing this special relief to US Airways would give it a competitive advantage over other airlines. It would also give other financially distressed

companies a blueprint for evading the statutory funding rules at the expense of the

pension insurance system and the 44 million workers it protects. Mr. Chairman,

this is a slippery slope.

If US Airways, why not other financially troubled airlines? If airlines, why not

companies in other industries?

POSSIBLE REFORMS

Mr. Chairman, we believe there are three basic options to deal with the problems

facing the defined benefit system.

First, we could do nothing and hope that the system will self-correct. This approach risks putting off today’s problems to the next generation.

Second, Congress could enact a large, across-the-board premium increase, a

change that seems unfair to those well-funded plans that are already subsidizing

the system.

Or third, we could look at how best to move underfunded plans to appropriate target funding levels over a reasonable period of time.

In an effort to improve pension security for workers and retirees by strengthening

the financial health of the defined benefit system, PBGC and the Departments of

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Labor, Treasury, and Commerce are currently examining a number of possible solutions. These ideas are still in the developmental stage, but I would like to share

with you some of our concerns.

Mr. Chairman, under current law benefits can be increased with little new funding as long as the plan is at least 60 percent funded. We are examining whether

the 60 percent threshold should be increased. In too many cases, management and

workers in financially troubled companies may agree to increase promised pensions.

The cost of wage increases is immediate, while the cost of pension increases can be

deferred. When plans of financially weak companies terminate, the pensions may be

fully protected by PBGC’s guarantee, although they have not been funded.

Another problem is that under current funding rules, a company with an underfunded plan may not be required to make an annual pension contribution. Under

current law, many of the companies that had plans that were highly underfunded

when trusteed by PBGC did not have to make contributions for many years prior

to termination. In addition, funding and premium rules do not take into account a

company’s financial health and the resulting risk to the pension protection system.

Still another concern is the need for fuller disclosure of the funded status of pension plans. For example, only participants in plans below a certain funding threshold receive annual notices of the funding status of their plans, and the information

provided does not reflect what the underfunding likely would be if the plan terminated. In addition, PBGC is prohibited from publishing termination liability data.

A final concern is the financial integrity of the pension insurance program. A

strong benefit guarantee program is necessary to assure the long-term stability of

the defined benefit pension system. To discourage moral hazard, ERISA provides for

the sharing of risk by companies and participants as well as PBGC. To fulfill this

sound principle, we must work to better link guarantees to the funding of benefits.

For example, current law requires that PBGC in many cases pay shutdown benefits—which are subsidized and supplemental early retirement benefits triggered by

plant shutdown or permanent layoffs—even though funding of these benefits does

not begin until the shutdown or layoff has occurred. These shutdown benefits—

which are similar to severance benefits not guaranteed by PBGC—account for billions of dollars of PBGC’s unfunded liability exposure.

Finally, PBGC is examining its premium structure in light of the massive increase

in claims. Under the current structure, premiums are computed based solely on the

number of plan participants and the dollar amount of pension underfunding. The

formula does not attempt to reflect the risk of a claim from a given plan. In general,

however, we continue to believe that well-funded plans represent a better solution

for participants and the pension insurance program than any changes we could

make on the premium side.

CONCLUSION

Mr. Chairman, we are working to find ways to improve pension security for workers and retirees by strengthening the financial health of the voluntary defined benefit system.

Former Representative J.J. [Jake] Pickle was one of the chief advocates of the

1987 and 1994 reforms. His comments on the floor at the time the 1994 pension

reforms were enacted are something we should remember:

‘‘I note that I would have personally preferred to make these reforms much

stronger, and I caution my colleagues that they should not expect these reforms

to immediately solve all the problems caused by underfunded pension plans. In

order to overcome strenuous objections by certain automobile, steel, and airline

companies we have included very generous transition rules for companies which

have maintained chronically underfunded pension plans . . . . I deeply regret that we have given another reprieve to companies who have shirked their

pension obligations for the 20 years since the passage of [ERISA].’’

Congressional Record, 103rd Cong., 2nd Sess., H11477, Nov. 29, 1994.

Mr. Chairman, the existence of the pension insurance program creates moral hazard, tempting management and labor. at financially troubled companies to defer

their pension obligations. This unfairly transfers the cost of underfunded pension

plans to responsible companies and their workers. These financially strong companies at some point will have had enough, and will exit the defined benefit system,

leaving only those which pose the greatest risk of claims. We need to make sure

the incentives in the system are changed so this doesn’t happen.

Again, I thank the Chairman for inviting me to testify this morning. I will be

happy to answer any questions.

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RESPONSES TO QUESTIONS FROM SENATOR GRASSLEY

Question 1: Please explain what shutdown benefits are and how they affect PBGC.

Answer: Shutdown benefits are found primarily in the pension plans of large

unionized companies in the auto, steel, and tire and rubber industries. Shutdown

benefits are triggered by a plant shutdown or a permanent layoff.

In pension plans of integrated steel companies, shutdown benefits provide an unreduced early retirement benefit as early as age 42 (i.e., a worker would receive at

age 42 the same monthly benefit that he would normally receive at age 62). Once

triggered, this early retirement benefit continues to be paid, even if the worker finds

new employment in the steel industry or any other industry. In addition, shutdown

benefits in the steel industry provide a $400 monthly supplement payable from the

time of shutdown or layoff until age 62. Because the increased benefits are usually

available to an entire group of participants (e.g., all the eligible employees at the

plant that shut down), the shutdown event can greatly increase a plan’s liabilities

in one stroke. Shutdown benefits may double or even triple the cost of a worker’s

benefit.

In general, shutdown benefits are not funded before a shutdown occurs. In the

1987 Pension Protection Act, Congress required employers to fund shutdown benefits on an accelerated basis (generally, in five to seven years), but beginning only

after the triggering event occurs. This post-event funding can achieve its goals in

the case of a small-scale shutdown, such as where an employer shuts down one or

two plants or lays off just one group of employees, but continues in business and

is able to fund the shutdown benefits for the affected employees. In recent years,

however, PBGC has encountered increasing exposure from situations where an employer shuts down virtually all of its facilities at more or less the same time, usually

while in bankruptcy. In these situations, the post-shutdown funding requirements

are ineffective because the employer is going out of business. In addition, because

plans are not required to recognize unfunded shutdown liabilities until after the

shutdown occurs, employers do not pay premiums to the PBGC to reflect the risk

(and potential cost) of these benefits.

Under a 1975 regulation, the subsidized portion of shutdown benefits is guaranteed by the PBGC only if the shutdown occurs prior to plan termination. The supplement part of shutdown benefits is generally not guaranteed regardless of when

the termination occurs. However, both the subsidized portion and the supplements

drain the plan of assets when they are paid out prior to the plan’s termination.

The PBGC can institute court proceedings to terminate a pension plan if it makes

one of several determinations, including that the PBGC’s ‘‘possible long-run loss . . .

may reasonably be expected to increase unreasonably if the plan is not terminated.’’

ERISA section 4042(a)(4). The PBGC has exercised this authority in a number of

cases to terminate plans whose liabilities were expected to increase substantially

due to anticipated plant or company-wide shutdowns. This statutory scheme, however, sometimes results in a race between the company to shut down a facility and

the PBGC to ask a court to terminate the plan (without notice to the company). In

response to a question from Senator Rockefeller at the hearing, I stated that this

‘‘race to the courthouse’’ scenario, with no prior notice to the company or workers,

was an unsatisfactory way to do business.

At present, there is a potential exposure of over $15 billion in shutdown benefits

in PBGC-insured plans. Yet, less than 5 percent of workers in PBGC-insured plans

have shutdown benefit provisions in their plans. Thus, the cost of unfunded shutdown benefits is borne by other companies, the vast majority of whose workers do

not have shutdown benefits in their plans. Other companies and workers in the defined benefit system should not have to bear the large cost of these unfunded shutdown benefits for a small group of companies.

It is important to note that companies are not required to offer workers a defined

benefit plan. It is a voluntary system. If premiums become too onerous, responsible

companies with well-funded pension plans may terminate their plans and exit the

system, thereby denying workers the security of a defined benefit plan, reducing

PBGC’s premium base, and putting in question the long-term viability of the defined

benefit insurance system.

Question 2: Is the cost of a terminated plan’s shutdown benefits discharged in the

employer’s bankruptcy case?

Answer: Shutdown benefits are a liability of the pension plan, not of the employer.

Thus, they are treated in bankruptcy like all other unfunded plan benefits. When

a pension plan covered by Title IV of ERISA terminates, PBGC becomes responsible

for collecting from the sponsoring employer all unfunded benefit liabilities, including

the value of shutdown benefits. If the employer is a debtor in bankruptcy, PBGC

files its claim as a general unsecured creditor for the plan underfunding. PBGC diVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00067 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
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vides its recovery on the claim between itself (to help pay for unfunded guaranteed

benefits) and participants (to help pay their non-guaranteed benefits). Any amount

of the claim that goes unpaid in the bankruptcy is discharged.

Question 3: During the hearing, you testified that you were in favor of legislative

changes regarding shutdown benefits. Can you explain in more detail what kind of

changes you are thinking of and why?

Answer: Unlike other pension benefits, shutdown benefits are not pre-funded and

companies pay no specific premium to PBGC to reflect the additional risk these benefits impose on the guarantee system. PBGC should not be exposed to liabilities that

are not funded. I favor legislation limiting PBGC’s exposure to these benefits.

The current treatment of shutdown benefits is not in anyone’s interest. As discussed above, PBGC must rush to court without notice to the parties to terminate

a plan before the shutdown. It also means that the parties are negotiating benefits

that the workers may never receive, often resulting in the frustration of participant

expectations.

Question 4: If Congress were to adopt a corporate bond rate as a replacement for

30-year Treasuries, what effect would that have on plan funding and on PBGC premium income?

Answer: The liabilities of a pension plan are a stream of future payments owed

to participants entitled to benefits under the plan. Each year, the plan’s actuary determines the value of plan liabilities (and the value of plan assets) in order to determine how much the employer must contribute to its plan for the year and the

amount of premiums owed to PBGC. To calculate the value of the liability stream,

the actuary uses certain assumptions such as the expected rate of future salary increases, when participants are expected to retire, when participants are expected to

die, and the interest rate used to discount future payments to reflect the time value

of money. Each of these assumptions is important in determining the value of a

plan’s liabilities.

Interest rate assumptions have the following impact on pension funding. A higher

interest rate reduces the value of plan liabilities for funding purposes. When liabilities are reduced, funding requirements are reduced. For companies paying the variable rate premium, reduced liabilities would also mean reduced premiums. Currently, there is significant underfunding in the defined benefit system.

Under current law, different interest rates are used for different purposes. The

interest rate on 30-year Treasuries is used in a number of calculations: to determine

the amount of lump sums given to participants, to determine the PBGC variable

rate premium, and to determine plan liabilities for purposes of the additional funding requirement for underfunded plans.

The Federal government has discontinued the issuance of 30-year Treasury bonds.

In addition, the spread between yields on Treasury bonds and high quality corporate

bonds has grown recently. In 2002, as part of the Job Creation and Worker Assistance Act, Congress provided funding relief for 2002 and 2003 by raising the top of

the permissive corridor in the funding rules from 105 percent to 120 percent of the

4-year weighted average of the 30-year Treasury rate. The corridor will drop again

to 105 percent in 2004 if legislative action is not taken.

Proposals have been put forward to substitute corporate bond rates for 30-year

Treasury rates in the current liability formula, when the corridor reverts back to

105 percent. Because 105 percent of the weighted average of corporate bond rates

is higher than the rate based on 120 percent of the weighted average of 30-year

Treasuries, reported pension liabilities will be lower. As a result of lower reported

pension liabilities, plan funding will decrease and PBGC variable rate premium income will also decline.

Some groups want to substitute corporate bond rates for 30-year Treasury rates

as a means of providing permanent funding relief. This confuses two concepts. We

must first find an accurate measure of pension liabilities. Once pension liabilities

are accurately measured, appropriate funding rules can be addressed.

PBGC has modeled the impact of simply substituting the Moody’s AA corporate

bond rates for 30-year Treasury rates for 10 very large plans, some of which are

sponsored by employers experiencing financial difficulty. Under current law (i.e.,

120 percent dropping to 105 percent in 2004) the average termination funded ratio

of these plans is projected to be 77 percent in five years. This five-year average

funded ratio is projected to drop to 70 percent if the current 120 percent cap on the

interest rate corridor is extended indefinitely. Using corporate bond rates, this fiveyear average is projected to drop even further to 63 percent. The attached charts

illustrate projected termination funding ratios for two sample plans.

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Question 5: Various media articles have reported that US Airways pilots will lose

about 75 percent of their retirement benefits due to PBGC maximum guarantee limits. Can you comment on this?

Answer: Based on the most recent information available, we believe that the assets in the US Airways pilots plan are sufficient so that US Airways pilots who were

retired or were eligible to retire three years prior to the date of plan termination

will receive benefits in excess of the maximum guaranteed limit. For example, we

expect that pilots who are 59 years old with 29 years of service and who have spent

their entire careers with US Airways will receive from PBGC, on average, annual

benefits of about $85,000 of the $110,000 they were expecting at age 60. This is significantly more than the PBGC maximum guaranteed benefit of $28,600 per year

that PBGC would otherwise pay starting at age 60.

For pension plans terminating in 2003, the maximum guaranteed benefit amount

is $3,664.77 per month ($43,977.24 per year) for a participant who commences benefit payments at age 65. This maximum guaranteed amount is lower if payments

commence before age 65 or if the pension includes benefits for a survivor or other

beneficiary. The limit is about $28,600 per year for a participant who begins receiving benefits at age 60. (The guarantee limit is higher if a participant commences

benefits after age 65 or is older than age 65 when the plan terminates.)

However, many US Airways pilots will receive more than the $28,600 maximum

limit because a participant may receive benefits in excess of the guaranteed

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amounts if there are enough plan assets or recoveries from employers. Section 4044

of ERISA establishes priorities for allocating the assets of a terminated pension

plan. First, assets are allocated to employee contributions (Priority Categories 1 and

2). Priority Category 3 (PC–3) includes the benefits of participants who were in pay

status, or who could have been in pay status, as of the beginning of the three-year

period ending on the date of plan termination, based on the least generous benefit

provisions in effect during the five years before termination. For a participant who

could have been, but was not, retired three years before plan termination, the benefit allocated to PC–3 is computed using the participant’s age and service three

years prior to the termination date. PC–3 contains both guaranteed and nonguaranteed amounts.

Question 6: How will PBGC rules affect the US Airways pilots who were previously employed by Eastern Air Lines and who will receive PBGC benefits based

on their years of participation in the Eastern Air Lines plan that was previously

trusteed by PBGC?

Answer: As noted above, for pension plans terminating in 2003, the maximum guaranteed benefit amount is $3,664.77 per month ($43,977.24 per year) for a worker who retires at age 65. If a worker is entitled to benefits under two or more plans,

however, the aggregate benefit payable by PBGC from its guarantee funds is limited

by law. Essentially, the maximum guarantee would be reduced by any amounts that

PBGC had to pay from its own funds under the first plan for unfunded guaranteed

benefits.

In the Eastern pilots plan, there were sufficient assets to pay all guaranteed benefits. Thus, PBGC is not paying any Eastern pilots benefits from its own funds. As

a result, the maximum Title IV benefit for a pilot under the US Airways pilots plan

would be unaffected by the fact that the pilot is also receiving benefits from PBGC

under the Eastern pilots plan.

Question 7: At the hearing, you also testified that the steel and airline industries

have accounted for about 70 percent of the claims against PBGC but fewer than 5

percent of insured participants. What is the percentage of total claims against

PBGC from companies with collectively bargained plans? .

Answer: Collectively bargained plans have accounted for between 71 percent and

83 percent of the total amount of PBGC’s claims over the 28-year period 1975–2002.

Total claims during that period were $16.7 billion. Claims by collectively bargained

plans, not including salaried plans that were related to collectively bargained plans,

were $11.92 billion. Claims by collectively bargained plans, including salaried plans

related to those collectively bargained plans, were $13.92 billion. Generally, these

salaried plans incorporated the benefit formulas of the related bargained plans, with

some modifications.

Question 8: Can you briefly explain PBGC’s multiemployer insurance program and

describe the underfunding in multiemployer plans?

Answer: PBGC administers a separate guarantee program for multiemployer defined benefit pension plans. PBGC’s multiemployer program covers about 9.5 million

workers and retirees in about 1,650 insured plans. The multiemployer program covers only collectively bargained plans involving two or more unrelated employers.

Multiemployer plans are common in certain industries, including construction,

trucking, mining, the hotel trades, and segments of the grocery business. Multiemployer plans pay PBGC a yearly premium of $2.60 per participant for benefit insurance coverage.

The current PBGC monthly benefit maximum guarantee level for multiemployer

plans is 100 percent of the first $11 multiplied by the participant’s years of service

under the plan plus 75 percent of the next $33 multiplied by the participant’s years

of service. For example, the benefit for a worker with 30 years of service in a multiemployer plan is $1,072.50 per month ($12,870 per year). For multiemployer plans,

the event triggering PBGC’s guarantee is the inability of a covered plan to pay benefits when due at the guaranteed level, rather than plan termination as required

under the single-employer program. PBGC provides financial assistance through

loans to insolvent plans to enable them to pay guaranteed benefits.

The multiemployer program received two new requests for financial assistance

during 2002. These requests raised to 31 the total number of plans that have received financial assistance from PBGC. Since 1980, PBGC has provided assistance

with a total value of approximately $159 million (net of repaid amounts). During

2002, 23 plans were receiving financial assistance totaling about $5 million.

The multiemployer program has been in surplus since 1982, with a surplus of

$158 million for FY 2002. The multiemployer program reported a gain of $42 million

in 2002 compared to a net loss of $151 million in 2001. The change in net income

was due to a smaller loss related to future financial assistance and an increase in

investment income. Premium income increased slightly to $25 million. Because the

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multiemployer program has a positive net position and most of its assets are invested in highly liquid Treasury securities, PBGC has sufficient resources to meet

its liquidity requirements. In 2003, we expect premium receipts to total approximately $25 million while benefit payments and financial assistance are expected to

be about $6 million, based on known claims.

Question 9: Can you explain how the funding rules for multiemployer pension

plans differ from those of single-employer plans.

Answer: In general, defined benefit plans are subject to minimum funding requirements and maximum funding limitations, but there are differences between the

funding rules for multiemployer plans and single-employer plans. The differences reflect the fact that contributions to multiemployer plans are set by multi-year collective bargaining agreements. As a result, multiemployer plans cannot immediately

adjust to large swings in contribution requirements. Multiemployer plans are allowed to amortize actuarial gains and losses over a 15-year period, versus 5 years

for single-employer plans. In addition, while multiemployer plans are not subject to

the ‘‘deficit reduction contribution’’ requirements that apply to underfunded singleemployer plans, poorly funded multiemployer plans are subject to enhanced ‘‘reorganization funding’’ rules.

Question 10: Does the Administration grant funding waivers to multiemployer

plans and have any been granted in the past 2 years? Are any pending? What is

the procedure for approving a funding waiver for multiemployer plans?

Answer: The IRS has jurisdiction over all requests for waivers of the minimum

funding standards, and we understand that it typically receives 1 to 3 requests per

year from multiemployer plans. Multiemployer plans can obtain a funding waiver

only if at least 10 percent of contributing employers demonstrate that they are suffering from a ‘‘substantial business hardship.’’ A plan can receive no more than 5

waivers in a 15-year period.

There are detailed IRS regulations that specify the information a plan must file

to request a waiver, and IRS is allowed to share that information with PBGC under

a special exception to the taxpayer confidentiality rules of Section 6103 of the Code.

Under those restrictions, however, PBGC cannot disseminate any specific information about waiver applications.

Question 11: If a multiemployer plan is requesting a funding waiver, what does

that suggest about the security of the plan that requested the waiver?

Answer: The IRS will grant a waiver only if it agrees that: (1) the employers who

support the plan are suffering from a substantial business hardship; (2) the plan

can be continued only if the waiver is granted; and (3) enforcement of the funding

requirements would be adverse to the interests of plan participants.

I thank you again for giving me the opportunity to testify at the hearing. Please

let me know if I can be of any further assistance.

PREPARED STATEMENT OF CHRISTOPHER W. O’FLINN

Mr. Chairman, members of the Committee, thank you for the opportunity to

present the views of The ERISA Industry Committee on the funding of defined benefit pension plans. I am Christopher O’Flinn, Vice President, Corporate Human Resources, AT&T Corporation, and Chairman of The ERISA Industry Committee

(ERIC), on whose behalf I am speaking today.

ERIC is a nonprofit association committed to the advancement of the employee

retirement, health, incentive, and benefit plans of America’s largest employers.

ERIC’s members provide comprehensive retirement, health care coverage, incentive,

and other economic security benefits directly to some 25 million active and retired

workers and their families. ERIC has a strong interest in proposals affecting its

members’ ability to deliver those benefits, their cost and effectiveness, and the role

of those benefits in the American economy.

ERIC has a unique interest in funding rules for defined benefit plans because

about 95 percent of the ERIC membership sponsor defined benefit pension plans.

They also provide 401(k), health, and other benefits.

Summary

In 2001 the U.S. Treasury ceased to issue the 30-year Treasury bond on which

the funding of defined benefit plans is statutorily based. As a result, we are left

with an artificial interest rate that fails to reflect any rational basis with which to

regulate pension plan funding. The lack of a rational rule has created uncertainty

that, among other effects, has caused the stock of sound companies to be undervalued by stock analysts concerned about their potential future funding obligations.

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Prompt action to replace the defunct 30-year Treasury bond rate for purposes of

regulating pension plans is critical to protect the retirement security of millions of

American workers and to avoid undercutting the ability of many companies to fuel

national economic recovery ERIC urges the Committee to replace the 30-year Treasury rate with a composite rate of high-quality, long-term corporate bond indices that

would be selected through Treasury regulations. ERIC also proposes to • Coordinate the new rate with related mortality assumptions; • Phase in the new rate for lump sum calculations; and • Reduce the frequency with which employers bounce in and out of the current

liability funding and quarterly contribution requirements.

(see attached proposal and background materials)

A composite corporate bond rate is generally recognized as a reasonable proxy for

annuity purchase rates, which corresponds to the rationale for choosing 30-year

Treasury rates as a benchmark in 1987. The proposed composite rate is higher than

today’s 30-year Treasury rate. But this is appropriate because the current use of the

Treasury rate overstates the minimum funding needed to assure retirement security

for plan participants.

The overstatement of liabilities frequently is requiring the diversion of hundreds

of millions of dollars in a single company. Overstating liabilities is forcing some employers to make economically rational decisions to freeze, modify, or abandon their

defined benefit plans, thus adversely impacting retirement security. Use of the

defunct 30-year Treasury rate also causes participants to elect lump sums in circumstances where they would be better protected by an annuity.

Other possible replacements for the 30-year Treasury rate do not provide the combination of simplicity, transparency, relevance, immunity from manipulation, and

availability provided by a composite corporate bond rate.

Congress must be careful not to overreact to reports raising concerns about the

current status of pension funding. Part of the problem is that current law

mismeasures the severity of any problems. In addition, the combined impact of a

dramatic drop in asset values combined with an increase in calculated liabilities due

to low interest rates is unusual and is not a sound platform for major reshaping

of pension funding requirements.

At the same time, Congress should recognize its ability and responsibility to improve the climate for defined benefit plans in the future. For example, Congress imposed ever-harsher deduction limits on voluntary contributions to pension plans during the 1980s and 1990s, a trend that the Grassley-Baucus pension reform measures

enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001

(P.L. 107–16) began to reverse. Had restrictive deduction limits not been imposed

during recent decades, many plans would be better funded today despite the current

economic slowdown.

Finally, the current financial status of the Pension Benefit Guaranty Corporation

(PBGC) should be monitored by Congress, but does not require any action at this

time. The PBGC’s funded ratio still is stronger than it has been for most of its history, and the corporation is abundantly able to pay promised benefits to participants

in plans it trustees for the foreseeable future.

Overview of Funding Rules

To ensure that a defined benefit pension plan has sufficient assets to pay benefits

when participants retire, ERISA and the Internal Revenue Code require the plan’s

sponsor to make minimum contributions to the pension plan. These minimum required contributions are calculated using reasonable assumptions and are equal to

the normal cost of the plan plus amounts necessary to amortize over specified periods unfunded past service liabilities, experience gains or losses, waived funding deficiencies, changes in actuarial assumptions, and certain other items. Most defined

benefit plans are funded under these original ERISA rules, as modified over time.

A plan that is either significantly or persistently underfunded will be subject to

an additional set of funding rules. Basically, these rules look at whether a plan is

likely to be able to buy annuities to cover its current level of accrued benefit promises. If a plan is far from being able to buy annuities, the rules require that additional cash be put into the plan, accelerating the pace of pension funding. These

rules, commonly called the ‘‘current liability’’ funding rules, were added to the law

in 1987 and modified in 1994, and are the focus of our discussion today.

The current liability funding rules require the sponsor to use a specified mortality

table and to calculate liabilities using an interest rate that is within a range of rates

based upon the four-year weighted average of 30-year Treasury bonds. As amended

in 1994, amendments, the permissible range is no lower than 90 percent of the 30-

year bond average and no higher than 105 percent of the 30-year bond average. For

2002 and 2003 only, a plan may use a rate of up to 120 percent of the 30-year bond

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average. Congress enacted this short term-higher range last March (P.L. 107–147)

in recognition of the fact that, as a result of the rise of budget surpluses followed

by the decision of the Treasury to cease issuing 30-year bonds, the 30-year bond rate

had dropped to levels that produced highly inaccurate and inflated calculations of

pension liability.

The current liability rules come into play if, using these mandated assumptions,

a plan is significantly or persistently underfunded—that is, if plan assets are less

than 80 percent of current liabilities or if a plan assets are less than 90 percent

of current liabilities for two of the last three years. Plans with any unfunded current

liabilities must also make contributions on a quarterly basis during the plan year

instead of making one annual contribution after the end of the plan year.

Current liability is also calculated to determine whether a plan sponsor will pay

a $19 per participant flat rate premium tax to the Pension Benefit Guaranty Corporation, or whether the sponsor must, in addition, pay a variable rate premium tax

based on the plan’s unfunded vested benefit liability.

The 30-year Treasury rate is also used (without averaging and without the corridor available for funding purposes) to calculate the minimum lump sum that may

be paid to a plan participant.

What happens if the 30-year Treasury rate is not promptly replaced?

If Congress fails to act, 2004 current liability calculations will be dictated by a

maximum rate of 105 percent of the four-year weighted average of (defunct) 30-year

Treasury bonds. Using the rates in effect on January 1, 2003, as a proxy, this would

mean that plans would be forced to calculate their current liabilities with a maximum interest rate of 5.82 percent compared to 7.41 percent under the ERIC proposal. If this were to occur—

• Current liability calculations would increase by 15 percent or more.

• Many additional companies, including companies with plans that are in fact

well-funded, would become subject to the special funding rules. Both they and

those already subject to the rules would experience a spike in their contribution

requirements. This will unnecessarily divert money that otherwise would have

be spent to build new plant, buy equipment, pay for research and development,

and support jobs.

• Plans that become subject to the current liability funding rules also must notify

employees of their underfunded status (even if the plan is not underfunded

using reasonable measures), and must pay variable rate premiums to the

PBGC. Business operations of these plan sponsors also come under increased

scrutiny by the PBGC.

There is no economic justification for these consequences. Thus, it is apparent

that affected companies will find their support for defined benefit plans diminished.

A strong financial incentive will be created to limit future liabilities. Where cash

is in short supply, companies will have no option but to freeze their plans.

There is additional fall-out just from the uncertainty companies currently face.

CEOs and CFOs need to know now whether they will be able to purchase new plant

and equipment, to invest in research and development, and to accomplish other vital

business objectives.

Consequences of the funding squeeze, caused in part by the continued reliance on

the 30-year Treasury rate, already are occurring. A recent survey by Deloitte & Touche indicated that more than four out of ten defined benefit plan sponsors are either

making or are considering making fundamental changes to their defined benefit

plans. About a quarter of those making or considering changes either already have

or are inclined to freeze benefits in the plan.

Action on a replacement rate is needed now. Analysts already are steering investors away from companies with a cloudy contribution forecast. Action by the end of

the second quarter, after which planning for 2004 becomes critical, is vital. Delay

means damage to plans and their participants, damage to companies, and damage

to companies’ ability to fuel economic recovery.

Why should a composite corporate bond rate be selected as the replacement for 30-

year Treasury rates?

The current liability funding rules are designed to shore up funding in a plan that

would have a serious shortfall if it were to terminate and purchase annuities to provide benefit payments. Thus, as the GAO reported less than two weeks ago, ‘‘the

interest rates used in current liability and lump-sum calculations should reflect the

interest rate underlying group annuity prices and not be subject to manipulation.’’

(GAO–03–313)

Insurance companies tend to invest in long-term corporate debt. Therefore, a composite corporate bond rate will track changes in annuity purchase rates.

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ERIC’S composite rate is composed of high-quality, long-term corporate bond indices. High quality (generally the top two quality levels) provides a reasonable level

of security for pension plan sponsors to defease their liabilities.

ERIC’s composite rate indices also are comprised of bonds with average maturities

of 2530 years (implying durations of 10–12 years), which corresponds to the typical

duration of pension plan liabilities.

When the 30-year Treasury bond rate was selected as a compromise basis for the

new pension funding rules established in 1987, Treasury rates were closer to corporate bond rates than they are today. Moreover, mortality assumptions in use at

the time were outdated, so having an interest rate that was overly conservative

made sense.

The composite corporate bond rate in the ERIC proposal is based on indices that

are published by major investment houses, based on disclosed methodology, and

publicly available. The composite rate is based on information familiar to plan actuaries; it is simple for plans to implement; it is transparent, and it is strongly immune from manipulation.

What about mortality assumptions?

Under current law, Treasury is required periodically (and at least every five

years) to review the mortality table required for current liability funding calculations and to update the table as appropriate to reflect the actual experience of pension plans (including permitting plan-specific adjustment factors such as employment classification, lifetime income, and other relevant demographic factors) and

projected trends in such experience. An update in the required table is overdue.

ERIC recommends that the use of the RP 2000 Combined Mortality Table, produced by the Society of Actuaries based on a large study of pension plan experience,

be required for funding and variable rate premium purposes at the time the composite rate becomes effective. Use of the new table will have the effect of increasing

current liability calculations for most plans, partially offsetting the effects of adopting the composite corporate bond replacement for the 30-year Treasury bond.

ERIC proposes no changes for mortality assumptions for lump-sum distributions,

since they already are being updated under a separate provision of law.

What about lump sum distributions?

It is important that the lump sum discount rate reflect the plan’s discount rate.

Any disconnect between the lump sum rate and the funding rate will cause plan

distributions to either exceed or fall short of estimates used in the plan.

Today’s low rate also presents participants deciding between a lump sum distribution and an annuity a choice that is overwhelmingly weighted toward the lump sum.

This is in direct contravention of long-established policy that the choice should be

economically neutral. As use of lump sums increases, fewer joint and survivor benefits are selected, adversely affecting long-term participant security. In addition, the

plan’s funding level is adversely impacted.

• Lump sums paid under a defunct Treasury rate are, in fact, windfall benefits

that have damaging side effects for long term retirement policy and for the company sponsoring the plan.

• Elderly widows and widowers and others who outlive their assets and have no

retirement income stream other than Social Security constitute one of the most

vulnerable pockets of poverty today. The current lump sum structure will increase the number of spouses and others left adrift in the future if that lump

sum is dissipated.

• Actuarial estimates indicate that a lump sum benefit under the current inappropriate discount rate increases the cost of the benefit to the plan by 17–40

percent. Many plans cannot absorb these costs and have been freezing or curtailing benefits. Thus, while some current retirees receive a windfall based on

an anomaly in the government debt structure, future retirees will receive reduced benefits overall.

• Finally, Internal Revenue Code section 417(e) not only dictates the minimum

lump sum rate, but also the rate that regulations encourage companies to use

as the interest credit rate in cash balance plans. Thus, maintaining an artificially low lump sum rate for some current retirees means that millions of participants in cash balance plans are losing benefits compared to what they would

be earning if the rate were rational.

ERIC proposes that the new interest rate be phased in over a three-year period.

The three-year phase-in will align the two rates over time while ensuring that the

shift from a defunct 30-year Treasury rate to the composite rate will not have abrupt effects on participants at or very near retirement.

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Historically, the lump sum discount rates have averaged about 7 percent. Today’s

mandated rate is 4.92 percent. Under the ERIC proposal, if current rates remained

in effect without change, this would gradually increase to a level of about 6.23 percent over a three-year period—still short of historical averages. The phase-in is designed to roughly approximate normal fluctuations of interest rates in a given year.

Thus the changes would be within the margins of change that already occur on a

year-to-year basis. In addition, in the second and third years, lump sums of many

employees would increase from estimates made today because additional years of

age and service would be included in the calculation.

What’s wrong with selecting another government rate or a yield curve instead of a

composite corporate bond rate?

Any other government rate is going to suffer from the same weaknesses as the

30-year Treasury rate—any relation to annuity purchase prices will be tangential

or accidental. Indeed, as the GAO noted (p. 5), ‘‘Treasury rates’ proximity to group

annuity purchase rates might be adversely affected if investors’ demand for risk-free

securities increases, causing Treasury rates to decline relative to other long-term

rates.’’

Government rates reflect the government’s cost of borrowing, not the rate of return on an insurance company’s portfolio. Thus they inherently lack relevancy for

the purpose at hand.

Corporate bond yield curves might enable a plan to more closely approximate its

group annuity purchase rate. However, the extra precision involved is outweighed

by several drawbacks. For example:

• There has been little public discussion of a yield curve, a complicated proposal.

Adequate consideration of a yield curve between now and July, when a replacement for 30-year Treasuries must be in place, could not occur. It would need

substantially more time for debate and analysis. There are a number of highly

technical issues involved in switching to a yield curve that have not been explored or addressed.

• Companies already unsure of their cash flow situation will be thrown into even

greater confusion, to the detriment of their ability to participate productively in

the economy.

• Since it would make no sense to average a yield curve over four years, an annual rate likely would be used. Unless some other ‘‘smoothing’’ mechanism is

devised, this will substantially increase pension funding volatility.

• In addition to decreasing pension funding volatility, the current averaging

mechanism gives plan sponsors the ability to estimate funding obligations well

inadvance of the year for which they are due. Basing contributions on an unknowable ‘‘spot rate’’ decreases the ability of sponsors to plan capital commitments.

• Introducing volatile, unpredictable cash flow requirements is a significant burden on plan sponsors. As a result, maintaining a defined benefit plan will become less and less economically feasible for more companies. It would be impossible for Congress to overestimate the negative impact of turning at this point

in time to a pension funding system that increased the volatility and unpredictability of required pension contributions.

• A yield curve would likely increase required contributions in plans with large

numbers of retirees. This could cause very severe economic hardship for those

companies.

• A yield curve, combined with the current law deduction limits, would result in

less ability for a plan sponsor to fund the plan while participants are younger

because it would delay the ability to deduct maximum contributions to periods

when the workforce is more mature and declining, and when the company may

face new or different economic pressures. It would, in effect, negate some of the

good of the Grassley-Baucus amendment in EGTRRA, which phases out deduction limits that had a similar effect of delaying funding over the past decades.

• If a ‘‘precise’’ interest rate such as a yield curve is mandated, a precise mortality assumption also must be considered. Otherwise, industrial plans whose

participants have shorter life spans will be required to excessively fund their

pension plan. However, such use of such an assumption is likely to be controversial and will require additional discussion, as it will have different impacts on different plans.

• It is unclear how a yield curve would be applied for purposes of lump sum payments, raising a host of additional issues.

• A yield curve is likely to be far less transparent than a composite index; it may

be more vulnerable to manipulation; it will be more difficult for the government

to police, and it certainly will be more complicated.

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A yield curve may impose these drawbacks on the defined benefit system for no

real long-term gain over the more simple approach of a composite corporate bond

rate.

What can Congress do to help?

Besides prompt enactment of a replacement for 30-year Treasury bond rates, Congress has important opportunities to improve the climate for defined benefit plans.

• Congress can provide for additional stability in companies’ funding requirements by enacting ERIC’s proposals regarding the volatility and quarterly contribution rules.

• Congress can also provide for increased deductibility for voluntary contributions

made in excess of the current required amounts.

Should Congress be concerned about allegations that the PBGC is in trouble?

The short answer is, ‘‘No.’’ Congress should monitor the financial status of the

PBGC, but should recognize that the PBGC’s funded status is better than it has

been for most of its existence. It is in fact not in trouble and appears readily able

to weather the current economic slowdown (see chart).

Should long-term problems emerge, there will be ample time and resources to address PBGC issues, unless short-sighted measures drive PBGC’s premium payors

away from the defined benefit system.

The loss of the PBGC’s surplus should not be a surprise in the current economic

circumstances and is, in itself, not a cause for alarm. Indeed, given the requirement

in ERISA sec. 4002 that the PBGC ‘‘maintain premiums established by the corporation . . . at the lowest level consistent with carrying out its obligations under this

title,’’ maintaining a surplus might be in violation of the corporation’s charter.

The economic health of the PBGC is determined not by whether it has a surplus

or deficit at any point in time but by its ability to pay benefits to participants of

plans it trustees. The PBGC has sufficient assets to pay benefits for the foreseeable

future. In fact, the PBGC has operated successfully in a deficit situation for most

of its history. (see chart)

The real security of the PBGC lies not in imposing new rules that force cashstrapped companies to choose between survival and putting more money into their

pension plans. It lies in fostering a vibrant system with lots of companies maintaining defined benefit plans on which they pay premium taxes to the PBGC.

We appreciate the opportunity to appear before the Committee and will be pleased

to respond to questions and engage in further discussions either at or after the hearing.

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PREPARED STATEMENT OF HON. JOHN D. ROCKEFELLER IV

Mr. Chairman, thank you very much for holding this important hearing. The Pension Benefit Guaranty Corporation plays an extremely important role in safeguarding the financial security of many workers. The extraordinary deterioration of

the Corporation’s insurance fund is startling and worrisome. I am committed to

working with my colleagues to enact reforms if necessary to ensure that the PBGC

is fundamentally sound and prepared to meet the needs of workers who are devastated by the failures of their pension plans.

Since its creation in 1974, workers have been able to rely on the PBGC to serve

as a critical safety net. Men and women work hard and plan for their retirements

according to benefits that they have been promised. In order to be sure that the

promised pension benefits are secure, employers pay insurance premiums to the

PBGC. This system was designed to protect the golden years of people who had

worked all their lives and to provide adequately for survivors.

The recent reversal of fortunes at the PBGC puts this safety net at risk. Just like

the much-touted surpluses that the federal government had expected to enjoy, the

almost $8 billion surplus in the PBGC’s insurance fund has evaporated and changed

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into a deficit of more than $3 billion. The apparent insolvency of the insurance fund

is extremely troubling because it calls into question the Corporation’s ability to continue to fulfill its mission and protect the pension benefits that have been promised

to workers around this country.

I am also concerned that in response to its new fiscal crisis, the PBGC may be

losing sight of the true nature of its mission. Last week, the PBGC announced, quite

suddenly, that it would involuntarily terminate the defined benefit pension plan of

the Wheeling-Pittsburgh Steel Corporation. Unfortunately, the PBGC decided to

take this drastic step without consulting with the company’s executives about the

steps that are still being taken to bring the company out of bankruptcy.

Apparently, PBGC took this drastic step in order to avoid any possibility of becoming liable for shutdown benefits. I respect the urge to minimize losses and recognize that the PBGC was acting within its authority in taking this drastic step. However, I am very concerned that the PBGC’s actions have the effect of punishing the

very workers it was intended to protect. Wheeling-Pitt is working very hard to recover and to keep the pension plan open for the benefit of current employees as well

as retirees. The PBGC’s precipitous actions will drastically reduce benefits for many

workers.

I am very interested in hearing Mr. Kandarian’s thoughts on whether the PBGC

is adequately serving working men and women in this country when it terminates

pension plans and imposes reduced retirement benefits. As I said, I am aware of

the dramatic losses that the PBGC has sustained recently. But I am interested in

constructive reform ideas that can protect the integrity of the PBGC’s mission. That

is, the agency is supposed to be protecting the retirement benefits that the workers

have been promised, rather than punishing workers in order to minimize its own

liabilities.

Again, Mr. Chairman, thank you for calling this hearing. I look forward to a productive discussion with today’s witnesses.

PREPARED STATEMENT OF CAPTAIN MARK SCHULER

I am Captain Mark Schuler of US Airways. Accompanying me is Captain Pete

McGuirk, also of US Airways, and a member of the Retirement and Insurance Committee of the US Airways Air Line Pilots Association. I appreciate the invitation of

Chairman Grassley and this committee, to discuss the effect of terminating the pilots’ pension plan on myself and my colleagues at US Airways.

As members of the committee are aware, US Airways is currently operating in

chapter 11 of the bankruptcy code, and plans to emerge from bankruptcy on March

31, 2003. The company has petitioned the Air Transportation Stabilization Board for

approval of a 900 million dollar seven year loan guarantee to secure exit financing.

ATSB approval of the loan guarantee and additional debtor in possession financing

is contingent in part upon successful resolution of the pilots’ pension issue. On January 31, 2003 US Airways announced its intention to terminate the pilot’s pension

plan effective March 31, 2003. Although the company met its minimum legal funding requirements, the drop in the stock market and low interest rates created a pilots pension funding deficit of $575 million in 2004, and $333 million in 2005. The

bankruptcy court of Virginia approved this termination in a decision March 1.

The company’s decision to terminate the plan followed significant restructuring of

labor agreements at US Airways in two rounds of negotiations. In each round of

these negotiations, the pilot took the lead among the labor groups and agreed to a

33 percent pay cut and significant reductions .in work rules. The company and the

pilot group also agreed to a revised and reduced retirement plan. All of these concessions together will save US Airways 5645 million annually, reducing the cost of employing a pilot at the company by nearly 46 percent. Downsizing the airline also resulted in many pilots moving from captain to first officer positions, generating a significant loss of pay. However, the most painful effect of the restructuring was the

furlough of several thousand employees, including 1827 pilots.

After unprecedented contract concessions and furloughs, the pilot group now faces

termination of the pension we have planned on for our entire careers. Assumption

of the plan by the Pension Benefit Guaranty Corporation presents US Airways pilots with an enormous loss of pension benefits. The formula for calculating the benefits includes variables such as a pilot’s age, time of employment and projected earnings, which depend on one’s seniority position. Therefore, it is difficult to capture

a single profile as illustrative of the group. However, all pilots must retire at age

60. This has the effect of reducing the PBGC maximum payment. In my own case,

my PBGC benefit at age 60 represents a 67 percent reduction in my retirement benefits compared to the revised retirement plan reached through a collective barVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00088 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
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gaining agreement between the union and the company in December 2002. That

agreement required amortizing the pension deficit to a 30 year term instead of the

current 7 year time frame. The PBGC declined to approve this restoration funding.

With the announcement to terminate the pilots’ pension the company proposed a

defined contribution plan to supplement the PBGC guarantee. This plan provides

retirement benefits below those of the agreement reached in December 2002. It requires an investment return of 8 percent to reach the planned targets, and is funded

only going forward until a pilot retires at age 60.

If a plan similar to this is created, many pilots loose the potential benefit of this

supplement to the PBGC guarantee. First Officer Charles Couch, who at 58 must

retire in 2 years, will realize a 56 percent loss of retirement benefits with the PBGC

maximum payment This monthly maximum payment for First Officer Couch will be

$2,382 per month, down from $5,409. Assuming a replacement plan is created requiring an 8 percent return and the funding for that plan begins April 1, 2003 he

will have only two years to earn any additional pension benefits. Captain Mike

Fairley’s was a veteran of Eastern Airlines and the Trump Shuttle. He will shortly

be 60 years old, and will receive a PBGC payment from the Eastern plan, which

was terminated when the company went out of business. Trump Shuttle was acquired by US Airways in 2000. Assuming the PBGC will provide a payment from

both the Eastern and US Airways plan Captain Fairley’s benefits are reduced from

an anticipated benefit of $5,880 to $3,760 per month. If dual payments are not allowed, his benefit is further reduced to $2,910 monthly. In either case, Captain

Fairley retires in June 2003, and has virtually no opportunity to accumulate increased pension fund earnings.

When I joined US Airways in 1985 1 was fulfilling a life long dream to fly for

a major carrier. Pilots plan their careers with a single carrier because moving laterally to another company is not possible. A move requires starting again at the bottom of a seniority list, and a pilot’s seniority determines crew assignment and earning potential. As I mentioned earlier, pilots are required by law to retire at age 60.

We must undergo semi-annual flight physicals, and risk the loss of our license and

profession from medical disqualification.

We spend a career committed to the safety of our passengers, and look forward

to the pension earned under our provisions of our contract. Now we face the loss

of that earned pension, and major losses in our retirement benefits. Without an opportunity to plan earlier for this change in our retirement plan, many will face a

significant loss of retirement security.

The agreement reached between ALPA and the company in December 2002 reducing the existing pension plan would significantly mitigate the loss of pay and benefits facing the pilot group. This change is possible under the provisions of S–119,

which would permit restoration funding by amortizing the funding requirements

over a period of 30 years. This would be a win for the pilot group, and a win for

the company. This solution would also avoid the need for the PBGC to take over

another distressed plan. I would like to thank the committee for this opportunity

to testify today, and for your consideration of the situation faced by US Airways pilots.

(87)

COMMUNICATIONS

STATEMENT OF AARP

AARP appreciates the opportunity to express its strong concern about proposals

to change plan funding rules that would have a significant negative impact on single-sum retirement benefits for millions of employees in defined benefit pension

plans. As your Committee and the Congress considers substitutes for the 30-year

Treasury interest rate and related changes to these pension provisions, we urge you

to protect and preserve participants’ benefits, including annuities and lump sums.

In short, while it is appropriate to review the use of the 30-year Treasury rate for

funding purposes, the use of a more conservative 30-year Treasury rate for determining lump sums should be maintained.

Overview

The interest rate on 30-year Treasury bonds is a key element of the statutory provisions determining the value of single-sum benefits in defined benefit plans, the

employer’s ability to cash out pension benefits without the employee’s consent, the

contributions required of employers sponsoring underfunded plans, and the premiums those employers must pay the Pension Benefit Guaranty Corporation, as

well as other provisions. Proposals to move away from the 30-year Treasury bond

rate have arisen because a weak stock market and low interest rates—combined

with the Treasury’s decision to stop issuing the 30-year Treasury bond—are currently imposing significant funding pressures on employers that sponsor defined

benefit plans.

However, individuals are also feeling the pressure of falling rates and a weak

market, which has dramatically lowered both the account balances and expected returns that had been counted on for a more secure retirement. Congress should not

compound this hardship by amending the statute to reduce guaranteed benefit

amounts. At a minimum, Congress should retain a rate consistent with the 30-year

Treasury rate, and maintain the traditional spread between the current statutory

single-sum rate and any selected higher market rate for funding purposes. To the

extent that legislation prescribes any new single-sum interest rate benchmark, even

one that attempts to replicate the traditional spread for the 30-year Treasury rate,

fundamental fairness to employees dictates that any change be phased in very

gradually.

Funding Rates and Lump Sum Rates Should Continue to Be Different

Some have argued that the interest rates used to determine plan funding and the

rates used to determine the amount of single sum distributions should be identical.

But those rates are not the same today, have not been the same for years, and

should continue to differ if Congress amends the relevant provisions. Under current

law, the rate used to determine the present value (the single-sum equivalent) of a

pension annuity benefit is the 30-year Treasury interest rate. By contrast, the rate

used to determine contributions to underfunded plans for 2002 and 2003 can be as

high as 120 percent of a four-year weighted average of 30-year Treasury interest

rates. Not only have the single-sum rate (the 30-year Treasury rate) and the maximum permissible funding rate been different, but the relationship between them

has varied from year to year as the four-year weighted average has changed and

as Congress reduced the maximum funding rate from 110 percent to 105 percent

of the four-year weighted average over a five-year period before increasing it temporarily to 120 percent of that average.

It is appropriate that the rates for these different purposes be different, and that

the lump sum rate be a more conservative rate. Employees and employers have different needs and different capacities to bear risk. In particular, an employer is in

a different position in relation to the risk that interest rate volatility will increase

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1 By contrast, employers’ choices are more sensitive to such differences because their funding

and other calculations are aggregate in nature, often covering thousands of employees over

many years.

plan liabilities than an employee is in when confronting the risk that interest rate

volatility will reduce her single-sum benefit below its anticipated level. Employers

often can compensate for uncertainties in the market by funding more in advance

and, if the plan’s funded status deteriorates, by contributing more to make up for

that after the fact.

By contrast, employees nearing retirement—who are counting on a single sum of

a specific value based on disclosures received from the plan—need greater protection

from the risk that a rise in rates will reduce the benefit they have reasonably been

expecting. Older employees in particular may not have sufficient time to adjust to

a benefit reduction. And as plans provide employees more and improved disclosure

of expected single-sum and other benefit values, employees will tend to place increasing reliance on the expected level of their benefits.

In recent times, we are seeing all too graphically the effects of market risk on individual employees’ retirement benefits in defined contribution plans (particularly

where employees are not diversified because their accounts are over-concentrated in

employer stock) and in individual retirement accounts. For employees, defined benefit pension plans can provide a refuge from market risk and other investment risk.

But if the benefits in defined benefit plans—which millions of employees have been

earning over many years—are reduced during the low points in the business cycle,

when markets and plan asset values are down, that would undermine the risk protective function of these plans—one of the principal virtues of the defined benefit

system.

There is no good time to cut pension benefits; but in a sense the worst time to

do so in defined benefit plans is at a time like this, when employees have suffered

major declines in their 401 (k) and IRA balances and when the interest rates and

other returns they can expect from investing pension distributions are so low. Low

interest rates for determining single-sum distributions are not out of line with the

low interest rates available to individuals on their investments outside of qualified

plans.

Lower Single-Sum Rates Are Consistent With Good Pension Policy

Some argue that lump sum interest rates should be increased significantly so as

to reduce the value of lump sums and thereby discourage employees from electing

them. The theory is that reducing lump sums would promote retirement security by

discouraging employees from choosing lump sums. But national pension policy

should enhance retirement security by minimizing ‘‘leakage,’’ or cash-outs, of benefits from the pension system, rather than reducing the value of employees’ singlesum benefits. In fact, by preserving larger lump sums, individuals will ultimately

realize greater retirement security. The notion that reducing the lump sum calculation will indirectly discourage such payments—and that fewer single sums mean

greater preservation of benefits—glosses over a number of important realities in the

pension system.

First, in many cases, employees have no choice between a single-sum payment

and annuity or other benefits. Involuntary lump-sum cash-outs of benefits that do

not exceed $5,000 in present value represent a very substantial percentage of all

single-sum distributions. These payments are chosen not by employees, but by employers. Paying involuntary lump sums allows plan sponsors to reduce costs by no

longer paying PBGC premiums for the cashed-out employees and by saving the administrative cost of maintaining the benefits and related records. When an employee

receives a single-sum payment, whether voluntarily or otherwise, the cost of maintaining those assets shifts to the employee (such as the cost of investing and administering the assets in an IRA or taxable account). Indeed, this shift of cost to the

individual is yet another reason the more conservative Treasury bond rate is the

appropriate benchmark.

Increasing the lump sum interest rate would also shift the benefits of more employees below the $5,000 threshold, thereby subjecting more employees to involuntary cash-out. Indeed, it is these small lump-sum distributions that are the ones

that are most often consumed instead of rolled over to another plan or IRA.

Second, when employees do have a choice between an annuity and a singlesum

benefit, it is not at all evident that their choices are particularly sensitive to incremental differences in actuarial value, as opposed to other factors that create a highly uneven ‘‘playing field’’ between annuities and single-sum options.1 These other

factors—which might favor or disfavor the single sum—include:

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2Defined benefit plan sponsors that offer single-sum distributions generally are not required

to do so, just as they are not required to make single-sum cashouts of small benefits; they choose

to do so. 3 In fact, plan sponsors’ interest in offering single-sum distributions—whether responding to

or stimulating employee interest in single sums, or some of both—has been one of the motives

for the widespread conversion of traditional defined benefit plans to cash balance plans. Many

cash balance plans present the single sum to employees as the presumptive form of benefit. And

cash balance plans, far more often than traditional defined benefit plans, typically offer lump

sums at termination of employment as opposed to only at retirement age. Accordingly, cash balance participants ordinarily decline the annuity (which the plan is required to offer) in favor

of the lump sum.

• the tendency of many employees to prefer large, immediate cash payments

(without regard to any mathematical comparison of the actuarial values of the

single-sum and annuity options); • the inclination of some employees to prefer a single sum because of the belief

that funds invested outside the plan would earn larger returns than any growth

that might occur if some or all of the benefits remained in the plan (again without regard to actuarial comparisons); • the current environment, where an annuity guaranteed for life may be more

preferable because it will always tend to be more secure than a single-sum payment, which might diminish in value if the employee invested it outside the

plan (again without performing or studying actuarial comparisons); • the fact that some plans heavily subsidize early retirement annuities but not

singlesum options, so that the early retirement annuity has a significantly

greater actuarial value than the single sum; • the expectation of an employee who is in ill health that his or her life expectancy will be brief and that a single sum payment is therefore preferable almost

without regard to the comparative actuarial analysis; or

• the wide differences in the availability of single-sum options among defined benefit plans sponsored by various employers—some offering no single sums (with

the possible exception of involuntary cashouts), others offering single sums only

at retirement age, and others offering single sums upon termination of employment at any age 2; and

• the strong tendency of hybrid plan designs, which portray the single sum as the

presumptive form of benefit, to move people to a single-sum payment (in fact,

the hybrid plan design may well become the most dramatic new factor promoting a shift from annuities to lump sums).3

Factors such as these generally overwhelm the effect a particular level of interest

rate will have on the likelihood that a given individual will opt for a single sum

as opposed to an annuity. Employees choosing between lump sums and annuities

do not generally think or behave like actuaries. This is further evidenced by the fact

that it is not unusual for participants in traditional defined benefit plans to choose

unsubsidized lump sums over subsidized early retirement annuities, even when the

latter are actuarially far more valuable. Such plan designs are not uncommon, and

are yet another reason why interest rates for lump sum purposes can reasonably

be lower than the rates that apply for plan funding purposes.

Reduced Lump Sum Amounts May Encourage Plans to Offer Lump Sum Option

Lower interest rates for determining single-sum options, which result in larger

single-sum amounts, may discourage at least some plan sponsors from offering single-sum options. Conversely, legislation increasing the level of the interest rate

benchmark for computing single sums would likely have the effect of increasing the

number of plans offering single sums (and the number of plans offering single sums

at termination of employment instead of only at early retirement age) by making

single sums less costly for the plan. (This is in addition to generating more nonconsensual single-sum payments by pushing more employees below the involuntary

cash-out threshold, as discussed above.) As a result, such a change would not only

reduce lump sum benefits across the board, but may result in even greater leakage

from the defined benefit system.

Single-Sum Payments Should Not Always be Avoided

It is not even so clear as a general proposition that single-sum payments are to

be avoided because they necessarily promote more leakage of benefits. Many pension

distributions are made when employees leave their jobs before reaching retirement

age. At such a point in an employee’s life, a single-sum payment might be the best

choice from a policy standpoint, provided it was rolled over to another employer plan

or IRA. By contrast, an immediate annuity could begin the consumption of retirement savings before retirement age; and leaving the benefit in the former employVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00093 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
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4The Pension Practice Council of the American Academy of Actuaries has stated that ‘‘[I[f participants can elect lump sums (generally determined using a 30-year Treasury rate or a possibly

lower plan rate), then plans should be allowed to use that lump sum interest rate in determining liabilities.’’ Parks, J. and Gebhardtsbauer, R., American Academy of Actuaries, Alternatives to the 30-Year Treasury Rate), July 17, 2002, page 8, n15. The actuaries suggest revising IRS Notice 90–11 ‘‘to allow the actuary to determine a plan’s liabilities reflecting expected

lump sum amounts for that percentage of participants who are expected to elect lump sums. . .

.’’

er’s traditional defined benefit plan might well cause the value of the benefit to

erode with inflation. While a single sum is the form of payment that is most at risk

to be consumed before retirement, it is also the form that may best serve the preservation of retirement savings through the rollover of such funds. Again, it is not the

lump sum that should be avoided, but the premature consumption of those funds

prior to retirement. In fact, larger lump sums, if preserved over time, will ultimately

lead to greater retirement security.

Preserving the Value of Single-Sum Benefits Need Not Cause Underfundina

Some have urged an increase in the interest rate for single-sum benefits (to an

amount equal to the annuity rate) on the ground that plans that pay single sums

will otherwise become underfunded or ‘‘defunded.’’ However, the principal problem

here appears to be constraints imposed by the IRS on the ability of underfunded

defined benefit plans to fund for projected single sums as opposed to annuities.4 One

possible solution would be to change the IRS position to clearly allow plans to fund

taking into account the size and frequency of anticipated single-sum payments.

Congress Has Other Means to Promote Preservation

Congress has more positive and more effective means of promoting preservation

of benefits than reducing benefits that are paid in single-sum form. For example,

the law can encourage annuities, rollovers, and plan-to-plan transfers, while discouraging early withdrawals that are not rolled over or transferred. We applaud the

Committee, and the leadership of Chairman Grassley and Senator Baucus, for enacting important benefit preservation measures as part of the Economic Growth and

Tax Relief Reconciliation Act of 2001 (EGTRRA). In addition to liberalizing the

availability of tax-deferred rollovers, EGTRRA, in section 657, provides for automatic rollover of involuntary cash-outs to IRAs unless distributees explicitly direct

a different disposition. (The effective date of the automatic rollover provision will

be effective pending guidance from the Department of Labor.) Such changes, strongly supported by AARP, are the types of changes that will promote preservation without reducing benefits.

Interest Rate Policy Should Address Needs of Both Employers and Employees

Plan sponsors have valid concerns about their funding obligations, particularly following Treasury’s decision to stop issuing the 30-year Treasury bond. At the same

time, employees have a valid interest in the preservation of their benefits, including

those that take the form of a single-sum payment. This point was made repeatedly

and forcefully to Congress by constituents receiving single-sum payments after enactment of GATT and the Retirement Protection Act, which reduced single-sum payments by raising the statutory interest rate. Aggrieved pension participants blamed

Congress and the Executive Branch for not only the portion of the reduction in single sums that was attributable to the legislative change, but also the portion of the

reduction that was attributable to the rise in interest rates that occurred shortly

after the legislation was enacted. We can once again expect a similar reaction from

participants whose lump sums have been reduced by an act of Congress.

Conclusion

While employer plan funding concerns are important, Congress must also recognize the needs of individuals. The conservative 30-year Treasury rate is an appropriate single sum benchmark that recognizes the shift of risk and cost to the individual and a rate consistent with the 30-year Treasury rate should be maintained.

Should Congress deem it appropriate to provide funding relief to plan sponsors, that

relief should not come at the expense of reductions in individuals’ guaranteed benefit amounts. This is particularly true at a time when employees are already struggling with significant declines in their personal and retirement savings accounts.

Congress should therefore prescribe different interest rates for these different purposes to address the legitimate needs of both employers and employees.

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STATEMENT OF JAY HINZE

Dear Chairman Grassley,

I would like to take this opportunity to provide a written statement for record regarding the U. S. Senate Committee on Finance hearing on 3–11–03 ‘‘The Funding

Challenge: Keeping Defined Benefit Pension Plans Afloat’’.

I am concerned about the lack of balance of witnesses during the hearing. Clearly

the voices of the American Academy of Actuaries, the American Benefits Council,

the ERISA Industry Committee and the Pension Benefit Guarantee Corporation are

one sided. Their voices were balanced by a lone opposing view—a pilot for U. S. Airways.

As a 28 year employee of Owens Corning I would like my voice to be heard. I

think I speak for millions of workers around the country who are concerned that

pension rules will be changed to benefit corporations at the expense of pensioners.

These industry lobbyists are colluding to change the pension interest rate benchmark from the 30-year treasury bond rate claiming that this rate is artificially high.

This rate is governed by the free market just as the stock market, real estate market, gold and bond market. In fact this rate has increased by about 0.03 percent

since your hearing last week based upon free trade.

The lobbiest claim that retiring employees will take the lump sum distribution

jeopardizing the future of the retiree and his spouse. The reality is that retirees will

invest the money in the companies these representatives are trying to save. It is

far more risky to take the annuity—especially if that annuity is not fully insured

by the PBGC.

Corporate leaders have got their pension plans in trouble by making very unrealistic assumptions about the returns of their plans. High expected returns have enabled them to under fund their plans. Even today rates of over 9 percent are being

used in their forecasts. As a result companies can artificially inflate their income

to lure investors. We are all feeling the pain of poor stock market performance.

What average pensioner would use a rate of 9 percent this year to forecast his retirement income?

Chairman Grassley, I have seen my 401 K investment in Owens Corning stock

go from $40/share to $0/share due to our bankruptcy filing. I have lost much of my

401 K investment. A few years ago Owens Corning changed its pension from a defined benefit plan to a defined contribution plan. Although I was ‘‘grandfathered’’

under the old plan, this plan was frozen in 2000 costing my pension thousands of

dollars.

The lobbyists at your hearing would like to strip my pension further by changing

the benchmark 30-year treasury to a 30 Corporate rate. According to the statements

made during your hearing, this would save corporations about 20 percent. When

considering their proposal remember that this savings will come at the expense of

workers. It will especially hit workers like me who are within 2 years of retirement—I would need to work 4 more years to make up for this loss in my pension.

I ask that you turn down the proposals by the lobbyists. Thank you for listening

to my point of view.

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STATEMENT OF MICHAEL PESKIN

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STATEMENT OF RYAN LABS INC.

[SUBMITTED BY RONALD J. RYAN, PRESIDENT]

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STATEMENT OF JEREMY GOLD

STOP THE INSANITY!

At the 2002 Enrolled Actuaries Meeting, Donald Segal and Tonya Manning asked

ERISA authorities to ‘‘Stop the Insanity.’’ In the authors’ response to comments on

our article ‘‘Reinventing Pension Actuarial Science,’’ Larry Bader and I have said

that funding rules require societal, or political, judgments. In this article, I try to

identify and thereby confine, the public’s interest in defined benefit plan funding.

Thus, for the time being, I put aside the pursuit of a new theory of pension actuarial

science in favor of a practical proposal to Stop the Insanity.

As Segal and Manning have documented, twenty-nine years of ERISA have resulted in a chaotic deluge of overlapping, often contradictory, measurements and reVerDate 11-MAY-2000 10:33 Sep 16, 2003 Jkt 000000 PO 00000 Frm 00146 Fmt 6601 Sfmt 6621 88593.000 SFINANC2 PsN: SFINANC2
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strictions designed to regulate the funding of qualified defined benefit plans for U.S.

employees. We may understand such rules as the expression of the public’s interest

in what otherwise would be a matter of private contracts between employers and

employees. I do not contest the legitimate public interest in these matters but I

would like to see if we can do the public will in a fashion that will Stop the Insanity.

Public interest in the funding of private defined benefit plans comprises two

issues:

• Funding should be sufficient to secure promises that have been made by employers and earned by employees—i.e., accrued benefits.

• Tax-deductible contributions should be limited. Such limitation may also be defined in relation to the value of accrued benefits.

The public does not have an interest in:

• Patterns of contributions over time, although this may be important to plan

sponsors and their constituents.

• Normal costs.

• Gain and loss amortization.

• Past service costs and amortizations.

• Interest on liabilities.

• Expected returns on assets.

I believe that the six bullets above, the basics of the traditional actuarial funding

processes that underlie ERISA, contribute to the Segal-Manning Insanity. PreERISA, these components helped the actuary rationalize the sponsor contribution

budgeting process. When the public chose to intervene, it framed the problem in

terms of these components and attempted to control funding outcomes by controlling

these inputs. Much of the insanity arose in response to undesirable outcomes. Thus,

for example, the PBGC saw the need to define and measure the Current Liability

after plans that met ERISA’s minimum funding rules failed to achieve adequate

funding levels.

My Sane proposal defines two simple limits: a minimum (sufficiency level) below

which contributions are required and a maximum (excess level) above which no contributions are allowed. Between these levels, the public has no interest and plan

funding is entirely discretionary. Actuaries may design funding schemes therein,

employers may negotiate with employees and their representatives therein, stockholders and lenders may argue with management therein. The public does not care.

My proposal is the ultimate safe harbor. Within the harbor, actuaries and plan

sponsors may use the elemental actuarial building blocks much as a sailor uses the

tiller and the positions of sails to guide a boat. As long as the boat neither runs

aground nor heads out to the open sea, the Coast Guard can rest easy.

The public must choose its measures of sufficiency and excess very carefully. Although setting the levels will be inherently political, the liability measure should

be financially sound, transparent, and objective. Discounting the cash flows implied

by benefit accruals to date at the Treasury yield curve meets these tests. Once set,

the measures should be administered with minimal discretion and subjected to

minimal political interference. Most of the political debate should be focused on setting the heights of the lower (sufficient) and upper (excessive) bars, each defined in

terms of the ratio of market-valued assets to the objective liability measure.

Suppose, and I really mean this as an example and not as a recommendation, that

the lower bar is set at 100 percent and that any shortfall must be one-third funded

currently. The shortfall has no history and no amortization schedule. If the plan is

three million dollars short, the sponsor must fund one million dollars currently regardless of whether it was underfunded or overfunded last year. There is no schedule for the other two million. If the plan remains underfunded next year, the sponsor must contribute one-third of the shortfall determined at that time. I would expect PBGC premiums to be collected from all qualified plans with a basic per-capita

amount for plans that are sufficiently funded and increased amounts for plans in

shortfall. Shortfall plans might be further restricted from making benefit increasing

amendments.

The tradeoff for the rigorous attack on poorly funded plans is the freedom offered

to the great majority of wellfunded plans. This combination should provide substantial incentive to sponsors to manage the asset/liability positions of their plans prudently as well as to exercise caution in granting benefit increases.

Suppose, again an example not a recommendation, the upper bar is set at 150

percent. The sponsor of a plan that is one million dollars short of this ceiling would

be permitted to contribute and deduct one million dollars if it desired. From the

public perspective, it seems to me that plans funded above the upper bar should be

free to recoup such excess funding without excise taxes and without strings on the

redeployment of such monies (after payment of appropriate income taxes). The IRS

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may want to limit this practice for companies that appear to be taking undue advantage.

The initial bar-setting process may be as technically complicated and as political

as the public will choose to demand/tolerate. Congress will be the arena for the barsetting process; the regulatory agencies will administer that which Congress devises. Congress might choose to assign authority for lower-bar issues to the DOL

and the PBGC and upper-bar issues to the IRS.

An example of a technical, complicating issue that lies within the initial process:

those who share my financial economics perspective may want the lower bar to be

set to recognize the nature of the plan’s asset/liability mismatch. Plans invested in

a liability-matching fashion might have a lower bar set at 95 percent, while poorly

matched plans might face a bar set at 115 percent.

A second example: if the IRS is concerned about excessive inside build-up as well

as excessive contributions, they may wish to define an upper-upper bar above which

funds would be mandatorily reverted and taxed. The IRS may also deem it necessary to limit tax deductions for small plans that principally serve as tax shelters

for owneremployees or other narrow groups.

I have tried to suggest a practical response to the Segal-Manning plea for sanity.

The success of such a simplification scheme requires that:

• The basis for liability measurement be scientific, objective and market oriented.

The thumb should be off the scale with respect to measurement.

• Setting the levels of the lower and upper bars should be as simple as possible,

but no more so.

Looking beyond the immediate and practical, I hope that the inner harbor will

provide substantial room for pension actuarial science to evolve, free of much of the

regulation that has stunted its growth over the last three decades. We really do

need to revisit and revitalize our science.

Æ