FYI: An Update on Emerging Issues in Banking

Could a Bull Market Be a Panacea for Defined Benefit Pension 

Plans?

January 13, 2004

Overview

Declining stock valuations, a sustained period of low interest rates, structural changes 

in the workplace, and a regulatory and accounting structure in need of reform have 

coalesced into a "perfect storm" for U.S. corporate defined benefit pension plans. Even 

though the stock market recently has rebounded, the Pension Benefit Guaranty 

Corporation (PBGC) estimates that U.S. pensions in defined benefit plans were 

underfunded by more than $350 billion as of September 15, 2003.

The PBGC was created by the Employee Retirement Income Security Act of 1974 

(ERISA) to protect retirement benefits of American workers in private defined benefit 

pension plans. The PBGC insures more than 32,000 private defined benefit pension 

plans valued at an estimated $1.5 trillion, but the cushion to protect these plans has 

eroded. The value of the agency's single employer insurance program declined 

dramatically from a $9.7 billion surplus in 2000 to an estimated $8.8 billion deficit in 

August 2003 (see Chart 1 below).

The erosion in PBGC's cushion was caused by several factors, including losses 

sustained by the assumption of several large plans, the negative effects of a 

depressed stock market on defined benefit pension plan asset valuations, and pension 

liabilities that have increased because of low interest rates. According to the PBGC, 12 

years of premiums, at current premium levels, would be required to cover claims from 

2002 alone. Other long-term problems adversely affecting the PBGC include a 

declining base of participants in defined benefit plans and a resulting concentration in 

traditional manufacturing firms that face stiff global competition. Due to the severity of 

the problem, the General Accounting Office placed PBGC's single insurer program in 

the "high risk" category in July 2003, adding it to the list of government programs in 

need of urgent attention. 1

A short-term solution to some problems with pension funding rules has been passed 

by the U.S. House of Representatives and will be considered by the U.S. Senate early 

in 2004. This short-term solution involves replacing the thirty-year Treasury rate 

currently used to discount pension funding obligations with a blend of corporate bond 

rates for two years. Since corporate bond rates are higher than Treasuries, this 

proposal will lessen pension liability in the short term. There is widespread recognition 

that reform is needed to address the long-term fundamental challenges facing defined 

benefit pension plans and the PBGC. However, a consensus for change has not 

developed among key stakeholders, including Congress, the accounting profession, 

business leaders, and labor. 

This report describes the serious challenges and outlook facing the PBGC and 

corporate defined benefit pension plans, and examines the effects on financial 

institutions insured by the FDIC. Defined benefit pension problems can affect the 

competitiveness and cash flow of sponsoring companies, some of which borrow from 

FDIC-insured institutions.
high-risk plans are classified as reasonably possible." The definition of high-risk 

plan is based on several criteria, including Chapter 11 bankruptcy of the sponsor.

19 McKinnon, John D. "Pension Agency Warns Against Corporate Relief," The Wall 

Street Journal Online, November 12, 2003.

20 Dale, Arden. "FASB Keeps Existing Format For Corporate Pension Data," The 

Wall Street Journal Online, November 11, 2003.

21 Hewitt Associates, "Regulatory Uncertainty Eroding Employer Support for 

Pension Plans, Hewitt Study Shows," January 6, 2004, press release.

22 Brandon, George. "Companies to Get Relief on Pension Contributions," 

Kiplingerforecasts.com, December 31, 2003.

23 SNC is a program operated jointly by federal bank and thrift supervisors that 

seeks to provide an efficient means of reviewing large, syndicated credits. SNC 

credits reviewed included a mix of companies, some of which sponsor defined 

benefit pension plans.

24 Flanagan, Terrence. "General Motors Debt Rating Lowered; Ford May be Cut," 

Bloomberg, October 17, 2002.

25 Shirouzu, Norihiko and Joseph B. White. "S&P Downshift Ford's Debt Rating -

Move Reflects Skepticism About Big 3," The Wall Street Journal, November 13, 

2003.

26 Manor, Robert and Christopher Steiner. "Steel Mill Retirees Feel Pinch From 

Caps," Chicago Tribune, November 5, 2003.

About FYI

FYI is an electronic bulletin summarizing current information about the trends that 

are driving change in the banking industry, plus links to the wide array of other 

FDIC publications and data tools. 

Disclaimer

The views expressed in FYI are those of the authors and do not necessarily reflect 

official positions of the Federal Deposit Insurance Corporation. Some of the 

information used in the preparation of this publication was obtained from publicly 

available sources that are considered reliable. However, the use of this 

information does not constitute an endorsement of its accuracy by the Federal 

Deposit Insurance Corporation.

Last Updated 01/13/2004
D

Role of the PBGC

The PBGC guarantees benefits in most private sector defined benefit pension plans, 

including cash balance plans. It does not guarantee defined contribution plans, federal 

or state pension plans or executive-only pension plans, pension plans of foreign 

workers, and small professional pension plans (fewer than 25 participants). The 

number of single-employer defined benefit plans insured by the PBGC has declined 

substantially, from 112,000 in 1985 to 30,600 in 2002.2 Since the 1980s, many 

corporations have shifted away from defined benefit plans and into defined 

contribution plans, seeking to transfer the liability for retirement saving to workers and 

retirees. 

Types of Pension Plans

Defined Benefit Plans

refer to a traditional 

pension plan in which a 

company offers certain 

payment during retirement 

based on some formula 

that usually includes years 

worked and salary.

Defined Contribution 

Plans, such as 401(k) 

plans, feature a 

contribution from the 

company and/or employee, 

and the payment at 

retirement will vary 

depending on how much 

money has accumulated 

over the course of a 

career.

Cash Balance Plans are 

a hybrid, although they 

are technically 

categorized as defined 

benefit plans. Typically, 

cash balance plans credit 

workers with a percentage 

of pay each year plus 

interest. At retirement, the 

benefit can be converted 

to a lump sum payment or 

an annuity.

The PBGC operates two programs. The Single Employer fund is the largest with 

assets of $25.4 billion as of year-end 2002 and an estimated net position (assets less 

liabilities) of negative $8.8 billion as of August 31, 2003. The MultiEmployer fund

holds assets of $944 million and has a net position of $158 million for the same 
period.3 The PBGC protects plan assets valued at approximately $1.5 trillion.

Insurance premiums paid by the participating defined benefit pension plans, 

investment income from assets, and assets acquired from failed pension funds are the 

PBGC's primary funding sources. However, these income sources have not kept pace 

with the growth in pension claims or in pension underfunding. While the PBGC has a 

borrowing line with the U.S. Treasury, currently it is only $100 million.

The Magnitude of the Problem

According to data provided in a Federal Reserve study, all U.S. pension plans lost an 

estimated $1 trillion during the recent downturn in the stock market.4 Even so, 

pensions are an important part of the household asset mix. To put the importance of 

pension assets in context, Gary Shilling, President of A. Gary Shilling & Company, 

reports that all U.S. pension assets represented well over 100 percent of disposable 

income in 2002.5

As a result of defined benefit pension fund asset erosion, several firms have 

terminated their plans, and many others have become significantly underfunded. The 

Federal Reserve study found that 353 of the S&P 500 corporations had defined benefit 

pensions at year-end 2002; ninety-one percent of these plans were underfunded by an 

aggregate $222 billion. Moreover, defined benefit plans sponsored by several large 

corporations – for example, Delta Airlines, Goodyear Tire, General Motors (GM), and 

McDermit International – at one time reported funding gaps in excess of their 2002 

market capitalization.

The PBGC sustained the largest one-year financial loss in its 28-year history in 2002, 

primarily due to record losses from completed and probable plan terminations. 

According to the agency's 2002 annual report, financially weak companies sponsored 

plans with $35 billion in unfunded vested benefits as of year-end 2002. About half this 

$35 billion represented underfunding in the troubled airline and steel industries. By the 

end of fiscal year 2003, the amount of defined benefit plan underfunding in financially 

troubled companies could more than double, possibly exceeding $80 billion.6

Pension Plan Obligations Can Hurt Corporate Cash Flow and Competitiveness

The U.S. automobile industry shows the effects of higher pension costs on the bottom 

line. The results of a Prudential Financial study state that pension and retiree benefits 

represent $631 of the cost of every Chrysler vehicle, $734 of the cost of every Ford 

vehicle, and $1,360 of the cost of every GM car or truck.7 In contrast, an article in the 

Detroit Free Press reported that pension and retiree benefit costs per vehicle at the 

U.S. plants of Honda and Toyota are estimated to be $107 and $180, respectively.8

An article in Bloomberg Markets points to a report by an automotive industry analyst 

with UBS Securities indicating margins for GM and Ford have fallen from 8 percent 

during the 1950s to 3 percent in 2002 and are likely to decline further as foreign 

companies expand product offerings.9 In such a low margin business, retiree costs 

significantly impact a company's cash flow and competitiveness. Indeed, this article 

notes that GM recently has used about $13 billion of a $17.6 billion debt offering – the 

largest ever made by a U.S. company – to help close its pension gap.10 On average, 

GM will pay a 7.54 percent yield on the debt, and hopes to earn 9 percent on the 

proceeds contributed to its pension fund.11 While cash flow requirements have been 

eased for now, if this long term expectation regarding returns proves problematic over 

time, GM will need to find other sources to pay their obligation.

Concerns on Both Sides of the Balance Sheet Challenge Pension Plans

Pension asset allocations are heavily weighted to equities. According to the PBGC, the 

typical U.S. defined benefit plan holds 63 percent of assets in equities, 30 percent in 
fixed income, and 7 percent in other assets. In comparison, the PBGC points out that 

insurance companies that act as trustees for pension type annuities typically hold 4 

percent in equities, 87 percent in fixed income, and 9 percent in other assets, clearly a 

more conservative mix.

The pension investment mix contributes to the volatility of defined benefit pension fund 

balances. Heavy equity positions were favorable for sponsoring companies during the 

unprecedented stock market gains of the 1990s. In fact, PBGC reports that plan 

sponsors made very little in the way of cash contributions between 1995 and 1999, 

relying instead on investment returns to fund pension contributions. However, when 

the stock market began its slide in 2000, asset values dropped markedly. Of particular 

concern were declines in the value of defined benefit pension plan assets in funds 

sponsored by companies in troubled industries, where earnings were not sufficient to 

make up the shortfall.

Some have argued that the stock market decline was an anomaly, and that the stock 

market's solid performance in 2003 and thus far in 2004 will buoy asset values and 

income. Indeed, a recent Wall Street Journal article emphasizes that because of 

stock market performance and an intersection of accounting and tax rules, companies 

currently have an incentive to put money in their defined benefit pension plans.12

However, while there has been a "bounce" in asset values and income from an 

improving stock market, again, it may be unrealistic to expect that the stock market will 

experience the extraordinary level of returns of the 1990s over the long term.13

There appears to be little in the way of short-term improvements to problems on the 

liability side of pension plan balance sheets. The sustained period of low interest rates 

has increased the present value of plan benefit obligations because more money has 

to be invested at the lower rates to pay future obligations. Moreover, structural 

changes in the workplace present unique challenges to pension plans and the PBGC. 

For instance, longer life expectancies have lengthened retirement, requiring greater 

payouts that will heighten plan benefit obligations.14 Also, traditional manufacturing 

industries face higher pension and health care costs due to an increasing number of 

older and retired workers. In fact, retirees already outnumber active workers in some 

old-line industries, such as steel. 

In general, there has been a shift in U.S. industry away from heavy manufacturing to 

service and knowledge-based companies. These "new economy" companies and their 

workers tend to prefer the flexibility and lower variable costs associated with other 

retirement planning tools, such as defined contribution plans and stock benefit plans. 

This has shrunk the pool of defined benefit plan participants leading to a concentration 

in plans operated by traditional manufacturers.

Regulatory and Accounting Rules May Exacerbate Underfunding

During recent Senate testimony, PBGC's Executive Director, Steven Kandarian, 

outlined what his agency believes are weaknesses in funding rules that have 

contributed to the current underfunding problem.15 PBGC considers the reform of 

these rules critical to a resolution of current problems. 

According to Mr. Kandarian, funding targets are set too low. Employers can stop 

making contributions when the defined benefit plan is funded at 90 percent of "current 

liability." The "current liability" calculation assumes a going concern valuation of assets 

and liabilities that can deviate substantially from the actual value when the plan is 

terminated. Additionally, the thirty-year Treasury rate (an instrument that is no longer 

issued) is used to discount the liability, rather than a rate that reflects the actual cash 

flow that will be needed to pay pension benefits according to actuarial assumptions. As 

a result of using a current liability calculation and a discount rate that does not match 
cash flows, risk to the PBGC may be understated. For example, according to the filing 

with the PBGC just prior to plan termination, the US Airways pilots' plan self-reported 

that it was 94 percent funded on a current liability basis. At termination, however, it 

was found to be only 35 percent funded on a termination basis, underfunded by $2.2 

billion.16

Under current pension regulatory rules, most companies pay the same premium rate, 

regardless of financial condition, although PBGC has a limited "variable" premium 

system applicable only to underfunded plans. The PBGC has expressed a preference 

to move to something similar to the FDIC's risk-based premium system whereby rates 

would be based on the type and level of risk posed by each plan to the pension 

system as a whole. Without reform, some caution that healthy companies with wellfunded plans may elect to leave the PBGC system over time (a situation termed 

"adverse selection"), rather than subsidize poorly funded plans. If such an exodus 

were to occur, it could cause future revenue shortfalls and concern for the PBGC's 

long-term viability.

The Financial Accounting Standards Board (FASB) issued FASB Statement No. 132 

(Employers' Disclosure about Pensions and Other Postretirement Benefits) on 

December 23, 2003. The standard requires that companies provide more details about 

their plan assets, benefit obligations, cash flows, benefit costs, and other relevant 

information. 

Very recently, some companies have been contributing large amounts to their defined 

benefit pension plans. Controversial accounting rules allow companies to use 

expected, rather than actual, rates of return to measure how pension plan funding 

affects earnings.17 These rules contribute to pension funding volatility as they provide 

an incentive to companies to fund pensions when it is advantageous to the corporate 

bottom line, rather than when pension plans need funding. However, the availability of 

this expected rate of return accounting treatment may not continue into the future. In 

its September 2003 Exposure Draft that preceded FASB Statement 132, the FASB 

indicated that while measurement and recognition are not being addressed at this 

time, a future project covering those areas is being considered. 

Current Reporting Requirements and Oversight of Pension Funds are Limited

Complex defined benefit pension fund accounting rules and regulations can materially 

affect company earnings and balance sheets; yet a clear understanding of a 

company's pension activity is often difficult to determine from financial statements and 

accompanying notes. FASB 132 should improve financial reporting going forward, but 

regulatory reporting requirements remain problematic.

For its part, the PBGC receives beginning of year asset and liability figures from most 

insured plans unless the plan becomes severely underfunded. However, this 

information can be significantly dated. Current pension regulations allow plan sponsors 

to report asset information as late as nine and one-half months after year-end to the 

Department of Labor. By the time the PBGC receives the information, liability 

information is almost two years old. As mentioned, another concern is that the liability 

information is reported on a current liability basis, rather than the termination basis, 

which would provide a much more accurate assessment of actual liability the PBGC 

would incur if required to take over a plan.

Moreover, defined benefit plans self report when they become underfunded. When 

underfunded plans sponsored by an employer exceed $50 million, additional reporting 

is required. Nevertheless, the PBGC has limited ability to make a routine independent 

assessment of each insured pension fund until the fund's financial condition becomes 

problematic. Once a pension fund has been identified as a "Probable" or "Reasonably 
Possible" claim, PBGC's Early Warning system staff will try to negotiate funding 

improvements or other protections if they think such actions are warranted.18 However, 

the PBGC has little in the way of enforcement authority, other than the ability to 

terminate the plan and act as trustee of the assets.

Once a plan is taken over by the PBGC, new rules apply, including maximum annual 

pension payout limits ($43,977 for 2003) that may reduce the benefits that employees 

were expecting to receive. Importantly, the liability incurred is not a sum certain value.

Rather, the PBGC is responsible to pay a retirement annuity for the rest of the 

participant's life, a significant obligation. Ultimately, pension liability relies on numerous 

assumptions, including employee retirement age, future compensation, and mortality, 

as well as discount rates and investment returns. 

Plans Would Address Short-Term Underfunding of Defined Benefit Pensions 

Certain industries, airlines in particular, with concentrations of underfunded pensions 

are lobbying Congress for temporary relief from requirements to make up the 

shortfalls. The Wall Street Journal has reported that the White House and the PBGC 

have strongly opposed legislative relief proposals (PBGC estimates that relief as 

proposed could add $40 billion to the underfunded balance), but other lawmakers see 

some form of relief as a way to preserve the viability of pensions over the long term.19

On October 8, 2003, the U.S. House of Representatives passed the "Pension Funding 

Equity Act of 2003" (H.R. 3108) -- legislation that would provide a two-year corporate 

bond replacement rate for the thirty-year Treasury rate.20 Since corporate bond rates 

are higher than Treasuries, this approach would lessen liability in the short term. 

However, the House bill also provides partial relief for airline companies from 

requirements to make up pension shortfalls. 

Under an agreement between the leadership of both parties, in January the Senate will 

consider a narrower version of the House bill dealing with the two-year replacement 

rate. The Senate leadership has agreed to limit amendments to this narrow bill, 

possibly speeding up the enactment of a final House/Senate compromise pension bill 

early in 2004.

The Outlook is Mixed for Pension Funds – Can the Level of Underfunding Be 

Overcome in the Long Term?

The performance of stocks and bonds is of course tied to economic and geopolitical 

developments, making it difficult to gauge pension fund asset returns. Defined benefit 

pension fund administrators may adopt a more conservative asset risk allocation that 

not only would minimize volatility, but also would make it less likely that companies 

could realize large gains, as was the case in the late 1990s. At that time, excess 

funded positions reduced pension fund contribution requirements and bolstered 

corporate earnings. 

Several scenarios also are possible on the liability side. Should interest rates rise,

defined benefit pension liabilities would decline. However, if long-term rates rise too 

rapidly, bond portfolio valuations could fall as well given the inverse price/yield 

relationship. If legislation is enacted that would mandate a change in the discount rate 

from a thirty-year U.S. Treasury rate to a corporate bond rate, underfunding might 

improve in the short run. However, unless a long-term solution is adopted that requires 

the discount rate to reflect the actuarially calculated future liability, instances in which 

pension funds fall far short of actual liabilities will continue to occur. Additionally, 

should relief from catch-up provisions be granted to one or more industries, PBGC's 

already weak financial condition would be stressed further.

As stressed companies continue to post substandard profits, management may decide 
to terminate traditional defined benefit plans and move into other employee retirement 

vehicles, such as 401(k) plans. In fact, one survey concludes that unless Congress 

and regulators provide funding relief, an estimated 21 percent of employers with 

defined benefit plans intend to freeze benefits while 17 percent would halt benefits to 

new employees.21 However, the ability of corporations to unwind or unilaterally modify 

existing retirement programs remains unclear. In one case with potentially significant 

ramifications, International Business Machines Corporation was successfully sued by 

employees that claimed the conversion in 1999 from a traditional defined benefit 

program to a cash-balance program unfairly penalized older employees. As a result, 

the Internal Revenue Service has established a moratorium on issuing determination 

letters that would approve new conversions pending the outcome of this and several 

other recent court cases. According to Kiplingerforecasts.com, the Senate Bill to be 

considered in early 2004 will also end the moratorium on conversions and resolve 

legal issues raised by two appeals court rulings.22

Implications for the Banking Industry

It is difficult to determine whether pension obligations are already adversely affecting 

corporate credit quality at banks because information on individual loans is not publicly 

available. However, the results of the 2003 Shared National Credit Review (SNC) 

indicated that, in general, the quality of large bank loans has stabilized, although 

adversely-rated loans remain at an elevated level requiring close vigilance.23 Financial 

institution examiners during the SNC Review considered pension liabilities when 

evaluating credit to companies with defined benefit plans and ensured that bankers 

were also considering this factor in underwriting decisions. 

However, pension liabilities are hurting companies' debt ratings. For instance, GM's 

long-term credit rating was lowered to two notches above junk status by Standard &

Poors (S&P) on October 17, 2002, due largely to pension liabilities.24 S&P 

downgraded Ford's long-term debt rating to just above junk status on November 12, 

2003, citing competitive pressures and a lack of pricing power stemming in part from 

pension and health care liabilities.25 Among other things, credit rating downgrades can 

result in increased borrowing costs for companies.

Pension underfunding could also have a secondary effect on consumers, particularly 

in areas with a greater share of retirees and areas with large concentrations of workers 

employed in old-line industries (e.g. auto, steel, and air transportation). Seizure of 

plans by the PBGC could reduce benefits. Retirees in these instances could have less 

disposable income that, while difficult to measure, could have something of a "ripple 

effect" on local economies. For example, The Chicago Tribune recently reported that 

hundreds of employees who took early retirement from Bethlehem Steel were shocked 

to see their pensions reduced from up to $30,000 a year to less than $18,000.26

In his October 14, 2003 testimony, PBGC Director Steven Kandarian noted that in a 

worst-case scenario, the PBGC could take on so many claims from underfunded 

pension plans that a taxpayer bailout could be the only recourse. This could weaken 

public confidence in pension funds and constrain consumer and business spending. If 

companies were required to immediately re-fund pension shortfalls, cash flows would 

be directed away from capital investment, expansion, and debt service. Old-line 

industries would be particularly hard hit, and the global competitiveness of these 

companies undoubtedly would suffer. In this scenario, the FDIC would expect that 

corporate credit quality would be affected. However, even if this very serious scenario 

does not develop, bankers and financial institution supervisors should closely monitor 

pension trends and cash flows regarding the implications of underfunded pension 

plans. 
1 According to the GAO, historically, high-risk areas have involved traditional 

vulnerabilities due to their greater susceptibility to fraud, waste, abuse, and 

mismanagement. As the GAO's high-risk program has evolved, the agency has 

increasingly used this designation to draw attention to areas associated with the 

economy, efficiency, effectiveness, and accountability of government programs 

and operations.

2 PBGC Pension Insurance Data Book 2002.

3 The multiemployer fund covers pension plans set up by collectively bargained 

agreements involving more than one unrelated employer, generally in one 

common industry.

4 "Underfunding of Private Pension Plans," Federal Reserve Bank of San 

Francisco, June, 13, 2003, 

http://www.frbsf.org/publications/economics/letter/2003/el2003-16.html. Note: the 

$1 trillion loss was calculated from 1999 to 2002.

5 Shilling, Gary. "Pension Profits Become Corporate Costs," Forum on Emerging 

Issues, October 2003.

6 Testimony by Steven A. Kandarian, PBGC Executive Director, before the Senate 

Special Committee on Aging, October 14, 2003.

7 "Analyzing The Big Three's Pension and OPEB Costs," Prudential Financial 

Research, July 15, 2003. 

8 Butters, Jamie. "UAW To Target Chrysler For Talks, Analyst Says Improved 

Benefits May Come At The Cost Of Jobs," Detroit Free Press, March 19, 2003.

9 Lippert, John. "Detroit Breakdown," Bloomberg Markets, October 2003.

10 Ibid.

11 Ibid.

12 Schultz, Ellen E., and Theo Francis. "GM, Others Boost Their Earnings By 

Pouring Billions Into Pensions" The Wall Street Journal, December 4, 2003.

13 The compounded growth rate for the Standard and Poor's 500 Index was 15.6 

percent during the 1990s, more than twice the rate during the preceding twenty 

years (1970 - 1990).

14 The PBGC estimates that the average number of years spent in retirement for 

males increased from 11.5 years between 1950 and 1955 to 18.1 years during the 

late 1990s.

15 Kandarian, Steven A., October 14, 2003.

16 Ibid. 

17 Schultz, Ellen E. and Theo Francis. December 4, 2003.

18 According to the PBGC 2002 Annual Report, "The PBGC specifically reviews 

each plan identified as high risk and classifies those plans as probable if, based 

on available evidence, PBGC concludes that plan termination is likely. Otherwise, 
Chart 1

The Value of the PBGC Single 

Employer

Program Has Declined to Historic 

Lows

(Net Position Assets Less Liabilities)

Date $ Millions

1980 -95

1981 -189

1982 -333

1983 -523

1984 -462

1985 -1,325

1986 -2,026

1987 -1,549

1988 -1,543

1989 -1,124

1990 -1,913

1991 -2,503

1992 -2,737

1993 -2,897

1994 -1,240

1995 -315

1996 869

1997 3,481

1998 5,012

1999 7,038

2000 9,704

2001 7,732

2002 -3,638

Aug2003 -8,800

Source: Pension Benefit Guaranty 

Corporation, August 2003 estimate is 

from testimony provided September 15, 

2003 to Congress.