Private Pensions: Revision of Defined Benefit Pension Plan Funding Rules Is an Essential Component of Comprehensive Pension Reform
Published: 2005-06-07T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses our recent report on the rules that govern the funding of defined benefit (DB) plans and the implications of those rules for the problems facing the Pension Benefit Guaranty Corporation (PBGC) and the DB pension system generally. In recent years, the PBGC has encountered serious financial difficulties. Prominent companies, such as Bethlehem Steel, U.S. Airways, and United Airlines, have terminated their pension plans with severe gaps between the assets these plans held and the pension promises these plan sponsors made to their employees and retirees. These terminations, and other unfavorable market conditions, have created large losses for PBGC's single-employer insurance program--the federal program that insures certain benefits of the more than 34 million participants in over 29,000 plans. The single-employer program has gone from a $9.7 billion accumulated surplus at the end of fiscal year 2000 to a $23.3 billion accumulated deficit as of September 2004, including a $12.1 billion loss for fiscal year 2004. In addition, financially weak companies sponsored DB plans with a combined $96 billion of underfunding as of September 2004, up from $35 billion as of 2 years earlier. Because PBGC guarantees participant benefits, there is concern that the expected continued termination of large plans by bankrupt sponsors will push the program more quickly into insolvency, generating pressure on the Congress, and ultimately the taxpayers, to provide financial assistance to PBGC and pension participants. Given these concerns, we placed the PBGC's single-employer program on GAO's high-risk list of agencies and programs that need broad-based transformations to address major challenges. In past reports, we identified several categories of reform that the Congress might consider to strengthen the program over the long term. We concluded that the Congress should consider comprehensive reform measures to reduce the risks to the program's long-term financial viability and thus enhance the retirement income security of American workers and retirees. More broadly, pension reform represents a real opportunity to address part of our long-term fiscal problems and reconfigure our retirement security systems to bring them into the 21st century. This opportunity has many related pieces: addressing our nation's large and growing long-term fiscal gap; deciding on the appropriate role and size of the federal government--and how to finance that government--and bringing the wide array of federal activities into line with today's world. Continuing on our current unsustainable fiscal path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security. We therefore must fundamentally reexamine major spending and tax policies and priorities in an effort to recapture our fiscal flexibility and ensure that our government can respond to a range of current and emerging security, social, economic, and environmental changes and challenges. The PBGC's situation is an excellent example of the need for the Congress to reconsider the role of government organizations, programs, and policies in light of changes that have occurred since PBGC's establishment in 1974.
section_title: What GAO Found
paragraphs: Our recent work on DB pension funding rules provides important insights in understanding the problems facing PBGC and the DB system. To summarize our findings, while pension funding rules are intended to ensure that plans have sufficient assets to pay promised benefit to plan participants, significant vulnerabilities exist. Although from 1995 to 2002 most of the 100 largest DB plans annually had assets that exceeded their current liabilities, by 2002 over half of the 100 largest plans were underfunded, and almost one-fourth of plans were less than 90 percent funded. Further, because of leeway in the actuarial methodology and assumptions that sponsors may use to measure plan assets and liabilities, underfunding may actually have been more severe and widespread than reported. Additionally, on average over 60 percent of sponsors of these plans made no annual cash contributions to their plans. One key reason for this is that the funding rules allow a sponsor to satisfy minimum funding requirements without necessarily making a cash contribution each year, even though the plan may be underfunded. Further, very few sponsors of underfunded plans were required to pay an additional funding charge (AFC), a funding mechanism designed to reduce severe plan underfunding. Finally, our analysis confirms the notion that plans sponsored by financially weak firms pose a particular risk to PBGC, as these plans were generally more likely to be underfunded, to be subject to an additional funding charge, and to use assumptions to minimize or avoid cash contributions than plans sponsored by stronger firms.

section_title: Letter
paragraphs: More broadly, pension reform represents a real opportunity to address  part of our long-term fiscal problems and reconfigure our retirement  security systems to bring them into the 21st century. This opportunity has  many related pieces: addressing our nation’s large and growing long-term  fiscal gap; deciding on the appropriate role and size of the federal  government—and how to finance that government—and bringing the wide  array of federal activities into line with today’s world. Continuing on our  current unsustainable fiscal path will gradually erode, if not suddenly  damage, our economy, our standard of living, and ultimately our national  security. We therefore must fundamentally reexamine major spending and  tax policies and priorities in an effort to recapture our fiscal flexibility and  ensure that our government can respond to a range of current and  emerging security, social, economic, and environmental changes and  challenges. The PBGC’s situation is an excellent example of the need for  the Congress to reconsider the role of government organizations,  programs, and policies in light of changes that have occurred since  PBGC’s establishment in 1974.
PBGC’s challenges bear many similarities to the challenges facing our  Social Security system. Both programs have adequate current revenues  and assets to pay promised benefits for a number of years; yet, both face  large and growing accumulated deficits on an accrual basis. As a result,  timely action to address both private pension and Social Security reform is  needed. In pursuing such reforms, consideration should be given to the  interactive effects of any such reforms and how they contribute to  addressing our nation’s large and growing fiscal challenge, key  demographic, economic and workforce trends, and the economic security  of Americans in their retirement years.
Our recent work on DB pension funding rules provides important insights  in understanding the problems facing PBGC and the DB system. To  summarize our findings, while pension funding rules are intended to  ensure that plans have sufficient assets to pay promised benefit to plan  participants, significant vulnerabilities exist. Although from 1995 to 2002  most of the 100 largest DB plans annually had assets that exceeded their  current liabilities, by 2002 over half of the 100 largest plans were  underfunded, and almost one-fourth of plans were less than 90 percent  funded. Further, because of leeway in the actuarial methodology and  assumptions that sponsors may use to measure plan assets and liabilities,  underfunding may actually have been more severe and widespread than  reported. Additionally, on average over 60 percent of sponsors of these  plans made no annual cash contributions to their plans. One key reason  for this is that the funding rules allow a sponsor to satisfy minimum  funding requirements without necessarily making a cash contribution each  year, even though the plan may be underfunded.  Further, very few  sponsors of underfunded plans were required to pay an additional funding  charge (AFC), a funding mechanism designed to reduce severe plan  underfunding. Finally, our analysis confirms the notion that plans  sponsored by financially weak firms pose a particular risk to PBGC, as  these plans were generally more likely to be underfunded, to be subject to  an additional funding charge, and to use assumptions to minimize or avoid  cash contributions than plans sponsored by stronger firms.
subsections: section_title: Background
paragraphs: In DB plans, formulas set by the employer determine employee benefits.  DB plan formulas vary widely, but benefits are frequently based on  participant pay and years of service, and typically paid upon retirement as  a lifetime annuity, or periodic payments until death. Because DB plans  promise to make payments in the future and because tax-qualified DB  plans must be funded, employers must use present value calculations to  estimate the current value of promised benefits. The calculations require  making assumptions about factors that affect the amount and timing of  benefit payments, such as an employee’s retirement age and expected  mortality, and about the expected return on plan assets, expressed in the  form of an interest rate. The present value of accrued benefits calculated  using mandated assumptions is known as a plan’s “current liability.”  Current liability provides an estimate of the amount of assets a plan needs  today to pay for accrued benefits.
The Employee Retirement Income Security Act of 1974 (ERISA), and  several amendments to the law since its passage, established minimum  funding requirements for sponsors of pension plans in order to try to  ensure that plans have enough assets to pay promised benefits.  Compliance with the minimum funding requirements is recorded through  the plan’s funding standard account (FSA). The FSA tracks events that  affect the financial health of a plan during that plan year: credits, which  reflect improvements to the plan’s assets, such as contributions, amortized  experience gains, and interest; and charges, which reflect an increase in  the plan’s financial requirements, such as the plan’s normal cost and  amortized charges such as the initial actuarial liability, experience losses,  and increases in a plan’s benefit formula.
ERISA and the Internal Revenue Code (IRC) prescribe rules regarding the  assumptions that sponsors must use to measure plan liabilities and assets.  For example, for plan years 2004 and 2005, the IRC specifies that the  interest rate used to calculate a plan’s current liability must fall within 90  to 100 percent of the weighted average of the rate on an index of long-term  investment-grade corporate bonds during the 4-year period ending on the  last day before the beginning of the plan year. Similarly, rules dictate that  sponsors report an “actuarial” value of assets that must be based on  reasonable assumptions and must take into account the assets’ market  value. This value may differ in any given year, within a specified range,  from the current market value of plan assets, which plans also report.  While different methodologies and assumptions will change a plan’s  reported assets and liabilities, sponsors eventually must pay the amount of  benefits promised; if the assumptions used to compute current liability  differ from the plan’s actual experience, current liability will differ from  the amount of assets actually needed to pay benefits.
Funding rules generally presume that the plan and the sponsor are ongoing  entities, and plans do not necessarily have to maintain an asset level equal  to current liabilities every year. However, the funding rules include certain  mechanisms that are intended to keep plans from becoming too  underfunded. One such mechanism is the AFC, introduced by the Omnibus  Budget Reconciliation Act of 1987 (OBRA ‘87). The AFC requires sponsors  of plans with more than 100 participants that have become underfunded to  a prescribed level to make additional plan contributions in order to  prevent funding levels from falling too low. With some exceptions, plans  with an actuarial value of assets below 90 percent of current liabilities are  affected by the AFC rules.
In addition to setting funding rules, ERISA established PBGC to guarantee  the payment of the pension benefits of participants, subject to certain  limits, in the event that the plan could not. Under ERISA, the termination  of a single-employer DB plan may result in an insurance claim with the  single-employer program if the plan has insufficient assets to pay all  benefits accrued under the plan up to the date of plan termination. PBGC  may pay only a portion of a participant’s accrued benefit because ERISA  places limits on the PBGC benefit guarantee. For example, PBGC generally  does not guarantee benefits above a certain amount, currently $45,614  annually per participant at age 65. Additionally, benefit increases arising  from plan amendments in the 5 years immediately preceding plan  termination are not fully guaranteed, although PBGC will pay a portion of  these increases. Further, PBGC’s benefit guarantee amount is limited to  the monthly straight life annuity benefit the participant would receive if  she were to commence the annuity at the plan’s normal retirement age.  Sponsors of PBGC-insured DB plans pay annual premiums to PBGC for  their coverage. Premiums have two components: a per participant charge  paid by all sponsors (currently $19 per participant) and a “variable-rate”  premium that some underfunded plans pay based on the level of unfunded  benefits.
The recent decline of PBGC’s single-employer program has occurred in the  context of the long-term stagnation of the DB system. The number of  PBGC-insured plans has decreased steadily from approximately 110,000 in  1987 to about 29,000 in 2004. While the number of total participants in  PBGC-insured single-employer plans has grown approximately 25 percent  since 1980, the percentage of participants who are active workers has  declined from 78 percent in 1980 to 50 percent in 2002. Unless something  reverses these trends, PBGC may have a shrinking plan and participant  base to support the program in the future.
section_title: Many of the 100 Largest Plans’ Liabilities Exceeded Plan Assets from 1995 to 2002, and Few Sponsors Were Required to Make Cash Contributions
paragraphs: From 1995 to 2002, while most of the 100 largest plans had sufficient  assets to cover their plan liabilities, many did not. Furthermore, because of  leeway in the actuarial methodology and assumptions sponsors can use to  measure plan assets and liabilities, underfunding may actually have been  more severe and widespread than reported at the end of the period.  Because of flexible funding rules permitting the use of accounting credits  other than cash contributions to satisfy minimum funding obligations, on  average 62.5 of the 100 largest plans each year received no cash  contributions from their sponsors.
Although as a group, funding levels among the 100 largest plans were  reasonably stable and strong from 1996 to 2000, by 2002, more than half of  the largest plans were underfunded (see fig. 1). Two factors in the  deterioration of many plans’ finances were the decline in stock prices and  prevailing interest rates. From 2000 to 2002, stock prices declined sharply  each year, causing a decline in the value of many plans’ pension assets. In  addition, over the sample period, 30-year Treasury bond rates, which  served as the benchmark for the rate used by plans to calculate pension  liabilities, generally fell steadily, raising current liabilities. The  combination of lower asset values and higher pension liabilities had a  serious, adverse effect on overall DB plan funding levels.
subsections: section_title: Rules May Allow Reported Funding Levels to Overstate Current Funding Levels
paragraphs: Accurate measurement of a plan’s liabilities and assets is central to the  sponsor’s ability to maintain assets sufficient to pay promised benefits, as  well as to the transparency of a plan’s financial health. Because many  plans chose allowable actuarial assumptions and asset valuation methods  that may have altered their reported liabilities and assets relative to  market levels, it is possible that funding over our sample period was  actually worse than reported for a number of reasons. These include the  use of above-market rates to calculate current liabilities and actuarial  measurement of plan assets that differ from market values.
Reported current liabilities are calculated using a weighted average of  rates from the 4-year period before the plan year. While this allows  sponsors to smooth fluctuations in liabilities that sharp swings in interest  rates would cause, thereby reducing volatility in minimum funding  requirements, it also reduces the accuracy of liability measurement  because the rate anchoring reported liabilities is likely to differ from  current market values. To the extent that the smoothed rate used to  calculate current liabilities exceeds current rates, the 4-year smoothing  could reduce reported liabilities relative to those calculated at current  market values. Further, rules allowed sponsors to measure liabilities using  a rate above the 4-year weighted average. The 4-year weighted average of  the reference 30-year Treasury bond rate exceeded the current market rate  in 76 percent of time in the months between 1995 and 2002, and the  highest allowable rate for calculating current liabilities exceeded the  current rate in 98 percent of those months. Sponsors of the plans in our  sample chose the highest allowable interest rate to value their current  liabilities 62 percent of the time from 1995 to 2002. For example, an  interest rate 1 percentage point higher than the statutorily required  interest rate would decrease the reported value of a typical plan’s current  liability by around 10 percentage points.
As with liabilities, the actuarial value of assets used for funding may also  differ from current market values. Under the IRC, actuarial asset values  cannot be consistently above or below market, but in a given year may be  anywhere from 80 to 120 percent of market asset levels. Among the plans  we examined, on average each year, 86 percent reported a different value  for actuarial and market assets. On average, using the market value  instead of the actuarial value of assets would have raised reported funding  levels by 6.5 percent each year. However, while the market value exceeded  the actuarial value of assets during the late 1990s, when plan funding was  generally strong, in the weaker funding year of 2002 market assets dipped  below actuarial assets. In 2001 and 2002, calculating plan funding levels  using market assets would have greatly increased the number of plans  below 90 percent funded each year. A similar calculation for 2002 would  have drastically increased the number of large plans below 80 percent  funded, from 6 to 24. Thus, we see some evidence that using actuarial  asset values lowered the volatility of reported funding levels relative to  those using market asset values. However, the use of the actuarial value of  assets also may have disguised plans’ funded status as their financial  condition worsened.
Two large plans that terminated in 2002 illustrate the potential effects of  discrepancies between reported and actual funding. The Bethlehem Steel  Corporation in 2002 reported that its plan was 85.2 percent funded on a  current liability basis; yet, the plan terminated later that year with assets of  less than half of the value of promised benefits. The PBGC single-employer  program suffered a $3.7 billion loss as a result of that termination, its  largest ever at the time. Similarly, LTV Steel Company reported that its  pension plan for hourly employees was over 80 percent funded on its  Form 5500 filing for plan year 2001. When this plan terminated in March,  2002, it had assets equal to 52 percent of benefits, a shortfall of $1.6 billion.
section_title: Most Sponsors of Large Plans Did Not Make Annual Cash Contributions, but Satisfied Funding Requirements through Use of Accounting Credits
paragraphs: For the 1995 to 2002 period, the sponsors of the 100 largest plans each  year on average made relatively small cash contributions to their plans.  Annual cash contributions for the top 100 plans averaged approximately  $97 million on plans averaging $5.3 billion in current liabilities, with  figures in 2002 dollars. This average contribution level masks a large  difference in contributions between 1995 and 2001, during which period  annual contributions averaged $62 million, and in 2002, when  contributions increased significantly to almost $395 million per plan.  Further, in 6 of the 8 years in our sample, a majority of the largest plans  made no cash contribution to their plan (see fig. 2). On average each year,  62.5 plans received no cash contribution, including an annual average of 41  plans that were less than 100 percent funded.
The funding rules allow sponsors to meet their plans’ funding obligations  through means other than cash contributions. If a plan has sufficient FSA  credits from other sources, such as an existing credit balance or large  interest or amortization credits, to at least match its FSA charges, then the  plan does not have to make a cash contribution in that year. Because  meeting minimum funding requirements depends on reconciling total  annual credits and charges, and not specifically on cash contributions,  these other credits can substitute for cash contributions.
From 1995 to 2002, it appears that many of the largest plan sponsors relied  more heavily on other FSA credits than on cash contributions to meet  minimum funding obligations. The average plan’s credit balance carried  over from a prior plan year totaled about $572 million (2002 dollars) each  year, and 88 percent of plans on average carried forward a prior credit  balance into the next plan year from 1995 to 2002. Not only could these  accumulated credit balances help a plan to meet minimum funding  obligations in future years, but they also accrue interest that augments a  plan’s FSA credits and further helps meet minimum funding requirements.  In contrast, annual cash contributions averaged only $97 million, in 2002  dollars. On average each year, cash contributions represented 90 percent  of the minimum required annual funding (from cash and credits).  However, this average figure was elevated by high levels of contributions  by some plans in 1995, 1996, and 2002. From 1997 to 2000, when funding  levels were generally strong, cash contributions averaged only 42 percent  of minimum required annual funding. During these years, a majority of  plans in our sample received no cash contribution.
Cash contributions represented a smaller percentage of annual minimum  required funding during years when plans were generally well funded,  indicating that in these years more plans relied more heavily on credits to  meet minimum funding obligations. In addition to large credit balances  brought forward from prior years, sponsors were able to apply funding  credits from other sources, such as net interest credits ($42 million per  plan per year, on average), and credits from the excess of a plan’s  calculated minimum funding obligation above the plan’s full funding  limitation ($47 million). Other plan events result in plan charges, which  reflect events that increase the plan’s obligations. For example, plans  reported annual amortization losses, which could result from actual  investment rates of return on plan assets below assumed rates of return  (including outright losses) or increases in the generosity of plan benefits;  these net amortization charges averaged almost $28 million in our sample.  Funding credits, offset by charges, may help satisfy a plan’s minimum  funding obligation, substituting for cash contributions, and may explain  why a significant number of sponsors made zero cash contributions to  their plans in many years.
The FSA credit accounting system provides some advantages to DB plan  sponsors. Amortization rules require the sponsor to smooth certain events  that affect plan finances over several years, and accumulated credit  balances act as a buffer against swings in future funding requirements.  These features often allow sponsors to better regulate their annual level of  contributions, compared to annual fluctuations if funding were based  strictly on yearly differences between the market value of plan assets and  current liabilities. Similarly, current-law measurement and funding rules  provide a plan with some ability to dampen volatility in required funding  caused by economic events that may sharply change a plan’s liabilities or  assets. Pension experts told us that this predictability and flexibility make  DB sponsorship more attractive to employers.
However, the FSA accounting system, by smoothing annual contributions  and liabilities, may distort a plan’s funding level. For example, suppose a  sponsor accrues a $1 million credit balance from making a contribution  above the required minimum in a year. Suppose then that this $1 million  purchases assets that lose all of their value by the following year. Even  though the plan no longer had this $1 million in assets, the sponsor could  still use that credit balance (plus interest on the credit balance) to reduce  this year’s contribution to the plan. Because of amortization rules, the  sponsor would have to report only a portion of that lost $1 million in asset  value as a plan charge the following year. Similarly, sponsors are required  to amortize the financial effect of a change in a plan’s benefit formula,  which might result in increased benefits and therefore a higher funding  obligation, over a 30-year period. Thus, even though higher benefits would  immediately raise a plan’s obligation to fund, the sponsor must spread this  effect in the plan’s FSA over 30 years. This disconnection between the  reported and current market condition of plan finances raises the risk that  plans will not react quickly enough to deteriorating plan conditions.  Further, it reduces the transparency of plan financial information to  stakeholders, such as participants, and investors.
The experience of two large plans that terminated in a severely  underfunded state help illustrate the potential disconnection between FSA  accounting and the plan’s true funded status. As stated earlier, the  Bethlehem Steel Corporation and LTV Steel Company both had plans  terminate in 2002, each with assets approximately equal to 50 percent of  the value of benefits. Yet each plan was able to forgo a cash contribution  each year from 2000 to 2002 by using credits to satisfy minimum funding  obligations, primarily from large accumulated credit balances from prior  years. Despite being severely underfunded, each plan reported an existing  credit balance in 2002, the year of termination.
section_title: Full Funding Limitation Rule May Have Allowed Some Plan Sponsors to Forgo Plan Contributions
paragraphs: Another possible explanation for the many instances in which sponsors  made no annual cash contribution regards the full funding limitation  (FFL). The FFL is a cap on minimum required contributions to plans that  reach a certain funding level in a plan year. However, the FFL does not  represent the contribution that would raise plan assets to the level of  current liability. The FFL represents a “maximum minimum” contribution  for a sponsor in a given year—a ceiling on the sponsor’s minimum funding  obligation for the plan. Between 1995 and 2002, rules permitted some  plans with assets as low as 90 percent of current liability to reach the FFL,  meaning that a plan could be considered fully funded without assets  sufficient to cover all accrued benefits. The FFL is also distinct from the  plan’s annual maximum tax-deductible contribution. Because sponsors  may be subject to an excise tax on contributions above the maximum  deductible amount, the annual maximum contribution can act as a real  constraint on cash contributions.
Flexibility in the FFL rule has allowed many plan sponsors to take steps to  minimize their contributions. In our sample, from 1995 to 2002  approximately two-thirds of the sponsors in each year made an annual  plan contribution at least as large as the plan’s FFL. However, in 65  percent of these instances, the sponsor had chosen the highest allowable  rate to calculate current liability; using a lower rate to calculate current  liability may have resulted in a higher FFL and, therefore, may have  required a higher contribution. Further, the FFL was equal to zero for 60  percent of plans each year, on average. This means that these plans were  permitted to forego cash contributions as a result of the FFL rule. This  reflects the fact that if a plan’s FFL equaled zero, that plan had assets at  least equal to 90 percent of current liabilities that year and would not be  required to make an additional contribution.
The interaction between the FFL rule and the annual maximum tax- deductible contribution also has implications on the amount that plan  sponsors can contribute. In some years, the maximum deductible  contribution rules truly constrained some sponsors from making any cash  contribution. In 1998, 50 of the 60 plans that contributed to the maximum  deductible amount had a maximum deductible contribution of zero (see  fig. 3). This meant that any cash contribution into those plans that year  would generally subject the sponsor to an excise tax. For 37 of these  plans, this was the case even if the sponsor had chosen the lowest  statutorily allowed interest rate for plan funding purposes, which would  have produced the highest calculated current liabilities. This constraint  did not apply to as many plans in some other years. For example, in 1996,  52 plans contributed the maximum deductible amount. Thirty of these  plans had a maximum deductible contribution of zero. Fourteen of the  plans in this situation could not have made any additional contributions.  However, the other 16 could have made at least some contributions by  choosing a lower interest rate to raise their maximum deductible  contribution level.
section_title: Very Few Sponsors of Underfunded Large Plans Paid an AFC from 1995 to 2002
paragraphs: Funding rules dictate that a sponsor of a plan with more than 100  participants in which the plan’s actuarial value of assets fall below 90  percent of liabilities, measured using the highest allowable interest rate,  may be liable for an AFC in that year. More specifically, a plan that is  between 80 and 90 percent funded is subject to an AFC unless the plan  was at least 90 percent funded in at least 2 consecutive of the 3 previous  plan years. A plan with assets below 80 percent of liabilities, calculated  using the highest allowable rate, is assessed an AFC regardless of its  funding history.
Despite the statutory threshold of a 90 percent funding level for some  plans to owe an AFC, in practice a plan needed to be much more poorly  funded to become subject to an AFC. While about 10 plans in our sample  each year had funding below 90 percent on a current liability basis, on  average fewer than 3 plans each year owed an AFC (see fig. 4). From 1995  to 2002, only 6 of the 187 unique plans that composed the 100 largest plans  each year were ever assessed an AFC, and these plans owed an AFC a  total of 23 times in years in which they were among the 100 largest plans.  By the time a sponsor owed an AFC, its plan had an average funding level  of 75 percent, suggesting that by the time the AFC was triggered, the plan’s  financial condition was weak. Further, while we observed 60 instances  between 1995 and 2002 in which a plan had funding levels between 80 and  90 percent, only 5 times was a plan in this funding range subject to an  AFC. This would indicate that, in practice, 80 percent represented the  realistic funding threshold for owing or avoiding the AFC.
Even with those plans subject to an AFC, other FSA credits may help a  plan satisfy minimum funding obligations. Among plans in our sample  assessed an AFC, the average annual AFC owed was $234 million, but  annual contributions among this group averaged $186 million, with both  figures in 2002 dollars. In addition, 61 percent of the time a plan was  subject to an AFC, the sponsor used an existing credit balance to help  satisfy its funding obligation. Over 30 percent of the time a plan was  assessed an AFC, the funding rules allowed the sponsor to forgo a cash  contribution altogether that year. Sponsors that owed an AFC had mixed  success at improving their plans’ financial conditions in subsequent years,  and most of these plans remained significantly underfunded. Among the 6  plans that owed the AFC, funding levels rose slightly from an average 75  percent when the plan was first assessed an AFC to an average 76 percent,  looking collectively at all subsequent years. All of these plans were  assessed an AFC more than once.
Again, terminated plans provide a stark illustration of weaknesses in the  rules’ ability to ensure sufficient funding. Bethlehem Steel’s plan was  assessed an AFC of $181 million in 2002, but the company made no cash  contribution that year, just as it had not in 2000 or 2001, years in which the  plan was not assessed an AFC. When the plan terminated in late 2002, its  assets covered less than half of the $7 billion in promised benefits. LTV  Steel, which terminated its pension plan for hourly employees in 2002 with  assets of $1.6 billion below the value of benefits, had its plan assessed an  AFC each year from 2000 to 2002, but for only $2 million, $73 million, and  $79 million, or no more than 5 percent of the eventual funding shortfall.  Despite these AFC assessments, LTV Steel made no cash contributions to  this plan from 2000 to 2002. Both plans were able to apply existing credits  instead of cash to fully satisfy minimum funding requirements.
section_title: Large Plans’ Sponsors’ Credit Ratings Appear Related to Certain Funding Behavior and Represent Risk to PBGC
paragraphs: The recent funding experiences of large plans, especially those sponsored  by financially weak firms, illustrate the limited effectiveness of certain  current funding rules and represent a potentially large implicit financial  risk to PBGC. The financial health of a plan sponsor may be key to plan  funding decisions because sponsors must make funding and contribution  decisions in the context of overall business operations. From 1995 to 2002,  on average, 9 percent of the largest 100 plans were sponsored by a firm  with a speculative grade credit rating, suggesting financial weakness and  poor creditworthiness.
Financial strength of plan sponsors’ business operations has been a key  determinant of risk to PBGC. Financially weak sponsors of large,  underfunded plans are, by the nature of the insurance offered by PBGC,  likely to cause the most financial burden to PBGC and other premium  payers. For instance, PBGC typically trustees a plan when a covered  sponsor is unable to financially support the plan, such as in the event of  bankruptcy or insolvency. Current funding rules, coupled with the  presence of PBGC insurance, may create incentives for financially  distressed plan sponsors to avoid or postpone contributions and increase  benefits. Many of the minimum funding rules are designed so that  sponsors of ongoing plans may smooth contributions over a number of  years. Sponsors that are in financial distress, however, may have a more  limited time horizon and place other financial priorities above “funding  up” their pension plans. To the extent that the presence of PBGC  insurance causes financially troubled sponsors to alter their funding  behavior, PBGC’s potential exposure increases.
Underfunded plans sponsored by financially weak firms pose the greatest  immediate threat to PBGC’s single-employer plans. PBGC’s best estimate  of the total underfunding of plans sponsored by companies with credit  ratings below investment grade and classified by PBGC as “reasonably  possible” to terminate was an estimated $96 billion as of September 30,  2004 (see fig. 5).
subsections: section_title: Plans Sponsored by Financially Weak Firms Exhibit Riskier Funding Behavior
paragraphs: From 1995 to 2002, we observed that plans sponsored by speculative  grade-rated firms had lower levels of average funding compared with the  average for the 100 largest plans. For instance, the average funding of  these plans was 12 percentage points lower on average than the funding  level for all plans from 1995 to 2002. Plans sponsored by speculative grade- rated firms were also more likely to be underfunded. From 1995 to 2002,  each year, on average, 18 percent of plans sponsored by speculative grade- rated firms had assets that were below 90 percent of current liability.  Plans sponsored by nonspeculative grade-rated firms had just over half  this incidence, or an average of 10 percent of plans funded below 90  percent of current liability.
Large plans sponsored by firms with a speculative grade rating were also  more likely to incur an AFC. While plans sponsored by speculative grade- rated firms accounted for only 9 percent of all plans that we examined  over the 1995 to 2002 period, they accounted for just over one-third of all  instances in which a sponsor was required to pay an AFC. In contrast, no  high investment grade sponsors (those rated AAA or AA) were required to  pay an AFC for this period. While the AFC is intended to be a backstop for  underfunded plans, to the extent that plans sponsored by speculative  grade-rated firms are considered to pose a significant risk for near-term  termination, it may not be an effective mechanism for improving a plan’s  funding level. Plans sponsored by firms that are in financial distress are, by  definition, having difficulty paying off debts and may be ill equipped to  afford increased contributions to their plan. That is, the AFC itself may be  a symptom of plan distress rather than a solution to improve a plan’s  funding level.
Large plans with sponsors rated as speculative grade were also generally  more likely to use the highest allowable interest rate to compute their  current liability under the minimum funding rules. While a majority of  sponsors from all credit rating categories used the highest allowable  interest rate, over the entire 1995 to 2002 period, speculative grade-rated  sponsors used the highest rate at an incidence 23 percentage points above  the incidence for all other plans in the sample. The use of higher interest  rates likely lowers a plan’s reported current liability and minimum funding  requirement. To the extent that this depresses cash contributions, such  plans may have a higher chance of underfunding, thus creating additional  financial risk to PBGC.
PBGC’s claims experience shows that financially weak plans have been a  source of substantial claims. Of the 41 largest claims in PBGC history in  which a rating was known, 39 of the plan sponsors involved were credit  rated as speculative grade at least 3 years prior to termination (see fig. 6).  These claims account for 67 percent of the value of total gross claims on  the single-employer program from 1975 to 2004. Most of the plan sponsors  involved in these claims were given speculative grade ratings for many  more years prior to their eventual termination. Even 10 years prior to plan  termination, 33 of these 41 claims involved sponsors rated as speculative  grade.
section_title: Conclusions
paragraphs: Widely reported recent large plan terminations by bankrupt sponsors and  the financial consequences for PBGC have pushed pension reform into the  spotlight of national concern. Our analysis here suggests that certain  aspects of the funding rules have contributed to the general underfunding  of pensions and, indirectly, to PBGC’s recent financial difficulties. The  persistence of a large number of underfunded plans, even during the  strong economic period of the late 1990s, implies that current funding  rules are not stringent enough to ensure that sponsors can fund their  pensions adequately. Further, the rules appear to lack strong mechanisms  to compel sponsors to make regular contributions to their plans, even  those that are underfunded or subject to an AFC. Perhaps most troubling  is that current rules for measuring and reporting plan assets and liabilities  may not reflect true current values and often understate the true degree of  underfunding.
The current rules have the reasonable and important goals of long-term  funding adequacy and short-term funding flexibility. However, our work  shows that although the current system permits flexibility, it also permits  reported plan funding to be inadequate, misleading, and opaque; even so,  funding and contributions for some plans can still swing wildly from year  to year. This would appear not to serve the interest of any DB pension  stakeholders effectively. The challenge is determining how to achieve a  balance of interests: how to temper the need for funding flexibility with  accurate measurement, adequate funding, and appropriate transparency.
Despite flaws in the funding rules, our work here shows that most of the  largest plans appear to be adequately funded. Rules should acknowledge  that funding will vary with cyclical economic conditions, and even  sponsors who make regular contributions may find their plans  underfunded on occasion. Periodic and mild underfunding is not usually a  major concern, but it becomes a threat to workers’ and retirees’ economic  security in retirement and to PBGC when the sponsor becomes financially  weak and the risk of bankruptcy and plan termination becomes likely. This  suggests that perhaps the stringency of certain funding rules should be  adjusted depending on the financial strength of the sponsor, with stronger  sponsors being allowed greater latitude in funding and contributions than  weaker sponsors that might present a near-term bankruptcy risk.  However, focusing more stringent funding obligations on weak plans and  sponsors alone may not be adequate, because strong companies and  industries can quickly become risky ones, and, once sponsors and plans  become too weak, it may be difficult for them to make larger contributions  and still recover.
It should be noted also that while funding rule change is an essential piece  of the overall reform puzzle, it is certainly not the only piece. Indeed,  pension reform is a challenge precisely because of the necessity of fusing  together so many complex, and sometimes competing, elements into a  comprehensive proposal. Ideally, effective reform would  improve the accuracy of plan asset and liability measurement while  minimizing complexity and maintaining contribution flexibility;   develop a PBGC insurance premium structure that charges sponsors fairly,  based on the risk their plans pose to PBGC, and provides incentives for  sponsors to fund plans adequately;    address the issue of severely underfunded plans making lump-sum  distributions;  resolve outstanding controversies concerning cash balance and other  hybrid plans by safeguarding the benefits of workers regardless of age;  and improve plan information transparency for PBGC, plan participants,  unions, and investors in a manner that does not add considerable burden  to plan sponsors.
As deliberations on reform move forward, it will be important that each of  these individual elements be designed so that all work in concert toward  well-defined goals. Even with meaningful, carefully crafted reform, it is  possible that some DB plan sponsors may choose to freeze or terminate  their plans. While these are serious concerns, the overarching goals of  balanced pension reform should be to protect the retirement benefits of  American workers and retirees by providing employers reasonable funding  flexibility while also holding those employers accountable for the  promises they make to their employees.
As I noted in my opening remarks, PBGC’s challenges parallel the  challenges facing our Social Security system. While both programs have  adequate current revenues and assets to pay promised benefits today, both  face large and growing accumulated deficits on an accrual basis. Further,  timely action to address both private pension and Social Security reform is  needed. However, consideration must be given to the interactive effects of  any such reforms and how they contribute to addressing our nation’s large  and growing fiscal challenge, key demographic, economic and workforce  trends, and the economic security of Americans in their retirement years.
Mr. Chairman, this concludes my statement. I would be happy to respond  to any questions you or other Members of the Committee may have.
section_title: Contact and Acknowledgments
paragraphs: For further information, please contact Barbara Bovbjerg at (202) 512- 7215. Contact points for our Office of Congressional Relations and Public  Affairs may be found on the last page of this testimony. Other individuals  making key contributions to this testimony included Charlie Jeszeck, Mark  Glickman, and Chuck Ford.
This is a work of the U.S. government and is not subject to copyright protection in the  United States. It may be reproduced and distributed in its entirety without further  permission from GAO. However, because this work may contain copyrighted images or  other material, permission from the copyright holder may be necessary if you wish to  reproduce this material separately.