Pension Benefit Guaranty Corporation: Structural Problems Limit Agency's Ability to Protect Itself from Risk
Published: 2005-03-02T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: More than 34 million workers and retirees in about 30,000 singleemployer defined benefit plans rely on a federal insurance program managed by the Pension Benefit Guaranty Corporation (PBGC) to protect their pension benefits. However, the insurance program's long-term viability is in doubt and in July 2003 we placed the single-employer insurance program on our high-risk list of agencies with significant vulnerabilities for the federal government. In fiscal year 2004, PBGC's single-employer pension insurance program incurred a net loss of $12.1 billion for fiscal year 2004, and the program's accumulated deficit increased to $23.3 billion from $11.2 billion a year earlier. Further, PBGC estimated that underfunding in single-employer plans exceeded $450 billion as of the end of fiscal year 2004. This testimony provides GAO's observations on (1) some of the structural problems that limit PBGC's ability to protect itself from risk and (2) steps PBGC has taken to forecast and manage the risks that it faces.
section_title: What GAO Found
paragraphs: Existing laws governing pension funding and premiums have not protected PBGC from accumulating a significant long-term deficit and have exposed PBGC to "moral hazard" from the companies whose pension plans it insures. The pension funding rules, under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC), were not designed to ensure that plans have the means to meet their benefit obligations in the event that plan sponsors run into financial distress. Meanwhile, in the aggregate, premiums paid by plan sponsors under the pension insurance system have not adequately reflected the financial risk to which PBGC is exposed. Accordingly, PBGC faces moral hazard, and defined benefit plan sponsors, acting rationally and within the rules, have been able to turn significantly underfunded plans over to PBGC, thus creating PBGC's current deficit. Despite the challenges it faces, PBGC has proactively attempted to forecast and mitigate its risks. The Pension Insurance Modeling System, created by the PBGC to forecast claim risk, has projected a high probability of future deficits for the agency. However, the accuracy of the projections produced by the model is unclear. Through its Early Warning Program, PBGC negotiates with companies that have underfunded pension plans and that engage in business transactions that could adversely affect their pensions. Over the years, these negotiations have directly led to billions of dollars of pension plan contributions and other protections by the plan sponsors. Moreover, PBGC has changed its investment strategy and decreased its equity exposure to better shield itself from market risks. However, despite these efforts, the agency ultimately lacks the authority, unlike other federal insurance programs, to effectively protect itself.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the underlying structural  problems and long-term challenges facing the defined benefit pension  system and the Pension benefit Guaranty Corporation (PBGC). Before  addressing these matters specifically, I would like to place these  challenges in the context of the larger challenges facing the federal  government today, which we discuss in our recently issued 21st Century  Challenges report. There is a need to bring the federal government and its  programs into line with 21st century realities. This challenge 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 panoply 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 programs and priorities respond to emerging security, social,  economic, and environmental changes and challenges.
The PBGC is an excellent example of the need for Congress to reconsider  the role of government organizations, programs, and policies. The  Employee Retirement Income Security Act (ERISA) was enacted in 1974 to  respond to trends and challenges that existed at that time. One impetus  for the passage of ERISA was the failure of Studebaker’s defined benefit  pension plan in the 1960s, in which many plan participants lost their  pensions. Along with other changes, ERISA established PBGC to pay the  pension benefits of defined benefit plan participants, subject to certain  limits, in the event that an employer could not. ERISA also required PBGC  to encourage the continuation and maintenance of voluntary private  pension plans and to maintain premiums set by the corporation at the  lowest level consistent with carrying out its obligations. PBGC was thus  mandated to serve a social purpose and remain financially self-sufficient.  When ERISA was enacted, defined benefit pension plans were the most  common form of employer-sponsored private pension and were growing  both in number of plans and number of participants. In 1974, Congress  may well have expected continued growth of defined benefit plans in the  years and decades to come. Today, defined benefit pensions cover an ever  decreasing percentage of the U.S. labor force, a fact that raises several  questions about federal policy on pensions in general, and defined benefit  plans and the PBGC, in particular.
In light of past trends and future challenges, some of the fundamental  questions that need to be addressed as we move forward include these:    Should the federal government continue to promote defined benefit  pension plans?
What features of various pension plans should the government promote  to meet retirement income security needs of increasingly mobile  American workers?
What changes should be made to enhance the retirement income  security of workers while protecting the fiscal integrity of the PBGC  insurance program?
Should PBGC act as self-sustaining insurer, according to market-based  principles, should it be a social insurance program, or should it be a  hybrid entity? As defined benefit pension coverage declines, there is an  inherent tension between these two approaches that Congress  presumably did not foresee when ERISA was enacted.
What legislative changes are necessary to allow the pension insurance  program and the PBGC to succeed in their missions? And how much  authority and flexibility should be provided to PBGC to manage its risk  and respond to the fiscal challenges it faces?
Should the government’s pension insurance program be used as a tool  to provide restructuring assistance to industries that have been  negatively affected by certain macroeconomic forces such as  globalization and deregulation? Should such costs be handled  differently than other pension insurance losses?
What portion of the PBGC’s premium revenue should be fixed versus  variable rate premiums and for what purposes? Should variable rate  premiums be more risk-related? If so, how can they be adjusted to  accomplish this objective?
What should PBGC’s investment strategy be and what impact, if any,  should that have on pension funding, recovery, premium, and other  calculations?
It is critical that we address these fundamental issues as soon as possible  so that we take actions consistent with our broader policy objectives.  Furthermore, failure to enact the proper reforms could expedite the  demise of the defined benefit pension system. As part of GAO’s efforts to  help Congress and other policymakers address such issues, I recently  convened a group of pension experts at a Comptroller General’s Forum  entitled “The Future of the Defined Benefit System and the PBGC.” We will  convey the observations of the forum participants in a forthcoming GAO  report.
I will now turn to the specific issues before this subcommittee today. In  particular, I will discuss some of the structural problems that limit PBGC’s  ability to protect itself from risk and steps PBGC has taken to forecast and  manage the risks that it faces. In summary, existing laws governing  pension funding and premiums have not protected PBGC from  accumulating a significant long-term deficit and have not limited PBGC’s  exposure to “moral hazard” from the companies whose pension plans it  insures. The pension funding rules, under ERISA and the Internal Revenue  Code (IRC), were not designed to ensure that plans have the means to  meet their benefit obligations in the event that plan sponsors run into  financial distress. Meanwhile, in the aggregate, premiums paid by plan  sponsors under the pension insurance system have not adequately  reflected the financial risk to which PBGC is exposed. Accordingly,  defined benefit plan sponsors, acting rationally and within the rules, have  been able to turn significantly underfunded plans over to PBGC, thus  creating PBGC’s current deficit.
Despite the challenges it faces, PBGC has proactively attempted to  forecast and mitigate its risks. The Pension Insurance Modeling System,  created by PBGC to forecast claim risk, has projected a high probability of  future deficits for the agency. However, the accuracy of the projections  produced by the model is unclear. Through its Early Warning Program,  PBGC negotiates with companies that have underfunded pension plans  and that engage in business transactions that could adversely affect their  pensions. Over the years, these negotiations have directly led to billions of  dollars of pension plan contributions and other protections by the plan  sponsors. Moreover, PBGC has changed its investment strategy and  decreased its equity exposure to better shield itself from market risks.  However, despite these efforts, the agency, unlike other federal insurance  programs, ultimately lacks adequate authority to effectively protect itself.
subsections: section_title: Background
paragraphs: Before enactment of the Employee Retirement Income Security Act of  1974, few rules governed the funding of defined benefit pension plans, and  participants had no guarantees that they would receive the benefits  promised. Among other things, ERISA established rules for funding  defined benefit pension plans and created the PBGC to protect the  benefits of plan participants in the event that plan sponsors could not  meet the benefit obligations under their plans. More than 34 million  workers and retirees in about 30,000 single-employer defined benefit plans  rely on PBGC to protect their pension benefits.
PBGC finances the liabilities of underfunded terminated plans partially  through premiums paid by plan sponsors. Currently, plan sponsors pay a  flat-rate premium of $19 per participant per year; in addition, some plan  sponsors pay a variable-rate premium, which was added in 1987, to  provide an incentive for sponsors to better fund their plans. For each  $1,000 of unfunded vested benefits, plan sponsors pay a premium of $9. In  fiscal year 2004, PBGC received nearly $1.5 billion in premiums, including  more than $800 million in variable rate premiums, but paid out more than  $3 billion in benefits to plan participants or their beneficiaries.
The single-employer program has had an accumulated deficit—that is,  program assets have been less than the present value of benefits and other  obligations—for much of its existence. (See fig. 1.) In fiscal year 1996, the  program had its first accumulated surplus, and by fiscal year 2000, the  accumulated surplus had increased to about $10 billion, in 2002 dollars.  However, the program’s finances reversed direction in 2001, and at the end  of fiscal year 2002, its accumulated deficit was about $3.6 billion. In July  2003, we designated the single-employer insurance program as “high risk,”  given its deteriorating financial condition and the long-term vulnerabilities  of the program. In fiscal year 2004, PBGC’s single-employer pension  insurance program incurred a net loss of $12.1 billion and its accumulated  deficit increased to $23.3 billion, up from $11.2 billion a year earlier.  Furthermore, PBGC estimated that total underfunding in single-employer  plans exceeded $450 billion, as of the end of fiscal year 2004.
section_title: Structural Problems Limit PBGC’s Ability to Protect Itself from Risk
paragraphs: Existing laws governing pension funding and premiums have not protected  PBGC from accumulating a significant long-term deficit and have not  limited PBGC’s exposure to moral hazard from the companies whose  pension plans it insures. The pension funding rules, under ERISA and the  IRC, were not designed to ensure that plans have the means to meet their  benefit obligations in the event that plan sponsors run into financial  distress. Meanwhile, in the aggregate, premiums paid by plan sponsors  under the pension insurance system have not adequately reflected the  financial risk to which PBGC is exposed. Accordingly, defined benefit plan  sponsors, acting rationally and within the rules, have been able to turn  significantly underfunded plans over to PBGC, thus creating PBGC’s  current deficit. Earlier this year, the Administration released a proposal  that aims to address many of the structural problems that PBGC faces by  calling for changes in the funding rules and premium structure, among  other things. Meanwhile, employers who responsibly manage their defined  benefit pension plans are concerned about their exposure to additional  funding and premium uncertainties.
subsections: section_title: Minimum Funding Rules Do Not Prevent Plans from Being Severely Underfunded
paragraphs: As the PBGC takeovers of severely underfunded plans suggest, the IRC  minimum funding rules have not been designed to ensure that plan  sponsors contribute enough to their plans to pay all the retirement  benefits promised to date. The amount of contributions required under  IRC minimum funding rules is generally the amount needed to fund that  year’s “normal cost” – benefits earned during that year plus that year’s  portion of other liabilities that are amortized over a period of years. Also,  the rules require the sponsor to make an additional contribution if the plan  is underfunded to a specified extent as defined in the law. However,  sponsors of underfunded plans may sometimes avoid or reduce minimum  funding contributions if they have earned funding credits as a result of  favorable experience, such as contributing more than the minimum in the  past. For example, contributions beyond the minimum may be recognized  as a funding credit.  These credits are not measured at their market value  and accrue interest each year, according to the plan’s long-term expected  rate of return on assets. If the market value of the assets falls below the  credited amount, and the plan is terminated, the assets in the plan will not  suffice to pay the plan’s promised benefits.  Thus, some very large and  significantly underfunded plans have been able to remain in compliance  with the current funding rules while making little or no contributions in  the years prior to termination (e.g., Bethlehem Steel).
Further, under current funding rules, plan sponsors can increase plan  benefits for underfunded plans, even in some cases where the plans are  less than 60 percent funded. This may create an incentive for financially  troubled sponsors to increase pension benefits, possibly in lieu of wage  increases, even if their plans have insufficient funding to pay current  benefit levels. Thus, plan sponsors and employees that agree to benefit  increases from underfunded plans as a sponsor is approaching bankruptcy  can essentially transfer this additional liability to PBGC, potentially  exacerbating the agency’s financial condition.
In addition, many defined benefit plans offer employees “shutdown  benefits,” which provide employees additional benefits, such as significant  early retirement benefit subsidies in the event of a plant shutdown or  permanent layoff. In general, plant shutdowns are inherently  unpredictable, so that it is difficult to recognize the costs of shutdown  benefits in advance and current law does not include the cost of benefits  arising from future unpredictable contingent events. Under current law,  PBGC is responsible for at least a portion of any benefit increases,  including shutdown benefits, even if the benefit was added to the plan  within 5 years of plan termination. However, many of these provisions  were included in plans years ago. As a result, shutdown benefits pose a  problem for PBGC not only because they can dramatically and suddenly  increase plan liabilities without adequate funding safeguards, but also  because the related additional benefit payments drain plan assets.
Finally, because many plans allow lump sum distributions, plan  participants in an underfunded plan may have incentives to request such  distributions. For example, where participants believe that the PBGC  guarantee may not cover their full benefits, many eligible participants may  elect to retire and take all or part of their benefits in a lump sum rather  than as lifetime annuity payments, in order to maximize the value of their  accrued benefits. In some cases, this may create a “run on the bank,”  exacerbating the possibility of the plan’s insolvency as assets are  liquidated more quickly than expected, potentially leaving fewer assets to  pay benefits for other participants.
section_title: PBGC’s Premium Structure Does Not Properly Reflect Risks to the Insurance Program
paragraphs: PBGC’s current premium structure does not properly reflect risks to the  insurance program. The current premium structure relies heavily on flat- rate premiums that, since they are unrelated to risk, result in large cost  shifting from financially troubled companies with underfunded plans to  healthy companies with well-funded plans. PBGC also charges plan  sponsors a variable-rate premium based on the plan’s level of  underfunding. However, these premiums do not consider other relevant  risk factors, such as the economic strength of the sponsor, plan asset  investment strategies, the plan’s benefit structure, or the plan’s  demographic profile. PBGC is currently operated somewhat more on a  social insurance model since it must cover all eligible plans regardless of  their financial condition or the risks they pose to the solvency of the  insurance program.
In addition to facing firm-specific risk that an individual underfunded plan  may terminate, PBGC faces market risk that a poor economy may lead to  widespread underfunded terminations during the same period, potentially  causing very large losses for PBGC. Similarly, PBGC may face risk from  insuring plans concentrated in vulnerable industries affected by certain  macroeconomic forces such as deregulation and globalization that have  played a role in multiple bankruptcies over a short time period, as  happened in the airline and steel industries. One study estimates that the  overall premiums collected by PBGC amount to about 50 percent of what  a private insurer would charge because its premiums do not adequately  account for these market risks. Others note that it would be hard to  determine the market rate premium for insuring private pension plans  because private insurers would probably refuse to insure poorly funded  plans sponsored by weak companies.
section_title: PBGC Is Subject to Moral Hazard
paragraphs: Despite a series of reforms over the years, current pension funding and  insurance laws create incentives for financially troubled firms to use  PBGC in ways that Congress did not intend when it formed the agency in  1974. PBGC was established to pay the pension benefits of participants in  the event that an employer could not. As pension policy has developed,  however, firms with underfunded pension plans may come to view PBGC  coverage as a fallback, or “put option,” for financial assistance. The very  presence of PBGC insurance may create certain perverse incentives that  represent moral hazard—struggling plan sponsors may place other  financial priorities above “funding up” their pension plans because they  know PBGC will pay guaranteed benefits. Firms may even have an  incentive to seek Chapter 11 bankruptcy in order to escape their pension  obligations. As a result, once a plan sponsor with an underfunded pension  plan experiences financial difficulty, existing incentives may exacerbate  the funding shortfall for PBGC while also affecting the competitive  balance within an industry. This should not be the role for the pension  insurance system.
This moral hazard has the potential to escalate, with the initial bankruptcy  of firms with underfunded plans creating a vicious cycle of bankruptcies  and terminations. Firms with onerous pension obligations and strained  finances could see PBGC as a means of shedding these liabilities, thereby  providing them with a competitive advantage over firms that deliver on  their pension commitments. This would also potentially subject PBGC to a  series of terminations of underfunded plans in the same industry, as we  have already seen with the steel and airline industries in the past 20 years.
In addition, current pension funding and pension accounting rules may  also encourage plans to invest in riskier assets to benefit from higher  expected long-term rates of return. In determining funding requirements, a  higher expected rate of return on pension assets means that the plan needs  to hold fewer assets in order to meet its future benefit obligations. And  under current accounting rules, the greater the expected rate of return on  plan assets, the greater the plan sponsor’s operating earnings and net  income. However, with higher expected rates of return comes greater risk  of investment loss, which is not reflected in the pension insurance  program’s premium structure. Investments in riskier assets with higher  expected rates of return may allow financially weak plan sponsors and  their plan participants to benefit from the upside of large positive returns  on pension plan assets without being truly exposed to the risk of losses.  The benefits of plan participants are guaranteed by PBGC, and weak plan  sponsors that enter bankruptcy can often have their plans taken over by  PBGC.
section_title: Administration Has Proposed Reforms to Address PBGC’s Long- Term Challenges
paragraphs: Earlier this year, the Administration released a proposal for strengthening  funding of single-employer pension plans. The Administration’s proposal  focuses on three areas:  reforming the funding rules to ensure pension promises are kept by  improving incentives for funding plans adequately;  improving disclosure to workers, investors, and regulators about  pension plan status; and    adjusting premiums to better reflect a plan’s risk and ensure the  pension insurance system’s financial solvency.
Among other things, the proposal would require all underfunded plans to  pay risk-based premiums and it would empower PBGC’s board to adjust  the risk-based premium rate periodically so that premium revenue is  sufficient to cover expected losses and to improve PBGC’s financial  condition.
Employer groups have expressed concern about their exposure to  additional funding and premium uncertainties and have claimed that the  Administration’s proposal may strengthen PBGC’s financial condition at  the expense of defined benefit plan sponsors. For example, one  organization has stated that in its view, the current proposal would result  in fewer defined benefit plans, lower benefits, and more pressures on  troubled companies.
section_title: PBGC Has Attempted to Improve Its Ability to Forecast and Manage Risk but Ultimately Lacks Adequate Authority to Properly Do So
paragraphs: PBGC has proactively attempted to forecast and mitigate the risks that it  faces. The Pension Insurance Modeling System (PIMS), created by PBGC  to forecast claim risk, has projected a high probability of future deficits for  the agency. However, the accuracy of the projections produced by the  model is unclear. Also, through its Early Warning Program, PBGC  negotiates with companies that have underfunded pension plans and that  engage in business transactions that could adversely affect their pensions.  Over the years, these negotiations have directly led to billions of dollars of  pension plan contributions and other protections by the plan sponsors.  Moreover, PBGC has begun an initiative called the Office of Risk  Assessment that combines aspects of both PIMS and the Early Warning  Program and will enable the agency to better quantitatively analyze claim  risks associated with individual plan sponsors. PBGC has also changed its  investment strategy and decreased its equity exposure to better shield  itself from market risks. However, despite these efforts, the agency, unlike  other federal insurance programs, ultimately lacks the authority to  effectively protect itself, such as by adjusting premiums according to the  risks it faces.
subsections: section_title: PBGC Uses Its Pension Insurance Modeling System to Forecast Its Potential Exposure to Future Claims, but Forecasting Firm Bankruptcies Is Difficult
paragraphs: Over the long term, many variables, such as interest rates and equity  returns, affect the level of PBGC claims. Moreover, large claims from a  small number of bankruptcies constitute a majority of the risk that PBGC  faces. Consequently, PBGC created the Pension Insurance Modeling  System—a stochastic simulation model that quantifies risk and exposure  for the agency over the long run. PIMS simulates the flows of claims that  could develop under thousands of combinations of various  macroeconomic and company and plan-specific data. In lieu of predicting  future bankruptcies, PIMS is designed to generate probabilities for future  claims.
In recent annual reports, PBGC has discussed the methodologies used to  develop PIMS. Furthermore, as far back as 1998, PBGC has reported PIMS  results that forecast the possibility of large deficits for the agency. For  example, at fiscal year end 2003—the most recent year for which PBGC  has released an annual report—the model’s simulations forecasted about  an 80 percent probability of deficit by the year 2013. This included a 10  percent probability of the deficit reaching $49 billion within this time  frame. These forecasts, made at the end of fiscal year 2003, did not include  the $14.7 billion in losses that PBGC experienced from terminated plans in  fiscal year 2004. Therefore, PIMS appears to have understated the extent  of PBGC’s long-term deficit, given that by the end of fiscal year 2004, the  agency’s cumulative deficit had already grown to $23.3 billion.
The extent to which PIMS can accurately assess future claims is unclear.  There is simply too much uncertainty about the future, with respect both  to the performance of the economy and of companies that sponsor defined  benefit pension plans. It is difficult to accurately forecast which industries  and companies will face economic pressures resulting in bankruptcies and  PBGC claims. Furthermore, because PBGC’s risk lies primarily in a  relatively small number of large plans, the failure or survival of any single  large plan may lead to significant variance between PBGC’s actual claims  and the projected claims reported by PBGC in its annual reports.  Academic papers report varying rates of success in predicting bankruptcy  with various models that measure companies’ cash flows or financial  ratios, such as asset-to-liability ratios. One paper we reviewed reports that  one model succeeded at a rate of 96 percent in predicting bankruptcies 1  year in advance and a rate of 70 percent for predicting bankruptcies 5  years in advance. However, another paper concludes that no single  bankruptcy prediction model proposed in the existing literature is entirely  satisfactory at differentiating between bankrupt and nonbankrupt firms  and that none of the models can reliably predict bankruptcy more than 2  years in advance.
section_title: PBGC’s Early Warning Program Is One Tool For Managing Risk
paragraphs: PBGC’s Early Warning Program is designed to ensure that pensions are  protected by negotiating agreements with certain companies engaging in  business transactions or events that could adversely affect their pension  plans. Companies of particular interest to the PBGC are those that are  financially troubled, have underfunded pension plans, and are engaged in  transactions such as restructurings, leveraged buyouts, spin-offs, and  payments of extraordinary dividends, to name a few. The Early Warning  Program proactively monitors financial information services and news  databases to identify these potentially risky transactions in a timely  fashion.
If PBGC, after completing an extensive screening process, concludes that  a transaction could result in a significant loss to the pension plan, the  agency will seek to negotiate with the company to obtain protections for  the plan. The Early Warning Program thus raises awareness of pension  underfunding, may change corporate behavior, and may allow PBGC to  prevent losses before they occur. Under the program, PBGC currently  monitors about 3,200 pension plans covering about 29 million participants.  Since 1992, the program has protected over 2 million pension plan  participants through about 100 settlement agreements valued at over $18  billion (one settlement accounted for about $10 billion). Some recent  representative cases include the 2004 settlement with Invensys that  provided for over $175 million of additional cash contributions to the  pension plan and the 2005 agreement with Crown Petroleum whereby the  plan has been assumed by a financially sound parent company and $45  million of additional cash will be contributed to the pension plan.
section_title: PBGC Has Developed an Initiative to Better Quantitatively Assess the Risk Associated with Individual Firms
paragraphs: PBGC has recently undertaken an initiative to create an Office of Risk  Assessment, which will focus on improving the agency’s ability to  quantitatively model individual firms’ claim potential. According to PBGC,  neither PIMS nor the Early Warning Program provides this information.  For example, PIMS projects systemwide surpluses and deficits and is not  designed to predict specific company results. Meanwhile, the Early  Warning Program targets specific companies, but in a manner that is  qualitative in nature. The Office of Risk Assessment, however, will attempt  to combine the concepts of both tools and better attempt to quantitatively  analyze the claim risk associated with individual companies.
PBGC has consulted with other federal agencies, such as the Federal  Deposit Insurance Corporation (FDIC), that have implemented similar  approaches for assessing risk. In March 2003, FDIC established a Risk  Analysis Center. Guided by FDIC’s National Risk Committee, which is  composed of senior managers, the center is intended to “monitor and  analyze economic, financial, regulatory and supervisory trends, and their  potential implications for the continued financial health of the banking  industry and the deposit insurance funds.” The center does so by bringing  together FDIC bank examiners, economists, financial analysts, resolutions  and receiverships specialists, and other staff members. These members  represent several FDIC organizational units and use information from a  variety of sources, including bank examinations and internal and external  research. According to FDIC, the center serves as a clearinghouse for  information, including monitoring and analyzing economic and financial  developments and informing FDIC management and staff of these  developments. FDIC officials believe that the center enables them to be  proactive in identifying industry trends and developing comprehensive  solutions to address significant risks to the banking industry.
section_title: PBGC Has Also Taken Steps to Better Protect Its Investment Portfolio from Certain Market Risks
paragraphs: In early 2004, PBGC adopted a new investment strategy to better manage  its approximately $40 billion in assets. Although many factors that affect  PBGC’s financial health are beyond the agency’s control, a well-crafted  investment strategy is one of the few tools PBGC has to proactively  manage the financial risks facing the pension insurance program. Under  the new investment policy, PBGC is decreasing its asset allocation in  equities from 37 percent as of fiscal year end 2003 to within a range of 15  to 25 percent. Since many of the pension plans that PBGC insures are  already heavily invested in equities, some pension and investment experts  have said that the agency can create more financial stability by  establishing an asset allocation that can hedge against losses in the equity  markets. The equity exposure reduction ensures that PBGC’s own  financial condition will not deteriorate to the same degree as the assets in  the pension plans it insures. However, PBGC continues to benefit when  equity markets rise because the plans it insures will rise in value. In  addition, PBGC claims that this strategy moves the agency closer to the  asset mix typically associated with private sector annuity providers.  However, it is too soon tell what effects this new investment strategy will  have on PBGC’s long-term financial condition.
section_title: Unlike Other Federal Insurance Programs, PBGC Has Limited Ability to Protect Itself From Risk
paragraphs: Although PIMS and the Early Warning Program help PBGC assess and  manage risk to some extent, PBGC lacks the regulatory authority available  to other federal insurance programs, such as the FDIC, to effectively  protect itself from risk. Whereas PBGC’s premiums are determined by  statute, Congress provided FDIC the flexibility to set premiums and adjust  them every 6 months based on its analysis of risk to the deposit insurance  system. Furthermore, FDIC can reject applications to insure deposits at  depository institutions when it determines that a depository institution  carries too much risk to the Bank Insurance Fund. By contrast, PBGC  must insure all plans eligible for PBGC’s insurance coverage. Last, FDIC  may issue formal and informal enforcement actions for deposit institutions  with significant weaknesses or those operating in a deteriorated financial  condition. When necessary, the FDIC may oversee the re-capitalization,  merger, closure, or other resolution of the institution. By contrast, PBGC  is limited to taking over a plan in poor financial condition to prevent it  from accruing additional liabilities. PBGC has no authority to seize assets  of the plan sponsor, who is responsible for adequately funding the plan.
section_title: Conclusion
paragraphs: The current financial challenges facing the PBGC reflect, in part, the  significant changes that have taken place in employer-sponsored pensions  since the passage of ERISA in 1974. Given the decline in defined benefit  plans over the last two decades, it is time to make changes in the rules  governing the defined benefit system and reexamine PBGC’s role as an  insurer. In recent years an irreconcilable tension has arisen between  PBGC’s role as a social insurance program and its mandate to remain  financially self-sufficient. Unless something reverses the decline in defined  benefit pension coverage, PBGC may have a shrinking plan and participant  base to support the program in the future and may face the likelihood of a  participant base concentrated in certain potentially more vulnerable  industries. In this regard, effectively addressing the uncertainties  associated with cash balance and other hybrid pension plans may serve to  help slow the decline in defined benefit plans.
One of the underlying assumptions of the current insurance program has  been that there would be a financially stable and growing defined benefit  system. However, the current financial condition of PBGC and the plans  that it insures threaten the retirement security of millions of Americans  because termination of severely underfunded plans can significantly  reduce the benefits participants receive. It also poses risks to the general  taxpaying public, who ultimately could be made responsible for paying  benefits that PBGC is unable to afford.
To help PBGC manage the risks to which it is exposed, Congress may wish  to grant PBGC additional authorities to set premiums or limit the  guarantees on the benefits it pays to those plans it assumes. However,  these changes would not be sufficient in themselves because the primary  threat to PBGC and the defined benefit pension system lies in the failure of  the funding rules to ensure that retirement benefit obligations are  adequately funded. In any event, any legislative changes to address the  challenges facing PBGC should provide plan sponsors with incentives to  increase plan funding, improve the transparency of the plan’s financial  information, and provide a means to hold sponsors accountable for  funding their plans adequately. However, policymakers must also be  careful to balance the need for changes in the current funding rules and  premium structure with the possibility that any changes could expedite  the exit of healthy plan sponsors from the defined benefit system while  contributing to the collapse of firms with significantly underfunded plans.
The long-term financial health of PBGC and its ability to protect workers’  pensions is inextricably bound to the underlying change in the nature of  the risk that it insures, and implicitly to the prospective health of the  defined benefit system. Options that serve to revitalize the defined benefit  system could stabilize PBGC’s financial situation, although such options  may be effective only over the long term. Our greater challenge is to  fundamentally consider the manner in which the federal government  protects the defined benefit pensions of workers in this increasingly risky  environment. We look forward to working with Congress on this crucial  subject.
Mr. Chairman, this concludes my statement. I would be happy to respond  to any questions you or other members of the Subcommittee may have.
section_title: Contacts and Acknowledgments
paragraphs: For further information, please contact Barbara Bovbjerg at (202) 512-7215  or George Scott at (202) 512-5932. Other individuals making key  contributions to this testimony included David Eisenstadt, Benjamin  Federlein, and Joseph Applebaum.
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.