Private Pensions: The Pension Benefit Guaranty Corporation and Long-Term Budgetary Challenges
Published: 2005-06-09T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: More than 34 million workers and retirees in over 29,000 single-employer defined benefit plans rely on a federal insurance program managed by the Pension Benefit Guaranty Corporation (PBGC) to protect their pension benefits. However, the single-employer insurance program's long-term viability is in doubt, and this may have significant implications for the federal budget. In fiscal year 2004, PBGC's single-employer pension insurance program incurred a net loss of $12.1 billion, and the program's accumulated deficit increased to $23.3 billion. Further, PBGC has estimated that it is exposed to almost $100 billion of underfunding in plans sponsored by companies with credit ratings below investment grade. This testimony provides GAO's observations on the nature of the challenges facing PBGC and why it is preferable for Congress to act sooner rather than later. This testimony also notes the broader context in which reform proposals should be considered and the criteria that GAO has suggested for reform.
section_title: What GAO Found
paragraphs: A combination of recent events, long-term structural problems, and weaknesses in the legal framework governing the defined benefit system has left PBGC with a significant long-term deficit and many large plans badly underfunded. Lower interest rates and equity prices since 2000 have increased the present value of pension liabilities and lowered the value of significant portions of pension plan assets. Meanwhile, PBGC is exposed to significant risk from underfunded plans in key industries at the same time that its revenue base is threatened by the long-term decline in defined benefit plan participation. In addition, the basic legal framework governing pension insurance and plan funding has failed to help ensure that plan sponsors deliver on their pension promises and safeguard the PBGC's financial condition. PBGC's current premium structure does not properly reflect the risks to its insurance program and facilitates moral hazard behavior by plan sponsors. Further, current pension funding rules have not provided sufficient incentives for plan sponsors to properly fund their benefit obligations. As a result, bankrupt plan sponsors, acting rationally and within the rules, have transferred the obligations of their large and significantly underfunded plans to PBGC. These weaknesses contribute to and are exacerbated by a lack of timely, accurate and transparent information that make it difficult for participants, investors, and others to have a clear understanding of the true financial condition of pension plans. Comprehensive reform is required to ensure that workers and retirees receive the benefits promised to them. Ideally, effective reform would (1) improve the accuracy of plan funding measures while minimizing complexity and maintaining contribution flexibility; (2) revise the current funding rules to create incentives for plan sponsors to adequately finance promised benefits; (3) develop a more risk-based PBGC insurance premium structure and provides incentives for sponsors to fund plans adequately; (4) address the issue of underfunded plans paying lump sums and granting benefit increases; (5) modify PBGC guarantees of certain plan benefits (6) resolve outstanding controversies concerning hybrid plans by safeguarding the benefits of workers regardless of age; and (7) improve plan information transparency for pension plan stakeholders without overburdening plan sponsors. Pension reform is only part of a broader fiscal, economic and retirement security challenge. Looking ahead in the federal budget, Social Security, together with Medicare and Medicaid, will dominate the federal government's future fiscal outlook. Reform should also be considered in the context of the problems currently facing our nation's Social Security system. Importantly, as is the case with Social Security, acting sooner rather than later will make comprehensive pension reform less costly and more feasible.

section_title: Letter
paragraphs: I am pleased to be here today to discuss the problems and long-term  challenges facing the defined benefit (DB) pension system, the Pension  Benefit Guaranty Corporation (PBGC), the retirement security of workers  and retirees covered by DB plans, and American taxpayers. In particular, I  will discuss the factors contributing to those problems and suggest  elements of the comprehensive reform necessary to address them. As I  have noted before, these problems are a subset of the broader challenges  facing the federal government and our nation’s retirement income system.  These programs, which include Social Security, Medicare, and Medicaid,  represent large, growing, and unsustainable claims on the federal budget  because America’s population is aging, life expectancies are increasing,  workforce growth is slowing, and health care costs are rising.
The long-term effect of federal retirement programs on the budget is so  significant that neither slowing the growth of discretionary spending nor  allowing tax cuts to expire—nor both options combined—would by  themselves eliminate our long-term fiscal imbalance (see fig. 1). Therefore,  as we discussed in our 21st Century Challenges report, tough choices  need to be made about the appropriate role and size of the federal  government—and how to finance that government—and how to bring the  panoply of federal policies, programs, functions and activities into line  with the realities of today’s world and tomorrow’s challenges. More  specifically to federal retirement policy, we need to make choices about  how to promote current and long-term economic security in retirement. In  that latter context, comprehensively considering our citizens’ needs for  income, health care, and long-term care is important.
From our nation’s overall fiscal perspective, 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.
Therefore, we 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.
PBGC is an excellent example of the need for Congress to reconsider the  role of government programs, in general, and federal retirement programs,  in particular, in light of past changes and 21st century challenges. In 1974,  Congress passed the Employee Retirement Income Security Act (ERISA)  to respond to trends and challenges that existed at that time. Among other  things, 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. 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 in number of participants.  Today, defined benefit pensions cover an ever-decreasing percentage of  the U.S. labor force, a fact that raises questions about federal policy on  pensions in general, and defined benefit plans and the PBGC, in particular.
I would now like to outline the challenges facing the defined benefit  pension system and PBGC and suggest a framework for evaluating  potential policy responses. In summary, a combination of recent events,  long-term structural problems, and weaknesses in the legal framework  governing pensions has left PBGC with a significant long-term deficit and  many large plans badly underfunded. Lower interest rates and equity  prices since 2000 have combined to significantly increase pension  underfunding through an increase in the present value of pension  liabilities, and decreases in the value of pension plan assets. Meanwhile,  intense cost competition as a result of globalization and deregulation has  led to bankruptcies of plan sponsors in key industries like steel and  airlines, and is exposing PBGC to the risk of significant future losses in  these and other industries. This competitive restructuring has occurred  simultaneously with a long-term decline in defined benefit plan  participation that threatens PBGC’s revenue base. In addition, the basic  legal framework governing pension insurance and plan funding has failed  to safeguard the benefit security of American workers and retirees and the  PBGC’s financial condition. Too many companies are making pension  promises that they are not required to deliver on, in part because of  perverse incentives and “put options” created under the current pension  insurance system.
PBGC’s current premium structure does not properly reflect the risks to  its insurance program and facilitates moral hazard by plan sponsors.
Further, as we have shown in a recent report, current pension funding  rules have not provided sufficient incentives, transparency, and  accountability mechanisms for plan sponsors to properly fund their  benefit obligations and deliver on their promises. As a result, bankrupt  plan sponsors, acting rationally and within the rules, have transferred the  obligations of their large and significantly underfunded plans to PBGC.  These weaknesses in the legal framework contribute to and are  exacerbated by a lack of transparent information that makes it difficult for  interested stakeholders to understand the true financial condition of and  risk associated with selected pension plans.
Given pension plans’ crucial significance to our nation’s retirement  security net, it is useful to compare the challenges facing PBGC’s  insurance program and Social Security. Both systems require meaningful,  comprehensive reform that restores solvency, assures sustainability, and  protects the benefits of participants. Similar to that of Social Security,  PBGC’s current condition does not represent a crisis, though delaying  reform will result in serious adverse consequences for individuals, the  federal budget, and our economy. Furthermore, like Social Security, PBGC  has plenty of cash on hand today to pay benefits to participants in the  short term, but it faces large and growing unfunded obligations and  escalating cash flow deficits in the future.
The termination of United Airlines’ defined benefit pension plans is just  the latest in a recent series of large, underfunded plans taken over by  PBGC, and will not be the last. In July 2003, GAO designated PBGC’s  single-employer insurance program as “high-risk,” given its deteriorating  financial condition and long-term vulnerabilities. At the end of fiscal year  2004, PBGC estimated that it was exposed to almost $100 billion of  underfunding in plans sponsored by companies with credit ratings below  investment grade. Though smaller in scale than Social Security, Medicare,  and Medicaid, PBGC’s deficit threatens to worsen our government’s long- term fiscal position. While PBGC is not explicitly backed by the full faith  and credit of the U.S. government, policymakers would undoubtedly face  intense pressure to provide PBGC the resources to continue paying earned  pension benefits to millions of retirees if PBGC were to become insolvent.
In light of the intrinsic problems facing the defined benefit system,  meaningful and comprehensive reform will be needed to ensure that  workers and retirees receive the benefits promised to them and to secure  PBGC’s financial future. At this time, the Administration, members of  Congress, and others have proposed reforms that seek to address many of  the problems facing PBGC and the defined benefit system. This is a  promising development that can be a critical first step in addressing part  of the long-term fiscal problems facing this country.
subsections: section_title: Background
paragraphs: Before enactment of the Employee Retirement Income Security Act of  1974 (ERISA), few rules governed the funding of defined benefit pension  plans, and participants had no guarantees that they would receive their  promised benefits. Among other things, ERISA 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. ERISA also  established rules for funding defined benefit pension plans, instituted  pension insurance premiums, promulgated certain fiduciary rules, and  developed annual reporting requirements. When a plan is terminated with  insufficient assets to pay its guaranteed benefits, PBGC takes over the plan  and assumes responsibility for paying benefits to participants. According  to PBGC’s 2004 annual report, PBGC provides insurance protection for  over 29,000 single-employer pension plans, which cover 34.6 million  workers, retirees, and their beneficiaries.
PBGC receives no direct federal tax dollars to support the single-employer  pension insurance program. Instead, the program receives the assets of  terminated underfunded plans and any of the sponsor’s assets that PBGC  recovers during bankruptcy proceedings. PBGC finances the unfunded  liabilities of terminated plans with premiums paid by plan sponsors and  income earned from the investment of program assets. 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 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. 2.) 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 fiscal  year 2004, the single-employer 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.
In defined benefit plans, formulas set by the employer determine employee  benefits. DB plan formulas vary widely, but benefits are frequently based  on participant earnings and years of service, and traditionally 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.
ERISA and the Internal Revenue Code (IRC) prescribe rules regarding the  assumptions that sponsors must use to measure plan liabilities and assets.  While different 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 a pension plan and its 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 additional funding  charge (AFC), which applies to plans with more than 100 participants.  The AFC requires plan sponsors to make additional contributions to plans  that fall below a prescribed funding level. With some exceptions, plans  with reported asset values below 90 percent of current liabilities are  affected by the AFC rules.
section_title: PBGC’S Problems Stem from Recent Events, Long-Term Structural Trends, and Weaknesses in the Legal Framework Governing DB Pensions
paragraphs: A combination of recent events, long-term structural problems, and  weaknesses in the legal framework governing the DB system has left  PBGC with a significant long-term deficit and many large plans badly  underfunded. Lower interest rates and equity prices since 2000 have  combined to significantly increase pension underfunding through an  increase in the present value of pension liabilities, and decreases in the  value of pension plan assets. Meanwhile, intense cost competition as a  result of globalization and deregulation has led to bankruptcies of plan  sponsors in key industries like steel and airlines, and is exposing PBGC to  the risk of significant future losses in these and other industries. This  competitive restructuring has occurred simultaneously with a long term  decline in defined benefit plan participation that threatens PBGC’s  revenue base. In addition, the basic legal framework governing pension  insurance and plan funding has failed to safeguard the benefit security of  American workers and retirees and the PBGC’s financial condition. Too  many companies are making pension promises that they are not required  to deliver on, in part because of perverse incentives and “put options”  created under the current pension insurance system.
PBGC’s current premium structure does not properly reflect the risks to  its insurance program and facilitates moral hazard by plan sponsors.  Further, current pension funding rules have not provided sufficient  incentives, transparency, and accountability mechanisms for plan  sponsors to properly fund their benefit obligations and deliver on their  promises. As a result, bankrupt plan sponsors, acting rationally and within  the rules, have transferred the obligations of their large and significantly  underfunded plans to PBGC. These weaknesses in the legal framework  contribute to and are exacerbated by a lack of transparent information  that makes it difficult for interested stakeholders to understand the true  financial condition of and risk associated with selected pension plans.
subsections: section_title: Recent Economic Factors Exacerbated the Underfunding of Large Terminated Plans by Bankrupt Sponsors
paragraphs: Over the last 5 years, many large pension plans have been adversely  affected by simultaneous declines in broad equity indexes and long-term  interest rates, as well as by the financial difficulties of their plan  sponsors. Poor investment returns from stock market declines affected  the asset values of pension plans to the extent that plans invested in  stocks. According to the ERISA Industry Committee, assets in private  sector defined benefit plans totaled $2.056 trillion at the end of 1999,  dropped to $1.531 trillion at the end of 2002, and climbed back to  $1.8 trillion by the end of 2004. Lower equity values since the end of 1999  have been particularly problematic because interest rates have also  declined and thus increased the present value of plan liabilities. Some  sponsors of large pension plans that were terminated were not in  sufficiently strong financial condition to meet their pension funding  requirements because of weaknesses in their primary business activities.  Bankruptcies and pension plan terminations increased around the U.S.  economic recession of 2001 and around prior recessions.
These conditions played a part in increasing the unfunded liabilities of  plans terminated by bankrupt sponsors since 2000. For example,  according to the filing of its annual regulatory report for pension plans,  Bethlehem Steel’s plan went from 86 percent funded in 1992 to 97 percent  funded in 1999. From 1999 to its plan termination in December 2002, plan  funding fell to less than 50 percent as assets decreased and liabilities  increased and sponsor contributions were not sufficient to offset the  changes.
section_title: Long-Term Declines of Key Industries and in Defined Benefit Pension Coverage Have Contributed to PBGC’s Weakening Financial Condition
paragraphs: Long-term trends in some sectors of the economy and in defined benefit  pension coverage are threatening both PBGC’s future solvency and the  economic security in retirement of workers and retirees. PBGC’s risk of  inheriting underfunded pensions largely stems from the fact that more  than half of the pension participants it insures are in the manufacturing  and airline sectors, which have been exposed to lower cost competition  because of several factors including globalization and deregulation. A  potentially exacerbating risk to PBGC is the cumulative effect of  bankruptcy in these industries: if a critical mass of firms go bankrupt and  terminate their underfunded pension plans, their competitors may also  declare bankruptcy to similarly avoid the cost of funding their plans.
PBGC also faces the possibility of long-term revenue declines from  demographic changes in the population of defined benefit plan  participants and a shrinking number of DB plans. Over the long term, an  aging population of defined benefit plan participants threatens to reduce  PBGC’s ability to raise premium revenues as participants die and are not  replaced by enough new participants. The percentage of participants who  are active workers has declined from 78 percent in 1980 to just under 50  percent in 2002. Furthermore, PBGC cannot effectively diversify its risk  from the terminations of plans in declining economic sectors because  companies in other growing industries have generally not sponsored new  defined benefit plans. As plan sponsors in weak industries go bankrupt  and terminate their pension plans, PBGC not only faces immediate  changes in its financial position from taking over underfunded plans, but  also faces losses of future revenues from these terminated plans.
A related factor eroding PBGC’s premium base is the growth of lump-sum  pension distributions. More and more plan participants are exiting the  defined benefit system by taking lump-sum distributions from their plans.  After a lump-sum distribution is paid, the participant is out of the defined  benefit system and the plan sponsor no longer has to contribute to the  pension insurance system on the participant’s behalf. In addition, lump- sum distributions to participants in underfunded plans can create the  effect of a “run on the bank” and worsen a plan’s underfunding. In such  cases, the plan may terminate without enough assets to pay full benefits to  other participants and PBGC may incur losses.
The increasing prevalence of lump-sum distributions in defined benefit  plans and the growth of defined contribution plans also raise significant  questions about whether many Americans will enjoy an economically  secure retirement. Many Americans are at risk of outliving their  retirement assets as life expectancies, health care, and long-term care  costs continue to increase.
section_title: Legal Framework Has Not Encouraged Adequate Plan Funding, Contributing to PBGC’s Financial Difficulties
paragraphs: Existing laws and regulations governing pension funding and premiums  have contributed to PBGC’s financial difficulties and exposed PBGC to  greater risks from the companies whose pension plans it insures. PBGC’s  current premium structure does not properly reflect the risks to its  insurance program and facilitates moral hazard by plan sponsors. Further,  the pension funding rules, under ERISA and the IRC, have not ensured that  plans have the means to meet their benefit obligations in the event that  plan sponsors run into financial distress. First, the current rules likely  allowed plans to appear better funded than they actually were, in both  good years and bad years. And even these reported funding levels  indicated significant levels of underfunding in our study of the 100 largest  DB plans. Second, plan sponsors often substituted “account credits” for  cash contributions, even as the market value of plan assets may have been  in decline. And third, the AFC, the primary mechanism for improving the  financial condition of poorly funded plans, was ineffective in doing so.  These weaknesses contribute to and are exacerbated by a lack of  transparent information that makes it difficult for plan participants,  investors, and others to have a clear understanding of their plan’s financial  condition. As a result, financially weak benefit plan sponsors, acting  rationally and within the current law, have been able to avoid large  contributions to underfunded plans prior to bankruptcy and plan  termination, thus adding to PBGC’s current deficit.
subsections: 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, which, 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 plans 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 has  happened recently 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: Current pension funding and insurance laws create incentives for  financially troubled firms to use PBGC in ways that Congress likely did not  intend when it formed the agency in 1974. At that time, PBGC was  established to pay the pension benefits of participants, subject to certain  limits, in the event that an employer could not. However, since that time,  some firms with underfunded pension plans may have 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 what economists call moral hazard—where 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, these moral  hazard incentives may exacerbate the funding shortfall for PBGC.
This moral hazard effect 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 these companies with a competitive  advantage over other 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 airlines industries in the past 20 years.
Moral hazard effects are likely amplified by current pension funding and  pension accounting rules that 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 volatility, 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: Current Funding Rules Do Not Provide Sufficient Incentives for Sponsors to Adequately Fund Their Plans
paragraphs: The pension funding rules, under ERISA and the IRC, have not provided  sufficient incentives for plan sponsors to properly fund their benefit  obligations. The funding rules generally presume that pension plans and  their sponsors are ongoing entities and therefore allow for a certain extent  of plan underfunding that can be made up over time. However, the  measures of plan funding used to determine contribution requirements can  significantly overstate the true financial condition of a plan. And even  these reported funding levels indicated significant levels of underfunding  in our study of the 100 largest DB plans. Furthermore, when plan  sponsors make contributions to their plans, they can use account credits,  rather than cash, even in cases when plans are underfunded. The funding  rules include certain mechanisms—primarily, the AFC—that are intended  to prevent plans from becoming too underfunded. However, our analysis  shows that for several reasons, the AFC proved ineffective in restoring  financial health to poorly funded plans.
Rules May Allow Plans to Overstate Their Current Funding Levels  Current funding rules may allow plans to overstate their current funding  levels to plan participants and the public. Because many plans in our  sample chose legally 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.
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. 3). On average, each year 39  of these plans were less than 100 percent funded, 10 had assets below  90 percent of their current liabilities, and 3 plans were less than 80 percent  funded. In 2002 there were 23 plans less than 90 percent funded.
Reported funding levels may have been overstated for a number of  reasons. These include the use of above-market interest rates, which leads  to an understatement of the cost of settling benefit obligations through the  purchase of group annuity contracts. Also, actuarial asset values may have  differed by as much as 20 percent from current market value of plan  assets. The funding rules allow for smoothing out year-to-year fluctuations  in asset and liability values so that plan sponsors are gradually, and not  suddenly, affected by significant changes in interest rates and the values of  their assets. When current interest rates decline, the use of a 4-year  weighted average interest rate lags behind, and thus measurements of the  present value of plan liabilities do not accurately reflect the cost of settling  a plan’s benefit obligations.
The terminations of the Bethlehem Steel and LTV Steel pension plans in  2002 (two of the largest plan terminations, to date) illustrate the potential  discrepancies between reported and actual funding. In 2002, the  Bethlehem Steel Corporation 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. In 2001, LTV  Steel reported that its plan for hourly employees was 80 percent funded,  yet when the plan terminated in March 2002, it was only 52 percent  funded. From these terminations PBGC’s single-employer program  suffered losses of $3.7 billion and $1.6 billion, respectively.
Most Sponsors Most Years Made No Cash Contributions to Plans  but Satisfied Funding Requirements through Use of Accounting  Credits  The amount of contributions required under IRC minimum funding rules is  generally the amount needed to fund benefits earned during that year plus  that year’s portion of other liabilities that are amortized over a period of  years. This minimum contribution requirement may be met by the plan  sponsor putting cash into the plan or by applying earned funding credits.  These funding credits are not measured at their market value and are  credited with interest each year, according to the plan’s long-term  expected rate of return on assets. When the market value of a plan’s  assets declines, the value of funding credits may be significantly  overstated.
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  (see fig. 4). Annual cash contributions for the 100 largest plans averaged  approximately $97 million on plans averaging $5.3 billion in current  liabilities (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 (in 2002 dollars), and in 2002,  when contributions increased significantly to $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. On average each year, 62.5 plans  received no cash contribution, including an annual average of 41 percent  of plans that were less than 100 percent funded.
As stated earlier, Bethlehem Steel and LTV Steel both had plans terminate  in 2002 that were only about 50 percent funded. Yet each plan was able to  forgo a cash contribution each year from 2000 to 2002, instead 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 at the time of  termination.
AFC, Primary Mechanism for Improving Funding of Underfunded  Plans, Proved Ineffective  The funding rules’ primary mechanism for improving the financial  condition of underfunded plans, the additional funding charge proved  ineffective in helping underfunded plans for four main reasons:  1.  Very few plans in our sample were actually assessed an AFC because  the rules, despite the statutory threshold of a 90 percent funding level  for some plans to owe an AFC, in practice require a plan to be much  more poorly funded to be subject to this requirement. From 1995 to  2002, an average of only 2.9 of the 100 largest DB plans each year were  assessed an additional funding charge, even though on average 10  percent of plans each year reported funding levels below 90 percent.  Over the entire 8-year period, only 6 unique plans that were among the  100 largest plans in any year from 1995 to 2002 owed an AFC. These 6  plans owed an AFC during the period a total of 23 times in years in  which they were among the 100 largest plans, meaning that plans that  were assessed an AFC were likely to owe it again.  2.  AFC rules also specify a current liability calculation method that may  overstate actual plan funding, relative to market-value measures,  thereby reducing the number of plans that might be assessed an AFC.  The specified interest rate for this calculation exceeded current  market rates in 98 percent of the months between 1995 and 2002.  3.  The AFC rules generally call for sponsors to pay only a percentage of  their unfunded liability, rather than requiring restoration of full  funding. On average, by the time a plan was assessed an AFC, it was  significantly underfunded and was likely to remain chronically  underfunded in subsequent years. Among the 6 plans that owed the  AFC, funding levels rose slightly from an average of 75 percent when  the plan was first assessed an AFC to an average of 76 percent, looking  collectively at all subsequent years. All of these plans were assessed an  AFC more than once.  4.  Plan sponsors can meet the AFC requirement by applying funding  credits earned in prior years in place of cash contributions. The  account value of these credits, which accumulate interest, may not  reflect the underlying value of the assets in the plan. Many plans  experienced significant market value losses of their assets between  2000 and 2002 while they were able to apply these funding credits.  Among the 100 largest plans, just 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.
The experience of two large terminated plans illustrates the  ineffectiveness of the AFC. For example, 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  its plan from 2000 to 2002. Both plans were able to apply existing credits  instead of cash to satisfy minimum funding requirements. In addition, both  sponsors had unused funding credits at the time their plans were  terminated.
section_title: Weaknesses in Funding Rules Amplified by Lack of Transparency Hinders Sound Policy making
paragraphs: Unclear measures of pension funding and a lack of timely information  have made it difficult for plan participants, investors, regulators, and  policy makers to accurately assess the financial condition of pension  plans. Without timely and reasonably accurate data about the financial  condition of pension plans, the various stakeholders cannot make timely  and informed decisions on retirement savings, employment, and other key  life issues. The primary regulatory filing for pension plans—the Form  5500--requires multiple measures of pension assets and liabilities, yet none  of these measures tell PBGC and plan participants what share of the  benefit obligations are funded in the event of plan termination.  Furthermore, by the time these regulatory reports are publicly available,  the information is usually at least 2 years old. In a time of significant  changes in interest rates and equity prices, it is possible that reported  measures of pension funding will substantially differ from current  measures of plan funding. PBGC does receive more current information  about plans that are underfunded by at least $50 million. This more current  information includes estimates of funding measures if the plan were to be  terminated; however, by law this information is not disclosed to the  public.
Our cash-based budgetary framework for federal insurance programs also  contributes to a lack of transparency that, at worst, may create  disincentives for policy makers to enact reform measures. With the  current cash-based reporting, premiums for insurance programs are  recorded in the budget when collected, and outlays are reported when  claims are paid. This focus on annual cash flows generally does not  adequately reflect the government’s cost for federal insurance programs  because the time between the extension of the insurance, the receipt of  premiums and other collections, the occurrence of an insured event, and  the payment of claims may extend over several budget periods. As a result,  the government’s cost may be understated in years that a program’s  current premium and other collections exceed current payments and  overstated in years that current claim payments exceed current  collections. This is especially problematic in the case of pension insurance  because of the erratic occurrence of plan terminations as well as the  mismatch between premium collections and benefit payments that can  extend over several decades.
Cash-based budgeting also may not be a very accurate gauge of the  economic impact of federal insurance programs. Although discerning the  economic impact of federal insurance programs can be difficult, private  economic behavior generally is affected when the government commits to  providing insurance coverage. In the case of PBGC, the existence of  pension insurance may encourage plan sponsors and employees to agree  to pension benefit increases in lieu of wage increases when the plan  sponsor faces economic difficulties.
Cash-based budgeting for federal insurance programs may provide neither  the information nor incentives necessary to signal emerging problems,  make adequate cost comparisons, control costs, or ensure the availability  of resources to pay future claims. Because the cash-based budget delays  recognition of emerging problems, it may not provide policy makers with  information or incentives to address potential funding shortfalls before  claim payments come due. Policy makers may not be alerted to the need to  address programmatic design issues because, in most cases, the budget  does not encourage them to consider the future costs of federal insurance  commitments. Thus, reforms aimed at reducing costs may be delayed. In  most cases, by the time costs are recorded in the budget, policy makers do  not have time to ensure that adequate resources are accumulated to pay  for them or to take actions to control them. The late budget recognition of  these costs can reduce the number of viable options available to policy  makers, ultimately increasing the cost to the government.
section_title: Retirement Income Security Requires Meaningful and Comprehensive Reform
paragraphs: In light of the intrinsic problems facing the defined benefit system,  meaningful and comprehensive pension reform is required to ensure that  workers and retirees receive the benefits promised to them and to secure  PBGC’s financial future. While PBGC’s current financial condition does  not represent a crisis, delaying reform will result in serious adverse  consequences for plan participants, the federal budget, and our nation’s  economy. At this time, the Administration, members of Congress, and  others have proposed reforms that seek to address many of the problems  facing PBGC and the defined benefit system. Such comprehensive  effective pension reform would likely include elements that would  improve measures of pension funding and enhance transparency of plan  information, strengthen funding rules (while preserving some contribution  flexibility for plan sponsors, modify certain PBGC guarantees, develop an  enhanced and more risk-based insurance premium structure, and resolve  outstanding controversies concerning hybrid plans, such as cash balance  plans.
subsections: section_title: GAO Has Suggested Elements of Pension Reform
paragraphs: Pension reform is a challenge 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 funding measures while minimizing  complexity and maintaining contribution flexibility;  revise the current funding rules to create incentives for plan sponsors to  adequately finance promised benefits;    develop a more risk-based PBGC insurance premium structure and  provides incentives for sponsors to fund plans adequately;     address the issue of underfunded plans paying lump sums and granting    modify PBGC guarantees of certain plan benefits (e.g., shutdown benefits); resolve outstanding controversies concerning hybrid plans by  safeguarding the benefits of workers regardless of age; and   improve plan information transparency for pension plan stakeholders  without overburdening plan sponsors.
Furthermore, if policy makers decide to provide measures of relief to  sponsors of poorly funded pension plans, there should be mechanisms  built into such laws that would prevent any undue exacerbation of PBGC’s  financial condition.
Developed in isolation, solutions to some of these concerns could erode  the effectiveness of other reform components or introduce needless  complexity. 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 defined benefit 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  workers’ benefits by providing employers the flexibility they need in  managing their pension plans while also holding those employers  accountable for the promises they make to their employees.
The debate over defined benefit pension reform should not take place in  isolation of larger related issues. Challenges in the defined benefit system,  together with the recent public debate over the merits of including  individual accounts as part of a more comprehensive Social Security  reform proposal, should lead us to consider fundamental questions about  how who should bear certain risks and responsibilities for economic  security in retirement.
Individual savings require greater responsibility and offer greater potential  rewards and the possibility of bequeathing any unused retirement savings.  However, longevity risk—the risk of outliving retirement savings—and  poor investment choice are significant concerns, particularly as health  care and long-term care costs and life expectancies continue to rise.
The federal government is in the best position to share risk across the  population, and social insurance programs, including Social Security,  Medicare, and Medicaid already reflect this fact. However, the current  structure of existing federal retirement programs is unsustainable.
Employer-sponsored pensions can alleviate longevity risk for plan  participants and are generally presumed to be better placed to manage  investment risk. However, poor management of plans can lead to shortfalls  in funding that can damage the competitiveness of the plan sponsors.  Furthermore, many employers are cutting or reducing retiree health  benefits, and even employee health benefits, as growing health care costs  threaten their competitiveness.
section_title: Experts Identified a Variety of Broad Pension Reforms
paragraphs: Earlier this year, GAO convened a forum on the future of the defined  benefit system and the PBGC that included a diverse group of about 40  pension experts, representing various interests, to discuss various reforms  to the defined benefit pension system. In addition to debating changes to  the funding rules and PBGC premiums, participants also talked about  ways to address pension legacy costs (the costs of terminated and  underfunded pension plans) and features of pension plans that  government policy should encourage.
According to participants in the GAO forum, resolution of pension legacy  costs and clarification of the legal status of cash balance and other hybrid  pension plans could play a significant role in shoring up the defined  benefit system. Separating legacy costs from the existing and future  liabilities of the remaining defined benefit plans might encourage plan  sponsors to remain in the defined benefit system. Many plan sponsors are  concerned that through increased PBGC premiums, they may be required  to pay for the failures of other companies to responsibly fund and manage  their pension plans. Some participants added that resolving legacy costs  could be a key component of any pension reform legislation that tightened  the funding rules and assessed premiums according to PBGC’s risk. Also,  some participants supported, and other participants opposed, the idea of  separately addressing the pension legacy costs of specific industries, such  as airlines and steel, which have imposed the most significant costs on  PBGC. Separately addressing pension legacy costs does not necessarily  imply a taxpayer bailout, as some participants suggested other ways to  cover their cost, such as through an airline ticket fee to cover the airlines’  share of PBGC’s deficit. Others noted that resolving the uncertain legal  status of cash balance and other hybrid pension plans could encourage  greater participation in the defined benefit system. Expanding the universe  of pension plan sponsors could lead to an increase in PBGC’s premium  income.
Some forum participants also suggested that the debate over federal  retirement policy needs to move beyond distinctions between defined  benefit and defined contribution plans. Others added that discussions of  retirement policy need to focus on ways to create incentives and remove  barriers for employers to set up retirement plans, and how to get American  workers to build adequate retirement savings and security. This may be  achieved by thinking about the interaction of private pensions and Social  Security and by looking at hybrid pension plans, such as cash balance  plans and plans that combine the best features of defined benefit and  defined contribution plans. Participants suggested new pension plan  designs be developed that explore the following features:    allowing automatic participation of the covered population in order to  expand pension coverage generally; improving the portability of pension benefits to accommodate workers  who frequently change jobs;   providing for professional money management and pooled investment    minimizing early withdrawals and borrowing—a problem known as  leakage—from retirement savings; and   providing incentives to receive benefits in the form of a fixed annuity,  rather than a lump-sum distribution.
section_title: Conclusions
paragraphs: Widely reported recent large plan terminations by bankrupt sponsors and  the resulting adverse consequences for plan participants and the PBGC  have pushed pension reform into the spotlight of national concern. Our  analysis here suggests that a variety of factors have contributed to the  current state of affairs: recent declines in interest rates and financial  markets, a soft economy, industry restructuring because of changes in the  national and world economies, weaknesses in the legal framework  governing pensions that has encouraged moral hazard by sponsors, the  underfunding of plans, and a lack of timely, accurate, useful and  transparent information that limits participants, unions, investors and  other stakeholders from being able to make accurate and timely decisions.
In light of the intrinsic problems facing the defined benefit system,  meaningful and comprehensive pension reform is required to ensure that  workers and retirees receive the benefits promised to them. At this time,  the Administration, members of Congress, and others have proposed  reforms that seek to address many of the problems facing PBGC and the  defined benefit system. This is a promising development that can be a  critical first step in addressing part of the long-term fiscal problems facing  this country. Such reform will demand wisdom and patience, given 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 funding measures while minimizing  complexity and maintaining contribution flexibility;  revise the current funding rules to create incentives for plan sponsors to  adequately finance promised benefits;    develop a more risk-based PBGC insurance premium structure and  provides incentives for sponsors to fund plans adequately;     address the issue of underfunded plans paying lump sums and granting    modify PBGC guarantees of certain plan benefits (e.g., shutdown benefits); resolve outstanding controversies concerning hybrid plans by  safeguarding the benefits of workers regardless of age; and   improve plan information transparency for pension plan stakeholders  without overburdening plan sponsors.
However, it is also necessary to keep in mind that pension reform is only  part of the broader fiscal, economic, workforce, and retirement security  challenges facing our nation. If you look ahead in the federal budget,  Social Security, together with the rapidly growing health programs  (Medicare and Medicaid), will dominate the federal government’s future  fiscal outlook. These are far larger and more urgent challenges,  representing an unsustainable burden on future generations. Furthermore,  pension reform should be considered in the context of the problems facing  our nation's Social Security system.  How we reform DB pensions has  crucial implications for directions taken in reforming Social Security. For  example, pension reforms that reduce the scope of the private pension  system or change the dominant form of private pension design may have  consequences for those elements of Social Security reform packages that  reduce benefits or include an individual accounts feature.
This also means that acting sooner rather than later will make reform less  costly and more feasible. Though smaller in scale than actuarial deficits in  Social Security, Medicare, and Medicaid, PBGC’s deficit threatens to  worsen our government’s long-term fiscal position. Finally, as with Social  Security, it is also important to evaluate pension reform proposals as  comprehensive packages. The elements of any reform proposal interact;  every package will have pluses and minuses, and no plan will satisfy  everyone on all dimensions. If we focus on the pros and cons of each  element of reform by itself, we may find it impossible to build the bridges  necessary to achieve consensus.
We look forward to working with Congress on these crucial issues.
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. Individuals making key contributions to this testimony include  David Eisenstadt and Charlie Jeszeck.
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