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. 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. 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. 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. 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.