Don't Repeat Costly Policy Mistakes with Employer-Provided Pensions

The risk that the nation’s pension insurance system will become untenable continues to climb, threatening dire future choices between widespread worker benefit losses and a taxpayer-financed bailout. Last November it was revealed that the deficit in the PBGC pension insurance system (the shortfall of its assets relative to its projected liabilities) had reached $26 billion, and that the cost of “reasonably possible” terminations of insured pension plans had jumped to a sobering $250 billion. PBGC’s net deficit is now the highest in its history. As policy makers confront this situation, they must take care not to repeat past policy mistakes that are virtually certain to lead to future disaster.

Employer-provided pensions are insured by the Pension Benefit Guaranty Corporation (PBGC), a federally-chartered corporation. Pension sponsors pay premiums for this insurance. If a pension plan terminates, often because of a sponsor’s bankruptcy, the PBGC takes over both the benefit obligations (up to a statutory cap) and the assets of the plan. Federal law determines the premiums that sponsors must pay, how they measure their pension assets and liabilities, and the funding contributions they must make. If a plan terminates while underfunded, the finances of the insurance system take a hit and workers (those promised benefits in excess of the cap) can lose pension benefits.

The PBGC insurance system has been in serious and worsening financial condition for several years. Its deficit spiked in 2009 after the financial markets plunged, but it faced significant problems well before then. In each of the last nine years, PBGC’s liabilities have been measured as being at least 15 percent larger than its assets, and usually much more.

In my paper published by the Mercatus Center last year, and in my book “Pension Wise,” I describe the factors that have led to pensions being underfunded: inaccurate measurements of plan assets and liabilities, inadequate statutory funding targets, allowance of unfunded benefit increases, special preferences for certain industries and other loopholes, inadequate premiums, legal constraints upon PBGC, political economy/moral hazard factors, periodically legislated funding relief, inadequate funding disclosure, and statutory barriers to sponsors funding up during good economic times.

One of these factors – special preferences for certain industries – has recently risen up to bite policy makers in a big way. In 2006, as part of the Pension Protection Act (PPA), airline pension sponsors were given special funding breaks not provided to others. They were allowed to use an unrealistically high (8.25 percent) interest rate to shrink the apparent size of their benefit obligations, as well as a longer amortization period for addressing plan underfunding.

Last November American Airlines nevertheless filed for bankruptcy and moved to terminate its pension plans. PBGC has argued, rightly, that the funding relief given to airlines means that the pension insurance system is now being asked to pick up the tab for a bigger share of American’s pension promises.

Of course, the biggest problem with the airline funding relief was always that it was a special deal for the airlines alone. As I wrote last year, “There should be no special exemptions for politically favored industries as exist under current law. These are unfair, they undermine funding adequacy, and they establish troublesome and potentially costly precedents. A private insurer would not be allowed to discriminate between covered entities based on political preference; the public pension insurance system should be bound by a similar ethic.”

The airline funding break would also have been bad policy if applied across all industries. Airlines had lobbied for the relief with the argument that without it they would be forced to terminate their troubled, underfunded pension plans. But the reality is that when funding relief is given to the sponsor of an underfunded plan, a likely outcome is that the plan simply grows more underfunded – meaning a costlier later hit on the pension insurance system (and, if it becomes insolvent, on taxpayers).

Lawmakers need to remember this episode as they consider the latest lobbying push to relieve pension sponsors of their statutory funding obligations. The relief sought would employ higher-than-market discount rates to shrink the apparent size of pension liabilities and greatly lengthen the amortization period over which pension underfunding is addressed. Not coincidentally, these are the same two levers that were used to deliver funding relief to the airlines in the 2006 PPA.

I am sympathetic to the argument that during troubled economic times, pension sponsors may need some relief to maintain their plans. That said, many wrong arguments are being made for such relief, and the wrong remedies are being prescribed.

To frame the argument for pension funding relief in terms of “raising revenue and saving jobs,” as the lobbying effort has done, is the wrong way to think about pension policy. While it’s true that if employers are excused from funding their pension promises they will make fewer tax-deductible contributions and thus expose more corporate income to tax, this hardly implies that pensions should deliberately be left underfunded as a “revenue raiser.” This would only increase the risk that other taxpayer dollars will eventually be tapped to rescue the pension insurance system.

Similarly, while pension sponsors could undoubtedly offer more jobs if the costs of their pension promises were shifted to third parties, this does not render it sound policy to relax pension funding obligations in the name of “job creation.” Pension funding policy should be based on what is good for pensions. If we want to give a helping hand to job creators, it should not be done by having third parties pick up the tab for worker compensation in the form of pension benefits.

It’s an unavoidable reality that the present value of pension liabilities rises when interest rates are low as they now are. Papering over that reality doesn’t eliminate it. Pension sponsors are already receiving something of a funding break by being allowed to use corporate bond rates to measure their liabilities, rather than the Treasury bond rates that economists generally agree are appropriate for discounting benefits that are “risk-free” due to being insured. While the financial pressures on employers are real, plan sponsors are nevertheless being somewhat shielded already from the real-world cost of their pension promises. No matter what, future pension contributions will need to be higher than the unsustainably low levels of recent years.

As lawmakers consider whether to provide additional funding relief to pension sponsors, I offer a few rules of thumb:

1. Any such relief should only be given through contribution rules, not by allowing the use of outdated, higher-than-market discount rates. If the policy intent is to limit the volatility of annual required contributions, this is most straightforwardly accomplished by doing just that: statutorily limiting the volatility of annual required contributions. This should not be done by distorting liability measurements via “smoothing” with outdated interest rates. Lawmakers must be careful not to confuse the goal of limiting contribution volatility with backtracking on pension accounting transparency.
2. There should be one amortization period for everyone and it should aim at 100% funding. It is reasonable to argue that funding amortization periods should be something other than the seven-year period established under the PPA. But Congress should avoid the complexity and unintended consequences associated with allowing multiple amortization periods, and should also avoid having any schedule aim (at least as its ultimate target) at less than 100% funding.
3. Funding relief should not last longer than economic conditions warrant. It is reasonable to establish a protracted amortization schedule if Congress concludes that temporary economic conditions warrant it. For example, a single schedule of N + 7 years could be used for everyone, with N being a period over which payments may be limited to covering a plan’s annual accruals and interest on its shortfall (so that a plan’s funding hole doesn’t grow deeper) before the 7-year amortization period resumes. N could be chosen to reflect expectations of a return to more normal economic conditions. But Congress should not establish lengthy amortization periods that would continue to foster underfunding even if the economy rebounds. If pension sponsors cannot restore their plans to sound funding even after the economy returns to normal, then it is best to face the consequences of their termination now before the funding hole grows too much larger.

The American Airlines pension situation is a case study in what happens when lawmakers react to pension underfunding by deliberately allowing more of it. Congress needs to think twice before extending this mistake to the entire community of pension plan sponsors.

Charles Blahous is a research fellow with the Hoover Institution, a senior research fellow with the Mercatus Center, and the author of Social Security: The Unfinished Work.