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Testimony:

Before the Subcommittee on Government Management, Finance and 
Accountability, Committee on Government Reform, House of 
Representatives:

United States Government Accountability Office:

GAO:

For Release on Delivery Expected at 2:00 p.m. EST:

Wednesday, March 2, 2005:

Pension Benefit Guaranty Corporation: 

Structural Problems Limit Agency's Ability to Protect Itself from Risk:

Statement of David M. Walker, Comptroller General of the United States:

GAO-05-360T:

GAO Highlights:

Highlights of GAO-05-360T, a report to Subcommittee on Government 
Management, Finance, and Accountability, Committee on Government 
Reform, House of Representatives: 

Why GAO Did This Study:

More than 34 million workers and retirees in about 30,000 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 insurance programs 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, PBGCs 
single-employer pension insurance program incurred a net loss of $12.1 
billion for fiscal year 2004, and the programs 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 GAOs observations on (1) some of the 
structural problems that limit PBGCs ability to protect itself from 
risk and (2) steps PBGC has taken to forecast and manage the risks that 
it faces.

What GAO Found:

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 PBGCs 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.

Assets, Liabilities, and Net Financial Position of PBGCs Single-
Employer Insurance Program, 1980-2004: 

[See PDF for image]

[End of figure]

www.gao.gov/cgi-bin/getrpt?GAO-05-360T.

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Barbara Bovbjerg, (202) 
512-7215, bovbjergb@gao.gov.

[End of section]

Mr. Chairman and Members of the Subcommittee:

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.[Footnote 1] 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.[Footnote 2] 
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.[Footnote 3] 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.[Footnote 4] 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.[Footnote 5] PBGC was thus 
mandated to serve a social purpose and remain financially self- 
sufficient.[Footnote 6] 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.[Footnote 7] 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.

Background:

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.[Footnote 8] 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.[Footnote 9]

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.[Footnote 
10] 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.

Figure 1: Assets, Liabilities, and Net Financial Position of PBGC's 
Single-Employer Insurance Program, 1980-2004:

[See PDF for image]

[End of figure]

Structural Problems Limit PBGC's Ability to Protect Itself from Risk:

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.

Minimum Funding Rules Do Not Prevent Plans from Being Severely 
Underfunded:

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.[Footnote 11] 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.[Footnote 12] 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.[Footnote 13] 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.[Footnote 14] 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.[Footnote 15] 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.[Footnote 16]

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 Premium Structure Does Not Properly Reflect Risks to the 
Insurance Program:

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.[Footnote 17] 
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.

PBGC Is Subject to Moral Hazard:

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.

Administration Has Proposed Reforms to Address PBGC's Long-Term 
Challenges:

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.[Footnote 18]

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.

PBGC Has Attempted to Improve Its Ability to Forecast and Manage Risk 
but Ultimately Lacks Adequate Authority to Properly Do So:

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.

PBGC Uses Its Pension Insurance Modeling System to Forecast Its 
Potential Exposure to Future Claims, but Forecasting Firm Bankruptcies 
Is Difficult:

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.[Footnote 19] 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.[Footnote 20]

PBGC's Early Warning Program Is One Tool For Managing Risk:

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.

PBGC Has Developed an Initiative to Better Quantitatively Assess the 
Risk Associated with Individual Firms:

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.

PBGC Has Also Taken Steps to Better Protect Its Investment Portfolio 
from Certain Market Risks:

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.

Unlike Other Federal Insurance Programs, PBGC Has Limited Ability to 
Protect Itself From Risk:

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.[Footnote 21] 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.

Conclusion:

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.

Contacts and Acknowledgments:

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.

FOOTNOTES

[1] See GAO, 21st Century Challenges: Reexamining the Base of the 
Federal Government, GAO-05-325SP. (Washington, DC: February, 2005)

[2] ERISA has been amended a few times, notably in 1987 (Public Law 100-
203) and again in 1994 (Public Law 103-465), to respond to challenges 
facing the defined benefit pension system and PBGC.

[3] The company and the union agreed to terminate the plan along the 
lines set out in the collective bargaining agreement; retirees and 
retirement eligible employees over the age of 60 received full 
pensions, and vested employees under age 60 received a lump-sum payment 
worth about 15 percent of the value of their pensions. Employees, whose 
benefit accruals had not vested, including all employees under age 40, 
received nothing. James A. Wooten, "The Most Glorious Story of Failure 
in Business: The Studebaker-Packard Corporation and the Origins of 
ERISA." Buffalo Law Review, vol. 49 (Buffalo, NY: 2001):731.

[4] Some defined benefit plans are not covered by PBGC insurance; for 
example, plans sponsored by professional service employers, such as 
physicians and lawyers, with 25 or fewer employees.

[5] See section 4002(a) of P.L. 93-406, Sept. 2, 1974.

[6] ERISA authorized PBGC to borrow up to $100 million from the U.S. 
Treasury to cover temporary cash shortfalls.

[7] Moral hazard surfaces when the insured parties--in this case, plan 
sponsors--engage in risky behavior knowing that the guarantor will 
assume a substantial portion of the risk. In the case of the pension 
insurance system, this might include the willingness of parties to 
enter into agreements that increase pension liabilities, rather than 
taking wage increases.

[8] PBGC also assumes the assets of the plans it takes over in a plan 
termination and any investment income from these assets may be used to 
pay out benefits to participants of terminated plans.

[9] For most of its history, PBGC has received most of its premium 
income from flat-rate premiums.

[10] See GAO, Pension Benefit Guaranty Corporation Single-Employer 
Insurance Program: Long-Term Vulnerabilities Warrant "High Risk" 
Designation, GAO-03-1050SP (Washington, DC: July 23, 2003).

[11] Pension funding rules include minimum funding requirements for all 
plans and additional funding requirements for underfunded plans that 
set minimum contribution requirements for plan sponsors.

[12] Under one of the amendments to ERISA in 1987, an additional 
funding requirement rule was added. Generally speaking, large single- 
employer plans are subject to a deficit reduction contribution if the 
value of plan assets is less than 90 percent of a standardized 
liability measure. To determine whether the additional funding rule 
applies to a plan, the IRC requires sponsors to calculate this 
liability using the highest interest rate allowable for the plan year. 
See 26 U.S.C. 412(l)(9)(C).

[13] See 26 U.S.C. 412(b).

[14] Some measures exist to limit losses incurred by PBGC from benefits 
added to a plan within the 5-year period prior to plan termination.

[15] See 26 U.S.C. 412(m)(4)(D).

[16] Shutdown benefit payments begin immediately after a facility 
closes, using assets accumulated to pay other plan benefits.

[17] Boyce, Steven, and Richard A. Ippolitio, "The Cost of Pension 
Insurance," The Journal of Risk and Insurance, (2002) Vol 69, No. 2, 
pp.121-170.

[18] PBGC's board is composed of the Secretary of Labor, the Secretary 
of the Treasury, and the Secretary of Commerce.

[19] Altman, Edward. "Predicting Financial Distress of Companies: 
Revisiting the Z-Score and Zeta Models," July 2000. Retrieved from 
http://pages.stern.nyu.edu/~ealtman/Zscores.pdf 

[20] Mossman, Charles, et al. "An Empirical Comparison of Bankruptcy 
Models," The Financial Review, (1998) Vol 33, pp. 35-54.

[21] Before granting access to the federal deposit insurance system, 
FDIC evaluates the potential risk to the funds. It assesses the 
adequacy of an applicant's capital, financial history and condition, 
and its future earnings potential, as well as the general character of 
its management.