Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in Funding Rules
GAO-05-294: Published: May 31, 2005. Publicly Released: May 31, 2005.
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Pension funding rules are intended to ensure that plans have sufficient assets to pay promised benefits to plan participants. However, recent terminations of large underfunded plans, along with continued widespread underfunding, suggest weaknesses in these rules that may threaten retirement incomes of these plans' participants, as well as the future viability of the Pension Benefit Guaranty Corporation (PBGC) single-employer insurance program. We have prepared this report under the Comptroller General's authority, and it is intended to assist the Congress in improving the financial stability of the defined benefit (DB) system and PBGC. We have addressed this report to each congressional committee of jurisdiction to help in their deliberations. This report examines: (1) the recent funding and contribution experience of the nation's largest private DB plans; (2) the funding and contribution experience of large underfunded plans, and the role of the additional funding charge (AFC); and (3) the implications of large plans' recent funding experiences for PBGC, in terms of risk to the agency's ability to insure benefits.
Each year from 1995 to 2002, while most of the largest DB pension plans had assets that exceeded their current liabilities, 39 percent of plans on average were less than 100 percent funded. By 2002, almost one-fourth of the 100 largest plans were less than 90 percent funded. Further, because of leeway in the actuarial methodology and assumptions sponsors may use to measure plan assets and liabilities, underfunding may actually have been more severe and widespread than reported. Additionally, 62.5 percent of sponsors of the largest plans each year on average made no cash contribution because the rules allow sponsors to satisfy minimum funding requirements through plan accounting credits that substitute for cash contributions. From 1995 to 2002, only 6 unique plans in our sample were subject to an additional funding charge (AFC), the primary funding mechanism to address underfunding, a total of 23 times. By the time a firm was subject to an AFC, its plan was likely significantly underfunded, and such plans remained poorly funded. By using other funding credits, just over 30 percent of the time sponsors of these plans were able to forgo cash contributions in the years their plans were assessed an AFC. Two very large and significantly underfunded plans terminated without their sponsors owing a cash contribution in the 3 years prior to termination, illustrating further weaknesses in the AFC. To the extent that financially weak firms sponsor underfunded plans, weaknesses in funding rules create a potentially large financial risk to PBGC and thus retirement security generally. From 1995 to 2002, on average each year, 9 of the largest 100 plans had a sponsor with a speculative grade credit rating, suggesting financial weakness and poor creditworthiness. Plans of speculative grade-rated sponsors had lower average funding levels and were more likely to incur an AFC than other plans. As of September 30, 2004, PBGC estimated that plans of financially weak companies with a "reasonably possible" chance of termination had plans with an estimated $96 billion in underfunding.
Matters for Congressional Consideration
Status: Closed - Implemented
Comments: With the passage (and subsequent enactment) of the Pension Protection Act of 2006 (HR 4, P.L. 109-280), Congress has enacted among the most significant and broad-reaching changes to private pension law since the original passage of ERISA in 1974. Regarding PBGC premiums, the law effectively raises the variable rate premium by eliminating the waiver previously allowed for plans at the full funding limit. Further, fixed-rate premiums were raised by earlier legislation, the Deficit Reduction Act of 2005 (S. 1932), which raised premiums from $19/participant to $30/participant, which will adjust upwards to reflect wage growth. Both bills also implement a new termination premium of $1250/participant for sponsors that terminate a plan in bankruptcy and re-emerge from bankruptcy. Regarding lump sums, the law phases in a modified yield curve, similar to one that plans would use to calculate plan liabilities and the lump-sum present value of benefits, thereby maintaining neutrality between annuity payments and lump sums. The law sets an interest rate floor of 5.5% for calculating lump sum payments. It also places restrictions on lump-sum distributions made by plans that are 60 to 80 percent funded, and prohibits plans below 60 percent funded from paying lump sums. Such plans below 60 percent funded may also not pay shutdown benefits, and PBGC would now phase in the guarantee of shutdown benefits over 5 years from the time of the shutdown, equivalent to the funding of plan amendments. Regarding the additional funding charge, the law enacts several changes to increase contributions for underfunded plans. These include raising the full funding target from 90 to 100 percent, requiring stricter funding of plans considered at greater risk for termination, and requiring funding of plan funding deficits within 7 years. It thus effectively replaces the AFC with simplified rules to get all plans toward a 100 percent funding target.
Matter: As we have noted in previous reports, the Congress may wish to consider broad pension reform that is comprehensive in scope and balanced in effect. Along with changes in the areas of PBGC's premium structure, lump-sum distributions, shutdown benefits, and other areas, funding rule changes should be an essential element of DB pension reform. Such reform may result in a system with features very different from the framework currently governing DB plans and PBGC. However, significant reforms that would place the DB system and PBGC on a sounder financial footing could also be enacted and could retain many of the features of the current regulatory system. Should the Congress choose to move in this latter direction, this report highlights certain areas where carefully crafted changes could improve plan funding. Specifically, the Congress should consider measures that include strengthening the additional funding charge. One way to do this would be to consider raising the threshold levels of funding that trigger the AFC so that any sponsor with a plan less than 90 percent funded would have to make additional contributions. So that plans do not have an incentive to fund just barely above 90 percent, additional consideration may be given for a gradual phase-in of the AFC for plans that are underfunded between 90 percent and 100 percent of current liability. Requiring that financially weak plans that owe an AFC base their contributions on termination liability rather than current liability might add stringency to the minimum funding rules and might be appropriate, since weak sponsors of underfunded plans present a greater risk of distress termination to PBGC than other sponsors. These reforms could be enacted singly or jointly, but each would subject more plans to an AFC, and the reforms would shore up at-risk plans before underfunding becomes severe.
Status: Closed - Implemented
Comments: The Pension Protection Act of 2006 places new restrictions on the use of FSA credits as a means of meeting funding requirements. The law reduces the ability of plans to use existing credit balances toward minimum funding requirements by requiring plans to make certain funding calculations net of these balances. However, plans that are at least 80 percent funded may continue to use credit balances to offset minimum funding requirements. The law also amends the assumed interest rate return on credit balance to reflect recent market conditions.
Matter: As we have noted in previous reports, the Congress may wish to consider broad pension reform that is comprehensive in scope and balanced in effect. Along with changes in the areas of PBGC's premium structure, lump-sum distributions, shutdown benefits, and other areas, funding rule changes should be an essential element of DB pension reform. Such reform may result in a system with features very different from the framework currently governing DB plans and PBGC. However, significant reforms that would place the DB system and PBGC on a sounder financial footing could also be enacted and could retain many of the features of the current regulatory system. Should the Congress choose to move in this latter direction, this report highlights certain areas where carefully crafted changes could improve plan funding. Specifically, the Congress may wish to consider limiting the use of funding standard account (FSA) credits toward meeting minimum funding requirements. We have noted that some sponsors repeatedly relied on FSA credits, such as a prior year credit balance or net interest credits, to avoid making cash contributions to their plans, and that this has been particularly problematic for underfunded plans prior to their termination. While FSA credits may have the benefit of moderating contribution volatility in the near term, they also have the weakness of allowing the sponsors of severely underfunded plans to avoid cash contributions and may contribute to volatility later. The Congress may wish to consider ways, even if it retains the FSA, to scale back the substitution of credits for annual cash contributions.