Private Pensions: Recent Experiences of Large Defined Benefit	 
Plans Illustrate Weaknesses in Funding Rules (31-MAY-05,	 
GAO-05-294).							 
                                                                 
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.							 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-294 					        
    ACCNO:   A25378						        
  TITLE:     Private Pensions: Recent Experiences of Large Defined    
Benefit Plans Illustrate Weaknesses in Funding Rules		 
     DATE:   05/31/2005 
  SUBJECT:   Amortization					 
	     Employee retirement plans				 
	     Federal funds					 
	     Fringe benefits					 
	     Funds management					 
	     Interest rates					 
	     Pensions						 
	     Program evaluation 				 
	     Program management 				 
	     Risk management					 
	     Financial analysis 				 
	     Benefit-cost tracking				 
	     Defined benefit plans				 

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GAO-05-294

United States Government Accountability Office

GAO

                       Report to Congressional Committees

May 2005

PRIVATE PENSIONS

Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in
                                 Funding Rules

GAO-05-294

[IMG]

May 2005

PRIVATE PENSIONS

Recent Experiences of Large Defined Benefit Plans Illustrate Weaknesses in
Funding Rules

What GAO Found

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.

Funding Levels among the Annual 100 Largest DB Plans, 1995-2002 Percentage
of 100 largest DB plans 100

80

60

40

20

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Less than 80% to less

90% to less than 100% funded

100% to less 110% funded

80% funded than 90% funded

than 110% funded or above Source: GAO analysis of PBGC Form 5500 research
data.

United States Government Accountability Office

Contents

Letter

Results in Brief
Background
Many of the 100 Largest Plans' Liabilities Exceeded Plan Assets

from 1995 to 2002, and Few Sponsors Were Required to Make Cash
Contributions Very Few Sponsors of Underfunded Large Plans Paid an AFC
from 1995 to 2002 Large Plans' Sponsors' Credit Ratings Appear Related to
Certain

Funding Behavior and Represent Risk to PBGC Conclusions Matters for
Congressional Consideration Agency Comments

                                       1

                                      3 5

11

25

30 37 40 41

Appendix I Scope and Methodology

Appendix II	Statistics for Largest 100 Defined Benefit Plans, 1995-2002

Appendix III Comments from the Department of Labor

Appendix IV	Comments from the Pension Benefit Guaranty Corporation

Appendix V GAO Contact and Staff Acknowledgments

                                  Glossary 53

                            Related GAO Products 55

Tables

Table 1: FSA Credits and Charges for Bethlehem Steel and LTV

Steel Plans, 2000-2002 Table 2: Average Plan Size and Funding Levels Table
3: Cash Contributions Table 4: Funding Standard Account (FSA) Credits,
Other than Cash

Contributions Table 5: Full Funding Limitation (FFL) Table 6: Additional
Funding Charge (AFC) 23 46 46

47 47 48

Figures

Figure 1: Accumulated Surplus/Deficit and Annual Net Gain/Loss of

PBGC Single-Employer Program 10 Figure 2: Almost One-Fourth of the Largest
Pension Plans Were Less than 90 Percent Funded on a Current Liability
Basis in 2002 13

Figure 3: Most Sponsors Made No Cash Contribution Most Years 17 Figure 4:
Average Cash Contributions, as a Percentage of Minimum

Required Annual Funding, Were Lowest during Strong

Funding Years 19 Figure 5: Distribution of Average Cash Contributions, as
a Percentage of Minimum Required Annual Funding, Illustrates that Plans
Relied More Heavily on FSA Credits to Meet Minimum Funding Obligations
from 1997 to 2000 20 Figure 6: For Selected Years from 1996 to 2002, Most
Sponsors

Contributed the Plan's Maximum Deductible Amount,

Which for a Number of Plans Was Zero 25 Figure 7: Most Plans Less than 90
Percent Funded Were Not Assessed an AFC 27 Figure 8: AFC Assessments
Sometimes Exceeded Cash Contributions of Plans Subject to AFC, 1995-2002
29 Figure 9: Plans Sponsored by Firms with a Speculative Grade

Rating Generally Had Lower Levels of Funding on a

Current Liability Basis 32 Figure 10: Sponsors with Speculative Grade
Ratings Are More Likely to Use the Highest Allowable Interest Rate to
Estimate Current Plan Liabilities 33 Figure 11: Total Underfunding among
All DB Plans, and among

Those Considered by PBGC as Reasonably Possible for

Termination, Has Increased Markedly since 2001 35

Figure 12: Over 80 Percent of Sponsors Associated with PBGC's Largest
Termination Claims Had Speculative Grade Ratings 10 Years prior to
Termination

Abbreviations

AFC additional funding charge
DB defined benefit
DRC deficit reduction contribution
ERISA Employee Retirement Income Security Act
FFL full funding limitation
FSA funding standard account
IRC Internal Revenue Code
OBRA '87 Omnibus Budget Reconciliation Act of 1987
PBGC Pension Benefit Guaranty Corporation
PRAD Policy, Research and Analysis Department
S&P Standard and Poor's

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United States Government Accountability Office Washington, DC 20548

May 31, 2005

Congressional Committees

The Pension Benefit Guaranty Corporation's (PBGC) single-employer
insurance program is a federal program that insures certain benefits of
the more than 34 million worker, retiree, and separated vested
participants of over 29,000 private sector defined benefit (DB) pension
plans. In recent years, because of unfavorable economic conditions and the
collapse of large underfunded pension plans sponsored by well-known firms
like Bethlehem Steel, U.S. Airways, and United Airlines, the program's
financial condition has worsened significantly. From a $9.7 billion
surplus at the end of fiscal year 2000, the program reported a $23.3
billion deficit as of September 2004, including a $12.1 billion loss for
fiscal year 2004.1 In addition, financially weak firms sponsored DB plans
with a combined $96 billion of underfunding as of September 2004, up from
$35 billion as of 2 years earlier.2 These figures illustrate both PBGC's
current financial difficulties and the ongoing threat underfunded DB
pension plans pose to the agency.

The Employee Retirement Income Security Act of 1974 (ERISA), as amended,
and the Internal Revenue Code (IRC) prescribe pension funding rules to
determine how much a firm sponsoring a DB pension plan (or "sponsor") must
contribute to its plans each year.3 An amendment to ERISA and the tax code
added the additional funding charge (AFC), a

1This figure represents the excess of the net present value of PBGC's
single-employer program's future benefit payments to participants of
terminated plans, plus expenses, over the program's assets, plus
anticipated losses from probable future terminations. The $23.3 billion
deficit for fiscal year 2004 already includes the recent takeover by PBGC
of several United Airlines pension plans.

2The recent downgrading of the credit ratings for Ford and General Motors
to noninvestment grade status is likely to raise this $96 billion figure
significantly.

3For key legislative changes that have affected the single-employer
program, see GAO, Pension Benefit Guaranty Corporation: Single-Employer
Pension Insurance Program Faces Significant Long-Term Risks, GAO-04-90
(Washington, D.C.: Oct. 29, 2003), appendix II.

supplementary charge assessed to sponsors of certain underfunded plans.4
While these funding rules seek to ensure that plans contain sufficient
assets to pay promised pension benefits to plan participants, recent
terminations of large and severely underfunded pension plans have called
into question their effectiveness.

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 system and PBGC. As it may prove helpful
in the deliberations of committees with jurisdiction over pension issues,
we have addressed this report to each of these committees. In previous
reports, we have called for comprehensive DB pension reform that, among
other elements, would include changes to the current funding rules to
encourage firms to better, and more transparently, fund their plans. We
have also called for a range of PBGC insurance program and other related
reforms.5 Because of the risks facing the single-employer program, in July
2003 we placed the program on our high-risk list of government operations
facing significant vulnerabilities.6 Further, there are parallels between
the financial problems of the DB pension system and those of Social
Security, currently the focus of domestic public policy debate, as well as
the broader long-term budgetary challenges facing the federal government.7

To assess how well the minimum funding rules have performed and to better
understand how key rules work to protect plans from becoming severely
underfunded, we will address the following issues: (1) the recent trend in
funding and contribution behavior for the nation's largest private

4The AFC comprises different additional charges for specific underfunded
plan liabilities, including the deficit reduction contribution, or DRC.
Because the AFC combines the DRC with other charges and offsets, we refer
to the AFC, instead of the DRC, throughout this report as the "bottom
line" additional charge that some underfunded plans owe.

5Previously reported reforms include strengthening funding rules
applicable to poorly funded plans; modifying PBGC single-employer program
guarantees; restructuring PBGC premiums; and improving the availability of
information about plan investments, termination funding status, and
program guarantees. Several variations of reform were discussed within
each reform option. For further information, see GAO-04-90.

6For further information on the challenges facing PBGC, see GAO, Pension
Benefit Guaranty Corporation Single-Employer Pension Insurance Program:
Long-Term Vulnerabilities Warrant High-Risk Designation, GAO-03-1050SP
(Washington, D.C.: Jul. 23, 2003), and High-Risk Series: An Update,
GAO-05-207 (Washington, D.C.: Jan. 2005).

7See GAO, 21st Century Challenges: Re-Examining the Base of the Federal
Government, GAO-05-325SP (Washington, D.C.: Feb. 2005).

Results in Brief

DB plans, (2) the funding and contribution experience of large underfunded
plans and the role of the AFC, and (3) the implications of large plans'
recent funding experience for PBGC, in terms of risk to the agency's
ability to insure benefits.

Our analysis focused on DB pension data for the 100 largest plans as
ranked by current liabilities reported on Schedule B of the Form 55008
each year from 1995 to 2002, as well as on financial information on
sponsors of these large plans.9 For details on our scope and methodology,
please see appendix I. Our work was done in accordance with generally
accepted government auditing standards from November 2003 to May 2005.

From 1995 to 2002, while most of the 100 largest plans had assets that
exceeded their current liabilities, on average 39 of these plans each year
were less than 100 percent funded on a current liability basis; that is,
their plans' current liabilities exceeded plan assets reported at their
actuarial value. Overall, reported plan funding levels were generally
stable and strong over the late 1990s, with no more than 9 of the 100
largest plans less than 90 percent funded in any year from 1996 to 2000.
However, by 2002 over half of the 100 largest plans were less than 100
percent funded, and approximately one-fourth of plans were less than 90
percent funded. Further, because of leeway in the actuarial methodology
and assumptions that sponsors may use to measure plan assets and
liabilities, underfunding may actually have been more severe and
widespread than reported on the

8Form 5500 is a disclosure form that private sector employers with
qualified pension plans are required to file with the Internal Revenue
Service (IRS), Labor's Employee Benefit Security Administration (EBSA),
and PBGC. IRS administers and enforces tax code provisions concerning
private pension plans, EBSA enforces ERISA requirements regarding
disclosure and other issues, and PBGC insures the benefits of participants
in most private sector defined benefit pension plans that are eligible for
preferential tax treatment.

9These 100 plans are not a "closed group." For example, a plan that is one
of the 100 largest plans in one year may not be in the sample of plans if
its liabilities are not in the 100 largest plans for other years.
Twenty-five plans are in the sample every year from 1995 to 2002, and 51
plans are in at least 7 of the 8 years of the sample. From 1995 to 2002 we
witness 187 distinct plan identifiers called the employee identification
number (EIN) and plan identification number (PIN). However, the actual
number of completely unrelated plans in our sample may be lower than the
187 reported because a number of plan sponsors in our sample merged or
changed names. For various reasons, EINs and PINs used to identify Form
5500 filings can change throughout the life cycle of a plan. These changes
can occur because of changes in corporate structure, the sale of a
division or plant to another firm, or filer error.

Form 5500. Additionally, each year on average 62.5 percent of sponsors of
the 100 largest plans made no annual cash contributions to their plans.
One key reason for limited or no contributions is that the funding rules
allow a sponsor to satisfy minimum funding requirements without
necessarily making a cash contribution each year, even though the plan may
be underfunded.

From 1995 to 2002, very few sponsors of the 100 largest plans were
required to pay an additional funding charge (AFC), a funding mechanism
designed to reduce severe plan underfunding. Most of the affected plans
were less than 80 percent funded by the time they were assessed an AFC,
and those that owed an AFC were likely to remain significantly underfunded
and owe the AFC again in the future. Further, sponsors of 2 severely
underfunded plans that terminated were sometimes subject to a small or no
AFC, and made no cash contributions in the 3 years prior to termination.
Because funding rules allow sponsors owing an AFC to use credits other
than cash contributions to satisfy funding requirements, sponsors'
contributions on average were less than the AFC assessed. Just over 30
percent of the time a plan was assessed an AFC, the sponsor of that plan
did not make a cash contribution in the year that the AFC was assessed.

Underfunded plans sponsored by financially weak firms pose a greater risk
to PBGC than do other plans. From 1995 to 2002, on average, 9 percent of
the largest 100 plans each year had a sponsor with a speculative grade
credit rating, suggesting these firms' financial weakness and poor
creditworthiness. Firms with a speculative grade credit rating were more
likely to sponsor underfunded plans, implying that these plans presented a
significant risk to PBGC and other premium payers. As a group, these plans
had lower average funding levels and were more likely to incur an AFC. In
addition, speculative grade-rated sponsors generally had a higher
incidence of using the highest legally allowable interest rate to discount
reported plan liabilities. The use of higher interest rates tends to
depict plan funding in a more optimistic light. To the extent that the
interest rates used by plans are overly optimistic, these plans have the
potential to create additional financial exposure and thus risk to PBGC.
Of PBGC's 41 largest claims in which the rating of the sponsor was known,
39 have involved plan sponsors that were rated as speculative grade just
prior to termination. Among these claims, over 80 percent of plan sponsors
were rated as speculative grade 10 years prior to termination. The future
outlook is similar: Plans sponsored by companies with speculative grade
credit ratings and classified by PBGC as "reasonably possible" for
termination represent an estimated $96 billion in potential claims.

Background

Because the current DB pension funding rules appear to expose PBGC and
participants to the risk that plans will have insufficient assets to pay
promised benefits, this report raises two matters for congressional
consideration. To the extent that the current funding framework is
retained, these matters regard reforms to the funding rules that might be
considered to reduce the number and severity of underfunded plans and the
single-employer program's financial exposure.

In DB plans, formulas set by the employer determine employee benefits. DB
plan formulas vary widely, but benefits are frequently based on
participant pay and years of service, and typically paid upon retirement
as a lifetime annuity, or periodic payments until death.10 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.11 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 promised benefits.

Before the enactment of ERISA, few rules governed the funding of DB
pension plans, and participants had little assurance that they would
receive the benefits promised. ERISA, and several amendments to the law

10Lifetime annuities may also offer the option of continuing payments to a
survivor after the participant's death. Some DB plans also offer the
option of taking benefits as a lump-sum payment. For more on pension
dispositions, see GAO, Private Pensions: Participants Need Information on
Risks They Face in Managing Pension Assets at and during Retirement,
GAO-03-810 (Washington, D.C.: Jul. 29, 2003). In recent years, some
sponsors have converted their traditional DB plans to so-called hybrid, or
cash balance, plans. Cash balance plans are a form of defined benefit plan
that determines benefits on the basis of hypothetical individual accounts
and commonly offer a lump-sum feature. For more information on cash
balance plans, see GAO, Private Pensions: Implications of Conversions to
Cash Balance Plans, HEHS-00-185 (Washington, D.C.: Sept. 29, 2000), and
Cash Balance Plans: Implications for Retirement Income. HEHS-00-207
(Washington, D.C.: Sept. 29, 2000).

11Present value calculations reflect the time value of money-that a dollar
in the future is worth less than a dollar today, because the dollar today
can be invested and earn interest. Using a higher interest rate will lower
the present value of a stream of payments because it implies that a lower
level of assets today will be able to fund those future payments.

since its passage, established minimum funding requirements for sponsors
of pension plans in order to try to ensure that plans contain enough
assets to pay promised benefits. In principle, a sponsor must annually
fund the amount required to fund the plan's "normal cost," the amount of
earned benefits allocated during that year, plus a specified portion of
other liabilities that may be amortized over a period of years.

Compliance with the minimum funding requirements is recorded through the
plan's funding standard account (FSA). The FSA tracks events that affect
the financial health of a plan during that plan year: credits, which
reflect improvements to the plan's assets, such as contributions,
amortized experience gains,12 and interest; and charges, which reflect an
increase in the plan's financial requirements, such as the plan's normal
cost and amortized charges such as the initial actuarial liability,
experience losses, and increases in a plan's benefit formula.13 If FSA
credits exceed charges in a given plan year, the plan's FSA registers a
net "credit balance" that may be carried forward to the next plan year;
conversely, a prior year's funding deficiency also carries forward. The
FSA credit balance at year-end is equal to the FSA credit balance at the
beginning of the year plus FSA credits less FSA charges. Compliance with
the minimum funding standard requires that the FSA balance at the end of
the year is non-negative. An existing credit balance accrues interest and
may be drawn upon to help satisfy minimum funding requirements for future
plan years, and therefore may offset the need for future cash
contributions.

ERISA and the IRC prescribe rules regarding the assumptions that sponsors
must use to measure plan liabilities and assets. For example, for plan
years 2004 and 2005, the IRC specifies that the interest rate used to
calculate a plan's current liability must fall within 90 to 100 percent of
the weighted average of the rate on an index of long-term investment-grade
corporate bonds during the 4-year period ending on the last day before the

12Experience gains and losses reflect, among other things, the difference
between actual asset performance and the assumed rates of return on assets
for the plan, as reported in previous years.

13Plans may amortize experience gains or losses over a 5-year period.
Changes in the terms of the plan arising from plan amendments may be
amortized over a 30-year period. Thus, these events continue to affect the
FSA and plan funding for several years after they occur.

beginning of the plan year.14 Similarly, rules dictate that sponsors
report an "actuarial" value of assets that must be based on reasonable
assumptions and must take into account the assets' market value.15 This
value may differ in any given year, within a specified range,16 from the
current market value of plan assets, which plans also report. 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

17

benefits.

Funding rules generally treat a plan as an ongoing entity, 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 AFC, introduced by the Omnibus Budget
Reconciliation Act of 1987 (OBRA `87). The AFC requires sponsors of plans
with more than 100 participants that have become underfunded to a
prescribed level to make additional plan contributions in order to prevent
funding levels from falling too low. With some exceptions, plans with an
actuarial value of assets below 90 percent of current liabilities are
affected by the AFC

14The rate used to calculate current liability has usually been based on
the 30-year Treasury bond rate, with the allowable range above and below
the 4-year weighted average varying in different years. The Pension
Funding Equity Act of 2004 replaced the Treasury bond rate with the
corporate index for plan years 2004 and 2005. See IRC Section
412(b)(5)(B)(ii)(II). For further discussion of rates used to discount
pension liabilities, see GAO, Private Pensions: Process Needed to Monitor
the Mandated Interest Rate for Pension Calculations, GAO-03-313
(Washington, D.C.: Feb. 27, 2003).

1526 U.S.C. 412(c)(2)(A).

16Actuarial asset values cannot be consistently above or below market, but
in a given year may be anywhere from 80 to 120 percent of the market asset
level.

17A plan's current liability may differ from its "termination liability,"
which measures the value of accrued benefits using assumptions appropriate
for a terminating plan. Sponsors are required to provide PBGC with
termination liability information if, among other things, the aggregate
unfunded vested benefits of plans maintained by the contributing sponsor
and the members of its controlled group exceed $50 million. See 29 U.S.C.
1310. For further discussion of current versus termination liability, see
GAO-04-90, appendix IV.

rules.18 The rules for determining the amount of the AFC are complex, but
they generally call for sponsors to pay a percentage of their unfunded
liability. Under current law, plans that owe an AFC may still apply FSA
credits to meet their funding obligation and therefore may not be required
to satisfy the AFC with a cash contribution.

In addition to setting funding rules, ERISA established PBGC to guarantee
the payment of the pension benefits of participants, subject to certain
limits, in the event that the plan could not.19 Under ERISA, the
termination of a single-employer DB plan may result in an insurance claim
with the single-employer program if the plan has insufficient assets to
pay all benefits accrued under the plan up to the date of plan
termination.20 PBGC may pay only a portion of a participant's accrued
benefit because ERISA places limits on the PBGC benefit guarantee. For
example, PBGC generally does not guarantee benefits above a certain
amount, currently $45,614 annually per participant at age 65.21
Additionally, benefit increases arising from plan amendments in the 5
years immediately preceding plan termination are not fully guaranteed,
although PBGC will pay a portion of

18A single-employer plan may be subject to an AFC in a plan year if plan
assets fall below 90 percent of current liabilities. However, a plan is
not subject to an AFC if the value of plan assets (1) is at least 80
percent of current liability and (2) was at least 90 percent of current
liability for at least 2 consecutive of the 3 immediately preceding years.
To determine whether the AFC applies, the IRC requires sponsors to
calculate current liabilities using the highest interest rate allowable
for the plan year. See 26 U.S.C. 412(l)(9)(C).

19Some DB plans are not covered by PBGC insurance; for example, plans
sponsored by professional service employers, such as physicians and
lawyers, with 25 or fewer active participants.

20The termination of a fully funded DB plan is called a standard
termination. Plan sponsors may terminate fully funded plans by purchasing
a group annuity contract from an insurance company, under which the
insurance company agrees to pay all accrued benefits, or by paying
lump-sum benefits to participants if permissible. The termination of an
underfunded plan, termed a distress termination, is allowed if the plan
sponsor requests the termination and the sponsor satisfies other criteria.
Alternatively, PBGC may initiate an "involuntary" termination. PBGC may
institute proceedings to terminate a plan if the plan has not met the
minimum funding standard, the plan will be unable to pay benefits when
due, a reportable event has occurred, or the possible long-run loss to
PBGC with respect to the plan may reasonably be expected to increase
unreasonably if the plan is not terminated. See 29 U.S.C. 1342(a).

21This guarantee level applies to plans that terminate in 2005. The amount
guaranteed is adjusted (1) actuarially for the participant's age when PBGC
first begins paying benefits and (2) if benefits are not paid as a
single-life annuity. Because of the way ERISA allocates plan assets to
participants, certain participants can receive more than the PBGC
guaranteed amount.

these increases.22 Further, PBGC's benefit guarantee is limited to the
monthly straight life annuity benefit the participant would receive if she
were to commence the annuity at the plan's normal retirement age.23
Sponsors of PBGC-insured DB plans pay annual premiums to PBGC for their
coverage. 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

24

benefits.

Despite the presence of minimum funding rules and the AFC, plan
underfunding has persisted. In recent years, the level of total plan
underfunding has increased rapidly, from about $39 billion in 2000 to an
amount estimated to exceed $450 billion as of September 30, 2004. While
the single-employer program has over $39 billion in assets to pay benefits
in the near term, it already faces liabilities of over $62 billion. Thus,
there is concern that the expected continued termination of large plans by
bankrupt sponsors will push the program more quickly into insolvency,
generating greater pressure on the Congress, and ultimately the taxpayers,
to provide PBGC financial assistance to avoid reductions in guaranteed
payments to retirees.25 Because of concerns about the long-term viability
of the single-employer program, as illustrated by its growing accumulated
deficit (see fig. 1), in July 2003 we placed the program on GAO's
high-risk list of agencies and programs that need broad-based
transformations to address major challenges. In October 2003, we
identified several

22The guaranteed amount of the benefit amendment is calculated by
multiplying the number of years the benefit increase has been in effect,
not to exceed 5 years, by the greater of (1) 20 percent of the monthly
benefit increase calculated in accordance with PBGC regulations or (2) $20
per month. See 29 C.F.R. 4022.25(b).

23For more on PBGC guarantee limits, see Pension Benefit Guaranty
Corporation, Pension Insurance Data Book 1999 (Washington, D.C., Summer
2000), pp. 2-14.

24The additional premium equals $9.00 for each $1,000 (or fraction
thereof) of unfunded vested benefits. However, no such premium is charged
for any plan year if, as of the close of the preceding plan year,
contributions to the plan for the preceding plan year were not less than
the full funding limitation for the preceding plan year.

25PBGC has available a $100 million line of credit from the U.S. Treasury
for liquidity purposes if funds generated from premium receipts and
investment activities are insufficient to meet operating cash needs in any
period. However, while PBGC is a government corporation under ERISA, it is
not backed by the full faith and credit of the federal government. For
projections of the magnitude and timing of insolvency of PBGC's single
employer program, see, for example, "PBGC: Updated Cash Flow Model from
COFFI," Center on Federal Financial Institutions (COFFI) (Washington,
D.C.: Nov. 18, 2004).

categories of reform that the Congress might consider to strengthen the
program over the long term. We concluded that the Congress should consider
comprehensive reform measures to reduce the risks to the program's
long-term financial viability.26 These suggested reforms included
strengthening funding rules, along with possibly modifying program
guarantees; restructuring PBGC premiums; improving the transparency of
plan and program information; and certain other reforms.

Figure 1: Accumulated Surplus/Deficit and Annual Net Gain/Loss of PBGC
Single-Employer Program

Dollars in billions

                  1980 1983 1986 1989 1992 1995 1998 2001 2004

Year

Accumulated surplus/deficit Annual net gain/loss

               Source: the Pension Benefit Guaranty Corporation.

GAO has a statutory responsibility for auditing the overall financial
position of the executive branch of the U.S. government. In a recent
report, we describe the serious challenges facing the nation from current
fiscal policies that, if unchecked, will lead to large, escalating, and
unsustainable budget deficits.27 This fiscal challenge stems in part from

26GAO 04-90. 27See GAO-05-325SP.

Many of the 100 Largest Plans' Liabilities Exceeded Plan Assets from 1995
to 2002, and Few Sponsors Were Required to Make Cash Contributions

increasing obligations of retirement-related programs like Social
Security, which faces long-term financial insolvency because of increased
life expectancy. Improvements in life expectancy have extended the average
amount of time spent by workers in retirement, from 11.5 years in 1950 for
the average male worker to 18 years as of 2003.

In February 2005, the Administration proposed several measures designed to
strengthen funding for single-employer DB pension plans.28 The main
elements of reform include (1) reforming the funding rules to ensure that
sponsors keep their retirement promises; (2) improving disclosure to
workers, investors, and regulators about pension plan status; and (3)
reforming premiums to better reflect a plan's risk and restoring the PBGC
to financial health. The Administration asserts that such changes would
shore up the structural problems in the DB system and strengthen the
system's financial health.

From 1995 to 2002, while most of the 100 largest plans had sufficient
assets to cover their plan liabilities, many did not. On average, each
year 39 of these plans were less than 100 percent funded, and 10 had
assets below 90 percent of their current liabilities. Reported funding
levels for the group generally were stable and strong from 1996 to 2000,
but they worsened somewhat in 2001 before deteriorating noticeably in
2002. Furthermore, 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 at the end of the period. Because of flexible funding rules
permitting the use of accounting credits other than cash contributions to
satisfy minimum funding obligations, on average 62.5 of the 100 largest
plans each year received no cash contributions from their sponsors,
including 41 percent of plans that were less than 100 percent funded.

28See http://www.dol.gov/ebsa/pdf/SEPproposal2.pdf. Also see GAO-04-90,
appendix III, for more discussion of the Administration's earlier pension
reform proposal, announced on July 8, 2003.

Many Plans Each Year The 100 largest plans each year from 1995 to 2002
contained mostly well-Were Underfunded, and funded plans. However, on
average 39 of these plans each year were less More Became than 100 percent
funded; that is, for these plans, current liabilities Underfunded in
Recent exceeded the reported actuarial value of assets in the plan. An
average of

10 plans each year had asset levels below 90 percent of their currentYears
liability, and 3 plans were less than 80 percent funded (see fig. 2).29

29An underfunded plan does not necessarily indicate that the sponsor is
unable to pay current benefits. Underfunding means that the plan does not
currently have enough assets to pay all accrued benefits, a portion of
which will be paid in the future, under the given actuarial assumptions
about asset rate of return, retirement age, mortality, and other factors
that affect the amount and timing of benefits.

Figure 2: Almost One-Fourth of the Largest Pension Plans Were Less than 90
Percent Funded on a Current Liability Basis in 2002

Percentage of 100 largest DB plans 100

80

60

40

20

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Less than 80% funded

80% to less than 90% funded

90% to less than 100% funded

100% to less than 110% funded

110% funded or above

Source: GAO analysis of PBGC Form 5500 research data.

As a group, funding levels among the 100 largest plans were reasonably
stable and strong from 1996 to 2000. Except for 1999, in no year did more
than 39 plans have liabilities exceeding assets, and no more than 9 plans
each year were below 90 percent funded. In 2001 there were signs of
increased underfunding, and by 2002, more than half of the largest plans
were less than 100 percent funded, with 23 plans less than 90 percent
funded. Two factors in the deterioration of many plans' finances were the
decline in stock prices and in interest rates. From 2000 to 2002, the
Standard & Poor's (S&P) 500 stock index declined sharply each year. Given
that DB plans on average held approximately half of their assets in

stocks from 1995 to 2000,30 the decline in stock prices meant a sharp
decline in the value of many plans' pension assets. In addition, over the
sample period, 30-year Treasury bond rates, which served as the benchmark
for the rate used by plans to calculate pension liabilities, generally
fell steadily, raising liabilities.31 The combination of lower asset
values and higher pension liabilities had a serious adverse effect on
overall defined benefit funding levels.

Rules May Allow Reported Funding Levels to Overstate Current Funding
Levels

Use of an Above-Market Interest Rate to Calculate Liabilities

Accurate measurement of a plan's liabilities and assets is central to the
sponsor's ability to maintain assets sufficient to pay promised benefits,
as well as to the transparency of a plan's financial health. Because many
plans chose 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 for a number of reasons. These include the
use of above-market rates that differ from market values and the use of
actuarial asset values that may differ from current asset values. Two
large plans that terminated in 2002 illustrate the potential discrepancies
between reported and actual funding.

Reported current liabilities are calculated using a weighted average of
rates from the 4-year period before the plan year. This weighting offers
sponsors the advantage of being able to smooth fluctuations in liabilities
that sharp swings in interest rates would cause, thereby reducing
volatility in minimum funding requirements and making funding more
predictable. However, the weighting reduces the accuracy of liability
measurement because the rate anchoring reported liabilities is likely to
differ from current market values. If the rates used to calculate current
liabilities are falling, this would have the effect of decreasing the rise
in reported liabilities associated with lower rates, making plans appear
better funded

30See Board of Governors of the Federal System, "Flow of Funds Accounts of
the United States," Table L.119.b, Dec. 9, 2004. This approximation likely
understates stock holdings as a share of pension assets, as DB plans also
held assets in mutual fund shares, which may also contain stocks.

31Generally, a lower interest rate will raise plan liabilities, because a
lower rate implies a lower rate of return on plan assets, requiring a
higher level of assets to pay for benefits. However, in calculating
current liabilities, the IRC allowed plans to use an interest rate above
the benchmark 4-year weighted average, possibly offsetting the effects of
lower rates on current liability. For example, sponsors could pick a rate
up to 105 percent of the weighted average 30-year Treasury rate for plans
in 1999; in 2002, this upper range was changed to 120 percent of the
weighted average. See 26 U.S.C. 412(b)(5)(B).

Use of Actuarial versus Current Asset Values

than they actually were. In a rising interest rate environment, the
opposite would be true. However, because rules allowed sponsors to measure
liabilities using a rate above the 4-year weighted average, sponsors could
reduce plan current liabilities compared with what their value would be if
calculated at current rates.32 The 4-year weighted average of the
reference 30-year Treasury bond rate exceeded the current market rate in
76 percent of the months between 1995 and 2002, and the highest allowable
rate for calculating current liabilities exceeded the current rate in 98
percent of those months. Sponsors of the plans in our sample chose the
highest allowable interest rate to value their current liabilities 62
percent of the time from 1995 to 2002.

Similarly, for assets, the actuarial value of assets used for funding may
differ from current market values. The actuarial value of assets cannot be
consistently above or below market, but in a given year may be anywhere
from 80 to 120 percent of market asset level. In our sample, 86 percent of
plans reported a different value for actuarial and market assets. On
average, using the market value instead of actuarial value of assets would
have raised reported funding levels by 6.5 percent each year. However,
while the market value exceeded actuarial value of assets during the late
1990s, when plan funding was generally strong, in the weaker funding year
of 2002 market assets dipped below actuarial assets. In 2001 and 2002,
calculating plan funding levels using market assets would have greatly
increased the number of plans below 90 percent funded each year. A similar
calculation for 2002 would have drastically increased the number of large
plans below 80 percent funded, from 6 to 24. Thus, we see some evidence
that using actuarial asset values lowered the volatility of reported
funding levels relative to those using market asset values. However, the
actuarial value of assets also may have disguised plans' funded status as
their financial condition worsened.

32In 1987, the permissible range was not more than 10 percent above, and
not more than 10 percent below, the weighted average of the rates of
interest on 30-year Treasury bond securities during the 4-year period
ending on the last day before the beginning of the plan year. The top of
the permissible range was gradually reduced by 1 percent per year,
beginning with the 1995 plan year, to not more than 5 percent above the
weighted average rate effective for plan years beginning in 1999. The top
of the permissible range was increased to 20 percent above the weighted
average rate for 2002 and 2003. For 2004 and 2005, the Congress changed
the reference rate from the 30-year Treasury bond rate to a rate based on
long-term investment-grade corporate bonds, and reset the allowable range
for plans to 90 to 100 percent of this rate.

Two Terminated Plans Showed Large Differences between Reported and Actual
Funding

Some prominent recent plan terminations reveal some extreme discrepancies
between reported plan funding levels and market funding levels. The
Bethlehem Steel Corporation in 2002 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.
The PBGC single-employer program suffered a $3.7 billion loss as a result
of that termination, its largest ever at the time. Similarly, LTV Steel
Company reported that its pension plan for hourly employees was over 80
percent funded on its Form 5500 filing for plan year 2001. When this plan
terminated in March, 2002, it had assets equal to 52 percent of benefits,
a shortfall of $1.6 billion.33

Most Sponsors Most Years Made No Cash Contributions to Plans but Satisfied
Funding Requirements through Use of Accounting Credits

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.
Annual cash contributions for the 100 largest plans averaged approximately
$97 million on plans averaging $5.3 billion in current liabilities.34 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 (see fig. 3). 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.

33Several factors may explain the wide discrepancy between reported
funding levels and actual funding levels at termination. Reported funding
levels may use an actuarial value of assets, which may exceed the market
value at termination. In addition, termination liabilities are valued
using a different interest rate than that used for current liabilities.
Further, current liabilities and termination liabilities may be measured
at different times. Unfunded shutdown benefits may also raise termination
liabilities. For more discussion of the differences between termination
and current liabilities, see GAO-04-90, appendix IV.

34Figures are in 2002 dollars. The $97 million in contributions includes
contributions from both employers and employees, although the vast
majority of contributions come from employers. For 1995, the data set
contains only employer contributions.

Figure 3: Most Sponsors Made No Cash Contribution Most Years

Percentage of 100 largest DB plans with
sponsors forgoing cash contributions Average contributions (in millions of
2002 dollars)

80 400

70 350

60 300

50 250

40 200

30 150

20 100

10 50

00
1995 1996 1997 1998 1999 2000 2001 2002

Year

Average annual contribution for 100 largest plans

Percentage of plans with sponsors forgoing cash contributions

Source: GAO analysis of PBGC Form 5500 research data.

Note: Average contributions for 2002 are largely driven by one sponsor's
contribution to its plan. Disregarding this $15.2 billion contribution
reduces the average plan contribution for 2002 from $395 million to $246
million.

The funding rules allow sponsors to meet their plans' funding obligations
through means other than cash contributions. If a plan has sufficient FSA
credits from other sources, such as an existing credit balance or large
interest or amortization credits, to at least match its FSA charges, then
the plan does not have to make a cash contribution in that year. Because
meeting minimum funding requirements depends on reconciling total annual
credits and charges, and not specifically on cash contributions, these
other credits can substitute for cash contributions.

From 1995 to 2002, it appears that many of the largest plan sponsors
substituted a significant amount of FSA credits for cash contributions.
The average plan's credit balance carried over from a prior plan year
totaled about $572 million (2002 dollars) each year, and 88 percent of
plans on average carried forward a prior credit balance into the next plan
year from 1995 to 2002. Not only could these accumulated credit balances
help a plan to meet minimum funding obligations in future years, but they
also accrue

interest that further augments a plan's FSA credits. In contrast to large
prior-year credit balances, annual cash contributions averaged only $97
million, in 2002 dollars. On average each year, cash contributions
represented 90 percent of the minimum required annual funding (from cash
and credits).35 However, this average figure was elevated by high levels
of contributions by some plans in 1995, 1996 and 2002. From 1997 to 2000,
when funding levels were generally strong, cash contributions averaged
only 42 percent of minimum required annual contributions (see fig. 4).
During these years, a majority of plans in our sample received no cash
contribution (see fig. 5). Cash contributions represented a smaller
percentage of annual minimum required funding during years when plans were
generally well funded, indicating that in these years more plans relied
more heavily on credits to meet minimum funding obligations.

35Minimum required annual funding equals annual total FSA charges, less
net amortization credits and interest applied to these amortization
credits.

Figure 4: Average Cash Contributions, as a Percentage of Minimum Required
Annual Funding, Were Lowest during Strong Funding Years

Average cash contribution, as a percentage of plans' minimum required
funding

300

250

200

150

100

50

0 1995 1996 1997 1998 1999 2000 2001 2002 Year Source: GAO analysis of
PBGC Form 5500 research data. Note: This figure reports the average
percentage across plans for each year. Minimum required annual funding
equals total FSA charges, less amortization credits and interest on these
credits. Sponsors can use other FSA credits, if applicable, to satisfy
minimum funding requirements in lieu of cash. Plans with missing
components of the minimum required annual funding calculation or with
credits that exceed charges (1 plan per year on average) are excluded from
the figure.

Figure 5: Distribution of Average Cash Contributions, as a Percentage of
Minimum Required Annual Funding, Illustrates that Plans Relied More
Heavily on FSA Credits to Meet Minimum Funding Obligations from 1997 to
2000

Percentage of 100 largest DB plans

100

80

60

40

20

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Cash contributions accounted for 100% or more of minimum required annual
funding

Cash contributions accounted for 50% to less than 100% of minimum required
annual funding Cash contributions accounted for greater than 0% to less
than 50% of minimum required annual funding

Cash contributions accounted for 0% of minimum required annual funding
Source: GAO analysis of PBGC Form 5500 research data.

Note: Minimum required annual funding equals total FSA charges, less
amortization credits and interest on these credits. Sponsors can use other
FSA credits, if applicable, to satisfy minimum funding requirements in
lieu of cash. Plans with missing components of the minimum required annual
funding calculation or with credits that exceed charges (1 plan per year
on average) are excluded from the figure.

In addition to large credit balances brought forward from prior years,
sponsors added funding credits from other sources. For example, plans
reported approximately $42 million (2002 dollars) each year in net
interest credits. These credits accrue to a plan's FSA like interest on a
bank account, accruing to an existing credit balance at the beginning of
the plan year and to other credits, such as contributions, added during
the plan year. Rules also allow plans to accrue credits from the excess of
a plan's calculated minimum funding obligation above the plan's full
funding

limitation; these credits averaged $47 million (2002 dollars) from 1995 to
2002.36 Other plan events result in plan charges, which reflect events
that increase the plan's obligations. For example, plans reported annual
amortization losses, which could result from actual investment rates of
return on plan assets below assumed rates of return (including outright
losses) or increases in the generosity of plan benefits; these net
amortization charges averaged almost $28 million (2002 dollars) in our
sample. Total funding credits, offset by charges, may help satisfy a
plan's minimum funding obligation, substituting for cash contributions,
and may explain why a significant number of sponsors made zero cash
contributions to their plans in many years.

FSA Accounting Rules Can Make Required Contributions Less Volatile but May
Obscure Funded Status and Reduce Contributions

The FSA credit accounting system provides some advantages to DB plan
sponsors. Amortization rules require the sponsor to smooth certain events
that affect plan finances over several years, and accumulated credit
balances act as a buffer against swings in future funding requirements.37
These features often allow sponsors to better regulate their annual level
of contributions. In contrast, contributions and funding levels might
fluctuate greatly from year to year if funding were based strictly on
yearly differences between the market value of plan assets and current
liabilities. Thus, a contribution system with an FSA accounting feature
may make funding requirements less volatile and contributions more
predictable than one in which funding was based entirely on current assets
and liabilities. Similarly, current-law measurement and funding rules
provide a plan with some ability to dampen volatility in required funding
caused by economic events that may sharply change a plan's liabilities or
assets. Pension experts told us that this predictability and flexibility
make DB sponsorship more attractive to employers.38

36Full funding limitation rules set a ceiling for minimum annual funding
requirements for a plan each year, based on the plan's liabilities.

37Some experts argue that since a pension plan represents a long-term
financial commitment between a firm and its employees, and since current
liability measures include many benefits that will not be paid until far
in the future, it makes sense to smooth out year-to-year fluctuations
rather than force each plan to balance assets and liabilities at all
times.

38There are investment techniques, such as purchasing fixed income assets
whose payouts match the plan's expected payouts, that could make pension
funding relatively predictable, even without FSA smoothing. One possible
reason that such techniques are not widely used may be they are believed
to be more expensive, over the long term than an asset allocation with
significant equity investment exposure.

However, the FSA accounting system, by smoothing annual contributions and
liabilities, may distort a plan's funding level. For example, suppose a
sponsor accrues a $1 million credit balance from making a contribution
above the required minimum in a year. Suppose then that this $1 million
purchases assets that lose all of their value by the following year. Even
though the plan no longer had this $1 million in assets, the sponsor could
still use that credit balance (plus interest on the credit balance) to
reduce this year's contribution to the plan. Because of amortization
rules, the sponsor would have to report only a portion of that lost $1
million in asset value as a plan charge the following year.39 Similarly,
sponsors are required to amortize the financial effect of a change in a
plan's benefit formula, which might result in increased benefits and
therefore a higher funding obligation, over a 30-year period. Thus, even
though higher benefits would immediately raise a plan's obligation to
fund, the sponsor could spread this effect in the plan's FSA over 30
years. This disconnection between the reported and current market
condition of plan finances raises the risk that plans will not react
quickly enough to deteriorating plan conditions. Further, it reduces the
transparency of plan financial information to stakeholders, such as
participants, and investors.

The experience of two large plans that terminated in a severely
underfunded state help illustrate the potential disconnection between FSA
accounting and the plan's true funded status. As stated earlier, the
Bethlehem Steel Corporation and LTV Steel Company both had plans terminate
in 2002, each with assets approximately equal to 50 percent of the value
of benefits. 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 in 2002, the year of termination (see table 1).

39Conversely, a plan that experiences a large gain in assets must spread
this gain over several years, which would make the plan appear to be more
poorly funded that it actually was.

Table 1: FSA Credits and Charges for Bethlehem Steel and LTV Steel Plans,
                                   2000-2002

Figures in millions of dollars

                           Bethlehem Steel LTV Steel

                 Year                  2000  2001  2002    2000  2001    2002 
       Additional funding charge          0      0 181.2    2.2  73.3  
           Total FSA charges          277.0 281.0  457.9 351.8  342.9   179.4 
       Prior year credit balance      980.4 710.8  508.3 1294.3 1257.3 1169.2 
           Cash contribution              0      0   0        0      0 
           Total FSA credits          987.9 789.3  579.6 1609.1 1512.1 1218.5 
      End-of-year credit balance      710.8 508.3  121.7 1257.3 1169.2 1039.1 
     Funded percentage (actuarial                                      
      assets/current liabilities)     85.8% 83.9%  85.2% 88.1%  81.6%   58.4% 
Funded percentage at termination                                    
     (plan assets/future benefits)                 48.8%                51.9% 

Source: GAO Analysis of PBGC Form 5500 research data.

Note: For funded percentage at termination represents market-valued assets
as a percentage of PBGC-guaranteed benefits, plus any additional benefits
funded by the plan's assets after allocation under section 4044 of ERISA.
These benefits are valued at the PBGC interest rate, which is different
than that used to value current liability on Form 5500. For more
discussion of the differences between termination and current liabilities,
see GAO-04-90, appendix IV.

Full Funding Limitation Rule May Have Allowed Some Plan Sponsors to Forgo
Plan Contributions

Another possible explanation for the many instances in which sponsors made
no annual cash contribution regards the full funding limitation (FFL). The
FFL is a cap on minimum required contributions to plans that reach a
certain funding level in a given plan year.40 However, the FFL does not
necessarily represent the contribution that would raise plan assets to the
level of current liability. Between 1995 and 2002, rules permitted some
plans with assets as low as 90 percent of current liability to reach the
FFL, meaning that a plan could be considered fully funded without assets
sufficient to cover all accrued benefits. The FFL is also distinct from
the

40As with other funding rules, determining a plan's FFL is complicated.
From 1995 to 2002, the FFL equaled the higher of (1) 90 percent of the
plan's current liability or (2) the lower of (a) the accrued plan
liability or (b) 150 to 170 percent (depending on the year) of the current
liability. As of the 2004 plan year, the 150 to 170 percent measure no
longer factors in the determination of the FFL. For our sample of plans,
an average of 4 plans per year were above 150 to 170 percent (depending on
the year) of the current liability and had an FFL of zero. This means the
sponsors of these plans were most likely unable to make additional
contributions unless they paid an excise tax.

plan's annual maximum tax-deductible contribution.41 Because sponsors may
be subject to an excise tax on contributions above the maximum, the annual
maximum contribution can act as a real constraint on cash contributions.
In contrast, the FFL represents a "maximum minimum" contribution for a
sponsor in a given year-a ceiling on the sponsor's minimum funding
obligation for the plan.

Flexibility in the FFL rule has allowed many plan sponsors to take steps
to minimize their contributions. In our sample, from 1995 to 2002
approximately two-thirds of the sponsors in each year made an annual plan
contribution at least as large as the plan's FFL. However, in 65 percent
of these instances, the sponsor had chosen the highest allowable rate to
calculate current liability; using a lower rate to calculate current
liability may have resulted in a higher FFL, and therefore may have
required a higher contribution. Further, the FFL was equal to zero for 60
percent of plans each year, on average. This means that these plans were
permitted to forgo cash contributions as a result of the FFL rule. This
reflects the fact that if a plan's FFL equaled zero, that plan had assets
at least equal to 90 percent of current liabilities that year and would
not be required to make an additional contribution.

The interaction between the FFL rule and the annual maximum taxdeductible
contribution also has implications for the amount that plan sponsors can
contribute. In some years, the maximum deductible contribution rules truly
constrained some sponsors from making any cash contribution. In 1998, 50
of 60 plans that contributed to the maximum deductible amount had a
maximum deductible contribution of zero (see fig. 6). This meant that any
cash contribution into those plans that year would generally subject the
sponsor to an excise tax.42 For 37 of these plans, this was the case even
if the sponsor had chosen the lowest statutorily allowed interest rate for
plan funding purposes, which would have produced the highest calculated
current liabilities. This constraint did not apply to as many plans in
some other years. For example, in 1996, 52 plans contributed the maximum
deductible amount. Thirty of these

41A plan's maximum deductible contribution is based on some of the same
criteria as the FFL determination. A sponsor may also contribute up to the
unfunded current liability level in each year.

42For years after 2001, an employer may elect not to count contributions
as nondeductible up to the full-funding limitation that is based on the
accrued liability. Therefore, it could be possible for a sponsor to
contribute more than the maximum deductible amount and still avoid the
excise tax. See 26 U.S.C. 4972(c)(7).

plans had a maximum deductible contribution of zero. However, 16 of these
30 could have chosen a lower rate to raise their maximum deductible
contribution level.

Figure 6: For Selected Years from 1996 to 2002, Most Sponsors Contributed
the Plan's Maximum Deductible Amount, Which for a Number of Plans Was Zero

Percentage of 100 largest DB plans

70

60

50

40

30

20

10

0 1996 1998 2000 2001 2002

Year

Plans that contributed the maximum deductible amount with some cash
contributions Plans that contributed the maximum deductible amount with
zero cash contributions but could have used a lower interest rate to
increase cash contributions Plans that contributed the maximum deductible
amount with zero cash contributions and could not use a lower interest
rate to increase cash contributions Source: GAO analysis of PBGC Form 5500
research data matched to PBGC study on maximum deductible cash
contributions. Note: Years of analysis are not continuous, as the PBGC
study on maximum deductible contributions was conducted for years shown.
Information on maximum deductible contributions is missing for between 7
and 17 plans each year. Data for these plans were either missing or
incomplete to calculate the plan contributions with respect to the maximum
deductible contribution.

From 1995 to 2002, an average of only 2.9 of the 100 largest DB plans each
year were assessed an additional funding charge, the funding mechanism
designed to prevent severe plan underfunding, 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 placed 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. On average, by the time a

Very Few Sponsors of Underfunded Large Plans Paid an AFC from 1995 to 2002

plan was assessed an AFC, it was significantly underfunded and was likely
to remain chronically underfunded in subsequent years. Further, during
this period, 2 of these 6 plans that owed an AFC were terminated, each
with assets far below promised benefits and each without having had to
make a cash contribution in the 3 years prior to termination. As with
plans in general, funding rules allowed sponsors owing an AFC to use FSA
credits to help meet their funding obligations, in some years allowing
sponsors to forgo cash contributions altogether.

Few Plans Were Assessed an AFC, and These Plans Were Likely to Be Very
Underfunded

Funding rules dictate that a sponsor of a plan with more than 100
participants in which the plan's actuarial value of assets fall below 90
percent of liabilities, measured using the highest allowable interest
rate, may be liable for an AFC in that year. More specifically, a plan
that is between 80 and 90 percent funded is subject to an AFC unless the
plan was at least 90 percent funded in at least 2 consecutive of the 3
previous plan years.43 A plan with assets below 80 percent of liabilities,
calculated using the highest allowable rate, is assessed an AFC regardless
of its funding history.

Despite the statutory threshold of a 90 percent funding level for some
plans to owe an AFC, in practice a plan needed to be much more poorly
funded to become subject to an AFC. While about 10 plans in our sample
each year had funding below 90 percent on a current liability basis, on
average fewer than 3 plans each year owed an AFC (see fig. 7). From 1995
to 2002, only 6 of the 187 unique plans that composed the 100 largest
plans each year were ever assessed an AFC,44 and these plans owed an AFC a
total of 23 times in years in which they were among the 100 biggest plans.
By the time a sponsor owed an AFC, its plan had an average funding level
of 75 percent, suggesting that by the time the AFC was triggered, the
plan's financial condition was weak. Further, while we observed 60
instances between 1995 and 2002 in which a plan had funding levels between
80 and 90 percent, only 5 times was a plan in this funding range subject
to an

43For example, a sponsor of a plan that is 85 percent funded in 2003 would
be exempt from the AFC only if the plan's funding level exceeded 90
percent in 2000 and 2001 or in 2001 and 2002. See 26 U.S.C. 412(l)(9)(C).

44Unique plans refer to the number of plans we observed with distinct plan
identifiers called EINs and PINs. See footnote 9 for further information
on why the actual number of completely unrelated plans in our sample may
be lower than the 187 reported.

AFC. This would indicate that, in practice, 80 percent represented the
realistic funding threshold for owing or avoiding the AFC.

Figure 7: Most Plans Less than 90 Percent Funded Were Not Assessed an AFC

Percentage of 100 largest DB plans 25

20

15

10

5

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Plans less than 90% funded

Plans assessed an AFC

Source: GAO analysis of PBGC Form 5500 research data.

AFC rules specify a current liability calculation method that may
overstate actual plan funding, relative to using market measures, thereby
reducing the number of plans that might be assessed an AFC. To determine
if a sponsor owes an AFC, rules dictate that the sponsor calculate current
liability using the highest allowable interest rate, which results in a
plan's lowest possible measure of current liability. Because the highest
allowable rate exceeded current market rates in 98 percent of the months
from 1995 to 2002, this likely lowered current liability measures for AFC
purposes, which would cause fewer plans to be assessed an AFC. In our
sample, 5 plans that reported funding levels below 80 percent on a current
liability basis did not owe an AFC, perhaps because current liability does
not require the use of the highest allowable interest rate.

Sponsors that owed an AFC had mixed success at improving their plans'
financial conditions in subsequent years, and most of these plans remained
significantly underfunded. Among the 6 plans that owed the AFC at least

once, funding levels rose slightly from an average 75 percent when the
plan was first assessed an AFC to an average 76 percent, looking
collectively at all subsequent years. All of these plans were assessed an
AFC more than once, and 2 of the 6 plans terminated during the period,
each with a severe shortfall of assets relative to promised benefits,
creating large losses for PBGC's single-employer insurance program.
Further, the AFC was an imperfect mechanism for improving funding of these
plans prior to termination. Bethlehem Steel, which terminated its plan in
2002 with a funding level under 50 percent, was subject to an AFC that
year, but not from 1997 to 2001. LTV Steel, which terminated its pension
plan for hourly employees in 2002 with assets of $1.6 billion below the
value of benefits, did have 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 contributed no cash to its plan during those years,
instead using credits to satisfy its funding obligations (see table 1).

Funding Rules Allow Underfunded Plans, Including Those Owing AFC, to Forgo
Cash Contributions

While the formula to determine the amount is complex, the AFC equals
approximately 18 to 30 percent of the plan's unfunded liability, with more
underfunded plans owing a higher percentage than less underfunded plans.45
However, the funding rules allow sponsors to use other FSA credits, in
addition to cash contributions, to satisfy minimum funding obligations,
including the AFC. Among plans in our sample assessed an AFC, the average
annual AFC owed was $234 million, but annual contributions among this
group averaged $186 million, with both figures in 2002 dollars (see fig.
8). In addition, 61 percent of the time a plan was subject to an AFC, the
sponsor used an existing credit balance to help satisfy its funding
obligation. When it did so, the sponsor drew $283 million from the credit
balance-well above what sponsors owing an AFC contributed in cash, on
average. 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.

45The AFC represents the required payment in excess of the regular ERISA
minimum contribution, plus other possible additional charges. A plan owing
an AFC must pay between 18 and 30 percent of the plan's "unfunded new
liability," or liability incurred by the plan since the start of 1988,
plus other charges based on the plan's normal cost and other unfunded
liabilities. See 26 U.S.C. 412(l).

Figure 8: AFC Assessments Sometimes Exceeded Cash Contributions of Plans
Subject to AFC, 1995-2002

In millions of 2002 dollars

400

300

200

100

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Total AFC assessments

Total cash contributions by sponsors of plans with an AFC assessment

Source: GAO analysis of PBGC Form 5500 research data.

Again, terminated plans provide a stark illustration of weaknesses in the
rules' ability to ensure sufficient funding. 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.
Similarly, LTV Steel made no contributions to its plan from 2000 to 2002,
despite being assessed an AFC in each of those years. Both plans were able
to apply existing credits instead of cash to satisfy minimum funding
requirements.

Large Plans' Sponsors' Credit Ratings Appear Related to Certain Funding
Behavior and Represent Risk to PBGC

The recent funding experiences of large plans, especially those plans that
are sponsored by financially weak firms, illustrate the limited
effectiveness of certain current funding rules and represent a potentially
large implicit financial risk to PBGC. From 1995 to 2002, on average, 9
percent of the largest 100 plans had a sponsor with a speculative grade
credit rating, suggesting financial weakness and poor creditworthiness. As
a group, speculative grade-rated sponsors had lower average funding
levels, and were more likely to incur an AFC than other sponsors. In
addition, speculative grade-rated sponsors generally had a higher
incidence of using the highest legally allowable interest rate to discount
reported plan liabilities. Using a higher interest rate lowers a plan's
calculated current liabilities and may lower the plan's minimum funding
requirement; to the extent that this reduces contributions, using the
highest allowable interest rate may raise the chances of underfunding and
raise the financial exposure to PBGC. Of PBGC's 41 largest claims since
1975 in which the rating of the sponsor was known, 39 have involved plan
sponsors that were rated as speculative grade just prior to termination.
Among these claims, over 80 percent of plan sponsors were rated as
speculative grade 10 years prior to termination. The future outlook is
similar: plans sponsored by companies with speculative grade credit
ratings and classified by PBGC as "reasonably possible" of termination
represent an estimated $96 billion in potential claims.

Speculative Grade The financial health of a plan sponsor may be key to
plan funding Sponsors More Likely to decisions because sponsors must make
funding and contribution decisions Have Lower Funding in the context of
overall business operations. During our 1995 to 2002

Levels

sample period, we observed between 7 and 13 plans each year with sponsors
that had a speculative grade credit rating.46,47

From 1995 to 2002, we observed that plans with speculative grade-rated
sponsors had lower levels of average funding compared with the average for
the 100 largest plans. For instance, the average funding of plans of
sponsors that were rated as speculative grade was 12 percentage points
lower on average than the funding level for all plans from 1995 to 2002
(see fig. 9). Applying an alternative measure of plan funding that used
the reported market value measure of plan assets, we obtained broadly
similar results.48 Plans of speculative grade-rated sponsors were also
more likely to be underfunded. From 1995 to 2002, each year, on average,
18 percent of speculative grade-rated plans had assets that were below 90
percent of current liability. Plans of nonspeculative grade-rated sponsors
had just over half this incidence, or an average of 10 percent of plans
funded below 90 percent of current liability.

46The number of plans per year in our sample sponsored by firms with a
speculative grade rating is: 9 plans in 1995; 11 plans in 1996; 7 plans in
1997; 7 plans in 1998; 8 plans in 1999; 8 plans in 2000; 13 plans in 2001;
and 12 plans in 2002.

47Credit ratings are generally considered to be a useful proxy for a
firm's financial health. A credit rating, generally speaking, is a rating
service's current opinion of the creditworthiness of an obligor with
respect to a financial obligation. It typically takes into consideration
the creditworthiness of guarantors, insurers, or other forms of credit
enhancement on the obligation and takes into account the currency in which
the obligation is denominated. Moody's and Standard and Poor's (S&P) are
two examples of well-known ratings services. We use S&P ratings throughout
our report. S&P long-term credit ratings are divided into several
categories ranging from AAA, reflecting the strongest credit quality, to
D, reflecting the lowest. Ratings from AA to CCC may be modified by the
addition of a plus or minus sign to show relative standing within the
major rating categories. The term "investment grade" was originally used
by various regulatory bodies to connote obligations eligible for
investment by institutions such as banks, insurance companies, and savings
and loan associations. Over time, this term gained widespread usage
throughout the investment community. Ratings in the four highest
categories, AAA, AA, A, BBB, generally are recognized as being investment
grade. Debt rated BB or below generally is referred to as speculative
grade. Sometimes the term "junk bond" is used as a more irreverent
expression for this category of riskier debt.

48Using reported market assets as the numerator of the funding percentage,
the average funding of plans of sponsors that were rated as speculative
grade was 17 percentage points lower on average than the funding level for
all plans over the 1995-2002 period.

Figure 9: Plans Sponsored by Firms with a Speculative Grade Rating
Generally Had Lower Levels of Funding on a Current Liability Basis

Average funding level (in percent)

120

100

80

60

40

20

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Plans with investment grade-rated, unrated, or privately held sponsors

Plans with speculative grade-rated sponsors

Average of 100 largest DB plans

Source: GAO analysis of PBGC Form 5500 research data and COMPUSTAT data.

Large plans sponsored by firms with a speculative grade rating were also
more likely to incur an AFC. While speculative grade-rated sponsors
accounted for only 9 percent of all sponsors from 1995 to 2002, they
accounted for just over one-third (8 of 23) of all instances in which a
sponsor was required to pay an AFC.49 No high investment grade sponsors
(those rated AAA or AA) were required to pay an AFC for this period. While
the AFC is intended to be a backstop for underfunded plans, for our
sample, it affected only those plans that were rated A or lower. The AFC
may, to some extent, protect PBGC from additional losses so plans cannot
become even more underfunded, especially if the plan is at risk for
financial distress. However, to the extent that speculative grade-rated
sponsors are considered to pose a significant risk for near-term
bankruptcy, the AFC may not be an effective mechanism for improving a

49Six sponsors had plans that were assessed an AFC a total of 23 times
during the period.

plan's funding level. Plan sponsors that are in financial distress are, by
definition, having difficulty paying off debts and may be ill equipped to
increase cash contributions to their plan. That is, the AFC itself may be
a symptom of plan distress rather than a solution to improve a plan's
funding level. AAA or AA rated sponsors, on the other hand, were not
assessed an AFC from 1995 to 2002, as they likely had the financial
flexibility to increase contributions to avoid consistently falling below
funding levels that would have triggered the AFC.

Large plans with sponsors rated as speculative grade were generally more
likely to report current liabilities calculated by using the highest
allowable interest rate under the minimum funding rules. While a majority
of sponsors from all credit rating categories used the highest allowable
interest rate over the entire 1995 to 2002 period, speculative grade-rated
sponsors used the highest rate at an incidence 23 percentage points above
the incidence for all other plans in the sample (see fig. 10). The use of
higher interest rates likely lowers a plan's reported current liability
and minimum funding requirement. To the extent that this depresses cash
contributions, such plans may have a higher chance of underfunding, thus
creating additional financial risk to PBGC.

Figure 10: Sponsors with Speculative Grade Ratings Are More Likely to Use
the
Highest Allowable Interest Rate to Estimate Current Plan Liabilities
Percentage of plans with current liability calculated using the highest
allowable interest rate
100

75

50

25

0 1995 1996 1997 1998 1999 2000 2001 2002 Year

Plans with investment grade-rated, unrated, or privately held sponsors
Plans with speculative grade-rated sponsors
Average of 100 largest DB plans

    Source: GAO analysis of PBGC Form 5500 research data and COMPUSTAT data.

Speculative Grade-Rated Sponsors Represent Greater Risks to PBGC

Financial strength of plan sponsors' business operations has been a key
determinant of risk to PBGC. Financially weak sponsors are, by the nature
of the insurance offered by PBGC, likely to cause the most financial
burden to PBGC and other premium payers. For instance, PBGC typically
trustees a plan when a covered sponsor is unable to financially support
the plan, such as in the event of bankruptcy or insolvency.50 Current
funding rules, coupled with the presence of PBGC insurance, may create
certain incentives for financially distressed plan sponsors to avoid or
postpone contributions and increase benefits. Many of the minimum funding
rules are designed so that sponsors of ongoing plans may smooth
contributions over a number of years. Sponsors that are in financial
distress, however, may have a more limited time horizon and place other
financial priorities above "funding up" their pension plans. To the extent
that moral hazard from the presence of PBGC insurance causes financially
troubled sponsors to alter their funding behavior, PBGC's potential
exposure increases.51

Underfunded plans sponsored by financially weak firms pose the greatest
immediate threat to PBGC's single-employer program. PBGC's best estimate
of the total underfunding of plans sponsored by companies with credit
ratings below investment grade and classified by PBGC as reasonably
possible to terminate was an estimated $96 billion as of September 30,
2004 (see fig. 11).52

50In particular, a distress termination of a single employer's plan may
occur if the employer meets one of the following conditions: (1)
liquidation in bankruptcy or insolvency proceedings, (2) reorganization in
bankruptcy or insolvency proceedings where bankruptcy court determines
termination is necessary to allow reorganization, or (3) termination in
order to enable payment of debts while staying in business or to avoid
unreasonably burdensome pension costs caused by a decline of the
employer's covered workforce.

51For a discussion of moral hazard incentives, see GAO, Private Pensions:
Airline Plans' Underfunding Illustrates Broader Problems with the Defined
Benefit Pension System. GAO-05-108T (Washington, D.C.: Oct. 7, 2004).

52Criteria used for classifying a company as a reasonably possible
include, but are not limited to, one or more of the following conditions:
The plan sponsor is in Chapter 11 reorganization; funding waiver pending
or outstanding with the IRS; sponsor missed minimum funding contribution;
sponsor's bond rating is below-investment-grade for Standard & Poor's
(BB+) or Moody's (Ba1); sponsor has no bond rating but unsecured debt is
below investment grade; or sponsor has no bond rating, but the ratio of
long-term debt plus unfunded benefit liability to market value of shares
is 1.5 or greater.

Figure 11: Total Underfunding among All DB Plans, and among Those
Considered by PBGC as Reasonably Possible for Termination, Has Increased
Markedly since 2001

Dollars in billions

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Total underfunding among all PBGC insured DB plans other than plans
considered reasonably possible for termination

Underfunding among plans sponsored by firms that are speculatively rated
and considered reasonably possible for termination

        Source: PBGC 2003 annual data book and PBGC 2004 annual report.

Note: Underfunding figures for non-reasonably possible plans represent the
end of the calendar year, except for 2004, which represents the end of
fiscal year 2004 (September 30, 2004). Figures for reasonably possible
plans are taken as of the end of each fiscal year.

PBGC's claims experience shows that financially weak plans have been a
source of substantial claims. Of the 41 largest claims in PBGC history in
which a rating was known, 39 of the plan sponsors involved were credit
rated as speculative grade 3 years prior to termination (see fig. 12).
These claims account for 67 percent of the value of total gross claims on
the single-employer program from 1975 to 2004.53 Most of the plan sponsors

involved in these claims were given speculative grade ratings for many
more years prior to their eventual termination. Even 10 years prior to
plan

53Gross claims are the present value of future benefits less trusteed plan
assets.

termination, 33 of the 41 plan sponsors involved in the largest gross
claims, in which the rating of the sponsor was known, were rated as
speculative grade.54

Percentage of plan sponsors associated with PBGC's largest claims 100

90

80

70

60

50

40

30

20

10

0 109 876 543 21 Years prior to date of plan termination

Investment grade-rated

Speculative grade-rated

Source: PBGC.

Note: Based on 41 of PBGC's largest gross claims in which the rating of
the sponsor was known, representing over 67 percent of total gross claims
from 1975 to 2004. These 41 claims may include sponsors with more than one
plan and are not limited to those plans in our sample. Ratings based on
S&P rating.

54Speculative grade-rated issues tend to exhibit significant risk compared
with other rated issues, even under short time horizons. Historical
ratings indicate that speculative graderated plans are much more likely to
default on obligations than investment grade-rated issues. For instance,
over a 3-year period, the highest speculative grade (BB) rated issue
defaults roughly 7 percent of the time, or 4.3 times more frequently than
the lowest investment grade rating (BBB). Further, even lower-rated
speculative grade issuers tend to have even higher default probabilities
over a 3-year period-defaulting 19 and 45 percent of the time for B and
CCC/C rated companies respectively. Typically, an issued rating does not
change much from year to year. For example, looking at S&P ratings over
the 1981-2003 period, AAA-rated issuers were still rated AAA 1 year later
88 percent of the time and B rated-issuers remained B 1 year later 74
percent of the time.

Conclusions

Widely reported recent large plan terminations by bankrupt sponsors and
the financial consequences for PBGC have pushed pension reform into the
spotlight of national concern. Our past work has shown that the roots of
these current pension problems are broad and structural in nature, and
that the private DB pension system requires meaningful and comprehensive
reform. The Administration has already presented a proposal for reform and
others may soon emerge from the Congress. While the complexity of the
challenges suggests a considerable debate ahead, the emerging consensus
that action needs to be taken may be cause for optimism.

Our analysis here examines the effectiveness of certain funding rules and
suggests that these rules have contributed to the general underfunding of
pensions and, indirectly, to PBGC's recent financial difficulties. The
persistence of a large number of underfunded plans, even during the strong
economic period of the late 1990s, implies that current funding rules are
not stringent enough to ensure that sponsors can fund their pensions
adequately. Perhaps even more troubling is that current rules for
measuring and reporting plan assets and liabilities may not reflect true
current values and may understate the funding problem. Further, the very
small number of sponsors of underfunded plans that pay the AFC indicates
that the rule needs to be strengthened if it is to serve as the primary
mechanism for shoring up assets in underfunded plans.

The current rules have the reasonable and important goals of long-term
funding adequacy and short-term funding flexibility so as to reduce annual
contribution volatility. However, our work shows that although the current
system permits flexibility, it also permits reported plan funding to be
inadequate, misleading, and opaque, and even so, funding and contributions
for some plans can still swing wildly from year to year. This would appear
not to serve the interest of any DB pension stakeholders effectively. The
challenge is determining how to achieve a balance of interests: how to
temper the need for funding flexibility with accurate measurement,
adequate funding, and appropriate transparency. Our work shows that
although the current system permits flexibility, it also permits reported
plan funding to be inadequate, misleading, and opaque, and even so,
funding and contributions for some plans can still swing wildly from year
to year. This would appear not to serve the interest of any DB pension
stakeholders effectively.

Despite flaws in the funding rules, our work here shows that most of the
largest plans appear to be adequately funded. Rules should acknowledge
that funding will vary with cyclical economic conditions, and even

sponsors who make regular contributions may find their plans underfunded
on occasion. Periodic and mild underfunding is not usually a major
concern, but it becomes a threat to workers' benefits and to PBGC when the
sponsor becomes financially weak and the risk of bankruptcy and plan
termination becomes likely. This suggests that perhaps the stringency of
certain funding rules can be adjusted depending on the financial strength
of the sponsor, with stronger sponsors being allowed greater latitude in
funding and contributions than weaker sponsors that might present a
near-term bankruptcy risk.55 However, focusing more stringent funding
obligations on weak plans and sponsors is difficult in that strong firms
and industries can quickly become risky ones, and once sponsors and plans
become too weak, it may be difficult for them to make larger contributions
and still recover.

It should be noted also that while change in the funding rules is an
essential piece of the reform puzzle, it is certainly not the only piece.
Indeed, pension reform is a challenge precisely because of the necessity
of fusing together so many complex, and sometimes competing, elements into
a comprehensive proposal. Ideally, effective reform would

o  	improve the accuracy of plan asset and liability measurement while
minimizing complexity and maintaining contribution flexibility;

o  	develop a PBGC insurance premium structure that charges sponsors
fairly, based on the risk their plans pose to PBGC, and provides
incentives for sponsors to fund plans adequately;

o  	address the issue of severely underfunded plans making lump-sum
payments;

o  	resolve outstanding controversies concerning cash balance and other
hybrid plans by safeguarding the benefits of workers regardless of age;
and

o  	improve plan information transparency for PBGC, plan participants,
unions, and investors in a manner that does not add considerable burden to
plan sponsors.

55The Administration proposal moves in this direction by suggesting
sponsors of different financial strength have different funding targets.
See Strengthen Funding for Single Employer Pension Plans, U.S. Department
of Labor, Employee Benefits Security Administration, February 7, 2005.

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.

This reform effort should also be understood in the context of the
problems facing other components of retirement security and the federal
budget generally. For example, Social Security, Medicare, and Medicaid
serve the larger population of retired and disabled workers, many of whom
are also affected by DB reform. The demographic dynamics of increased
longevity in life and retirement affecting the DB system also affect these
other programs, intensifying existing fiscal pressures on the federal
budget. Thus, DB pension reform, with these other issues, has important
implications both for the distribution of retirement income for current
and future generations and for our overall success in addressing these
broader budgetary challenges.56

Even with meaningful, carefully crafted reform, it is possible that some
DB plan sponsors may choose to freeze or terminate their plans. Sponsor
exit is a serious concern, given the important role DB plans play in
providing retirement security. However, this is a natural consequence of
the inherent trade-off that exists in a private pension system that on one
hand depends on voluntary plan sponsorship and on the other is tax
subsidized and backed by federal insurance in order to promote the
retirement security of our nation's workers. The overarching goals of
balanced pension reform, and particularly of funding rule 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.

              56For more discussion, see GAO-04-325SP, pp. 54-57.

Matters for Congressional Consideration

As we have noted in previous reports,57 the Congress should 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

o  	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.

o  	Limiting the use of 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

57See GAO-04-90; GAO-05-108T; GAO, Pension Benefit Guaranty Corporation:
Single-Employer Pension Insurance Program Faces Significant Long-Term
Risks, GAO-03-873T (Washington, D.C.: Sept. 4, 2003); Pension Benefit
Guaranty Corporation: Long-Term Financing Risks to Single-Employer
Insurance Program Highlight Need for Comprehensive Reform, GAO-04-150T
(Washington, D.C.: Oct. 14, 2003); Private Pensions: Changing Funding
Rules and Enhancing Incentives Can Improve Plan Funding,

GAO-04-176T (Washington, D.C.: Oct. 29, 2003).

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 should
consider ways, even if it retains the FSA, to scale back the substitution
of credits for annual cash contributions.

While admittedly an extremely complicated matter, meaningful effective
reform must confront the issue of accurate measurement. We found that that
the measurement techniques of assets and liabilities that are permitted
under current funding rules can result in distortions masking the true
funding status of a plan and can permit sponsors to avoid making plan
contributions. Techniques that lead to misleading indicators of plan
health and impede information transparency are a disservice to all key
stakeholders; to plan participants in making retirement decisions; to
unions seeking to bargain in the interests of their members; to current
and potential shareholders in deciding where to invest; and finally to the
public, which is the ultimate protector of employee benefits.

Agency Comments 	We provided a draft of this report to the Department of
Labor, Treasury, and PBGC. The Department of Labor and PBGC provided
written comments, which appear in appendix III and appendix IV. Both the
Department of Labor's and PBGC's comments generally agree with the
findings and conclusions of our report. Treasury did not provide written
comments. The Department of Labor, Treasury, and PBGC also provided
technical comments, which we incorporated as appropriate.

We are sending copies of this report to the Secretary of Labor, the
Secretary of the Treasury, and the Executive Director of the PBGC,
appropriate congressional committees, and other interested parties. We
will also make copies available to others on request. In addition, the
report will be available at no charge on GAO's Web site at
http://www.gao.gov.

If you have any questions concerning this report, please contact me at
(202) 512-7215. Contact points for our Office of Congressional Relations
and Public Affairs may be found on the last page of this report. GAO staff
who made contributions are listed in appendix V.

Barbara Bovbjerg, Director
Education, Workforce, and Income Security Issues

List of Congressional Committees

The Honorable Charles E. Grassley
Chairman
The Honorable Max Baucus
Ranking Minority Member
Committee on Finance
United States Senate

The Honorable Michael B. Enzi
Chairman
The Honorable Edward M. Kennedy
Ranking Minority Member
Committee on Health, Education, Labor, and Pensions
United States Senate

The Honorable John A. Boehner
Chairman
The Honorable George Miller
Ranking Minority Member
Committee on Education and the Workforce
House of Representatives

The Honorable William M. Thomas
Chairman
The Honorable Charles B. Rangel
Ranking Minority Member
Committee on Ways and Means
House of Representatives

                       Appendix I: Scope and Methodology

To describe recent pension funding trends, we analyzed data from Schedule
B of the Form 5500. This schedule contains information on plan assets,
liabilities, contributions, funding standard account (FSA) credits and
charges, and additional funding charge (AFC) calculations.

Problems with the electronic data of the Form 5500 are well documented.1
To mitigate problems associated with the data we used Form 5500 research
data from the Pension Benefit Guaranty Corporation's (PBGC) Policy,
Research and Analysis Department (PRAD). PRAD analysts routinely and
systematically correct the raw 5500 data submitted by plans, and PRAD 5500
data are thought to be the most accurate electronic versions. Although we
did not independently audit the veracity of the PRAD data, we performed
routine data reliability checks. In instances where the data reliability
checks revealed inconsistencies, we contacted a PRAD analyst to check and,
if appropriate, correct the electronic data using information provided to
PRAD in hard copy.

For our analysis, we worked with a subset of the PBGC research data that
included the 100 largest plans, measured by current liability, annually
from 1995 to 2002.2 In 2002, the most recent, nearly complete year of
available Form 5500 data, these 100 plans, with average liabilities per
plan of $6.7 billion and 94,000 participants, represented approximately 50
percent of the total liabilities and about 28 percent of the total
participants of the approximately 30,000 defined benefit (DB) plans that
filed a Form 5500 for plan year 2002 as of February 2005. Thus, while our
sample data set represents only a small portion of the total plans in the
single-employer program, it constitutes a significant proportion of the
liabilities of the DB system and the financial risk to PBGC while allowing
for more manageable analysis. We did not directly test or compare our
sample for generalizability across the entire sample of single-employer
plans.

1See GAO, Private Pensions: Participants Need Information on the Risks of
Investing in Employer Securities and the Benefits of Diversification,
GAO-02-943 (Washington, D.C.: Sept. 6, 2002); Retirement Income Data:
Improvements Could Better Support Analysis of Future Retirees' Prospects,
GAO-03-337 (Washington, D.C.: Mar. 21, 2003); Private Pensions:
Multiemployer Plans Face Short- and Long-Term Challenges, GAO-04-423
(Washington, D.C.: Mar. 26, 2004); and Private Pensions: Publicly
Available Reports Provide Useful but Limited Information on Plans'
Financial Condition,

GAO-04-395 (Washington, D.C.: Mar. 31, 2004).

2Each year, our sample contains a new set of 100 largest plans based on
the plan liabilities in that year. That is, from year to year, the 100
largest plans will add and subtract plans from other years' 100 largest
plans.

Appendix I: Scope and Methodology

For 1999 and 2002, the best available data do not contain all possible
plans, and therefore it is possible that in those years complete data sets
would yield slightly different samples for our analysis. The 1999 data we
received from PBGC came from a sample that was missing an estimated 2,927
of the 37,536 plans in the single-employer program, because of missing
electronic records in that year. The 2002 data came from a sample still
missing approximately 300 plans, because of ongoing processing. We believe
that neither of these factors significantly affects our findings or our
conclusions.

To identify how the AFC is calculated and applied, we studied how the
relevant Employee Retirement Security Act of 1974 (ERISA) and Internal
Revenue Code (IRC) funding rules are applied, conducted a literature
review, and interviewed researchers, government officials, pension
actuaries, and pension sponsor groups familiar with pension funding rules.
To analyze potential risk to PBGC, we matched sponsor credit ratings from
the Standard and Poor's (S&P) COMPUSTAT database, provided to us by PBGC,
to the sponsor's pension plan data.3 PBGC also provided us with detailed
calculations to determine plans' full funding limitations for purposes of
the minimum funding requirements. Additionally, to analyze effects of
maximum deductible contributions, we matched the results from a previously
issued PBGC study on the subject to our sample of plans. Our work was done
in accordance with generally accepted government auditing standards.

3In each year of data we matched the relevant December ratings issue for
that year. Plans sponsored by a company subsidiary were given the rating
of the parent unless the subsidiary had its own rating. Additionally, the
same sponsor may sponsor a number of plans in the largest 100 plans for
any given year. We observe a number of sponsors with multiple plans in any
given year of our sample.

Appendix II: Statistics for Largest 100 Defined Benefit Plans, 1995-2002

                 Table 2: Average Plan Size and Funding Levels

(Dollar figures in millions of 2002 dollars)

                                  Mean Median

                                      Current liability  $5,341.6    $3,065.7 
                                 Actuarial asset levels  $6,019.3    $3,397.9 
                        Number of participants (actual)   80,431       59,508 
                                   Plan funding levelsa   112.7%       106.2% 
                                Plans below 100% funded    38.9    
                                 Plans below 90% funded    10.4    
                                 Plans below 80% funded    2.9     
                  Funding gap, plans below 100% fundedb   $425.7       $215.7 
            Plans using highest allowable interest rate            
                               to calculate liabilities   62.0%    

Source: GAO analysis of PBGC Form 5500 research data.

Notes: All figures represent per plan annual averages, from 1995 to 2002,
except as described differently. Annual dollar figures adjusted to 2002
dollars using annual consumer price index (CPI) data.

Median figures reported are the average of individual year median values.

For analysis, each year contains that year's 100 largest plans, ranked by
current liabilities. From 1995 to 2002, 187 unique plans appear in at
least 1 year's sample of 100 largest plans. See footnote 9 in main text
for further explanation.

aFunding levels calculated using actuarially measured assets as a
percentage of current liabilities.

bFunding gap equals current liabilities less actuarially valued assets,
for underfunded plans.

Table 3: Cash Contributions

      (Dollar figures in millions of 2002 dollars) Mean Median Total cash
                            contributions $97.4 $9.4

              Contributions/minimum funding obligation 90.5% 19.1%

Sponsors forgoing cash contributions 62.5%

Underfunded plans receiving no cash contribution 41.1%

Source: GAO analysis of PBGC Form 5500 research data.

Notes: All figures represent per plan annual averages, from 1995 to 2002,
except as described differently. Annual dollar figures adjusted to 2002
dollars using annual CPI data.

Median figures reported are the average of individual year median values.

For analysis, each year contains that year's 100 largest plans, ranked by
current liabilities. From 1995 to 2002, 187 unique plans appear in at
least 1 year's sample of 100 largest plans. See footnote 9 in main text
for further explanation.

Appendix II: Statistics for Largest 100 Defined Benefit Plans, 1995-2002

 Table 4: Funding Standard Account (FSA) Credits, Other than Cash Contributions
            (Dollar figures in millions of 2002 dollars) Mean Median

Plans drawing down accumulated credit balance 15.4%

              Accumulated credit balance from prior years  $573.7      $123.4 
                                 Net amortization credits  -$27.8          $0 
                          Full funding limitation credits     $46.7     $17.0 
                                     Net interest credits     $42.2      $4.9 

Source: GAO analysis of PBGC Form 5500 research data.

Notes: All figures represent per plan annual averages, from 1995 to 2002,
except as described differently. Annual dollar figures adjusted to 2002
dollars using annual CPI data.

Median figures reported are the average of individual year median values.

For analysis, each year contains that year's 100 largest plans, ranked by
current liabilities. From 1995 to 2002, 187 unique plans appear in at
least 1 year's sample of 100 largest plans. See footnote 9 in main text
for further explanation.

                     Table 5: Full Funding Limitation (FFL)

            (Dollar figures in millions of 2002 dollars) Mean Median

                                                     FFL amount $645.6  $24.3 
                                             Plans with FFL = 0  60.1%  
                  Sponsors contributing at least as much as FFL  64.4%  
           Instances in which plan making contribution at least         
              equal to FFL used highest allowable interest rate  65.5%  

Source: GAO analysis of PBGC Form 5500 research data.

Notes: All figures represent per plan annual averages, from 1995 to 2002,
except as described differently. Annual dollar figures adjusted to 2002
dollars using annual CPI data.

Median figures reported are the average of individual year median values.

For analysis, each year contains that year's 100 largest plans, ranked by
current liabilities. From 1995 to 2002, 187 unique plans appear in at
least 1 year's sample of 100 largest plans. See footnote 9 in main text
for further explanation.

Appendix II: Statistics for Largest 100 Defined Benefit Plans, 1995-2002

                    Table 6: Additional Funding Charge (AFC)

Dollar figures in millions of 2002 dollars

                                  Mean Median

Plans subject to AFCa 2.9

                                        AFC amount assessed  $234.1    $148.2 
                Current liabilities of plans subject to AFC $3,836.7 $3,693.6 
                        Funding gap of plan assessed an AFC  $837.1    $953.0 
                   Funded percentage of plan subject to AFC  78.2%      74.7% 
                      Plans below 90% funded subject to AFC  27.7%   
                      Plans 80 to 90% funded subject to AFC   8.3%   
                    Cash contribution, plans subject to AFC  $185.7    $118.9 
            Plans subject to AFC forgoing cash contribution  30.4%   
           Plans subject to AFC drawing down credit balance  60.9%   

Source: GAO analysis of PBGC Form 5500 research data.

Notes: Figures in this table represent averages and medians of those plans
subject to an AFC for the entire sample period, except as described
differently. Annual dollar figures adjusted to 2002 dollars using annual
CPI data.

Median figures reported are the average of individual year median values.

For analysis, each year contains that year's 100 largest plans, ranked by
current liabilities. From 1995 to 2002, 187 unique plans appear in at
least 1 year's sample of 100 largest plans. See footnote 9 in main text
for further explanation.

aThis represents the average annual number of plans subject to an AFC.
From 1995 to 2002, we observed 6 unique plans assessed an AFC, all of
which had repeat AFC assessments.

Appendix III: Comments from the Department of Labor

Appendix IV: Comments from the Pension Benefit Guaranty Corporation

Appendix IV: Comments from the Pension Benefit Guaranty Corporation

Appendix V: GAO Contact and Staff Acknowledgments

Contact Barbara Bovbjerg (202) 512-7215.

Staff In addition to the contact above, Charles A. Jeszeck, Charles J.
Ford, Joseph Applebaum, Mark M. Glickman, Scott Heacock, Roger J.
Thomas,Acknowledgments and Amy Vassalotti made important contributions to
this report.

Glossary

Actuarial value of assets-the smoothed value of DB plan assets, reflecting
recent market levels of assets. Rules dictate that the reported actuarial
assets must be between 80 and 120 percent of market asset levels and
cannot be consistently above or below market values.

Additional funding charge (AFC)-a surcharge assessed to DB plans that fail
specific funding level requirements that increases the minimum required
funding obligation for the plan sponsor.

Credit balance-the excess of credits over charges in a plan's funding
standard account, which can be carried forward to meet funding obligations
in future years.

Current liabilities-the measured value of a DB plan's accrued benefits
using an interest rate and other assumptions specified in applicable laws
and regulations.

Defined benefit (DB) pension plan-a pension plan that promises a
guaranteed benefit, generally based on an employee's salary and years of
service. (A different type of pension plan, a defined contribution, or DC,
plan, instead provides an individual account to an employee, to which
employers, employees, or both make periodic contributions.)

Employee Retirement Income Security Act of 1974 (ERISA)-the federal law
that sets minimum standards regarding management, operation, and funding
of pension plans sponsored by private employers.

Full funding limitation (FFL)-a limit on the required amount a sponsor
must contribute to a plan each year, dependent on the plan's funding
level.

Funded ratio-the ratio of plan assets to plan liabilities.

Funding standard account (FSA)-a plan's annual accounting record,
recording events that reflect an increase in a plan's obligations
(charges) and those that reflect an increase in the plan's ability to pay
benefits (credits).

Maximum deductible contribution-the maximum a sponsor can generally
contribute to a plan without facing an excise tax on the excess
contribution.

Glossary

Normal cost-the cost of pension benefits allocated to a specific plan
year.

Termination liabilities-the measured value of a DB plan's accrued
benefits, using assumptions appropriate for a terminating plan.

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