Pension Benefit Guaranty Corporation: Structural Problems Limit
Agency's Ability to Protect Itself from Risk (02-MAR-05,
GAO-05-360T).
More than 34 million workers and retirees in about 30,000
singleemployer defined benefit plans rely on a federal insurance
program managed by the Pension Benefit Guaranty Corporation
(PBGC) to protect their pension benefits. However, the insurance
program's long-term viability is in doubt and in July 2003 we
placed the single-employer insurance program on our high-risk
list of agencies with significant vulnerabilities for the federal
government. In fiscal year 2004, PBGC's single-employer pension
insurance program incurred a net loss of $12.1 billion for fiscal
year 2004, and the program's accumulated deficit increased to
$23.3 billion from $11.2 billion a year earlier. Further, PBGC
estimated that underfunding in single-employer plans exceeded
$450 billion as of the end of fiscal year 2004. This testimony
provides GAO's observations on (1) some of the structural
problems that limit PBGC's ability to protect itself from risk
and (2) steps PBGC has taken to forecast and manage the risks
that it faces.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-360T
ACCNO: A18518
TITLE: Pension Benefit Guaranty Corporation: Structural Problems
Limit Agency's Ability to Protect Itself from Risk
DATE: 03/02/2005
SUBJECT: Accountability
Employees
Federal employee retirement programs
Insurance
Insurance premiums
Pensions
Policy evaluation
Risk management
Strategic planning
Projections
Financial management
PBGC Early Warning Program
PBGC Pension Insurance Modeling System
******************************************************************
** This file contains an ASCII representation of the text of a **
** GAO Product. **
** **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced. Tables are included, but **
** may not resemble those in the printed version. **
** **
** Please see the PDF (Portable Document Format) file, when **
** available, for a complete electronic file of the printed **
** document's contents. **
** **
******************************************************************
GAO-05-360T
United States Government Accountability Office
GAO Testimony
Before the Subcommittee on Government Management, Finance and
Accountability, Committee on Government Reform, House of Representatives
For Release on Delivery
Expected at 2:00 p.m. EST
Wednesday, March 2, 2005 PENSION BENEFIT GUARANTY
CORPORATION
Structural Problems Limit Agency's Ability to Protect Itself from Risk
Statement of David M. Walker Comptroller General of the United States
GAO-05-360T
[IMG]
March 2, 2005
PENSION BENEFIT GUARANTY CORPORATION
Structural Problems Limit Agency's Ability to Protect Itself from Risk
What GAO Found
Existing laws governing pension funding and premiums have not protected
PBGC from accumulating a significant long-term deficit and have exposed
PBGC to "moral hazard" from the companies whose pension plans it insures.
The pension funding rules, under the Employee Retirement Income Security
Act (ERISA) and the Internal Revenue Code (IRC), were not designed to
ensure that plans have the means to meet their benefit obligations in the
event that plan sponsors run into financial distress. Meanwhile, in the
aggregate, premiums paid by plan sponsors under the pension insurance
system have not adequately reflected the financial risk to which PBGC is
exposed. Accordingly, PBGC faces moral hazard, and defined benefit plan
sponsors, acting rationally and within the rules, have been able to turn
significantly underfunded plans over to PBGC, thus creating PBGC's current
deficit.
Despite the challenges it faces, PBGC has proactively attempted to
forecast and mitigate its risks. The Pension Insurance Modeling System,
created by the PBGC to forecast claim risk, has projected a high
probability of future deficits for the agency. However, the accuracy of
the projections produced by the model is unclear. Through its Early
Warning Program, PBGC negotiates with companies that have underfunded
pension plans and that engage in business transactions that could
adversely affect their pensions. Over the years, these negotiations have
directly led to billions of dollars of pension plan contributions and
other protections by the plan sponsors. Moreover, PBGC has changed its
investment strategy and decreased its equity exposure to better shield
itself from market risks. However, despite these efforts, the agency
ultimately lacks the authority, unlike other federal insurance programs,
to effectively protect itself.
Assets, Liabilities, and Net Financial Position of PBGC's Single-Employer
Insurance Program, 1980-2004
United States Government Accountability Office
Mr. Chairman and Members of the Subcommittee:
I am pleased to be here today to discuss the underlying structural
problems and long-term challenges facing the defined benefit pension
system and the Pension benefit Guaranty Corporation (PBGC). Before
addressing these matters specifically, I would like to place these
challenges in the context of the larger challenges facing the federal
government today, which we discuss in our recently issued 21st Century
Challenges report.1 There is a need to bring the federal government and
its programs into line with 21st century realities. This challenge has
many related pieces: addressing our nation's large and growing long-term
fiscal gap; deciding on the appropriate role and size of the federal
government- and how to finance that government-and bringing the panoply of
federal activities into line with today's world. Continuing on our current
unsustainable fiscal path will gradually erode, if not suddenly damage,
our economy, our standard of living, and ultimately our national security.
We therefore must fundamentally reexamine major spending and tax policies
and priorities in an effort to recapture our fiscal flexibility and ensure
that our programs and priorities respond to emerging security, social,
economic, and environmental changes and challenges.
The PBGC is an excellent example of the need for Congress to reconsider
the role of government organizations, programs, and policies. The Employee
Retirement Income Security Act (ERISA) was enacted in 1974 to respond to
trends and challenges that existed at that time.2 One impetus for the
passage of ERISA was the failure of Studebaker's defined benefit pension
plan in the 1960s, in which many plan participants lost their pensions.3
Along with other changes, ERISA established PBGC to pay the
1See GAO, 21st Century Challenges: Reexamining the Base of the Federal
Government, GAO-05-325SP. (Washington, DC: February, 2005)
2ERISA has been amended a few times, notably in 1987 (Public Law 100-203)
and again in 1994 (Public Law 103-465), to respond to challenges facing
the defined benefit pension system and PBGC.
3The company and the union agreed to terminate the plan along the lines
set out in the collective bargaining agreement; retirees and retirement
eligible employees over the age of 60 received full pensions, and vested
employees under age 60 received a lump-sum payment worth about 15 percent
of the value of their pensions. Employees, whose benefit accruals had not
vested, including all employees under age 40, received nothing. James A.
Wooten, "The Most Glorious Story of Failure in Business: The
Studebaker-Packard Corporation and the Origins of ERISA." Buffalo Law
Review, vol. 49 (Buffalo, NY: 2001):731.
pension benefits of defined benefit plan participants, subject to certain
limits, in the event that an employer could not.4 ERISA also required PBGC
to encourage the continuation and maintenance of voluntary private pension
plans and to maintain premiums set by the corporation at the lowest level
consistent with carrying out its obligations.5 PBGC was thus mandated to
serve a social purpose and remain financially self-sufficient.6 When ERISA
was enacted, defined benefit pension plans were the most common form of
employer-sponsored private pension and were growing both in number of
plans and number of participants. In 1974, Congress may well have expected
continued growth of defined benefit plans in the years and decades to
come. Today, defined benefit pensions cover an ever decreasing percentage
of the U.S. labor force, a fact that raises several questions about
federal policy on pensions in general, and defined benefit plans and the
PBGC, in particular.
In light of past trends and future challenges, some of the fundamental
questions that need to be addressed as we move forward include these:
o Should the federal government continue to promote defined benefit
pension plans?
o What features of various pension plans should the government promote
to meet retirement income security needs of increasingly mobile American
workers?
o What changes should be made to enhance the retirement income security
of workers while protecting the fiscal integrity of the PBGC insurance
program?
o Should PBGC act as self-sustaining insurer, according to market-based
principles, should it be a social insurance program, or should it be a
hybrid entity? As defined benefit pension coverage declines, there is an
4Some defined benefit plans are not covered by PBGC insurance; for
example, plans sponsored by professional service employers, such as
physicians and lawyers, with 25 or fewer employees.
5See section 4002(a) of P.L. 93-406, Sept. 2, 1974.
6ERISA authorized PBGC to borrow up to $100 million from the U.S. Treasury
to cover temporary cash shortfalls.
inherent tension between these two approaches that Congress presumably did
not foresee when ERISA was enacted.
o What legislative changes are necessary to allow the pension insurance
program and the PBGC to succeed in their missions? And how much authority
and flexibility should be provided to PBGC to manage its risk and respond
to the fiscal challenges it faces?
o Should the government's pension insurance program be used as a tool to
provide restructuring assistance to industries that have been negatively
affected by certain macroeconomic forces such as globalization and
deregulation? Should such costs be handled differently than other pension
insurance losses?
o What portion of the PBGC's premium revenue should be fixed versus
variable rate premiums and for what purposes? Should variable rate
premiums be more risk-related? If so, how can they be adjusted to
accomplish this objective?
o What should PBGC's investment strategy be and what impact, if any,
should that have on pension funding, recovery, premium, and other
calculations?
It is critical that we address these fundamental issues as soon as
possible so that we take actions consistent with our broader policy
objectives. Furthermore, failure to enact the proper reforms could
expedite the demise of the defined benefit pension system. As part of
GAO's efforts to help Congress and other policymakers address such issues,
I recently convened a group of pension experts at a Comptroller General's
Forum entitled "The Future of the Defined Benefit System and the PBGC." We
will convey the observations of the forum participants in a forthcoming
GAO report.
I will now turn to the specific issues before this subcommittee today. In
particular, I will discuss some of the structural problems that limit
PBGC's ability to protect itself from risk and steps PBGC has taken to
forecast and manage the risks that it faces. In summary, existing laws
governing pension funding and premiums have not protected PBGC from
accumulating a significant long-term deficit and have not limited PBGC's
exposure to "moral hazard" from the companies whose pension plans it
insures.7 The pension funding rules, under ERISA and the Internal Revenue
Code (IRC), were not designed to ensure that plans have the means to meet
their benefit obligations in the event that plan sponsors run into
financial distress. Meanwhile, in the aggregate, premiums paid by plan
sponsors under the pension insurance system have not adequately reflected
the financial risk to which PBGC is exposed. Accordingly, defined benefit
plan sponsors, acting rationally and within the rules, have been able to
turn significantly underfunded plans over to PBGC, thus creating PBGC's
current deficit.
Despite the challenges it faces, PBGC has proactively attempted to
forecast and mitigate its risks. The Pension Insurance Modeling System,
created by PBGC to forecast claim risk, has projected a high probability
of future deficits for the agency. However, the accuracy of the
projections produced by the model is unclear. Through its Early Warning
Program, PBGC negotiates with companies that have underfunded pension
plans and that engage in business transactions that could adversely affect
their pensions. Over the years, these negotiations have directly led to
billions of dollars of pension plan contributions and other protections by
the plan sponsors. Moreover, PBGC has changed its investment strategy and
decreased its equity exposure to better shield itself from market risks.
However, despite these efforts, the agency, unlike other federal insurance
programs, ultimately lacks adequate authority to effectively protect
itself.
Before enactment of the Employee Retirement Income Security Act of 1974,
few rules governed the funding of defined benefit pension plans, and
participants had no guarantees that they would receive the benefits
promised. Among other things, ERISA established rules for funding defined
benefit pension plans and created the PBGC to protect the benefits of plan
participants in the event that plan sponsors could not meet the benefit
obligations under their plans. More than 34 million workers and retirees
in about 30,000 single-employer defined benefit plans rely on PBGC to
protect their pension benefits.
Background
7Moral hazard surfaces when the insured parties------in this case, plan
sponsors------engage in
risky behavior knowing that the guarantor will assume a substantial
portion of the risk. In the case of the pension insurance system, this
might include the willingness of parties to enter into agreements that
increase pension liabilities, rather than taking wage increases.
PBGC finances the liabilities of underfunded terminated plans partially
through premiums paid by plan sponsors.8 Currently, plan sponsors pay a
flat-rate premium of $19 per participant per year; in addition, some plan
sponsors pay a variable-rate premium, which was added in 1987, to provide
an incentive for sponsors to better fund their plans. For each $1,000 of
unfunded vested benefits, plan sponsors pay a premium of $9. In fiscal
year 2004, PBGC received nearly $1.5 billion in premiums, including more
than $800 million in variable rate premiums, but paid out more than $3
billion in benefits to plan participants or their beneficiaries.9
The single-employer program has had an accumulated deficit-that is,
program assets have been less than the present value of benefits and other
obligations-for much of its existence. (See fig. 1.) In fiscal year 1996,
the program had its first accumulated surplus, and by fiscal year 2000,
the accumulated surplus had increased to about $10 billion, in 2002
dollars. However, the program's finances reversed direction in 2001, and
at the end of fiscal year 2002, its accumulated deficit was about $3.6
billion. In July 2003, we designated the single-employer insurance program
as "high risk," given its deteriorating financial condition and the
long-term vulnerabilities of the program.10 In fiscal year 2004, PBGC's
single-employer pension insurance program incurred a net loss of $12.1
billion and its accumulated deficit increased to $23.3 billion, up from
$11.2 billion a year earlier. Furthermore, PBGC estimated that total
underfunding in single-employer plans exceeded $450 billion, as of the end
of fiscal year 2004.
8PBGC also assumes the assets of the plans it takes over in a plan
termination and any investment income from these assets may be used to pay
out benefits to participants of terminated plans.
9For most of its history, PBGC has received most of its premium income
from flat-rate premiums.
10See GAO, Pension Benefit Guaranty Corporation Single-Employer Insurance
Program: Long-Term Vulnerabilities Warrant "High Risk" Designation,
GAO-03-1050SP (Washington, DC: July 23, 2003).
Figure 1: Assets, Liabilities, and Net Financial Position of PBGC's
Single-Employer Insurance Program, 1980-2004
U.S. dollars in billions 70
60
50
40
30
20
10
0
-10
-20
-23,305
-30 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993
1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Assests
Liabilities Net position Source: Pension Benefit Guaranty Corporation.
Existing laws governing pension funding and premiums have not protected
PBGC from accumulating a significant long-term deficit and have not
limited PBGC's exposure to moral hazard from the companies whose pension
plans it insures. The pension funding rules, under ERISA and the IRC, were
not designed to ensure that plans have the means to meet their benefit
obligations in the event that plan sponsors run into financial distress.
Meanwhile, in the aggregate, premiums paid by plan sponsors under the
pension insurance system have not adequately reflected the financial risk
to which PBGC is exposed. Accordingly, defined benefit plan sponsors,
acting rationally and within the rules, have been able to turn
significantly underfunded plans over to PBGC, thus creating PBGC's current
deficit. Earlier this year, the Administration released a proposal that
aims to address many of the structural problems that PBGC faces by calling
for changes in the funding rules and premium structure, among other
things. Meanwhile, employers who responsibly manage their defined benefit
pension plans are concerned about their exposure to additional funding and
premium uncertainties.
Structural Problems Limit PBGC's Ability to Protect Itself from Risk
Minimum Funding Rules Do Not Prevent Plans from Being Severely Underfunded
As the PBGC takeovers of severely underfunded plans suggest, the IRC
minimum funding rules have not been designed to ensure that plan sponsors
contribute enough to their plans to pay all the retirement benefits
promised to date.11 The amount of contributions required under IRC minimum
funding rules is generally the amount needed to fund that year's "normal
cost" - benefits earned during that year plus that year's portion of other
liabilities that are amortized over a period of years. Also, the rules
require the sponsor to make an additional contribution if the plan is
underfunded to a specified extent as defined in the law.12 However,
sponsors of underfunded plans may sometimes avoid or reduce minimum
funding contributions if they have earned funding credits as a result of
favorable experience, such as contributing more than the minimum in the
past. For example, contributions beyond the minimum may be recognized as a
funding credit. These credits are not measured at their market value and
accrue interest each year, according to the plan's long-term expected rate
of return on assets.13 If the market value of the assets falls below the
credited amount, and the plan is terminated, the assets in the plan will
not suffice to pay the plan's promised benefits. Thus, some very large and
significantly underfunded plans have been able to remain in compliance
with the current funding rules while making little or no contributions in
the years prior to termination (e.g., Bethlehem Steel).
Further, under current funding rules, plan sponsors can increase plan
benefits for underfunded plans, even in some cases where the plans are
less than 60 percent funded. This may create an incentive for financially
troubled sponsors to increase pension benefits, possibly in lieu of wage
increases, even if their plans have insufficient funding to pay current
benefit levels.14 Thus, plan sponsors and employees that agree to benefit
increases from underfunded plans as a sponsor is approaching bankruptcy
11Pension funding rules include minimum funding requirements for all plans
and additional funding requirements for underfunded plans that set minimum
contribution requirements for plan sponsors.
12Under one of the amendments to ERISA in 1987, an additional funding
requirement rule was added. Generally speaking, large single-employer
plans are subject to a deficit reduction contribution if the value of plan
assets is less than 90 percent of a standardized liability measure. To
determine whether the additional funding rule applies to a plan, the IRC
requires sponsors to calculate this liability using the highest interest
rate allowable for the plan year. See 26 U.S.C. 412(l)(9)(C).
13See 26 U.S.C. 412(b).
14Some measures exist to limit losses incurred by PBGC from benefits added
to a plan within the 5-year period prior to plan termination.
can essentially transfer this additional liability to PBGC, potentially
exacerbating the agency's financial condition.
In addition, many defined benefit plans offer employees "shutdown
benefits," which provide employees additional benefits, such as
significant early retirement benefit subsidies in the event of a plant
shutdown or permanent layoff. In general, plant shutdowns are inherently
unpredictable, so that it is difficult to recognize the costs of shutdown
benefits in advance and current law does not include the cost of benefits
arising from future unpredictable contingent events.15 Under current law,
PBGC is responsible for at least a portion of any benefit increases,
including shutdown benefits, even if the benefit was added to the plan
within 5 years of plan termination. However, many of these provisions were
included in plans years ago. As a result, shutdown benefits pose a problem
for PBGC not only because they can dramatically and suddenly increase plan
liabilities without adequate funding safeguards, but also because the
related additional benefit payments drain plan assets.16
Finally, because many plans allow lump sum distributions, plan
participants in an underfunded plan may have incentives to request such
distributions. For example, where participants believe that the PBGC
guarantee may not cover their full benefits, many eligible participants
may elect to retire and take all or part of their benefits in a lump sum
rather than as lifetime annuity payments, in order to maximize the value
of their accrued benefits. In some cases, this may create a "run on the
bank," exacerbating the possibility of the plan's insolvency as assets are
liquidated more quickly than expected, potentially leaving fewer assets to
pay benefits for other participants.
PBGC's Premium Structure PBGC's current premium structure does not
properly reflect risks to the Does Not Properly Reflect insurance program.
The current premium structure relies heavily on flat-Risks to the
Insurance rate premiums that, since they are unrelated to risk, result in
large cost
shifting from financially troubled companies with underfunded plans to
Program healthy companies with well-funded plans. PBGC also charges plan
sponsors a variable-rate premium based on the plan's level of
underfunding. However, these premiums do not consider other relevant
15See 26 U.S.C. 412(m)(4)(D).
16Shutdown benefit payments begin immediately after a facility closes,
using assets accumulated to pay other plan benefits.
risk factors, such as the economic strength of the sponsor, plan asset
investment strategies, the plan's benefit structure, or the plan's
demographic profile. PBGC is currently operated somewhat more on a social
insurance model since it must cover all eligible plans regardless of their
financial condition or the risks they pose to the solvency of the
insurance program.
In addition to facing firm-specific risk that an individual underfunded
plan may terminate, PBGC faces market risk that a poor economy may lead to
widespread underfunded terminations during the same period, potentially
causing very large losses for PBGC. Similarly, PBGC may face risk from
insuring plans concentrated in vulnerable industries affected by certain
macroeconomic forces such as deregulation and globalization that have
played a role in multiple bankruptcies over a short time period, as
happened in the airline and steel industries. One study estimates that the
overall premiums collected by PBGC amount to about 50 percent of what a
private insurer would charge because its premiums do not adequately
account for these market risks.17 Others note that it would be hard to
determine the market rate premium for insuring private pension plans
because private insurers would probably refuse to insure poorly funded
plans sponsored by weak companies.
PBGC Is Subject to Moral Hazard
Despite a series of reforms over the years, current pension funding and
insurance laws create incentives for financially troubled firms to use
PBGC in ways that Congress did not intend when it formed the agency in
1974. PBGC was established to pay the pension benefits of participants in
the event that an employer could not. As pension policy has developed,
however, firms with underfunded pension plans may come to view PBGC
coverage as a fallback, or "put option," for financial assistance. The
very presence of PBGC insurance may create certain perverse incentives
that represent moral hazard-struggling plan sponsors may place other
financial priorities above "funding up" their pension plans because they
know PBGC will pay guaranteed benefits. Firms may even have an incentive
to seek Chapter 11 bankruptcy in order to escape their pension
obligations. As a result, once a plan sponsor with an underfunded pension
plan experiences financial difficulty, existing incentives may exacerbate
the funding shortfall for PBGC while also affecting the competitive
17Boyce, Steven, and Richard A. Ippolitio, "The Cost of Pension
Insurance," The Journal of Risk and Insurance, (2002) Vol 69, No. 2,
pp.121-170.
balance within an industry. This should not be the role for the pension
insurance system.
This moral hazard has the potential to escalate, with the initial
bankruptcy of firms with underfunded plans creating a vicious cycle of
bankruptcies and terminations. Firms with onerous pension obligations and
strained finances could see PBGC as a means of shedding these liabilities,
thereby providing them with a competitive advantage over firms that
deliver on their pension commitments. This would also potentially subject
PBGC to a series of terminations of underfunded plans in the same
industry, as we have already seen with the steel and airline industries in
the past 20 years.
In addition, current pension funding and pension accounting rules may also
encourage plans to invest in riskier assets to benefit from higher
expected long-term rates of return. In determining funding requirements, a
higher expected rate of return on pension assets means that the plan needs
to hold fewer assets in order to meet its future benefit obligations. And
under current accounting rules, the greater the expected rate of return on
plan assets, the greater the plan sponsor's operating earnings and net
income. However, with higher expected rates of return comes greater risk
of investment loss, which is not reflected in the pension insurance
program's premium structure. Investments in riskier assets with higher
expected rates of return may allow financially weak plan sponsors and
their plan participants to benefit from the upside of large positive
returns on pension plan assets without being truly exposed to the risk of
losses. The benefits of plan participants are guaranteed by PBGC, and weak
plan sponsors that enter bankruptcy can often have their plans taken over
by PBGC.
Administration Has Proposed Reforms to Address PBGC's Long-Term Challenges
Earlier this year, the Administration released a proposal for
strengthening funding of single-employer pension plans. The
Administration's proposal focuses on three areas:
o reforming the funding rules to ensure pension promises are kept by
improving incentives for funding plans adequately;
o improving disclosure to workers, investors, and regulators about
pension plan status; and
o adjusting premiums to better reflect a plan's risk and ensure the
pension insurance system's financial solvency.
PBGC Has Attempted to Improve Its Ability to Forecast and Manage Risk but
Ultimately Lacks Adequate Authority to Properly Do So
Among other things, the proposal would require all underfunded plans to
pay risk-based premiums and it would empower PBGC's board to adjust the
risk-based premium rate periodically so that premium revenue is sufficient
to cover expected losses and to improve PBGC's financial condition.18
Employer groups have expressed concern about their exposure to additional
funding and premium uncertainties and have claimed that the
Administration's proposal may strengthen PBGC's financial condition at the
expense of defined benefit plan sponsors. For example, one organization
has stated that in its view, the current proposal would result in fewer
defined benefit plans, lower benefits, and more pressures on troubled
companies.
PBGC has proactively attempted to forecast and mitigate the risks that it
faces. The Pension Insurance Modeling System (PIMS), created by PBGC to
forecast claim risk, has projected a high probability of future deficits
for the agency. However, the accuracy of the projections produced by the
model is unclear. Also, through its Early Warning Program, PBGC negotiates
with companies that have underfunded pension plans and that engage in
business transactions that could adversely affect their pensions. Over the
years, these negotiations have directly led to billions of dollars of
pension plan contributions and other protections by the plan sponsors.
Moreover, PBGC has begun an initiative called the Office of Risk
Assessment that combines aspects of both PIMS and the Early Warning
Program and will enable the agency to better quantitatively analyze claim
risks associated with individual plan sponsors. PBGC has also changed its
investment strategy and decreased its equity exposure to better shield
itself from market risks. However, despite these efforts, the agency,
unlike other federal insurance programs, ultimately lacks the authority to
effectively protect itself, such as by adjusting premiums according to the
risks it faces.
18PBGC's board is composed of the Secretary of Labor, the Secretary of the
Treasury, and the Secretary of Commerce.
PBGC Uses Its Pension Insurance Modeling System to Forecast Its Potential
Exposure to Future Claims, but Forecasting Firm Bankruptcies Is Difficult
Over the long term, many variables, such as interest rates and equity
returns, affect the level of PBGC claims. Moreover, large claims from a
small number of bankruptcies constitute a majority of the risk that PBGC
faces. Consequently, PBGC created the Pension Insurance Modeling System-a
stochastic simulation model that quantifies risk and exposure for the
agency over the long run. PIMS simulates the flows of claims that could
develop under thousands of combinations of various macroeconomic and
company and plan-specific data. In lieu of predicting future bankruptcies,
PIMS is designed to generate probabilities for future claims.
In recent annual reports, PBGC has discussed the methodologies used to
develop PIMS. Furthermore, as far back as 1998, PBGC has reported PIMS
results that forecast the possibility of large deficits for the agency.
For example, at fiscal year end 2003-the most recent year for which PBGC
has released an annual report-the model's simulations forecasted about an
80 percent probability of deficit by the year 2013. This included a 10
percent probability of the deficit reaching $49 billion within this time
frame. These forecasts, made at the end of fiscal year 2003, did not
include the $14.7 billion in losses that PBGC experienced from terminated
plans in fiscal year 2004. Therefore, PIMS appears to have understated the
extent of PBGC's long-term deficit, given that by the end of fiscal year
2004, the agency's cumulative deficit had already grown to $23.3 billion.
The extent to which PIMS can accurately assess future claims is unclear.
There is simply too much uncertainty about the future, with respect both
to the performance of the economy and of companies that sponsor defined
benefit pension plans. It is difficult to accurately forecast which
industries and companies will face economic pressures resulting in
bankruptcies and PBGC claims. Furthermore, because PBGC's risk lies
primarily in a relatively small number of large plans, the failure or
survival of any single large plan may lead to significant variance between
PBGC's actual claims and the projected claims reported by PBGC in its
annual reports. Academic papers report varying rates of success in
predicting bankruptcy with various models that measure companies' cash
flows or financial ratios, such as asset-to-liability ratios. One paper we
reviewed reports that one model succeeded at a rate of 96 percent in
predicting bankruptcies 1 year in advance and a rate of 70 percent for
predicting bankruptcies 5 years in advance.19 However, another paper
concludes that no single
19Altman, Edward. "Predicting Financial Distress of Companies: Revisiting
the Z-Score and Zeta Models," July 2000. Retrieved from
http://pages.stern.nyu.edu/~ealtman/Zscores.pdf
bankruptcy prediction model proposed in the existing literature is
entirely satisfactory at differentiating between bankrupt and nonbankrupt
firms and that none of the models can reliably predict bankruptcy more
than 2 years in advance.20
PBGC's Early Warning Program Is One Tool For Managing Risk
PBGC's Early Warning Program is designed to ensure that pensions are
protected by negotiating agreements with certain companies engaging in
business transactions or events that could adversely affect their pension
plans. Companies of particular interest to the PBGC are those that are
financially troubled, have underfunded pension plans, and are engaged in
transactions such as restructurings, leveraged buyouts, spin-offs, and
payments of extraordinary dividends, to name a few. The Early Warning
Program proactively monitors financial information services and news
databases to identify these potentially risky transactions in a timely
fashion.
If PBGC, after completing an extensive screening process, concludes that a
transaction could result in a significant loss to the pension plan, the
agency will seek to negotiate with the company to obtain protections for
the plan. The Early Warning Program thus raises awareness of pension
underfunding, may change corporate behavior, and may allow PBGC to prevent
losses before they occur. Under the program, PBGC currently monitors about
3,200 pension plans covering about 29 million participants. Since 1992,
the program has protected over 2 million pension plan participants through
about 100 settlement agreements valued at over $18 billion (one settlement
accounted for about $10 billion). Some recent representative cases include
the 2004 settlement with Invensys that provided for over $175 million of
additional cash contributions to the pension plan and the 2005 agreement
with Crown Petroleum whereby the plan has been assumed by a financially
sound parent company and $45 million of additional cash will be
contributed to the pension plan.
20Mossman, Charles, et al. "An Empirical Comparison of Bankruptcy Models,"
The Financial Review, (1998) Vol 33, pp. 35-54.
PBGC Has Developed an Initiative to Better Quantitatively Assess the Risk
Associated with Individual Firms
PBGC has recently undertaken an initiative to create an Office of Risk
Assessment, which will focus on improving the agency's ability to
quantitatively model individual firms' claim potential. According to PBGC,
neither PIMS nor the Early Warning Program provides this information. For
example, PIMS projects systemwide surpluses and deficits and is not
designed to predict specific company results. Meanwhile, the Early Warning
Program targets specific companies, but in a manner that is qualitative in
nature. The Office of Risk Assessment, however, will attempt to combine
the concepts of both tools and better attempt to quantitatively analyze
the claim risk associated with individual companies.
PBGC has consulted with other federal agencies, such as the Federal
Deposit Insurance Corporation (FDIC), that have implemented similar
approaches for assessing risk. In March 2003, FDIC established a Risk
Analysis Center. Guided by FDIC's National Risk Committee, which is
composed of senior managers, the center is intended to "monitor and
analyze economic, financial, regulatory and supervisory trends, and their
potential implications for the continued financial health of the banking
industry and the deposit insurance funds." The center does so by bringing
together FDIC bank examiners, economists, financial analysts, resolutions
and receiverships specialists, and other staff members. These members
represent several FDIC organizational units and use information from a
variety of sources, including bank examinations and internal and external
research. According to FDIC, the center serves as a clearinghouse for
information, including monitoring and analyzing economic and financial
developments and informing FDIC management and staff of these
developments. FDIC officials believe that the center enables them to be
proactive in identifying industry trends and developing comprehensive
solutions to address significant risks to the banking industry.
PBGC Has Also Taken Steps to Better Protect Its Investment Portfolio from
Certain Market Risks
In early 2004, PBGC adopted a new investment strategy to better manage its
approximately $40 billion in assets. Although many factors that affect
PBGC's financial health are beyond the agency's control, a well-crafted
investment strategy is one of the few tools PBGC has to proactively manage
the financial risks facing the pension insurance program. Under the new
investment policy, PBGC is decreasing its asset allocation in equities
from 37 percent as of fiscal year end 2003 to within a range of 15 to 25
percent. Since many of the pension plans that PBGC insures are already
heavily invested in equities, some pension and investment experts have
said that the agency can create more financial stability by establishing
an asset allocation that can hedge against losses in the equity markets.
The equity exposure reduction ensures that PBGC's own
financial condition will not deteriorate to the same degree as the assets
in the pension plans it insures. However, PBGC continues to benefit when
equity markets rise because the plans it insures will rise in value. In
addition, PBGC claims that this strategy moves the agency closer to the
asset mix typically associated with private sector annuity providers.
However, it is too soon tell what effects this new investment strategy
will have on PBGC's long-term financial condition.
Unlike Other Federal Insurance Programs, PBGC Has Limited Ability to
Protect Itself From Risk
Conclusion
Although PIMS and the Early Warning Program help PBGC assess and manage
risk to some extent, PBGC lacks the regulatory authority available to
other federal insurance programs, such as the FDIC, to effectively protect
itself from risk. Whereas PBGC's premiums are determined by statute,
Congress provided FDIC the flexibility to set premiums and adjust them
every 6 months based on its analysis of risk to the deposit insurance
system. Furthermore, FDIC can reject applications to insure deposits at
depository institutions when it determines that a depository institution
carries too much risk to the Bank Insurance Fund.21 By contrast, PBGC must
insure all plans eligible for PBGC's insurance coverage. Last, FDIC may
issue formal and informal enforcement actions for deposit institutions
with significant weaknesses or those operating in a deteriorated financial
condition. When necessary, the FDIC may oversee the re-capitalization,
merger, closure, or other resolution of the institution. By contrast, PBGC
is limited to taking over a plan in poor financial condition to prevent it
from accruing additional liabilities. PBGC has no authority to seize
assets of the plan sponsor, who is responsible for adequately funding the
plan.
The current financial challenges facing the PBGC reflect, in part, the
significant changes that have taken place in employer-sponsored pensions
since the passage of ERISA in 1974. Given the decline in defined benefit
plans over the last two decades, it is time to make changes in the rules
governing the defined benefit system and reexamine PBGC's role as an
insurer. In recent years an irreconcilable tension has arisen between
PBGC's role as a social insurance program and its mandate to remain
financially self-sufficient. Unless something reverses the decline in
defined benefit pension coverage, PBGC may have a shrinking plan and
participant
21Before granting access to the federal deposit insurance system, FDIC
evaluates the potential risk to the funds. It assesses the adequacy of an
applicant's capital, financial history and condition, and its future
earnings potential, as well as the general character of its management.
base to support the program in the future and may face the likelihood of a
participant base concentrated in certain potentially more vulnerable
industries. In this regard, effectively addressing the uncertainties
associated with cash balance and other hybrid pension plans may serve to
help slow the decline in defined benefit plans.
One of the underlying assumptions of the current insurance program has
been that there would be a financially stable and growing defined benefit
system. However, the current financial condition of PBGC and the plans
that it insures threaten the retirement security of millions of Americans
because termination of severely underfunded plans can significantly reduce
the benefits participants receive. It also poses risks to the general
taxpaying public, who ultimately could be made responsible for paying
benefits that PBGC is unable to afford.
To help PBGC manage the risks to which it is exposed, Congress may wish to
grant PBGC additional authorities to set premiums or limit the guarantees
on the benefits it pays to those plans it assumes. However, these changes
would not be sufficient in themselves because the primary threat to PBGC
and the defined benefit pension system lies in the failure of the funding
rules to ensure that retirement benefit obligations are adequately funded.
In any event, any legislative changes to address the challenges facing
PBGC should provide plan sponsors with incentives to increase plan
funding, improve the transparency of the plan's financial information, and
provide a means to hold sponsors accountable for funding their plans
adequately. However, policymakers must also be careful to balance the need
for changes in the current funding rules and premium structure with the
possibility that any changes could expedite the exit of healthy plan
sponsors from the defined benefit system while contributing to the
collapse of firms with significantly underfunded plans.
The long-term financial health of PBGC and its ability to protect workers'
pensions is inextricably bound to the underlying change in the nature of
the risk that it insures, and implicitly to the prospective health of the
defined benefit system. Options that serve to revitalize the defined
benefit system could stabilize PBGC's financial situation, although such
options may be effective only over the long term. Our greater challenge is
to fundamentally consider the manner in which the federal government
protects the defined benefit pensions of workers in this increasingly
risky environment. We look forward to working with Congress on this
crucial subject.
Contacts and Acknowledgments
(130477)
Mr. Chairman, this concludes my statement. I would be happy to respond to
any questions you or other members of the Subcommittee may have.
For further information, please contact Barbara Bovbjerg at (202) 512-7215
or George Scott at (202) 512-5932. Other individuals making key
contributions to this testimony included David Eisenstadt, Benjamin
Federlein, and Joseph Applebaum.
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
work may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this material
separately.
GAO's Mission
Obtaining Copies of GAO Reports and Testimony
The Government Accountability Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting its
constitutional responsibilities and to help improve the performance and
accountability of the federal government for the American people. GAO
examines the use of public funds; evaluates federal programs and policies;
and provides analyses, recommendations, and other assistance to help
Congress make informed oversight, policy, and funding decisions. GAO's
commitment to good government is reflected in its core values of
accountability, integrity, and reliability.
The fastest and easiest way to obtain copies of GAO documents at no cost
is through GAO's Web site (www.gao.gov). Each weekday, GAO posts newly
released reports, testimony, and correspondence on its Web site. To have
GAO e-mail you a list of newly posted products every afternoon, go to
www.gao.gov and select "Subscribe to Updates."
Order by Mail or Phone The first copy of each printed report is free.
Additional copies are $2 each. A check or money order should be made out
to the Superintendent of Documents. GAO also accepts VISA and Mastercard.
Orders for 100 or more copies mailed to a single address are discounted 25
percent. Orders should be sent to:
U.S. Government Accountability Office 441 G Street NW, Room LM Washington,
D.C. 20548
To order by Phone: Voice: (202) 512-6000 TDD: (202) 512-2537 Fax: (202)
512-6061
To Report Fraud, Contact:
Waste, and Abuse in Web site: www.gao.gov/fraudnet/fraudnet.htm
E-mail: [email protected] Programs Automated answering system: (800)
424-5454 or (202) 512-7470
Gloria Jarmon, Managing Director, [email protected] (202)
512-4400Congressional U.S. Government Accountability Office, 441 G Street
NW, Room 7125 Relations Washington, D.C. 20548
Public Affairs Susan Becker, Acting Manager, [email protected] (202)
512-4800 U.S. Government Accountability Office, 441 G Street NW, Room 7149
Washington, D.C. 20548
PRINTED ON RECYCLED PAPER
*** End of document. ***