Private Pensions: Revision of Defined Benefit Pension Plan	 
Funding Rules Is an Essential Component of Comprehensive Pension 
Reform (07-JUN-05, GAO-05-794T).				 
                                                                 
This testimony discusses our recent report on the rules that	 
govern the funding of defined benefit (DB) plans and the	 
implications of those rules for the problems facing the Pension  
Benefit Guaranty Corporation (PBGC) and the DB pension system	 
generally. In recent years, the PBGC has encountered serious	 
financial difficulties. Prominent companies, such as Bethlehem	 
Steel, U.S. Airways, and United Airlines, have terminated their  
pension plans with severe gaps between the assets these plans	 
held and the pension promises these plan sponsors made to their  
employees and retirees. These terminations, and other unfavorable
market conditions, have created large losses for PBGC's 	 
single-employer insurance program--the federal program that	 
insures certain benefits of the more than 34 million participants
in over 29,000 plans. The single-employer program has gone from a
$9.7 billion accumulated surplus at the end of fiscal year 2000  
to a $23.3 billion accumulated deficit as of September 2004,	 
including a $12.1 billion loss for fiscal year 2004. In addition,
financially weak companies sponsored DB plans with a combined $96
billion of underfunding as of September 2004, up from $35 billion
as of 2 years earlier. Because PBGC guarantees participant	 
benefits, there is concern that the expected continued		 
termination of large plans by bankrupt sponsors will push the	 
program more quickly into insolvency, generating pressure on the 
Congress, and ultimately the taxpayers, to provide financial	 
assistance to PBGC and pension participants. Given these	 
concerns, we placed the PBGC's single-employer program on GAO's  
high-risk list of agencies and programs that need broad-based	 
transformations to address major challenges. In past reports, we 
identified several 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 and thus enhance the retirement income security of	 
American workers and retirees. More broadly, pension reform	 
represents a real opportunity to address part of our long-term	 
fiscal problems and reconfigure our retirement security systems  
to bring them into the 21st century. This opportunity 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 wide array 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 government  
can respond to a range of current and emerging security, social, 
economic, and environmental changes and challenges. The PBGC's	 
situation is an excellent example of the need for the Congress to
reconsider the role of government organizations, programs, and	 
policies in light of changes that have occurred since PBGC's	 
establishment in 1974.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-794T					        
    ACCNO:   A25977						        
  TITLE:     Private Pensions: Revision of Defined Benefit Pension    
Plan Funding Rules Is an Essential Component of Comprehensive	 
Pension Reform							 
     DATE:   06/07/2005 
  SUBJECT:   Amortization					 
	     Employee retirement plans				 
	     Federal funds					 
	     Financial analysis 				 
	     Fringe benefits					 
	     Funds management					 
	     Interest rates					 
	     Pensions						 
	     Program evaluation 				 
	     Program management 				 
	     Risk management					 
	     Benefit-cost tracking				 
	     Defined benefit plans				 

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GAO-05-794T

                 United States Government Accountability Office

GAO	Testimony Before the Committee on Finance, United States Senate

For Release on Delivery

Expected at 10:00 a.m. EDT PRIVATE PENSIONS

Tuesday, June 7, 2005

Revision of Defined Benefit Pension Plan Funding Rules Is an Essential Component
                        of Comprehensive Pension Reform

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

GAO-05-794T

Mr. Chairman and Members of the Committee:

I am pleased to be here today to discuss our recent report on the rules
that govern the funding of defined benefit (DB) plans and the implications
of those rules for the problems facing the Pension Benefit Guaranty
Corporation (PBGC) and the DB pension system generally.1 In recent years,
the PBGC has encountered serious financial difficulties. Prominent
companies, such as Bethlehem Steel, U.S. Airways, and United Airlines,
have terminated their pension plans with severe gaps between the assets
these plans held and the pension promises these plan sponsors made to
their employees and retirees. These terminations, and other unfavorable
market conditions, have created large losses for PBGC's single-employer
insurance program-the federal program that insures certain benefits of the
more than 34 million participants in over 29,000 plans. The singleemployer
program has gone from a $9.7 billion accumulated surplus at the end of
fiscal year 2000 to a $23.3 billion accumulated deficit as of September
2004, including a $12.1 billion loss for fiscal year 2004. In addition,
financially weak companies sponsored DB plans with a combined $96 billion
of underfunding as of September 2004, up from $35 billion as of 2 years
earlier. Because PBGC guarantees participant benefits, there is concern
that the expected continued termination of large plans by bankrupt
sponsors will push the program more quickly into insolvency, generating
pressure on the Congress, and ultimately the taxpayers, to provide
financial assistance to PBGC and pension participants.

Given these concerns, we placed the PBGC's single-employer program on
GAO's high-risk list of agencies and programs that need broad-based
transformations to address major challenges. In past reports, we
identified several 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 and thus enhance the
retirement income security of American workers and retirees.2

1See GAO, Private Pensions: Recent Experiences of Large Defined Benefit
Plans Illustrate Weaknesses in Funding Rules, GAO-05-294 (Washington,
D.C.: May 31, 2005).

2See GAO, Pension Benefit Guaranty Corporation: Single-Employer Pension
Insurance Program Faces Significant Long-Term Risks, GAO-04-90
(Washington, D.C.: Oct. 29, 2003).

More broadly, pension reform represents a real opportunity to address part
of our long-term fiscal problems and reconfigure our retirement security
systems to bring them into the 21st century.3 This opportunity 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 wide array
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 government can respond to a range of current and
emerging security, social, economic, and environmental changes and
challenges. The PBGC's situation is an excellent example of the need for
the Congress to reconsider the role of government organizations, programs,
and policies in light of changes that have occurred since PBGC's
establishment in 1974.

PBGC's challenges bear many similarities to the challenges facing our
Social Security system. Both programs have adequate current revenues and
assets to pay promised benefits for a number of years; yet, both face
large and growing accumulated deficits on an accrual basis. As a result,
timely action to address both private pension and Social Security reform
is needed. In pursuing such reforms, consideration should be given to the
interactive effects of any such reforms and how they contribute to
addressing our nation's large and growing fiscal challenge, key
demographic, economic and workforce trends, and the economic security of
Americans in their retirement years.

Our recent work on DB pension funding rules provides important insights in
understanding the problems facing PBGC and the DB system. To summarize our
findings, while pension funding rules are intended to ensure that plans
have sufficient assets to pay promised benefit to plan participants,
significant vulnerabilities exist. Although from 1995 to 2002 most of the
100 largest DB plans annually had assets that exceeded their current
liabilities, by 2002 over half of the 100 largest plans were underfunded,
and almost one-fourth of plans were less than 90 percent

3See GAO, 21st Century Challenges: Re-Examining the Base of the Federal
Government, GAO-05-325SP (Washington, D.C.: Feb. 2005).

funded.4 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. Additionally, on average over 60 percent of sponsors of these
plans made no annual cash contributions to their plans. One key reason for
this 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. 5 Further, very few sponsors of
underfunded plans were required to pay an additional funding charge (AFC),
a funding mechanism designed to reduce severe plan underfunding. Finally,
our analysis confirms the notion that plans sponsored by financially weak
firms pose a particular risk to PBGC, as these plans were generally more
likely to be underfunded, to be subject to an additional funding charge,
and to use assumptions to minimize or avoid cash contributions than plans
sponsored by stronger firms.

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. 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.6 The calculations require making
assumptions about factors that affect the amount and timing of

Background

4We analyzed DB pension data for the 100 largest plans as ranked by
current liabilities reported on Schedule B of the Form 5500 for the years
1995 to 2002. The Form 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. While our sample of plans represented
only a small portion of the total plans in the single-employer program, it
constitutes approximately 50 percent of the total liabilities and about 28
percent of the total participants among DB plans that filed a Form 5500 in
2002. For more information on our methodology, see appendix I of
GAO-05-294.

5An 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, the majority 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.

6Present 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.

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 accrued benefits.

The Employee Retirement Income Security Act of 1974 (ERISA), and several
amendments to the law since its passage, established minimum funding
requirements for sponsors of pension plans in order to try to ensure that
plans have enough assets to pay promised benefits. 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, 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.7,8

ERISA and the Internal Revenue Code (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 beginning of the plan year.9 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. This value may differ in any given year, within a
specified range,

7Normal cost is the cost of pension benefits allocated to a specific plan
year.

8Plans 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.

9The 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).

from the current market value of plan assets, which plans also report.
While different methodologies and 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 benefits.10

Funding rules generally presume that the plan and the sponsor are ongoing
entities, 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 rules. 11

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.12 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

10A plan's current liability may differ from its "termination liability,"
which measures the value of accrued benefits using assumptions appropriate
for a terminating plan. For further discussion of current versus
termination liability, see GAO-04-90, appendix IV.

11A 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).

12Some 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.

benefits accrued under the plan up to the date of plan termination.13 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 65.14 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
these increases.15 Further, PBGC's benefit guarantee amount 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.16
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

17

benefits.

13The 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).

14This 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.

15The 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).

16For more on PBGC guarantee limits, see Pension Benefit Guaranty
Corporation, Pension Insurance Data Book 1999 (Washington, D.C., Summer
2000), pp. 2-14.

17The 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.

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

The recent decline of PBGC's single-employer program has occurred in the
context of the long-term stagnation of the DB system. The number of
PBGC-insured plans has decreased steadily from approximately 110,000 in
1987 to about 29,000 in 2004. While the number of total participants in
PBGC-insured single-employer plans has grown approximately 25 percent
since 1980, the percentage of participants who are active workers has
declined from 78 percent in 1980 to 50 percent in 2002. Unless something
reverses these trends, PBGC may have a shrinking plan and participant base
to support the program in the future.

From 1995 to 2002, while most of the 100 largest plans had sufficient
assets to cover their plan liabilities, many did not. Furthermore, because
of leeway in the actuarial methodology and assumptions sponsors can 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.

Although as a group, funding levels among the 100 largest plans were
reasonably stable and strong from 1996 to 2000, by 2002, more than half of
the largest plans were underfunded (see fig. 1). Two factors in the
deterioration of many plans' finances were the decline in stock prices and
prevailing interest rates. From 2000 to 2002, stock prices declined
sharply each year, causing a 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 current liabilities.
The combination of lower asset values and higher pension liabilities had a
serious, adverse effect on overall DB plan funding levels.

Figure 1: 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

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 to calculate current liabilities and actuarial
measurement of plan assets that differ from market values.

Reported current liabilities are calculated using a weighted average of
rates from the 4-year period before the plan year. While this allows
sponsors to smooth fluctuations in liabilities that sharp swings in
interest

                                       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.

Rules May Allow Reported Funding Levels to Overstate Current Funding Levels

rates would cause, thereby reducing volatility in minimum funding
requirements, it also reduces the accuracy of liability measurement
because the rate anchoring reported liabilities is likely to differ from
current market values. To the extent that the smoothed rate used to
calculate current liabilities exceeds current rates, the 4-year smoothing
could reduce reported liabilities relative to those calculated at current
market values. Further, rules allowed sponsors to measure liabilities
using a rate above the 4-year weighted average.18 The 4-year weighted
average of the reference 30-year Treasury bond rate exceeded the current
market rate in 76 percent of time in 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. For example,
an interest rate 1 percentage point higher than the statutorily required
interest rate would decrease the reported value of a typical plan's
current liability by around 10 percentage points.

As with liabilities, the actuarial value of assets used for funding may
also differ from current market values. Under the IRC, actuarial asset
values cannot be consistently above or below market, but in a given year
may be anywhere from 80 to 120 percent of market asset levels. Among the
plans we examined, on average each year, 86 percent reported a different
value for actuarial and market assets. On average, using the market value
instead of the actuarial value of assets would have raised reported
funding levels by 6.5 percent each year. However, while the market value
exceeded the 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

18In 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.

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 use of the actuarial value
of assets also may have disguised plans' funded status as their financial
condition worsened.

Two large plans that terminated in 2002 illustrate the potential effects
of discrepancies between reported and actual funding. 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.

Most Sponsors of Large Plans Did Not Make Annual Cash Contributions, 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 top 100 plans averaged approximately $97
million on plans averaging $5.3 billion in current liabilities, with
figures in 2002 dollars.19 This average contribution level masks a large
difference in contributions between 1995 and 2001, during which period
annual contributions averaged $62 million, and in 2002, when contributions
increased significantly to almost $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. 2). On average each year, 62.5 plans
received no cash contribution, including an annual average of 41 plans
that were less than 100 percent funded.

19 For the 100 largest plans that we examined, all dollar figures are
reported in constant 2002 dollars.

Figure 2: Most Large Plans Received No Annual Cash Contribution, 1995-2002

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.20 Because
meeting minimum funding requirements depends on reconciling total

20If 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 it, therefore may offset the need
for future cash contributions.

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
relied more heavily on other FSA credits than on cash contributions to
meet minimum funding obligations. 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
augments a plan's FSA credits and further helps meet minimum funding
requirements. In contrast, 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).21 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 funding. During these years, a
majority of plans in our sample received no cash contribution.

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. In addition to large credit balances
brought forward from prior years, sponsors were able to apply funding
credits from other sources, such as net interest credits ($42 million per
plan per year, on average), and credits from the excess of a plan's
calculated minimum funding obligation above the plan's full funding
limitation ($47 million).22 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 in
our sample. Funding credits, offset by charges, may help satisfy a plan's
minimum

21Minimum required annual funding equals annual total FSA charges, less
net amortization credits and interest applied to these amortization
credits.

22Full funding limitation rules set a ceiling for minimum annual funding
requirements for a plan each year, based on the plan's liabilities.

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.

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.
These features often allow sponsors to better regulate their annual level
of contributions, compared to annual fluctuations if funding were based
strictly on yearly differences between the market value of plan assets and
current 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.23

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. 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 must 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.

23There are investment techniques, such as purchasing fixed income assets
whose payouts match the plan's expected payouts, which 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.

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 by 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.

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 plan year.24 However, the FFL does not
represent the contribution that would raise plan assets to the level of
current liability. 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. 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 plan's annual maximum tax-deductible contribution. Because sponsors
may be subject to an excise tax on contributions above the maximum
deductible amount, the annual maximum contribution can act as a real
constraint on cash contributions.

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

24As 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.

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 forego 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 on 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 the 60 plans that contributed to the maximum deductible amount had a
maximum deductible contribution of zero (see fig. 3). This meant that any
cash contribution into those plans that year would generally subject the
sponsor to an excise tax.25 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 plans had a maximum deductible
contribution of zero. Fourteen of the plans in this situation could not
have made any additional contributions. However, the other 16 could have
made at least some contributions by choosing a lower interest rate to
raise their maximum deductible contribution level.

25 For 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).

Figure 3: 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.

Very Few Sponsors of 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
Underfunded Large percent of liabilities, measured using the highest
allowable interest rate, Plans Paid an AFC 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 from
1995 to 2002 was at least 90 percent funded in at least 2 consecutive of
the 3 previous plan years. A plan with assets below 80 percent of
liabilities, calculated

using the highest allowable rate, is assessed an AFC regardless of its
funding history.26

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. 4). From 1995
to 2002, only 6 of the 187 unique plans that composed the 100 largest
plans each year were ever assessed an AFC,27 and these plans owed an AFC a
total of 23 times in years in which they were among the 100 largest 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 AFC. This would indicate that, in practice, 80 percent represented
the realistic funding threshold for owing or avoiding the AFC.

26 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.

27 Unique plans refer to the number of plans we observed with distinct
plan identifiers called EINs and PINs. See footnote 9 of GAO-05-294 for
further information on why the actual number of completely unrelated plans
in our sample may be lower than the 187 reported.

Figure 4: 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.

Even with those plans subject to an AFC, other FSA credits may help a plan
satisfy minimum funding obligations. 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. 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. 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. 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, 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.

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

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

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.
LTV Steel, which terminated its pension plan for hourly employees in 2002
with assets of $1.6 billion below the value of benefits, had 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 Steel made no cash
contributions to this plan from 2000 to 2002. Both plans were able to
apply existing credits instead of cash to fully satisfy minimum funding
requirements.

The recent funding experiences of large plans, especially those sponsored
by financially weak firms, illustrate the limited effectiveness of certain
current funding rules and represent a potentially large implicit financial
risk to PBGC. The financial health of a plan sponsor may be key to plan
funding decisions because sponsors must make funding and contribution
decisions in the context of overall business operations. From 1995 to
2002, on average, 9 percent of the largest 100 plans were sponsored by a
firm with a speculative grade credit rating, suggesting financial weakness
and poor creditworthiness.28

Financial strength of plan sponsors' business operations has been a key
determinant of risk to PBGC. Financially weak sponsors of large,
underfunded plans 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. Current funding rules, coupled with the presence
of PBGC insurance, may create 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

28Credit 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.

limited time horizon and place other financial priorities above "funding
up" their pension plans. To the extent that the presence of PBGC insurance
causes financially troubled sponsors to alter their funding behavior,
PBGC's potential exposure increases.

Underfunded plans sponsored by financially weak firms pose the greatest
immediate threat to PBGC's single-employer plans. 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.
5).29

29 Criteria used for classifying a plan as a reasonably possible
termination 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 Internal Revenue Service; sponsor
missed minimum funding contribution; sponsor's bond rating is
below-investmentgrade 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 5: Total Underfunding among All DB Plans, and among Those
Considered by PBGC as Reasonably Possible for Termination, Has Increased
Markedly since 2001

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.

Plans Sponsored by Financially Weak Firms Exhibit Riskier Funding Behavior

From 1995 to 2002, we observed that plans sponsored by speculative
grade-rated firms had lower levels of average funding compared with the
average for the 100 largest plans. For instance, the average funding of
these plans was 12 percentage points lower on average than the funding
level for all plans from 1995 to 2002. Plans sponsored by speculative
graderated firms were also more likely to be underfunded. From 1995 to
2002, each year, on average, 18 percent of plans sponsored by speculative
graderated firms had assets that were below 90 percent of current
liability. Plans sponsored by nonspeculative grade-rated firms had just
over half this incidence, or an average of 10 percent of plans funded
below 90 percent of current liability.

Large plans sponsored by firms with a speculative grade rating were also
more likely to incur an AFC. While plans sponsored by speculative
graderated firms accounted for only 9 percent of all plans that we
examined over the 1995 to 2002 period, they accounted for just over
one-third of all instances in which a sponsor was required to pay an AFC.
In contrast, 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, to the extent that plans sponsored by
speculative grade-rated firms are considered to pose a significant risk
for near-term termination, it may not be an effective mechanism for
improving a plan's funding level. Plans sponsored by firms that are in
financial distress are, by definition, having difficulty paying off debts
and may be ill equipped to afford increased 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.

Large plans with sponsors rated as speculative grade were also generally
more likely to use the highest allowable interest rate to compute their
current liability 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. 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.

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 at least 3 years prior to termination (see fig.
6). These claims account for 67 percent of the value of total gross claims
on the single-employer program from 1975 to 2004. 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 termination, 33 of these 41 claims involved sponsors rated as
speculative grade.

Figure 6: Over 80 Percent of Sponsors Associated with PBGC's Largest
Termination Claims Had Speculative Grade Ratings 10 Years Prior to
Termination

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.

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 analysis here suggests that certain
aspects of the funding 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. Further, the rules appear to lack strong mechanisms to compel
sponsors to make regular contributions to their plans, even those that are
underfunded or subject to an AFC. Perhaps most troubling is that current
rules for measuring and reporting plan assets and liabilities may not
reflect true current values and often understate the true degree of
underfunding.

Conclusions

The current rules have the reasonable and important goals of long-term
funding adequacy and short-term funding flexibility. However, our work
shows that although the current system permits flexibility, it also
permits reported plan funding to be inadequate, misleading, and opaque;
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.

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' and retirees' economic
security in retirement 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 should 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. However,
focusing more stringent funding obligations on weak plans and sponsors
alone may not be adequate, because strong companies 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 funding rule change is an essential
piece of the overall 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
distributions;

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.

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. Even with meaningful, carefully crafted reform, it is
possible that some DB plan sponsors may choose to freeze or terminate
their plans. While these are serious concerns, the overarching goals of
balanced pension reform should be to protect the retirement benefits of
American workers and retirees by providing employers reasonable funding
flexibility while also holding those employers accountable for the
promises they make to their employees.

As I noted in my opening remarks, PBGC's challenges parallel the
challenges facing our Social Security system. While both programs have
adequate current revenues and assets to pay promised benefits today, both
face large and growing accumulated deficits on an accrual basis. Further,
timely action to address both private pension and Social Security reform
is needed. However, consideration must be given to the interactive effects
of any such reforms and how they contribute to addressing our nation's
large and growing fiscal challenge, key demographic, economic and
workforce trends, and the economic security of Americans in their
retirement years.

Contact and Acknowledgments

Mr. Chairman, this concludes my statement. I would be happy to respond to
any questions you or other Members of the Committee may have.

For further information, please contact Barbara Bovbjerg at (202) 5127215.
Contact points for our Office of Congressional Relations and Public
Affairs may be found on the last page of this testimony. Other individuals
making key contributions to this testimony included Charlie Jeszeck, Mark
Glickman, and Chuck Ford.

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