Pensions Lost in Translation

It has finally happened. The Pension Benefit Guaranty Corporation (PBGC) has assumed responsibility for the four defined benefit (DB) pension plans at United Airlines. The impact, as reported in The New York Times is as follows:

The federal government said yesterday that it had reached an agreement to take over all four of United Airlines' employee pension plans, with a shortfall of $9.8 billion, making it the biggest pension failure since the government began insuring pension benefits in 1974.

Because the PBGC caps the benefit amounts it insures, only $6.6 billion of this amount is guaranteed, but even that hit to its balance sheet will increase the PBGC's net deficit (reported as $23.3 billion last September) substantially. Plus, we can now expect all of the other legacy airlines to seek the same sort of treatment from the PBGC.

However, there has been a tendency in news reports to suggest that the American taxpayer is somehow on the hook for this money. That isn't true, unless the federal government passes new legislation to make it true. At present, it is the rest of the DB pension sponsors in the PBGC-insured universe who are on the hook. As the PBGC's press release explains:

By law, the PBGC is required to keep premiums as low as possible and has no call on the U.S. Treasury beyond a $100 million line of credit. ...

The PBGC is a federal corporation created under the Employee Retirement Income Security Act of 1974. It currently guarantees payment of basic pension benefits for about 44 million American workers and retirees participating in over 31,000 private-sector defined benefit pension plans.

Pension insurance--not the idea but its implementation, and certainly not the dedicated people who work at the PBGC--is a complete joke. There are three problem's with the PBGC's setup:

1) The premium amounts are too low. On average, companies do not pay enough to cover the risk to which they expose the PBGC.
2) The premium formula is inadequately linked to underfunding. Pension sponsors whose plans are underfunded do pay slightly more in premiums than pension sponsors whose plans are fully funded, but the amount of additional premiums does not adequately compensate the PBGC for the added risk of a claim.
3) The premium formula is unrelated to the PBGC's risk exposure--the portfolio allocation between stocks and bonds and the bankruptcy risk of the company.

There are some extremely smart people working on pension insurance, both at the PBGC and outside. The issue is not that we couldn't figure out how to charge the appropriate premiums. The issue is entirely that Congress will never allow the PBGC to charge actuarially fair premiums. That would put too large of a burden on key political constituencies. United would have been paying enormous premiums over the past few years. Airline, steel, autos--these are the industries that have been least responsible in funding their pension plans. So this is what we get--subsidized risk-taking at the expense of responsible plan sponsors.

Defined benefit (DB) pension plans pay out benefits to retirees (and often survivors and occasionally the disabled) based on formulas that may increase with age, years of service, and earnings. The obligations look like the payment stream from a bond. In fact, a pension sponsor with a steady aggregate earnings profile and employee hiring and turnover could fully fund the liabilities and insure against risk with a portfolio heavily weighted toward bonds.

With PBGC insurance, the company has an incentive to invest in a portfolio heavily weighted toward stocks. If the stocks do well, the company can cut back on future contributions. If the stocks do poorly, then in some cases, the company can terminate the plan and leave the liability with the PBGC. Classic moral hazard. When the economy goes through a period of weak stock market returns (so the pension fund's assets fall in value) and low interest rates (so the present value of the future liabilities rise in value), we get tremendous underfunding. And the laws governing minimum pension contributions don't require pension sponsors to make up the difference quickly enough.

What to do? Impose a levy on each DB pension plan sponsor that is proportional to the current value of all past PBGC premiums paid for current participants. Impose the levy based on 2004 data, so there is no rush to the exit. The levy should be enough to put the PBGC at a zero balance position. Then retire the PBGC and allow companies to obtain pension insurance privately if they so desire. For current sponsors, pass a law that moves pension participants' claims in bankruptcy ahead of all unsecured creditors. If this means that fewer firms offer DB pensions, then so be it. Unhealthy companies--like United--ought not to be making promises to pay beneficiaries decades into the future.

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