The retirement security of millions of workers who are covered by defined benefit pension plans is at risk because many of those plans do not have enough money to pay all of the benefits they have promised. While the federal Pension Benefit Guarantee Corporation (PBGC) has had to take over underfunded pension plans from two airlines and most of the steel industry, worse is yet to come. Other airlines are already in trouble, and the auto industry is also feeling the crush of massive pension obligations. The end result may be a massive bailout of PBGC that costs taxpayers tens of billions of dollars. To avoid this, Congress needs to act quickly. It should start by considering the Administration's proposal on defined benefit pension reform.

For proof that Congress should act sooner, not later, look no further than the recent United Airlines pension disaster. In April 2005, United Airlines defaulted on its defined benefit pension plan as part of its bankruptcy and passed its pension obligations to the PBGC. PBGC was left to deal with unfunded pension promises totaling nearly $10 billion, about half of which it will pay. The other half will be born by United's retirees, many of whom will receive lower pensions than they were promised. A new Government Accountability Office (GAO) report that details the level of underfunding in the 100 largest defined benefit pension plans between 1995 and 2002 shows that underfunding is getting worse.[1]

Defining the Problem

Many of the laws of the mid-20th century were built on a vision of corporate America where unchanging industries would have lifetime employees. The reality of today's dynamic economy means that those old laws are not only anachronistic, but unstable. The coming pension implosion looks like a repeat of the S&L crisis of the late 1980s, and the cost to taxpayers could exceed $100 billion.

The last twenty-five years has seen a major shift in pension plans. In the past, most pensions were defined benefit plans that guaranteed workers a certain level of income for the rest of their lives in retirement, based on his or her annual salary and length of employment. As defined benefit plans became too expensive, most companies changed to defined contribution pensions. In a defined contribution plan, employers and employees contribute to an investment account that finances the worker's retirement income.

Defined benefit plans have become more expensive in part due to changes in life expectancy. Retirees today are now live well past 65, several years longer than in the past. As life expectancy increases, so does the cost of defined benefit plans. This prohibitive cost is why defined contribution plans now outnumber defined benefit plans. Over the last twenty-five years, the number of defined contribution plans has doubled in size while the number of defined benefit plans has fallen by nearly two-thirds. Defined benefit plans still cover about 34 million Americans today-about 16 percent of the workforce.

The PBGC was set up in 1974 to guarantee pension benefits for employees of companies that fail. But like many government programs, it was encouraged by Congress to offer market-like services at non-market prices. Under-pricing insurance is an invitation to disaster, and ultimately the PBGC structure creates incentives for companies to over-promise and under-fund. When United workers negotiated a unionized contract, both sides were happy to settle on overly generous pension promises, knowing that PBGC would bail them out if the company ever went bankrupt.

The crux of the problem today is that a rising number of defined benefit pension plans are severely underfunded, and many have already failed. PBGC ended fiscal year (FY) 2004 with a $23.3 bil­lion deficit, the largest in its 30-year history and double the deficit of the year before. Taking on responsibility for United Airlines' pension plans adds another $5 billion to PBGC's deficit. If PBGC cannot find other ways to eliminate its deficit, a taxpayer bailout of the agency is inevitable.

To make matters worse, at-risk pension plans-underfunded by a total of almost $96 billion-could fail in the near future and would become the responsibility of PBGC. Overall, defined benefit pension plans in the U.S. have promised $450 billion more in benefits than they have in assets.

Many Pension Plans are Underfunded

"We have a huge pension underfunding problem," said Rep. John Boehner, the Ohio Republican who chairs the House committee that oversees private pensions. In 2004, PBGC reported that the liability of severely underfunded pension plans was $278.6 billion. In 2005, PBGC reported that all single-employer pension plans were underfunded by $450 billion. Plans underfunded by a total of almost $96 billion could fail in the near future and would have to be taken over by the agency.

Many companies assume that their pension plans will grow by a certain percentage each year. In good economic years, current funding rules may even allow companies to use this asset growth to avoid making cash contributions to their pension plans. GAO's report found that, on average, 62.5 percent of companies made no cash contribution to their pension plans between 1995 and 2002-years of strong economic growth. And when the economy or the stock market enters a downturn, pension assets can decline in real value. At the same time, poor economic conditions may also make it harder for companies to come up with the cash necessary to fully fund their pension plans-prompting them to delay contributions. This funding pattern, while technically legal, has increased underfunding. In 1999, the estimated pension shortfall was $18.4 billion. The 2001 recession and economic slowdown increased this number by over $260 billion. Congress and the President began to address PBGC's problems last year with the Pension Funding Equity Act. Unfortunately, that effort fell far short of its goal, and even that law will expire at the end of 2005.[2]

The GAO's new report details how weak the funding rules are and how severely defined benefit pension plans are deteriorating. Covering the period between 1995 and 2002, GAO found that, on average, 39 percent of the largest defined benefit plans were underfunded. By 2002, almost one out of four of these plans was less than 90 percent funded. To make matters worse, GAO found that the funding rules are so loose that underfunding may have been much worse and widespread than it was able to determine.

Bad Incentives

PBGC, despite its important mission, is a creation of government and would not exist in the marketplace in its current form. Just like the FDIC and the old Federal Savings and Loan Insurance Corporation, its protection is not free. Because PBGC distorts the marketplace with its mandatory coverage of defined benefit plans, its politically set insurance premiums and regulatory guidelines are prone to gaming by corporations that want to pass part of the cost of their pension plans to the taxpayer.

The mere existence of PBGC creates a problem in getting companies to fully fund their pension plans. Like any insurance, the ability of PBGC to take over failed pensions acts as a perverse incentive for companies to act irresponsibly. And once a company's pension plan is underfunded, the incentive is to leave it that way. There is a slippery-slope effect, too, that encourages companies and organized labor to agree on more outrageous pension promises. Now that United is reneging on its pension promises, for example, the relevant unions are outraged that PBGC won't fulfill 100 percent of the company's promised pensions.

Even worse, PBGC bailouts distort competition in the marketplace by giving an advantage to firms that have dumped their plans. United will no longer have to pay over $600 million a year in pension contributions. How will American or Delta respond? They will probably follow the same strategy, out of pure competitive necessity. And airlines are not the only industry facing potentially huge pension costs. Earlier this week, General Motors's bond rating was cut to junk bond status in part because of its pension liabilities.

But PBGC itself has major liability issues. Currently, PBGC has a liability of $23.3 billion in FY 2004, up $12 billion from 2003.[3] If other companies, such as GM, Ford, and Delta, transfer their pension liabilities to PBGC, this net liability would increase. In the upcoming years, PBGC will be unable to meet its obligations and will have to seek a bailout from Congress and taxpayers.

This is not to say that the agency does not serve a valuable purpose, but policymakers must recognize that its presence increases the risk that taxpayers will end up paying for the protection it offers. Until PBGC is reformed to charge firms a premium rate that includes a more effective measure of risk and implements funding rules that better measure the ability of pension plans to meet their promises, debates about pension funding status are going to reoccur on a regular basis.

The Administration's Plan

Elaine Chao, the Secretary of Labor and chair of the PBGC board, has put forward a pension reform plan that would make the PBGC operate much more like a real insurance business-charging something like market prices per worker, requiring business to pay a risk premium based on their bond ratings (effectively punishing firms with greater risk of default), and requiring all firms to fully fund pensions within seven years. This wise approach has been endorsed across the spectrum-even by the Washington Post editorial board.[4]

Most of PBGC's annual income, which is used to reduce the agency's deficit, comes from a $19 per worker annual insurance premium paid by covered pension plans. The Bush Administration proposes to raise premiums by $11 (equal to the amount of wage growth in the past 14 years) to $30 per worker and to index the premium to the annual growth in wages. This raise would take effect in FY 2006 and would be the first premium increase since 1991. Underfunded plans would also pay an annual risk-based premium that reflects the gap between bene­fit promises and funding targets. The PBGC board would set the amount based on the risk of plan fail­ure and the need to improve the agency's finances.

While the increased premiums will provide additional revenue to the agency, substantial reform of pension plan funding rules would also improve its finances. The current rules are extremely complex, and plans are evaluated with the assumption that the employer will always be able to make contributions, regardless of the risk of a firm's failure. For example, Beth­lehem Steel's pension plan was judged to be 84 per­cent funded even though it had only 45 percent of the assets needed to pay promised benefits. The PBGC was left to cover the $4.3 billion shortfall when the firm went bankrupt.

The Administration's proposed funding rules would both provide a more accurate picture of plan funding and require companies to meet their obligations. The rules would also prevent a company from expanding benefit promises while its plan is severely underfunded. Combined with the additional premiums, the new funding rules would sharply reduce the need for a major taxpayer bailout of the PBGC.

The one thing that Congress should not do is to repeat the sad experience of the 1980s. Unless there is hard evidence that a company will recover its economic health, Congress should not casually extend the amount of time that corporations have to fund their pension plans. While this may be justified on a case-by-case basis, a general rule would just mean that taxpayers will have to pay more to bail out the PBGC when it runs out of money.

Conclusion

Like Social Security, many defined benefit pension plans are dangerously underfunded. As other companies follow United in defaulting on their pension plans, PBGC's finances will become steadily worse and the need for a taxpayer bailout will grow. Taxpayers should not be expected to bail out companies that have over-promised and underfunded pension plans. Early congressional action on the Administration's reform plan will, at the very least, reduce the cost of such a bailout.

David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies, Tim Kane, Ph.D., is the Bradley Research Fellow in Labor Policy in the Center for Data Analysis, and Rea S. Hederman, Jr., is Manager of Operations and a Senior Policy Analyst in the Center for Data Analysis, at The Heritage Foundation.