Two decades ago, Congress decided to give a failing industry the benefit of the doubt, and it allowed ailing savings and loans to avoid raising new capital. The industry argued that it was in a temporary slump and would recover in just a few years. It did not. Business conditions had changed, and S&Ls were obsolete. The collapse of the industry cost American taxpayers over $100 billion. The cost could have been much lower if Congress had withstood political pressure and acted sooner.

The same situation is playing out today, and it could put the pensions of millions of workers at risk. If Congress fails to act responsibly, taxpayers could again be on the hook for a several hundred billion dollar bailout.

Special Treatment

In the Senate's Pension Security and Transparency Act, important pension reforms are overshadowed by ill-considered special treatment for airline pension plans that could greatly increase the cost of such a bailout to taxpayers. The bill, which combines separate legislation passed by the Senate Finance Committee and the Senate Committee on Health, Education, Labor, and Pensions, would give airlines up to 21 years to fully fund their pension plans.

On September 14, Delta Airlines and Northwest Airlines filed for bankruptcy the day before they would have had to contribute about $200 million, in total, to their pension plans. Both airlines' pension plans are severely underfunded, Delta's by about $10.6 billion and Northwest's by about $5.6 billion. If these plans are taken over by the federal Pension Benefit Guaranty Corporation (PBGC), the agency's deficit would rise over a third from its current $23.3 billion. Delta's pensions would put PBGC on the hook for $8.4 billion beyond the plans' assets, while Northwest's pensions would cost PBGC about $2.8 billion more than the plans have in assets.

All this follows the failure of United Airlines. In April 2005, United Airlines defaulted on its defined benefit pension plan as part of its bankruptcy and passed its pension obligations to 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 details underfunding in the 100 largest defined benefit pension plans between 1995 and 2002 and shows that the problem is getting worse.[1]

Special treatment for industries with the high risks of pension-plan default will not improve this situation. While airlines' pension plans are extremely expensive, the industry struggles on many other fronts. Delaying the funding of its pension plans with special treatment will result in even greater deficits, as the airlines continue to delay funding their plans and, at the same time, promise new and existing workers more and more in benefits.

To make matters worse, the airline industry is only the latest to face massive failures due in part to poorly funded pension plans. In the last few years, most of the steel industry went into bankruptcy and passed its pension obligations to PBGC. Today's airline failures could be followed by major bankruptcies in the auto parts industry and even by the bankruptcies of the auto manufacturers themselves.

For example, Delphi, a major auto parts maker, is likely to file for bankruptcy this week or the next, and Ford's recent announcement that it will buy parts from just a few manufacturers is likely to hasten the demise of other firms. PBGC's current deficit of $23.3 billion could grow to about $142 billion over the next 20 years, according to a September 2005 Congressional Budget Office (CBO) report.[2] CBO's report confirms GAO's conclusion that the underfunding of major pension plans is growing.[3]

Despite these looming liabilities, the Senate bill's special treatment of airlines would unnecessarily increase the cost to taxpayers further. No matter how Congress acts, Delta's and Northwest's pensions are almost certain to reach PBGC, and special treatment will just raise the eventual cost to taxpayers. Congress should delete the provision giving special treatment to airline pension plans from the Pension Security and Transparency Act.

Important Reforms

Although the airline provision has deservedly received much attention, the rest of the Senate bill contains important reforms that will improve the health of both defined benefit pension plans and PBGC. The past 25 years has seen a major shift in pensions. 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 annual salaries and lengths of employment. As defined benefit plans became too expensive, most companies switched to defined contribution pensions, in which 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 now live well past 65, years longer than in the past. As life expectancy increases, so does the cost of a defined benefit plan. For this reason, defined contribution plans now outnumber defined benefit plans. Over the past 25 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 34 million Americans today, or about 16 percent of the workforce. Due to faulty regulations and underfunding, many of the remaining defined benefit pensions are at risk.

Companies assume that their pension plans' assets will grow by a certain percentage each year. In good economic years, current funding rules allow companies to use this asset growth to avoid making cash contributions to their pension plans. For example, 62.5 percent of companies, on average, made no cash contribution to their pension plans between 1995 and 2002, when there was strong economic growth, according to GAO. Conversely, when the economy suffers a downturn, pension assets can decline in value. The same economic conditions may also make it harder for companies to come up with the cash to fully fund their pension plans, prompting them to delay contributions. This funding pattern, while technically legal, has increased underfunding. By 2002, almost one out of every four of major companies' defined benefit plans was less than 90 percent funded. Even worse, GAO found that the funding rules are so loose that underfunding may have been much worse and more widespread than it was able to determine.

In 2004, PBGC reported that the total 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.

Congress should deal with this situation by rapidly approving legislation containing the following reforms:

Increase PBGC Premiums. Most of PBGC's annual income, which is used to reduce the agency's deficit, comes from covered pension plans' payment of a $19-per-worker annual insurance premium. The Senate bill would raise this premium by $11 (equal to wage growth over the past 14 years, as premiums were last raised in 1991) to $30. This would phase in over three to five years (depending on each plan's funding status) beginning in FY 2006. Underfunded plans would also pay an annual risk-based premium that reflects the gap between bene­fit promises and funding targets. PBGC's board would set this premium based on the risk of plan fail­ure and the agency's finances.

Require a more accurate interest rate to calculate pension funding. The current rules for measuring plans' funding are extremely complex, and plans are evaluated under 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 84 per­cent funded, even though it had only 45 percent of the assets needed to pay promised benefits, shortly before the company's bankruptcy. The PBGC was left to cover the plan's $4.3 billion shortfall.

A key factor is the interest rate used to calculate funding. Current law uses a blended rate of corporate bonds, but the rate will automatically revert to the interest rate on 30-year Treasury bonds unless action is taken before December 31. The Senate bill uses the corporate rate for 2006, but substitutes a yield curve based on the 12-month average interest rate paid on corporate bonds starting in 2007.

Under current law, pension funds may calculate their financial position using an average of interest rates over the last four years. Limiting this period to 12 months is an extremely important step towards accurate valuation of pension plan assets.

Reduce "smoothing" to 12 months. Current law allows pension plan operators to average the gains and losses of plan investments over a period of five years. This averaging can seriously obscure a pension plan's inability to pay all of its benefit promises when stocks or other investments are in flux. The Senate bill limits smoothing to the 12-month unweighted average of asset values. This is an extremely important step towards more accurate reporting of pension plan assets.

Require full funding in seven years. Underfunded plans must be brought to full funding within seven years.

Require 100 percent funding of pension promises. Current law allows pension plans to be considered fully funded if they have enough assets to pay 90 percent of their pension promises. The Senate bill raises this funding target to 100 percent over three years, beginning in 2007. Small plans may take up to five years to reach this level.

Tie pension plan liability to the employer's credit ratings. There is a direct correlation between a company's credit rating and the probability that it will terminate its pension plans and turn them over to the PBGC. The Senate bill recognizes this and requires that companies that have experienced two years of declining bond ratings and whose bonds are below investment grade must contribute additional money to their underfunded pension plans. This only applies to plans that are less than 93 percent funded.

A firm's pension plans should terminate when it files for bankruptcy. Under the Senate bill, if a bankrupt company's pension plan is terminated and handed over to the PBGC, it is considered to have terminated on the date that the company filed for bankruptcy. Under current law, the actual plan termination may occur some time after that date, even though the bankruptcy caused the pension plan to terminate. This provision eliminates uncertainty for workers and plan administrators.

Severely underfunded plans cannot increase benefits. Under the Senate bill, pension plans that are less than 80 percent funded or that belong to companies that are bankrupt cannot increase pension benefits. This means that workers will continue to get credit for working additional years, but their plans cannot offer to pay them higher pensions than those to which they are currently entitled. In addition, pensions are frozen for plans that are less than 60 percent funded. In this case, a worker's pension is frozen at its current payment level, and he or she cannot even get credit for working additional years. This is an important measure to prevent a plan from falling even further behind in funding and driving up the burden on PBGC and taxpayers.

Underfunded plans must increase disclosure to PBGC. Under the Senate bill, underfunded pension plans must provide additional financial information to PBGC, and they must report more quickly than required under current law. This improves PBGC's ability to plan for future problems.

Change interest rates for calculating lump-sum withdrawals. Another important reform in the Senate bill changes interest rate assumptions for lump-sum distributions. Many plans allow workers to choose to take a large cash payment at retirement instead of regular monthly pension payments. Because the interest rate used to calculate lump-sum distributions is often too low, the lump sums are larger than appropriate and drain pension funds to the point that less is left for retirees taking monthly benefits. The Senate bill largely corrects this problem by using a yield curve based on the interest rate paid on high-grade corporate bonds over the preceding three months. In addition, underfunded plans of bankrupt companies and plans that are less than 60 percent funded are limited to making lump-sum payments equal to 50 percent of the amount that would be paid if the plan were fully funded.

Eliminate all credit balances. One serious weakness of the Senate bill is its failure to eliminate all "credit balances." A credit balance is created when a company pays more than its required minimum annual contribution to a pension plan. The amount in excess is assumed to grow using the same interest rate assumptions that the plan uses for its regular pension investments. A company can use credit balances to reduce or even eliminate its future required payments-even if the pension plan's overall funding has declined due to market losses. Thus, a credit balance can allow a company to skip making cash payments into its pension plan even when the plan is unable to make good on its promises because it has lost money during the year.

Under the Senate bill, companies can continue to use existing credit balances, but must use market interest rates to determine them. In addition, if the plan is under 80 percent funded, it must also make a cash contribution of 25 percent of the minimum required, or the plan's normal contribution, whichever is higher.

Conclusion

Taxpayers should not be expected to bail out companies that have over-promised and underfunded pension plans. Even worse, bankrupt companies such as Delta and Northwest should not receive special treatment that will almost certainly end up costing taxpayers billions. The Senate should remove the airline bailout provisions from its Pension Security and Transparency Act.

On the other hand, the provisions contained in the rest of the bill will reduce the amount of taxpayer money that PBGC will eventually need. Rather than bowing to special interests, the Senate should consider the needs of taxpayers. Companies and unions that have over-promised pension benefits and underfunded pension plans should be required to fund their promises fully. The Pension Security and Transparency Act is a major step in that direction.

David C. John is Research Fellow in Social Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.