Pension Finance Institute

Statement for the Record Committee on Ways and Means Subcommittee on Select Revenue Measures Hearing on the President's Proposal for Single-Employer Pension Funding Reform March 8, 2005 The President’s proposal is an important step in the right direction. Unlike many in the pension community, we prefer even more rigorous funding rules to apply after a suitable period of transition. Most of our comments address the permanent post-transition rules that we believe are necessary for a financially sound defined benefit pension system. Solvency We believe that pension plan solvency must be the fundamental goal of any pension reform. We can visualize many possible transition arrangements, but reform should require that all plans become fully funded by a specified date such as January 1, 2015* and remain fully funded at all times thereafter. Banks, insurance companies, mutual funds, brokerages, defined contribution plans, and all other financial institutions that serve the public are required to be solvent upon every periodic examination. Why should defined benefit plans be the exception? Funding below the solvency level is, in effect, borrowing by the plan sponsor from the plan and its beneficiaries. This borrowing is guaranteed by the PBGC – effectively by other plan sponsors and potentially by taxpayers. The involuntary guarantee provided by others encourages weak companies to make large and valuable pension promises to their employees. The guarantee also allows sponsors to disregard sound risk management practices and take large investment risks without regard to whether they can make good any possible losses. Although PBGC guarantees were established as “insurance,” the result is really a tax on successful plan sponsors to meet the obligations of unsuccessful ones. True insurance covers independent risks that are difficult for the insureds to control. The vast majority of sponsors insured by the PBGC, though, are deliberately taking the same risk: betting on equities instead of hedging their pension liabilities with bonds. The Administration proposal addresses solvency more directly than current law and sensibly discards many of the overlapping, even contradictory, rules of the past. Nonetheless, the proposal falls short of ever requiring permanent solvency such as that required of other financial institutions: The proposal allows seven-year funding for future losses (primarily due to poor plan risk management), for assumption changes, and for new benefit awards by (presumably) strong companies. These liability increases should be funded immediately. The proposal allows plans to measure their liabilities using corporate, rather than risk free, discount rates. Because plan solvency is a bankruptcy issue (when the firm cannot meet its ordinary debts, the plan assets act as collateral for benefits promised by the plan), defining a funding standard using risky debt assures that other parties will pay for some of the promises made by weak sponsors. Is Rigor Incompatible with DB Viability? It is a fact that strong funding requirements will cause some sponsors to freeze (and eventually terminate) their DB plans. Some sponsors and other commentators have used this fact as a cudgel to threaten policymakers. The implication of this threat is that DB plans are universally valuable to their sponsors, plan participants, and society. We agree that well-funded plans provide excellent value, but poorly funded plans are a menace to their sponsors, participants, and society. Accommodating such plans indefinitely is not an appropriate objective for pension reform. PBGC Premiums and Risks PBGC premiums must reflect plan risks. Because plan risks depend on sponsor strength in addition to plan factors (funding level and asset allocation), accurate risk assessment might require the PBGC to intrude excessively into the doings of plan sponsors. We prefer to focus on risk elimination through stronger funding standards. A requirement of full funding at all times would eventually reduce the role of the PBGC to collecting the very modest premiums needed to pay for rare accidents, rather than easily foreseen and preventable risks. Contribution Volatility Volatility is a property of the capital markets. These same markets have developed hedging and asset-liability management tools to manage volatility. Such tools can be very effective. Artificial tools, developed by actuaries and embedded in ERISA since its inception, however, are counterproductive. They encourage risk taking and moral hazard (clever gaming of the system). Obscuring risk is not the same as managing risk. Every accommodative provision in the administration’s proposal serves to perpetuate needless risk taking. All smoothing and off-market values should be eliminated, thereby increasing transparency and relevance. This will simplify the rules, reduce moral hazard, and encourage sound risk management. Although many commentators claim that full funding and strong asset-liability management are costly to plan sponsors, modern corporate finance principles show that under a sound insurance system, these practices generally add value for their sponsors. Credit Balance The credit balance is a flawed concept in any solvency based scheme. It should be eliminated during the transition. Maximum Deductible Funding The proposal allows for a full funding limit equal to 130% of the liability based on service to date with allowance for future salary increases. This amounts to a limit in excess of 150% of the solvency level for many pay-related plans. Although it is argued that companies will overfund in “good times” and thus be healthier in bad times, it is much more likely that companies looking for tax shelter will take advantage of this latitude; companies that have imposed substantial liabilities on the PBGC have typically funded at minimum levels for many years prior to their failures. Excise Tax Reform Those who advocate generous tax-deductible maximums also favor repeal of the excise tax on surplus asset reversions. This combination asks taxpayers to allow management to shelter excess cash flow, invest it riskily, and recover it without penalty. We favor reduction or even elimination of the excise tax but do so only in combination with maximum deductible limits in the range of 120% to 125% of solvency. Fellows of the Pension Finance Institute Lawrence N. Bader Zvi Bodie Jeremy Gold David R. Kass Christopher Levell Douglas A. Love Robert C. North, Jr. Pension Finance Institute March 8, 2005 * To the extent that some few companies, or even an industry, cannot meet this target date, we suggest that federal tolerance for these companies be offered in the form of loan guarantees that will permit such firms to borrow enough from banks and bond-buyers to fund their plans fully. The current practice of propping up failing firms through their pension plans is a disaster for pension America. If a company or an industry is worthy of public assistance after January 1, 2015, Congress can act directly and transparently to provide support without using the private pension system as a source of corporate welfare. The Pension Finance Institute provides policymakers, plan sponsors, participants, journalists, investors and others with pertinent information and objective analyses regarding the costs, risks and social advantages of U.S. defined benefit pension plans. The Institute, reflecting the principles of modern finance, addresses pension funding, investment, accounting, plan design, standard actuarial practices and the role of the PBGC.