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.