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.