Lecture 4: Funding DB
Pension Plans
By the end of this lecture, you
should be able to:
List types of funding arrangements
Describe plan termination rules
Explain the role of the PBGC
Discuss what happens when a plan is
underfunded
Discuss potential distortions that arise
as a result of pension accounting rules
First, A Question to Discuss …
How might you best achieve the goal of
providing workers and retirees with
protection against losing their pension
in the event that their employer goes
bankrupt?
What would an “ideal” policy look like?
IMPORTANT NOTE
Some of the details of funding
requirements in these slides have
changed as a result of the passage of
the Pension Protection Act, signed into
law.
Slides at the end of this lecture will
provide updates to the rules …
Overview of Pension Funding
Prior to ERISA (1974), a firm could pay
benefits as they came due
If firm went bankrupt, workers could lose their
entire pension (Studebaker)
Since 1974, ERISA requires that all qualified
plans must advance fund the benefits
obligations
Assets must be held by a funding agency, which is
a trust or an insurance company
Plan must purchase insurance from the Pension
Benefit Guarantee Corporation (PBGC)
Funding Agency
Trusts are the primary method of funding
qualified plans
Legal agreement with three parties
• Grantor of the trust (employer)
• The trustee (fiduciary)
• The beneficiaries (employees / plan participants)
Alternative is an insurance contract
Complex array of arrangements is available
The Basic Idea of Funding
Conceptually, the concept is straightforward:
Calculate NPV of the pension plan’s liabilities
• Estimate annual future benefit payments
– Benefit rules, earnings growth, job turnover, mortality
• Compute NPV using a discount rate
Calculate value of the plan assets
Compare the two measures to determine if plan is
adequately funded
In practice, this is a complex and confusing
area …
The Complexity of Pension Funding
Pension funding rules are extremely complex
for several reasons:
Liabilities computed on an accrual basis and
require numerous assumptions about the future
There are multiple measures / definitions of
pension plan liabilities
Accounting rules and ERISA (PBGC) funding rules
can be quite different (and IRS tax treatment can
differ from both!)
• Different interest rates
• Use different liability measures
Measuring Liabilities: Examples
Current liability
Represents an estimate of the benefits earned to
date, assuming the plans sponsor remains in
business and the plan is continued
Termination liability
Estimate of cost of terminating a pension & buying
a group annuity from an insurer to cover the
obligations
Accrued liability
Similar to current liability, but larger because it
includes additional items.
• Ex: Considers future wage growth in calculating future
benefits. (Current liability “freezes” wages)
Discount Rate
Choice of the discount rate has a HUGE effect
on the size of existing liabilities
Ex: PV of $1000 in 30 years
• R = .07
• R = .06
NPV = $131.37
NPV = $174.11 (32% higher!)
PBGC uses discount rate based on corporate
bond yields to calculate the current liability
for determining whether plan is fully funded
PBGC uses a different interest rate to
calculate the termination liability (based on
confidential survey of insurers)
Accounting rules are different still
Note on Discount Rate
Historically, PBGC required that plans use a
rate based on the 30 year Treasury bond, but
with flexibility
Allowed to be within 90% - 120% of 30 year rate
Could use a smoothed average of past 4 years
• What happens when interest rates are declining?
US Treasury stopped issuing 30 year bonds in
2001  now permitted to use corporate rates
These are higher  makes liabilities look smaller
The PBGC
The Pension Benefit Guarantee Corporation
was established by ERISA in 1974
Collects insurance premiums from employers that
sponsor insured pensions
• $33 per worker or retiree + $9 for every $1000 of
unfunded vested benefits
Insures benefits (up to a max) in case employer
goes bankrupt
• Currently pays benefits (up to a guaranteed maximum)
to about 460k retirees in over 3000 plans that have been
terminated
PBGC (ERISA) Funding Requirements
Goal is to require firm to contribute enough
to cover benefits earned during the year plus
interest on existing obligations
Changes in liability arising from changes in
assumptions, discount rates and asset values are
spread over multiple years
Must keep assets >= 90% of liabilities
“Full funding limit”: Upper limit on funding
To avoid using as a tax shelter
May have contributed to under funding problem
What if a Plan is Underfunded?
If underfunded, then firm must make “Deficit
Reduction Contributions” (DRC)
Firm is given approx. 3 to 7 years to bring plan
funding ratio back up to 90% or better
Precise schedule depends in part on the degree of
underfunding
Policy Goal: avoid underfunded plans becoming
a liability of the government (via the PBGC)
Past 5 Years: “The Perfect Storm”
Substantial drops in stock market
 plan assets decreased
Interest rates declined
 plan liabilities increased
RESULT: massive pension underfunding!
June 2005: DB pensions in the U.S. were
collectively under funded by $354 billion
 Hear PBGC Director discuss the problems
http://www.npr.org/templates/story/story.php?storyId=3877446
First Legislative Response
April 10, 2004: Pension Funding Equity Act
Temporarily replaced interest rate on 30 year
treasuries with long term investment grade
corporate bonds
Lets steelmakers and airlines cut their deficit
reduction contribution by 80% in 2004 (and by
60% in 2005).
“Saves” affected industries billions of dollars in
funding liabilities
Concerns About Pension
Funding Equity Act
Special provisions for airlines and steel
companies would increase the funding
problem for the very plans that are
currently most at risk.
Reminiscent of S&L “crisis” of the 1980s
Special provisions to help them out in the
short run led to longer run problems
Plan Termination
A requirement for plan qualification is that plan
is intended to be permanent
Plan can be terminated by employer unless prohibited
by collective bargaining agreements or other
employment contracts
100% vesting at termination
Excess plan assets can be returned to employer
through an asset-reversion termination, but
these are subject to a penalty
50% of reversion amount, reduced to 20% if:
• There is a replacement plan
• Benefits to participants are increased by 20% of reversion
• Employer is in bankruptcy
Termination Problem
“Current liability” of the pension is NOT the
same as its “termination liability”
Termination liability is what it would cost the
PBGC to buy group annuity contracts in private
market to make guaranteed payments
Termination liability tends to accrue more quickly
than current liability
RESULT: A plan can be “funded,” but if PBGC
takes it over, it may find the assets woefully
inadequate to cover termination benefit
obligations  PBGC is on the hook
Is Termination Problem Real?
Ex: Bethlehem Steel pension plan
reported that it was 84% funded
Upon termination, assets were equal to
only 45% if its termination liability
Ex: US Airways pilot plan reported that
it was 94% funded
Upon termination, assets were equal to
only 35% of its termination liability
Who Bears the Cost of a Terminated
Underfunded Pension?
The PBGC
Now experiencing significant underfunding
Plan beneficiaries
Article on United Airlines
• What is expected benefit of United Pilot before
bankruptcy?
• What is PBGC max benefit at age 60 (required
retirement age for pilots?)
PBGC Financial Situation
Under current law, the PBGC is only liable to
extent that it has resources to pay, but political
reality is that there is implied federal guarantee
Existing PBGC revenue structure inadequate to
finance PBGC liability exposure
$23 billion shortfall as of fiscal year end 2006
• Assets = $40 billion; Liabilities = $63 billion
• Not a short-term liquidity problem
United Airlines / US Airways bring total to over $30 b.
CBO projects add’l $48 billion over next 10 years
To fund this through premium increases alone would
require five-fold increase in premiums
Top Five PBGC Claims (1975-2005)
Company
UAL (United)
Year
2005
PBGC Claims
$6.4 billion
Bethl. Steel
US Airways
LTV Steel
National Steel
2003
2004 - 2005
2002 – 2004
2003 – 2004
$3.7 billion
$2.1 billion
$2.0 billion
$1.2 billion
Most recent losses (UAL and US Air) are
1st and 3rd largest in PBGC history.
Three Flaws of the PBGC Design
1. Poor Risk Adjustment  bad incentives
2. Failure to Ensure Adequate Funding
3. Lack of Information
Poor Risk Adjustment
Financially weak companies can create unfunded
liabilities and pass costs to PBGC if they fail
Examples:
Can increase benefits as long as funding ratio > 60% 
distressed firms can substitute pension promises for
wages
Firms increase asset risk because benefit from upside
gains, but have implicit put option on the downside
PBGC does not adjust premiums for risk
Ex: United Airlines paid only $75 million in premiums
from 1994 – 2005, despite junk bond status and massive
pension under funding (now a $6+ billion claim)
Inadequate Funding Mechanisms
Employers can “game” the system
Tremendous discretion in how liabilities calculated
• Using high interest rates without risk adjustment
Measure of under-funding used to calculate required
contributions bears no systematic relation to the actual
cost of plan termination
Asset values are smoothed
Funding rules do not consider plan termination risk
• Over 90% of largest 41 claims had junk bond status for 10 years
Ex: Bethlehem Steel was considered 84% funded
on current liability basis. But upon termination, it
had assets to cover only 45 percent of liabilities.
Inadequate Information
In rational model with full information,
workers will receive compensation to reflect
likelihood of benefit default
But when PBGC receives complete
information (Form 5500), it is typically 2.5
years old
Inadequate information provided to plan
participants and investors
Participants receive notice only if plan under
funding is extreme
Information insufficient to capture true market
cost of under funding
Ex: Bethlehem Steel (terminated 2003)
1996
1997
1998
1999
2000
2001
2002
78% 91% 99% 96% 86% 84%
NR
Required to
make DRC?
Yes
No
No
No
No
NR
NR
Required to
notify
participants
Yes
Yes
No
No
No
No
No
Debt Rating
B+
B+
BB-
BB-
B+
D
N/a
Funding ratio
Termination Benefit Liability Funded Ratio = 45%
Unfunded Benefit Liabilities = Approximately $4 billion
Possible Policy Options
Infuse taxpayer money (bail-out)
Raise fixed rate premium
Raise under funding premium
Vary premium based on credit risk
Vary premium with investment allocation
Tighten funding rules
Raise maximum pension funding limits
Raise PBGC priority during bankruptcy
Limit the PBGC guarantee
Privatize the role of the PBGC
Pension Protection Act of 2006
Stricter funding requirements
Now must have assets = 100% of liabilities
Interest rate based on segmented corporate bond
yield curves (5, 5-20, greater than 20)
Updated mortality tables every 10 years to reflect
plan’s actual experience
Loophole …
“Airline relief” provisions allow 17 years to fund
the plans and at a higher discount rate!
Pension Protection Act of 2006
Heavily underfunded plans restricted
from increasing benefits (80% rule)
Heavily underfunded plans restricted
from paying out lump sum distributions
(80% rule)
Reduces use of “smoothing” techniques
Net Results of PPA 2006
Improved the situation
But did not solve the underlying
problem …
Silver lining – the bill also contained
some improvements to 401(k)
landscape, that may prove more
important going forward
More to come on this point …