Commentary

Is Pension Insurance the Next S&L Crisis?

By Richard Ippolito
September 29, 2004

The Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures private-sector defined-benefit pension plans in the event of bankruptcy, is in bad shape financially and rapidly getting worse. From 2000 to 2003, the agency went from a surplus of $9.7 billion to a deficit of $11.2 billion. Pension plan underfunding stands at more than $350 billion. Fully $85 billion is held by pensions whose sponsors have a bond rating below investment grade, including $6.4 billion held by United Airlines, which is in bankruptcy.

Those numbers are daunting in relation to the PBGC annual revenue of roughly $1 billion. As the PBGC has been sinking further into deficit, Congress—instead of acting to shore up the agency it created in 1974—has dramatically increased the likelihood of a catastrophic shortfall.

What caused this predicament? First, it is legal for pension plans to carry significant amounts of underfunding (the positive difference between pension liabilities and pension assets). Second, the plans are permitted to hold assets that are mismatched to their liabilities (the main reason for the S&L crisis). Pension liabilities are like bonds and require a bond portfolio carefully matched for maturity to eliminate underfunding risks. But pensions hold large amounts of stock. Pension sponsors hope that stock investments will earn a higher return, reducing the need for contributions, but the PBGC holds the downside risks. In economic downturns, underfunding swells and bankruptcy rates increase, creating a potentially catastrophic rush on PBGC insurance.

The PBGC has two defenses against growing exposure. First, in theory, plans must pay a variable rate premium (VRP) of $9 per $1,000 of underfunding. But owing to various loopholes, the PBGC collects only 10 percent of that amount. In addition, there is no charge for mismatching assets to liabilities. Basically, it is free to present risk to the system.

Second, contributions are supposed to increase when underfunding grows, but pension sponsors have been adept at obtaining congressional relief from that obligation. In “temporary” legislation passed in April 2004, Congress reduced required contributions by an estimated $80 billion over two years and gave additional relief to steel and airline companies, the very sectors that pose the most immediate risk. This follows on the heels of another “temporary” relief bill that recently expired. Both bills redefine pension liabilities to make them look smaller, but do not change the actual amount of exposure facing the PBGC. Congress seems to be hoping that the problem will somehow find a way to resolve itself (reminiscent of the wishful thinking that led up to the S&L crisis).

It does not seem possible for Congress to run an insurance function at anything like market premiums. Lawmakers are too susceptible to political influence from the small group of firms that stand to gain from free insurance, and taxpayers, who ultimately have the responsibility to pay for shortfalls, often do not even know that the insurance exists.

Congress should recognize its shortcomings, and sever its ties to pension insurance. It should make the PBGC a true insurance pool. Pension insurance can continue to be mandatory, but after five years, each pension plan should be allowed to seek coverage in the private sector. In the meantime, the ownership of the pool should be turned over to the sponsors of the defined benefit plans, run by a board of directors elected by the plans according to procedure whereby votes are proportional to covered participants. The members of the pool would be liable for any further deficits that develop and they own any surplus that they create. Congress should pay in an amount that covers the problem they created as of the transfer date, allowing the pool to start fresh.

Once the insurance fund is managed by business people with a stake in the bottom line, one can confidently predict that the pool will accomplish what has evaded Congress for 30 years. Premiums will quickly converge to those that would exist in the private market, and both the amount and volatility of pension underfunding will quickly fall to manageable levels.

Richard Ippolito was the chief economist at the PBGC from 1986 to 1999 and is the author of “How to Reduce the Cost of Federal Pension Insurance” published by the Cato Institute.