1. Lecture 4: Funding DB Pension Plans Tuesday, September 4, 2007

2. 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

3. 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?

4. 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 just last year. Slides at the end of this lecture will provide updates to the rules …

5. 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)

6. 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

7. The Basic Idea of Funding Conceptually, the concept is straightforward: Calculate NPV of the pension plans 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 …

8. 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

9. 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)

10. 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 =.07NPV = $131.37 R =.06NPV = $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

11. 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

12. The PBGC The Pension Benefit Guarantee Corporation was established by ERISA in 1974 Collects insurance premiums from employers that sponsor insured pensions $19 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

13. 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

14. 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)

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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?)

22. 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 2004 Assets = $40 billion; Liabilities = $63 billion Not a short-term liquidity problem United Airlines / US Airways bring total to over $30 b. CBO projects addl $48 billion over next 10 years To fund this through premium increases alone would require five-fold increase in premiums

23. Top Five PBGC Claims (1975-2005) CompanyYearPBGC Claims UAL (United)2005$6.4 billion Bethl. Steel2003$3.7 billion US Airways2004 - 2005$2.1 billion LTV Steel2002 – 2004$2.0 billion National Steel2003 – 2004$1.2 billion Most recent losses (UAL and US Air) are 1 st and 3 rd largest in PBGC history.

24. Three Flaws of the PBGC Design 1.Poor Risk Adjustment bad incentives 2.Failure to Ensure Adequate Funding 3.Lack of Information

25. 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)

26. 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.

27. Inadequate Information In rational model with full information, workers will be 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

28. Ex: Bethlehem Steel (terminated 2003) 1996199719981999200020012002 Funding ratio 78%91%99%96%86%84%NR Required to make DRC? YesNo NR Required to notify participants Yes No Debt Rating B+ BB- B+DN/a Termination Benefit Liability Funded Ratio = 45% Unfunded Benefit Liabilities = Approximately $4 billion

29. 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

30. Pension Protection Act of 2006 Stricter funding requirements Now must have assets = 100% of liabilities Plans at risk of termination must also fund for choices that might increase liabilities Restrictions on use of credit balances Loophole … Airline relief provisions allow 17 years to fund the plans and at a higher discount rate!

31. Pension Protection Act of 2006 Heavily underfunded plans restricted from increasing benefits Eliminates exception to rule requiring payments of variable premium for underfunding Reduces use of smoothing techniques

32. 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 …