United Air Lines is trying to lighten its load. Last November, the bankrupt carrier proposed terminating up to four of its pension plans that were collectively underfunded by $8.3 billion. But doing so would transfer a payload of up to $6.4 billion to another struggling organization: the Pension Benefit Guaranty Corp. (PBGC).
The PBGC, the government agency that insures defined-benefit pension plans, already assumed responsibility last December for United's pilots' plan. And in early February, the agency announced it would take over US Airway's three pension programs, which added another $2.3 billion to its burden. These are merely the latest in a string of worrisome plan terminations. In fiscal 2004, which ended September 30, the agency's net loss of $12.1 billion included a $14.7 billion loss from completed and probable pension terminations. Its year-end deficit rose to $23.3 billion, up from $11.2 billion in 2003.
Discouraging numbers, to be sure. The question now is what precedent these bailouts will set for other distressed airlines. At the end of calendar year 2003, the PBGC had a potential $31 billion exposure to 11 airlines, whose plans covered 440,000 participants.
"Certainly, if we were to absorb all the defined-benefit plans in the airline industry, that would have an adverse financial impact on the pension insurance fund," says Bradley D. Belt, the agency's executive director.
In a worst-case scenario, companies in other beleaguered industries could follow suit and dump their defined-benefit plans, causing the private pension system to wobble. "I think it's horrible what many companies with underfunded defined benefit plans are doing in terms of dumping them to the federal government," says Mark White, CFO of SAP America, a subsidiary of software giant SAP AG. "They're pushing their problems to the taxpayers as a way of lowering costs." And companies like SAP, with well-funded pension plans, will also suffer by paying higher premiums to the PBGC.
For the near term, at least, the PBGC says it has adequate resources. "With $39 billion in assets, we can continue to meet our obligations for a number of years," said Belt last November. "But with more than $62 billion in liabilities, it is imperative that Congress act expeditiously so that the problem does not spiral out of control."
In January, Secretary of Labor and PBGC chair Elaine L. Chao announced that her department would soon introduce reforms designed to shore up the health of the pension system. Ultimately, of course, any such reforms will have to be approved by Congress (see "Underfunding Fixes," at the end of this story).
The worsening financial shape of the PBGC mirrors the declining health of the overall pension system. In 2004, 326 companies in the S&P 500 had underfunded defined-benefit plans, according to a recent study by Credit Suisse First Boston analysts David Zion and Bill Carcache, up from 320 in 2003. Zion estimates the aggregate shortfall for these plans now stands at $185 billion, compared with $172 billion in 2003. Among single-employer plans overall, the PBGC estimates that total underfunding for fiscal 2004 surpassed $450 billion, $100 billion greater than the total for 2003.
Much of the underfunding stems from the double whammy of declining stock prices, which depleted plan assets, and plummeting interest rates, which pumped up funding requirements. But another issue is that sponsors might have assumed unrealistic rates of return. The Securities and Exchange Commission is investigating half a dozen large companies that may have used overly optimistic assumptions to reduce pension contributions (see "Death to Smoothing?"). "Using a 9 or 10 percent assumption is not credible, and using that as a way to say you're fully funded is not credible," says White. SAP America assumes an 8 percent rate of return on the investment of its cash-balance pension plan's assets, he adds.
The widespread underfunding has come as an unpleasant surprise for many workers. For example, two years before it was shut down in 2003, the US Airways pilot pension plan reported that 94 percent of its liability was funded. After the plan was terminated, however, the PBGC found it was 33 percent funded on a termination basis, for a total shortfall of $2.5 billion. "It is no wonder US Airways pilots were shocked," fumes Steven Kandarian, Belt's predecessor at the PBGC.
Today, Belt seems especially annoyed about United's approach to funding its pensions. From 2000 to 2002, "notwithstanding the fact that asset values were falling precipitously, notwithstanding the fact that interest rates were coming down so the value of liabilities was going up, they contributed zero dollars to the pension plan," he notes. "And they also negotiated $800 million of new benefit increases" for the years 1997 through 2002. Those pension promises, offered largely in lieu of larger wage increases, were never fully funded. That United was able to contribute so little to its pension plans without breaking the law means there is a problem with the law, says Belt, who argues that legal funding targets are too low. (United officials declined to be interviewed for this story.)
Headed for a Bailout?
Even if a fair number of pension plans did shut down in one or two industries, the PBGC probably could manage. What Belt and others worry about is that a broader array of companies might use Chapter 11 as a way to dump their liabilities onto the agency's books. The PBGC already has big exposures in the steel, industrial equipment, motor parts, and rubber and plastics industries. Should a wide meltdown occur, "taxpayers may be called upon by Congress to bail out the pension insurance fund, just as they did more than a decade ago when the savings-and-loan industry collapsed," Belt told federal lawmakers last October.
The pension crunch is a much smaller problem than the thrift crisis, which cost taxpayers more than $124 billion. Still, there are "eerie similarities" between the two, says Belt. The two major likenesses are the presence of "moral hazard" — when having insurance encourages risky behavior — and foggy financial reporting. In the thrift crisis, the availability of deposit insurance came to be seen as a moral hazard for banks on the grounds that it encouraged them to make risky loans. Similarly, the presence of the PBGC enables companies low on cash to offer "generous new pension benefits" to workers and assure them they will be there, says Belt.
Indeed, when an underfunded employer negotiates a pension boost instead of a salary hike, it's essentially borrowing money from employees in the form of a loan backed by the PBGC, argues Jeremy Gold, a New Yorkbased consulting actuary. That arrangement hurts well-funded companies, too, he says, because the PBGC might have to raise its premiums if the "loans" become uncollectible. The two systems also share a lack of transparency, according to Belt. Thrifts hid their financial woes under generally accepted accounting principles with the banking system's more lenient regulatory accounting principles; pension sponsors can obscure results by use of a dual-reporting system. Belt explains that operating under both GAAP and the Employee Retirement Income Security Act (ERISA), employers sometimes engage in "information arbitrage" — choosing whichever system tells a better story.
Thus, some sponsors may discuss their plans' status under an ERISA provision called the "full-funding limit" rather than use GAAP's mark-to-market measure. The ERISA metric enables them to employ an interest rate smoothed over the previous four years. "Companies then say, 'We've met the full funding limit' as if they are in fact fully funded," says Belt, noting that there can be "a wide gulf" between the amount funded up to that limit and the actual settlement costs of terminating the plan.
With the history of the S&Ls in mind, some experts say the best way to avoid a breakdown of the pension system is to require pension plans to be fully funded at all times. The problem is that tightened funding rules could drive out stronger participants. "If we demanded instant soundness, many companies, especially weaker ones, would dump their plans, and that would be bad for the United States," admits Gold.
For his part, Belt has been pushing Congress to enact legislation to keep the stronger plans in the system and to avoid a future collapse. In general, pension rules focus too little on the risk that companies will go belly-up, according to the PBGC director, who wants rule changes to capture the sponsor's credit risk. "If a company is a triple-A credit, I'm not that concerned about the fact that it's underfunded," he says. "They're going to be around a long time. If it's borderline investment-grade, or if there's been a deterioration in credit quality, I start worrying."
To tilt the balance more toward better-funded sponsors, the White House wants to revamp the funding and disclosure rules and change the premium structure.
Belt contends that the stress on flat-rate premiums "shifts wealth from healthy companies to unhealthy companies." The proof is that 70 percent of PBGC's claims come from just two industries: airlines and steel. At the same time, the agency collects less than it might from plans with shortfalls because the ERISA full-funding requirement enables companies that are "fairly substantially underfunded" to avoid falling into the variable-rate premium pool, he says.
For the time being, however, well-funded sponsors have a good deal of latitude in their funding decisions. Many finance executives apparently choose to navigate between the minimum contribution needed to avoid paying variable-rate premiums and the top tax-deductible amount.
Still, some CFOs do supply their companies' pension plans with enough assets to cover all current and future liabilities. At SAP America, White says he makes sure the company's cash-balance pension plan is fully funded, even though the company has until September of the following year to fulfill the limit of tax-deductible contributions.
To be sure, coming up with the cash to top up SAP America's plan isn't as much of a challenge as it is for companies with larger fixed costs and capital outlays, White acknowledges. And since the plan is barely a decade old, the software supplier isn't strapped with the long-standing liabilities that companies with older defined plans tend to have.
But even those companies can do more to fund their plans. Consider, for example, General Motors Corp. Two years ago, the automaker's U.S. pension plans were underfunded by $17.8 billion, recalls GM treasurer Walter Borst, and it faced the prospect of having to contribute $15 billion in cash in the next five years in variable-rate premiums. So GM issued $13.5 billion in debt in 2003, set to mature in 20 years, and put the proceeds in the plans. That, along with other contributions, resulted in fully funded pension plans, decreasing the likelihood that GM will need to contribute to the plans for the remainder of the decade.
The move helped not only GM, but the pension system as a whole. It was, says Borst, "a beautiful deal."
David M. Katz is deputy editor of CFO.com.
On January 10, Secretary of Labor Elaine L. Chao announced the Bush Administration's plan to reform the rules governing private defined-benefit pension plans. More details were expected to be released at a later date. According to the Labor Department's Website, the plan's proposals cover three major areas:
1. Funding Rules.
Among other proposals, the plan would replace multiple measures of pension liabilities with one measure, adjusted to reflect risk of termination. Funding targets would be based on the plan sponsor's financial health, and sponsors would have "a reasonable period of time, e.g., seven years," to make up plan shortfalls. Companies with significantly underfunded plans would be barred from promising additional benefits.
Proposals include improved disclosure of plan funding status and public disclosure of certain information regarding underfunded plans, but no further detail was provided.
All underfunded plans would pay risk-based premiums, and the PBGC would periodically adjust the risk-based rate so that premium revenue covers expected losses. Flat-rate premiums would be raised from $19 per worker to $30, reflecting the growth in wages since 1991, and would be indexed for future wage growth. —D.K.