FRBSF Economic Letter
2003-25; August 29, 2003
The Present and Future of Pension Insurance
In the last two years, a large number of defined benefit pension plans
swung from record overfunding to record underfunding, exposing many workers
and retirees to pension risk. The Pension Benefit Guarantee Corporation
(PBGC), established by Congress in 1974, mitigates the pension risk to
some extent by providing pension insurance. However, many of the same
factors that put defined benefit pension plans in deficit also have left
the PBGC facing its largest deficit in its history. Recently, the U.S.
General Accounting Office put the corporation's single-employer pension
insurance program in its "high risk" category, reporting to
Congress that the insurance program needs "urgent attention" and
change. This Economic Letter discusses pension insurance, including how
it works, the financial health of the pension insurer, and what can be
done to improve it.
Overview of pension insurance
The PBGC was established by the Employee Retirement Income Security Act
(ERISA) of 1974 to protect participants in defined benefit pension plans
from plan terminations that do not have sufficient assets to pay promised
benefits. While PBGC is a government corporation, it is not formally
backed by the full faith and credit of the U.S. government, nor does
it receive any federal tax money, although it does have a line of credit
from the U.S. Treasury. The PBGC operates as a self-funded corporation
that derives its financial resources from four sources: insurance premiums
paid to the corporation by defined benefit pension sponsors; assets of
pension plans that the pension insurer has assumed from terminated plans;
recoveries in bankruptcy from former plan sponsors; and earnings on invested
The PBGC administers separate insurance programs to protect
participants in single-employer and multiemployer plans. At this point,
only the single-employer
plan is in deficit, so it is the focus of this discussion. Under its
single-employer program, the PBGC will terminate and take over a pension
plan when: (i) a pension plan runs out of money, (ii) a company liquidates
and has an underfunded plan, or (iii) a sponsoring company demonstrates
it cannot continue funding a pension plan and stay in business. Upon
taking over a pension plan and its assets, the PBGC assumes responsibility
for paying benefits to current and future retirees, but all benefit accruals,
vesting, and other regular plan obligations cease at that point.
pension insurance coverage offered by the PBGC is subject to a maximum
statutory limit stipulated by the ERISA, which is adjusted annually.
However, when the PBGC assumes responsibility for a terminated plan,
the coverage limit is set permanently at the level specified for that
year. For example, for plans that were terminated in 2002, the maximum
annual pension guarantee by the PBGC to workers who retire at age 65
is $42,950 yearly for a single life annuity, and is less (more) for those
who retire earlier (later) than age 65; for plans terminated in 2003,
that maximum guaranteed amount rose to $43,980. Of course, a participant
may receive higher benefits than the maximum guarantee if the pension
plan has adequate resources at termination.
Financial status of the PBGC
Figure 1 shows the net position, defined as the difference between total
assets and total liabilities, of the PBGC's single-employer program.
The corporation's liabilities reflect its obligations for pension payments
to retirees of terminated plans that were taken over by the pension insurer.
The net position was in deficit from its inception until 1996; it then
turned into a surplus that peaked at $9.7 billion in 2000. By 2002, the
net position had fallen to a deficit of $3.6 billion; according to its
2003 midyear unaudited financial statement, the deficit is currently
about $5.4 billion. The sharp drop in the net position was mainly a result
of terminating several very large pension plans, including LTV Steel
and Polaroid in 2002, Bethlehem Steel, National Steel, and US Airlines
Pilots in 2003. At the same time, declining stock prices eroded the PBGC's
financial assets, while lower interest rates raised the value of the
PBGC's liabilities, further driving down its net position.
It is useful to put the $5.4 billion deficit in perspective. Currently,
the PBGC's single-employer program insures pension benefits worth approximately
$1.5 trillion, making the deficit about 0.36% of insured benefits. At
the height of the most recent banking crisis in 1991, the Federal Deposit
Insurance Corporation bank insurance fund had a $7 billion deficit while
insuring against $1.9 trillion of bank deposits at that time, so that
the reserve ratio also was at negative 0.36%. During the savings and
loan crisis, the Federal Savings and Loan Insurance Corporation showed
a $6.3 billion reserve deficit, or about 0.71% of $890 billion insured
deposits in 1986 that eventually ballooned to $75 billion, or about 8%
in two years before collapsing.
Despite the PBGC's record deficit, it remains liquid and is able to
meet current promised payments. Of the over $25 billion financial assets
in its single-employer program, the PBGC contends that 98% were held
in marketable assets as of 2002. The PBGC's primary sources of cash are
from premium receipts and investment activities. If funds from these
sources are insufficient to meet operating cash needs, the corporation
has a $100 million line of credit from the U.S. Treasury, which it has
never used. Thus, in the near term, it appears that the PBGC should have
no difficulties in making benefit payments and meeting financial obligations
stemming from its operations.
The future of pension insurance
The PBGC faces multiple challenges. In addition to the record deficit
on its balance sheet, several very large defined benefit pension plans
currently insured by the corporation show substantial underfunding
(see Kwan 2003). The latest data indicate that total underfunding in
defined benefit plans insured by the PBGC currently stands at over
$300 billion. Although many underfunded plans are sponsored by financially
sound companies that pose relatively low risk to the pension fund insurer
at the moment, a number of pension plans with sizable underfunding
sponsored by less financially sound companies. For example, using the
bond rating as a rough indicator for financial soundness, the ten pension
plans with the largest underfunding by S&P 500 companies that have
below-investment-grade bond ratings had a total underfunding of $16.7
billion as of 2002. If a few of these sponsoring companies were to
encounter financial difficulties, termination of these large underfunded
plans could add to the corporation's already large deficit position.
Therefore, to be sustainable, the PBGC must take steps to shore up
its financial position.
In the near term, it appears that the agency may need to recapitalize
itself by raising insurance premiums. Absent any government bailout,
the two main sources of funds to deal with the corporation's net position
are insurance premiums paid by sponsoring companies and returns from
PBGC's investment portfolio. Without any extraordinary market movements,
the expected return from the corporation's asset portfolio would not
be enough to correct its deficit position.
Thus, to recapitalize the insurance fund, the PBGC needs to work with
its insurance premium. Currently, the corporation charges a flat-rate
premium and a variable-rate premium. The flat-rate premium is $19.00
per plan participant, and the variable-rate premium is $9 per $1,000
of unfunded vested benefits with no maximum. This premium schedule has
been in effect since 1996. Indeed, the $19.00 flat-rate premium has not
been raised since 1991; while the 0.9% variable rate premium schedule
also has been in place since 1991, it was capped at $53 per participant
until 1994 and the cap was raised twice before it was abolished in 1996.
Notice that as an insured pension plan swings from overfunding to underfunding,
the variable-rate premium kicks in, which by itself would increase the
premium received by the pension insurer and hence would help to alleviate
its deficit. However, recapitalizing the pension insurance fund fully
would require raising the insurance premium. How much the premium needs
to be raised would depend on how fast the corporation wants to recapitalize
the fund as well as on detailed projections of future underfunding and
asset returns which are beyond the scope of this article.
Over the longer term, a case can be made to reform the overall
pension insurance pricing structure. In theory, in order to be fully
the pension insurer must be able to charge an actuarially fair insurance
premium. In other words, over the long run, the premium rate should be
adjusted so that the net position of the insurance fund reverts to zero.
One way to achieve this is to have a pricing structure that varies with
the net position at the PBGC, so that some form of automatic recapitalization
is built into the insurance pricing. For example, the insurance premium
would rise when the net position falls below a certain threshold and
would drop when the net position is above a certain threshold.
reason for reforming the pension insurance pricing is that the pricing
scheme is based on only the number of participants and the amount
of underfunding in the pension plan, and not on the risks of the sponsoring
companies or pension fund assets. Consider two pension plans that are
similar in terms of their size and the amount of underfunding but that
differ in that one plan is sponsored by a AAA-rated company while the
other is sponsored by a financially weak firm with a much higher chance
of bankruptcy. Since both plans have the same amount of underfunding,
the current pension pricing charges both plans the same insurance premium.
However, it is quite clear that the plan sponsored by the weaker firm
is riskier, so its insurance premium should be commensurately higher.
Compounding this risk assessment is the asset risk in the pension plan.
From the option pricing theory literature, it is well known that the
cost of insuring a plan that invests in riskier assets is higher than
the cost of insuring a plan that invests in less risky assets. And the
theory was borne out in fact during the banking crises of the 1980s--especially
the S&L crisis, when banks and S&Ls had incentives to take on
excessive risk because of the cost of deposit insurance did not rise
with their risk-taking. Thus, it seems wise to apply the hard lessons
we learned from those crises to pension insurance pricing, as it bears
many important similarities to deposit insurance.
Pension insurance is designed to protect workers and retirees in the
event that their defined benefit pension plans are terminated when
the sponsoring company goes under. However, the PBGC, the pension insurer
itself, has a $5.4 billion deficit, the largest deficit in its history.
Moreover, with over $300 billion in underfunding in defined benefit
plans that are insured by the agency, terminations of more underfunded
plans would further weaken the PBGC's financial position. To restore
financial health to pension insurance, it appears that policymakers
may need to raise insurance premiums to recapitalize the pension insurance
fund in the near term. More fundamentally, the current insurance pricing
scheme, which does not take into consideration either firm risk or
asset risk, may need to be reformed to reflect the true cost of insurance
in order to attain structural soundness for the insurance fund over
the longer run.
Kwan, S. 2003. "Underfunding
of Private Pension Plans." FRBSF Economic Letter 2003-16
(June 13). http://www.frbsf.org/publications/economics/letter/2003/el2003-16.html