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The Next Big US Policy Issue

Author: Roger M. Kubarych
July 24, 2003
Council on Foreign Relations


What do the retired workers of Anchor Glass, Bethlehem Steel, Bradlees Department Stores, Polaroid, US Airlines, and 2,835 other American companies have in common? They worked for a corporation that went bankrupt, and the Trustee of their defined benefit pension plans is a little-known, but soon to be much more well-known, agency of the Federal Government. It is called the Pension Benefit Guaranty Corporation (PBGC). According to a terse one sentence statement on its website, the PBGC “protects the retirement incomes of about 44 million American workers in about 32,500 private defined benefit pension plans.”

One can think of the agency as a governmental safety net for the half of the private pension system made up of defined benefit pension plans. Those are plans in which companies pledge to pay their retired employees monthly benefits based on such guidelines as salary and length of service. In a defined benefit plan, a company funds accounts that are invested in equities, bonds, real estate and other assets. The earnings are used to pay the promised pensions to retired workers. But the funds belong to the company, not to the employees themselves. Government rules dictate how big these funds should be in order to be sufficient to pay for the pledged pension benefits. But companies that fall into bankruptcy frequently have underfunded fund that are insufficient to pay full benefits. So the PBGC must step in.

Defined benefit plans were the standard method by which large, heavily unionized corporations increased the compensation of their workers. But they have been supplanted by a more flexible - and, to the employer, cheaper and less risky - system of defined contribution pension plans— most familiarly 401k accounts. Companies and workers pay into segregated accounts that belong to employees themselves, although they normally are administered by companies on behalf of employees. These funds are legally separate from corporate financial resources, so that if a company goes bankrupt, these funds simply revert to their employee-owners.

The table below shows how big these two types of funds are and how they have been acquiring or disposing of net financial assets, according to the most recently available data published by the Federal Reserve. What’s striking is that corporations have been consistently withdrawing money from their defined benefit plans since 1995.

US Private Pension Funds: Total Assets

$ billions end-of-year2002199919951990
Defined Benefit plans$1,58521021460900
Defined Contribution plans$2,07325281463735

US Private Pensions: Net acquisition of financial assets

$ billions annual average2000-20021995-19991990-1994
Defined Benefit plans-39.8-44.225.8
Defined Contribution plans32.94551.4

In the late 1990s most of these plans were overfunded. The stock market boom had swelled assets above the levels actuaries determined were necessary to sustain promised pension benefits. So the companies diverted the money to general corporate purposes. The trouble is that they continued to do that even as the stock market tumbled. As a result, the level of defined benefit funds is barely above what it was at the end of 1995, even though pension liabilities have increased substantially.

By contrast, defined contribution plans have continued to increase in size and contributions continue to be positive, although smaller than in the heyday of the stock market boom.

On the same day this week, two leading newspapers featured op ed pieces and an editorial about the problem of corporate pension programs in the US. In the Wall Street Journal, Treasury Undersecretary Peter Fisher, who will leave his position this fall and so is the perfect messenger for unpleasant news, warns us that US corporate pension funds are now underfunded by over $300 billion. [About $60 billion is in one industry alone, the automobile industry, which is struggling.] This situation leaves retirees uncertain about their future and investors unsure about the eventual effects on corporate balance sheets.

How did things turn out so badly? As in the case of many recent troubles, it was faulty accounting. Specifically companies have been allowed to smooth changes in market values over time and to use a discount rate in calculating the present value of liabilities that flatters the current position. That lulled them into a false sense of security. The outcome is significantly underfunded defined benefit pension plans.

Why does the Treasury care? Because the PBGC may be left with the bill, if and when more large corporations go bankrupt. Then the retirees can turn to the safety net. They normally don’t get the full amount of their pensions. Because there is an upper limit of government-insured benefits of $43,177 a year, 60% is the average return. But they fare considerably better than unsecured private creditors who may get little or nothing back on their claims against an insolvent company.

In the Financial Times, Thomas Healey, a former assistant secretary of the Treasury in the Reagan administration and now a senior fellow at Harvard’s Kennedy School of Government, warned that the financial condition of PBGC is getting shakier. [Fisher knows this, too, since his boss, the Secretary of the Treasury, by statute sits on its board, along with the Secretaries of Commerce and Labor.] Healey points out that the PBGC went from a $7.7 billion surplus to a $3.6 billion deficit in fiscal 2002. And it has suffered a further $1.8 billion loss in the current fiscal year. Healey concludes that if things don’t improve, the US Congress may be looking at a fiasco much like the savings and loans crisis of the 1980s.

At a time when the US Federal Government is already looking at a mountain of budgetary deficits over the coming years, the prospect of another bail-out of the magnitude of the savings and loans calamity, which cost the taxpayer upwards of $300 billion, was enough to spur Peter Fisher, the top financial markets official of the US Treasury, to warn companies to shape up. This is merely the opening shot in a policy debate that may soon push other more familiar economic issues into the shadows.

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