Kicking the Pension Underfunding Can Down the Road

A recent opinion piece by Robert C. Pozen, a non-resident fellow in Economic Studies at the Brookings Institute, entitled "The Underfunding of Corporate Pension Plans" examines how the current low interest rate environment is impacting the ability of corporations to guarantee their payouts to future pensioners.  I realize that I've posted on this several times recently, however, with the current seemingly endless period of very low interest rates and the growing number of pension-eligible Americans, this issue is going to get worse before it gets better and may well have a big negative impact on both future pensioners and the bottom line of many American corporations.

Pension plan future obligations are calculated using a "discount rate", the return that the plan can reliably expect to earn on its portfolio of investments between now and when the plan begins to pay out benefits.  Long-term benefit obligations are calculated using the benefit schedule and a projection of the life span of the workers who will collect these benefits.  The lower the discount rate (or rate of return) the higher the plan's estimated obligations and vice versa.  With the current low discount rate (or, in other words, low return on the low-risk investments (i.e. bonds) that are held by pension plans), there is a growing gap between what companies have set aside for our pensions and what they will have to pay out in the future.  This is what is termed the underfunding pension problem.  Corporations will have choices to make; make up the shortfall which cuts into corporate profits, raise pension contributions, invest in higher risk and hopefully higher return investments or cut benefits to existing and future beneficiaries.  Each option has both an upside and an accompanying downside.

Recently, the Senate passed Surface Transportation Bill S.1813 which changed the rules for calculating the future obligations of private sector, single-employer sector pension plans.  These changes can be found in Section 40315 , "Pension Funding Stabilization", hidden among legislation for child seats, odometer tampering  and impaired driving countermeasures.  Sneaky, huh?  In the past, corporations used a discount rate based on the average interest rate on two year highly rated, low risk bonds.  This new legislation allows corporate pension plans to now use a discount rate that is an average of interest rates over the past twenty-five years.  Keeping in mind that higher interest rates were the norm during most of the past two and a half decades, the discount rate for most pension plans will increase by one to two percentage points from four to six percent.  Remember, the higher the discount rate, the lower the plan's estimated future obligations which lessens the corporation's contributions.  Pension plan liabilities are estimated to change roughly 15 percent for every one percentage point change in the discount rate; the higher the discount rate, the lower the apparent, actuarial obligations.  As if by magic, pension underfunding has been cured!

Here are examples of how this change has impacted three large corporations:

1.) UPS - the required 2013 pension plan contribution drops from $1.62 billion to $47 million.

2.) Lockheed Martin - the required 2013 pension plan contribution drops from $2.35 billion to $1.4 billion.

3.) Boeing - the required 2013 pension plan contribution drops from $2.655 billion to $zero.

Just how big is this underfunding problem in Corporate America?  A study of 1,354 pension plans by David Zion, Amit Varshney and Nichole Burnap of Credit Suisse suggests that the private sector multi-employer pension plans (i.e union-related) alone are $369 billion underfunded with a funding rate of only 52 percent!  Many of the underfunded companies are found in the construction, transport, mining and supermarket sectors.  Funding rates below 65 percent are considered to be critical.

On the upside of the recent legislative changes, insurance premiums paid by corporations to the Pension Benefit Guaranty Corporation, a government entity that guarantees up to $56,000 in annual benefits for bankrupt companies with underfunded pension plans, will rise.  PBGC is currently protecting pensions for 44 million participants in more than 27,000 pension plans and in thirty-seven years, has covered pensioners in 4,300 failed pension plans.  In 2011 alone, 152 underfunded single-employer pension plans terminated, pushing PBGC's total obligations up to nearly $107 billion.  In 2011, the Pension Benefit Guaranty Corporation recorded a deficit of $26 billion and paid out nearly $5.5 billion to pensioners; under the new legislation, premium increases of $9.6 billion over the next decade would take place.  While it's a start, one would hardly expect that PBGC would have the means to bailout a massive pension failure.  Here's a quote from their 2011 Annual Report:

"Nonetheless, PBGC’s obligations are clearly greater than its resources.  We cannot ignore PBGC’s future financial condition any more than we would that of the pension plans we insure."

Reassuring, isn't it?  It's especially reassuring when one realizes that American taxpayers are on the hook for any PBGC funding shortfalls.

The new pension legislation is phased out by 2016, however, if interest rates are still very low at that time, we can expect lobbyists representing the pension plans of Corporate America to come begging hat in hand for another kick at the higher discount rate legislation can.  Right now, Congress is just kicking the pension can further down the road since the pension obligations will exist no matter what legislative changes are made.  Remember, the pensions must be fed!