Human Capital & Careers

Pension Upheaval

Will proposed pension reforms actually save the system, or cause more of Corporate America to opt out?
Russ BanhamSeptember 8, 2005

It is 2005 and the pension system is in crisis — again. Just as in the mid-1990s, Congress and columnists are warning of the imminent demise of the defined-benefit retirement plan. And again, thanks are due to the failure of a few companies — mostly in the airline industry — to meet their obligations. Back then it was TWA. Today, United Air Lines leads the roster of bad apples. But this time, the government seems determined to step in, and a revolution in how companies calculate their pension-funding obligations may be in the offing.

The government has three proposals on the table. One is from President Bush; another is wending its way through the U.S. House of Representatives. The business community is not happy with either, especially the President’s. Corporate spokespeople contend that Bush’s proposal to overhaul the pension system will backfire, and could force employers to freeze or terminate their current plans. A third option, already passed by the Senate Finance Committee, is closer to the Bush proposal than the House’s, and gives the airlines 14 years to fully fund their pensions.

Both the Bush and the House proposals would require companies to fully fund their defined-benefit pension plans much sooner, raising the level to 100 percent from the current 95 percent. But by changing the methodologies for calculating plan funding, the proposals undermine the ability of CFOs to figure out their pension obligations in a given year. Both proposals also require firms with defined-benefit pensions to pay higher premiums to the federal Pension Benefit Guaranty Corp. (PBGC), the financially shaky agency that insures corporate plans. And they will institute these changes rapidly — by next year in many cases.

“CFOs I talk to tell me the reforms will be expensive. But what they are really concerned about is their ability to predict their fund contributions accurately, compromising their need to plan, budget, and tell Wall Street, ‘Here’s what we are spending on our pensions over the next few years and how much money we will have available for other things,’” says James Klein, president of the American Benefits Council, a Washington, D.C.-based employer advocacy group.

The Usual Suspects

Everyone agrees that the corporate plans are massively underfunded (through April, by an aggregate $354 billion). Moreover, employers are dropping their pensions as fast as they can. “The system is hanging by a thread,” says Klein. “From 1994 to 2004, we went from 58,000 defined-benefit plans nationwide to 29,000, not counting the high number of plans that have been frozen to new hires.”

But it is the default rate that is forcing the issue of reform. In the last three years, almost 600 companies have reneged on pension-fund obligations, with 21 totaling $100 million or more, topped by United’s pension-fund failure at $9.8 billion, the biggest since the government began guaranteeing pensions in 1974. In June, Delta Air Lines and Northwest Airlines told Congress their plans would default unless legislators extended the funding deadline. The automakers, short by $55 billion to $60 billion, may not be far behind.

Such defaults have swelled the PBGC’s deficit to $23.3 billion, a figure that is expected to balloon to $71 billion during the next decade, according to the Congressional Budget Office. To beef up the PBGC’s resources, both the Bush Administration’s pension reforms and the Pension Protection Act (HR 2830, co-sponsored by Rep. John Boehner (R-Ohio) and Rep. Bill Thomas (R-Calif.), chairman of the Ways & Means Committee) call for increasing the premiums paid to the PBGC from $19 per employee to $30 per employee in order to avoid a public bailout, says PBGC executive director Bradley Belt. “We need to change the rules to make sure companies honor their obligations,” he comments.

Others argue that companies that default on their pensions should just face the consequences. Mark White, CFO of enterprise-software vendor SAP America, says there should be no accommodation for “companies that default, or threaten to default, on their pensions. I’m tired of companies that think they can blackmail the federal government,” he explains. “If they need to default, they should just do it and get it over with.”

No Smooth Sailing

Beyond funding the PBGC, three issues in the reforms are receiving the lion’s share of the criticism: elimination of credit balances, use of a yield curve to measure pension liabilities, and the continued use of current pension-fund-smoothing techniques.

As heated accounting issues go, pension smoothing ranks right up there with stock-option expensing. According to current rules, companies are permitted to smooth fluctuations in the market value of plan assets by averaging this value over a five-year period. The average asset value may range from 80 percent to 120 percent of the plan assets’ fair-market value. Bush’s proposal would end this practice. In support of this position, the PBGC’s Belt argues that smoothing “distorts an accurate portrayal of the financial condition of a pension plan, and should be banned.”

Mike Johnston, practice leader in the retirement business of human-resource-services firm Hewitt Associates, begs to differ. He calls the Administration’s bill “ugly” because it eliminates smoothing. Slightly better in his view is the Pension Protection Act, which permits a measure of smoothing. It reduces the smoothing period, however, from the current five years to three, and restricts smoothed-asset valuations to no less than 90 percent or no more than 110 percent of the fair-market value of plan assets. “Boehner’s bill gives more leeway as far as the ability to predict funding costs,” Johnston says.

The House proposal also preserves another corporate favorite — credit balances — at least to a degree. Under current rules, companies can make voluntary prepayments to their plans to offset future funding requirements. Continental Airlines did so before taking a credit in 2004. The Administration’s proposal expressly bans the use of credit balances, which “allows a plan to take a contribution holiday without regard to whether the additional contributions have earned the assumed rate of interest or have instead lost money in a down market,” says Belt. The Boehner bill preserves credit balances, but it actually may compel some companies to waive them, say critics, essentially forcing employers to write off their existing credit balances. That could happen, say, if their plans are below 80 percent funding levels.

The upshot is that taking the credit may invite more trouble than it warrants. “Companies want an incentive to fund plans more during good economic periods and get a bit of a break during the bad [times],” says Christopher Bone, national retirement practice leader at Aon Consulting. “The Bush proposal does not provide that incentive; the House bill represents a preliminary start in that direction.”

Finally, the Bush plan’s use of a yield curve to calculate pension funding is also under attack. At present, calculations for fund contributions are linked to a long-term, investment-grade, corporate bond rate that Congress enacted on a temporary basis last year. Now, the Administration is proposing to base calculations on a complex yield curve. “The idea is for companies to match how much they will have to pay in the future with a conservative, high-quality, corporate bond rate today that best fits this expectation,” explains Klein. “A company that estimates what it must pay out in 2008, for example, would look for a corporate bond of a three-year duration that matches closely with this estimate. Obviously, this is a very complex calculation.”

Critics also argue that the yield curve is an inappropriate yardstick for pension liabilities since they lack a definite maturity date. The upshot is that companies believe the yield curve, as well as a more modified version suggested by Boehner, will result in larger short-term-funding obligations. “A yield-curve measure will cause significant incremental cash to be contributed to pension plans, potentially leaving many plans overfunded with surplus assets that would be difficult to access,” says David Beik, director of benefits finance at New York–based Verizon Communications.

Others are concerned the yield-curve proposal will reduce the effective discount rate for a mature plan below the long-term corporate bond rate, “resulting in contributions that would be materially in excess of those needed to pay benefits,” says Kenneth W. Porter, director of global benefits at DuPont, on behalf of the American Benefits Council. “For mature plans, the increase could be 10 percent.”

Boehner’s modified yield-curve concept, in which plan sponsors determine lump-sum contributions using a “three-segment” yield curve, is seen by companies as a slight improvement, but by no means a winner. The three segments include payments payable in the five-year period starting on the first day of the current plan year, payments payable in the following 15 years, and payments payable after that 15-year period. For each segment, Treasury would publish a single interest rate that would apply for determining the present value of pension liability payable during that segment. Each interest rate would be based on a three-year weighted average of an investment-grade corporate-bond yield curve: weighted 50 percent for the immediately preceding plan year, 35 percent for the year before that, and 15 percent for the next preceding year.

A bit labyrinthine? Klein thinks so. “It introduces unnecessary complexity into the law. We get a marginal increase in economic accuracy, but it is outweighed by the administrative complexities. Furthermore, the bill gives Treasury no guidance as to how to set each segment rate. Without rules, the provision is a question mark and could end up being extremely adverse for companies.”

Imminent Deadlines

Apart from complaints about specific provisions of the reform bills, companies question the time frame for enacting them. Many rules, such as the 100 percent funding target and the requirement that projected lump sums be taken into account for funding purposes, go into effect in 2006. “Some companies are so far away from 100 percent [funding], they couldn’t make it all up in a year,” says White. Beik concurs: “Businesses cannot adjust to these new burdens overnight. The transition is too fast and jarring.”

White, however, argues that many companies have had more than enough time to address their pension obligations. “Companies whose plans are underfunded should have sat down with their employees long ago and said, ‘Here’s how much cash I have to fund my known obligations, and here’s what I can afford,’” he says. “The sooner companies have that discussion, the better off they will be. I look at United and think its employees would have been willing to take 80 cents on the dollar, rather than risk pension default and get 40 cents from the PBGC.”

Congress is expected to vote on pension reform this fall.

Russ Banham is a contributing editor of

Models of Reform?

In preparing for its own reforms, the Senate Finance Committee asked 36 companies to present details of their pension plans. The committee said the data available through government agencies was “outdated, stale, or incomplete,” and requested detailed information going back to 1999 so it could examine the impact of interest rate and market declines on a variety of plans under the existing rules. Lawmakers declined to release the names of the companies, which were identified as having the most significantly underfunded private-pension plans in the United States, collectively underfunded by more than $120 billion. (CFO has learned that insurance broker Marsh, the subject of an intense investigation by New York Attorney General Eliot Spitzer in 2004, was among the companies contacted. Marsh CEO Michael Cherkasky said that the firm’s pension plan is not underfunded and that it continues to fund at required levels.)

The requests by the senators are part of their ongoing effort to understand the scope of pension underfunding. “I’ve been shocked by some of the problems we’ve uncovered in pension plans,” said Sen. Chuck Grassley (R-Iowa), chairman of the finance committee. “Some of these companies are making big profits, but don’t appear to be putting enough money in their plansÂÂÂ… Unfortunately, we’ve been able to get only a 30,000-foot view of some of the problems. When we get more-accurate information about what’s going on in some of these problem plans, we can do a better job of reforming our pension laws.” — R.B.