Corporate Pension Reform Gathers Steam
By Oxford Analytica
Friday, 10-14-05

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The federal Pension Benefit Guaranty Corporation estimated on Oct. 11 that the workers' pension fund at Delphi, a bankrupt auto parts supplier, is underfunded by $10.8 billion. Corporate pension reform is set to take center stage in Washington. Recent Chapter 11 bankruptcy filings by Delta and Northwest airlines, and a Congressional Budget Office report forecasting huge deficits at the PBGC, have increased the political impetus for change.

The Employee Retirement Income Security Act (ERISA) created the PBGC in 1974 to insulate employees from some of the downside risk of a defined benefit (DB) pension fund collapse. The PBGC is in an increasingly precarious financial situation. Temporary legislation designed to shore up its finances will expire on Dec. 31. Lawmakers have taken seriously DB pension-plan underfunding and the precarious financial position of the PBGC:

-- The House Education and the Workforce Committee approved the Pension Protection Act on June 30, a piece of legislation that would dramatically alter the rules governing multiemployer pension plans.

-- The Senate Finance Committee approved its own pension reform bill on July 26.

-- The Senate Health, Education, Labor and Pensions Committee approved the Defined Benefit Security Act on Sept. 8.

-- The Bush Administration included as part of its 2006 budget proposal an overhaul of regulations governing pension funding.

Each of these reform proposals tightens the rules for companies that sponsor traditional DB pension plans. Pension funding rules, under ERISA and subsequent amendments, are intended to ensure that DB plans have pension assets available to pay promised benefits. Recent plan terminations and soaring levels of plan underfunding suggest that the current rules are inadequate. However, in order to prevent market inefficiencies, lawmakers, in addition to tightening current funding rules (and increasing PBGC insurance premiums), face the challenge of confronting two chronic issues:

1. "Moral Hazard." Corporate DB plan sponsors have a tendency to change their behavior after acquiring PBGC coverage. To counteract moral hazard, Congress may consider strengthening funding rules to create incentives for firms fully to fund their plans.

2. Adverse Selection. More and more firms have decided to terminate existing DB plans due to their excessive administrative and regulatory costs, or to provide only defined contribution (DC) pension plans (not covered by the PBGC). From 1980 to 1998, the percentage of workers with DB private pensions fell from 80% to 45%, according to the PBGC.

If all corporate pension providers participated in the PBGC, risk pooling would be effective and the PBGC would function properly. However, as the most financially sound firms move out of the DB market, the remaining pool of firms seeking PBGC coverage will become weaker, exposing the PBGC to greater risks. This adverse selection will inevitably force higher premiums to offset higher risks.

Reform efforts focused on strengthening the PBGC and increasing DB plan funding will affect participating firms in various ways:

-- Changing Market. Premiums are set to increase dramatically, for both weak and strong firms. The voluntary nature of pension provision suggests that the rising cost of DB plans will push profit-maximizing firms to seek cheaper options.

-- Firm Valuations. By changing the funding rules and increasing PBGC premiums, pension reform targets companies' cash flows. Since investors value companies by forecasting and discounting future cash flows, pension reform threatens to seriously reduce firm valuations.

-- Premium Increases. Credit Suisse First Boston estimates that DB plan sponsors in the S&P 500 would have to contribute an extra $9 billion in 2005 if pension reform was fully phased in for 2005. Many distressed companies, that already pose the greatest threat to the financial solvability of the PBGC, may not be able to handle that burden.

Lawmakers face the delicate task of strengthening the PBGC and improving DB pension funding without overburdening weak plan sponsors or encouraging stronger firms to terminate their DB plans. New legislation is almost certain to come before the end of 2005. Taxpayers may be forced to assume more of the burden, as large premium increases will meet fierce opposition from the business community.

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