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March 2, 2005
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Good morning Chairman Boehner, Ranking Member Miller, and
members of the Committee. Thank you for inviting me to discuss the
Administration’s proposal to reform and strengthen the single-employer
defined benefit pension system.
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The Bush Administration believes that the pension
promises companies have made to their workers and retirees must be kept.
Single-employer, private sector defined benefit pension plans cover 16
percent of the nation’s private workforce, or about 34 million Americans.
The consequences of not honoring pension commitments are unacceptable—the
retirement security of millions of current and future retirees is put at
risk.
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However, the current system does not ensure that pension
plans are adequately funded. As a result, pension promises are too often
broken.
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Termination of plans without sufficient assets to pay
promised benefits has a very real human cost. Many workers’ and retirees’
expectations are shattered, and, after a lifetime of work, they must change
their retirement plans to reflect harsh, new realities. Underfunded plan
terminations are also placing an increasing strain on the pension guaranty
system.
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Increased claims from terminations of significantly
underfunded pension plans have resulted in a record deficit in the
single-employer fund of the PBGC. For the fiscal year ending September 30,
2004, the PBGC reported a record deficit of $23.3 billion in that fund. The
increasing PBGC deficit and high levels of plan underfunding are themselves
a cause for concern. More importantly, they are symptomatic of serious
structural problems in the private defined benefit system.
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It is important to strengthen the financial health of the
defined benefit plan system now. If significantly underfunded pension plans
continue to terminate, not only will some workers lose benefits, but other
plan sponsors, including those that are healthy and have funded their plans
in a responsible manner, will be called on to pay far higher PBGC premiums.
Underfunding in the pension system must be corrected now to protect worker
benefits and to ensure taxpayers are not put at risk of being called on to
pay for broken promises.
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The Administration has developed a reform package to
improve pension security for workers and retirees, stabilize the defined
benefit system, and avoid a taxpayer bailout of PBGC. The President’s
proposal is based on three main elements:
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First, the funding rules must be reformed to ensure that
plan sponsors adequately fund their plans and keep their pension promises.
The current system is ineffective and needlessly complex. The rules fail to
ensure that many pension plans are and remain adequately funded.
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Second, disclosure to workers, investors and regulators
about pension plan status must be improved. Workers need to have good
information about the funding status of their pension plans to make informed
decisions about their retirement needs and financial futures. Too often in
recent years, participants have mistakenly believed that their pension plans
were well funded, only to receive a rude shock when the plan is terminated.
Regulators and investors also require more timely and accurate information
about the financial status of pension plans than is provided under current
law.
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Third, premium rates must be revised to more accurately
reflect the risk of a plan defaulting on its promises and to help restore
the PBGC to financial health. The current premium structure encourages
irresponsible behavior by not reflecting a plan’s true level of risk.
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The proposal would strengthen the funding rules and
defined benefit system, so that the nation’s workers and retirees can be
confident of the secure retirement they have worked for all their lives. I
will now discuss the key provisions for each element of the President’s
proposal and the reasons these provisions are needed to protect the pensions
of the 34 million Americans who are relying on the single-employer defined
benefit pension promises made by their employers.
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The funding rules are complicated and ineffective.
Current funding rules do not establish accurate funding targets and the lack
of adequate consequences for underfunding a plan provides insufficient
incentive for plans to become well funded. In addition, the funding rules
fail to take into account the risk that a plan sponsor will fail.
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Weaknesses in the current rules include, for example,
multiple and inaccurate asset and liability measures and discount rates,
smoothing mechanisms, credit balances that allow funding holidays to
continue even as funding levels deteriorate, excessive discretion over
actuarial assumptions, and varying and excessively lengthy amortization
periods. As a result, companies can say their plans are fully funded when in
fact they are substantially underfunded. Together these weaknesses allow
companies to avoid making contributions when their plans are substantially
underfunded. And in some circumstances, they actually prevent companies that
want to increase funding of their pension plans from making additional
contributions during good economic times.
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These weaknesses contribute to the ability to manipulate
funding targets which is of particular concern given the fact that they are
set too low. There is no uniformity in liability measures under current law.
In some cases, employers can stop making contributions when a plan is funded
at 90 percent of “current liability.” But current liability is not an
accurate measure of pension funding requirements; even 100 percent of
current liability is often far less than what will be owed if a plan is
terminated. As a result, employers can stop making contributions before a
plan is sufficiently funded to protect participants in the event of
termination.
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Why is current liability such a poor measure of true
pension costs? One reason is that the interest rate used in determining
current liability can be selected from an interest rate corridor that is
based on an average of interest rates over the prior 48 months. As a result,
during periods of rapidly changing interest rates, the current liability
interest rate may bear little relationship to economic reality and misstate
the risks to plan participants. Even if the current liability interest rate
reflected current market conditions, it would produce an inaccurate measure
of the plan’s true liability because it is based on a long-term interest
rate and fails to take into account the actual timing of when benefit
payments will be due under the plan. That timing often is considerably
sooner, especially for plans with a large number of older participants near
retirement age.
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Current liability also fails to account for the risk of
plan termination. This is important because terminating plans incur
additional costs not reflected in current liability. For example, when plans
terminate, participants are more likely to draw benefits early and elect
lump sums. Terminating plans must purchase insurance annuities at prices
that reflect market interest rates and administrative expenses. These
factors combine to escalate costs above those reflected in current
liability, often by large amounts. While it is not necessary for all plans
to fund to such a standard, in the case of a plan with a substantial risk of
terminating, the pension funding target should take into account the
additional costs of terminating the plan.
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Another weakness in the funding rules is their reliance
on the so-called “actuarial value” of plan assets. The actuarial value
of plan assets may differ from the fair market value of plan assets. It may
be determined under a formula that “smooths” fluctuations in market
value by averaging the value over a number of years. The use of a smoothed
actuarial value of assets distorts the funded status of the plan. Using fair
market value for purposes of the funding rules would give a clearer and more
accurate picture of a plan’s ability to pay promised benefits.
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As an example of how all of this can affect workers and
retirees, the U.S. Airways pilots’ plan was 94 percent funded on a current
liability basis, but the plan was only 33 percent funded on a termination
basis, with a $1.5 billion shortfall. After believing their pensions were
substantially secure, U.S. Airways pilots were shocked to learn how much of
their promised benefits would be lost. Bethlehem Steel's plan was 84 percent
funded on a current liability basis, but the plan turned out to be only 45
percent funded on a termination basis, with a total shortfall of $4.3
billion.
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The current funding rules must be strengthened to ensure
that accrued benefits are adequately funded. This is particularly important
for those plans at the greatest risk of terminating. The Administration’s
plan will bring simplicity, accuracy, stability, and flexibility to the
funding rules, encouraging employers to fully fund their plans and ensuring
that benefit promises are kept.
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Under the President’s proposal, the multiple sets of
funding rules applicable to single-employer defined benefit plans would be
replaced with a single set of rules. The rules would provide for each plan a
single funding target that is based on meaningful, accurate measures of its
liabilities that reflect the financial health of the employer and use fair
market values of assets. Funding shortfalls would be amortized and paid over
7 years. Plan sponsors would have the opportunity to make additional,
tax-deductible contributions in good years, even when the plan’s assets
are substantially above its funding target. In addition to the changes to
the funding rules, new limits would be placed on unfunded benefit promises,
reporting and disclosure of funding information would be improved, and PBGC
premiums would be reformed to more fully reflect the risks and costs to the
insurance program.
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Funding targets will depend on the plan sponsor’s
financial health. Pension liability computations should
reflect the true present value of accrued future benefits – this is a key
component of accuracy. Workers and retirees are interested in the present
value of liabilities so that they can determine whether their plans and
promised benefits are adequately funded. Plan sponsors and investors are
interested in the present value of liabilities in order to determine the
demands pension liabilities will place on the company’s cash flows.
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The Administration's proposal provides a single
conceptual measure of liabilities based on benefits earned to date.
Assumptions are modified as needed to reflect the financial health of the
plan sponsor and the risk of termination posed by the plan. A plan’s
funding target would be the plan’s ongoing, or alternatively, its at-risk
liability, depending on the sponsor’s financial health.
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For a plan sponsor that is healthy, the funding target
would be the plan’s ongoing liability. The plan sponsor is considered
financially healthy if any member of the plan sponsor’s control group has
senior unsecured debt rated as being investment grade (Baa or better). If a
plan sponsor is financially weak, the funding target generally would be the
plan’s at-risk liability. A plan sponsor is considered financially weak if
its senior unsecured debt is rated as below investment grade by every rating
agency that rates the sponsor. A plan’s funding target would phase up from
ongoing to at-risk over a five-year period. Conversely, if a plan’s credit
rating is upgraded to investment grade, its funding target would immediately
drop to ongoing liability.
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Credit ratings are used to measure financial health
because empirical evidence shows that a company’s time spent in below
investment grade status is a strong indicator of the likelihood of plan
termination. It is also critical that a market-based test be used to
establish financial health.
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A plan’s ongoing liability is equal to the present
value of all benefits that the plan is expected to pay in the future, based
on benefits earned through the beginning of the plan year. Workers are
assumed to retire and to choose lump sums as others have in the past. A plan’s
at-risk liability is based on the same benefits, but assumes that employees
will take lump sums and retire as soon as they can, and includes an
additional amount reflective of the transaction cost of winding up a plan.
These assumptions are designed to reflect behavior that typically occurs
prior to plan termination when the financial health of the employer
deteriorates.
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The applicable funding target is calculated by
discounting benefit liabilities based on a yield curve of long-term
corporate bonds. The discount rate would reflect the duration of the
liabilities. A plan’s actuary would project the plan’s cash flow in each
future year and discount payments using the appropriate interest rate for
the payment. In general, with a typical yield curve, plans with older
workforces where payments are due sooner will discount a greater proportion
of their liabilities with the lower interest rates from the short-end of the
yield curve than plans with younger workforces where larger cash payments
are delayed into the future. The corporate bond yield curve would be
published by the Secretary of Treasury and would be based on the interest
rates, averaged over 90 business days, for high quality corporate bonds
rated AA, with varying maturities.
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The use of a single conceptual measure of liabilities
will simplify the funding rules. It will tell plan sponsors, investors,
regulators, and most importantly, workers and retirees, whether a plan is
adequately funded.
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Funding shortfalls should be made up over a
reasonable period. Another problem with the current funding
rules is that underfunded plans are permitted to make up their shortfalls
over too long a period of time. In addition, underfunded plans are permitted
funding holidays. These rules put workers at risk of having their plans
terminate without adequate funding.
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Under current law, if the unfunded accrued liability is
attributable to a plan amendment, the amortization period for making up the
shortfall is 30 years. Experience shows this is too long. There is too much
risk that the plan will be terminated before 30 years has passed.
Furthermore, collectively bargained plans often have a series of benefit
increases every few years, which has the effect of increasing all of the
liabilities accrued prior to the benefit increase as well as increasing
future liabilities. As a result, these plans are perennially underfunded.
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The credit balance rules for plan funding under current
law also contribute to plan underfunding. The credit balance rules allow an
employer to apply its contributions in excess of minimum requirements from
an earlier year as an offset to the minimum funding requirement for a
subsequent year without restrictions. This loophole allows a plan to have 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 – and, more importantly, regardless of the current funded
status of the plan. Credit balance rules harm the retirement security of
workers and retirees. In the Bethlehem Steel and the U.S. Airways pilots’
plan termination cases, for example, no contributions were made (or required
to be made, as a result of credit balances) to either plan during the three
or four years leading up to plan termination.
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Under the Administration’s proposal, plans would
annually contribute enough to address their funding shortfall over a
reasonable period of time, without funding holidays, until the shortfall is
eliminated. Plan funding shortfalls would be amortized over a 7-year period.
The current law provision allowing an extension of amortization periods
would no longer be available.
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Opportunity to increase funding in good years.
We also must address the overly prescriptive funding rules for well-funded
plans that discourage companies from building up a cushion to minimize
contributions in lean years. To keep healthy companies in the defined
benefit system, we need to give them better incentives.
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The current funding rules can place a pension plan
sponsor in the position of being unable to make deductible contributions in
one year and then being subject to accelerated deficit reduction
contributions in a subsequent year. This problem is caused by the
interaction of the minimum funding requirements and the rules governing
maximum deductible contributions. The rules restrict employers’ ability to
build up a cushion that could minimize the risk that contributions will have
to be severely increased in poor economic times. This volatility in required
contributions makes it difficult for plan sponsors to predict their funding
obligations, and makes it difficult to prevent large required contributions
during economic downturns when the company is least able to pay.
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The Administration’s proposal would permit plan
sponsors to make additional deductible contributions up to a new higher
maximum deductible amount. This would permit companies to increase funding
during good economic times. Funding would be permitted on a tax-deductible
basis to the extent the plan’s assets on the valuation date are less than
the sum of the plan’s funding target for the plan year, the applicable
normal cost and a specified cushion. The cushion amount would enable plan
sponsors to protect against funding volatility, and would be equal to 30
percent of the plan’s funding target plus an amount to pre-fund projected
salary increases (or projected benefit increases in a flat dollar plan).
Plans would always be permitted to fund up to their at-risk liability
target.
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This cushion will help provide workers and retirees
greater retirement security by increasing the assets available to finance
retirement benefits.
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Limitations on plans funded below target levels.
The current rules encourage some plans to be chronically underfunded, in
part, because they shift potential losses to third parties. This is what
economists refer to as a “moral hazard.” Under current law, sponsors of
underfunded plans can continue to provide for additional accruals and, in
some situations, even make new benefit promises, while pushing the cost of
paying for those benefits off into the future. For this reason, some
companies have an incentive to provide generous pension benefits that they
cannot currently finance, rather than increase wages. The company, its
workers and any union officials representing them know that at least some of
the additional benefits will be paid, if not by their own plan, then by
other plan sponsors in the form of PBGC guarantees. Under our proposed
funding rules, financially strong companies, in contrast, have little
incentive to make unrealistic benefit promises because they know that they
fund them in a reasonably timely manner.
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If a company’s plan is poorly funded, the company
should be precluded from adopting further benefit increases unless it fully
funds them, especially if it is in a weak financial position. If a plan is
severely underfunded, retiring employees should not be able to elect lump
sums and similar accelerated benefits. The payment of those benefits allows
those participants to receive the full value of their benefits while
depleting the plan assets for the remaining participants. A similar concern
applies when a severely underfunded plan purchases annuities.
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The Administration believes that we must ensure that
companies, especially those in difficult financial straits, make only
benefit promises they can afford, and take steps to fulfill their promises
already made by appropriately funding their pension plans. In order to
accomplish this goal, the proposal would place additional meaningful
limitations on plans that are funded substantially below target levels.
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First, the rules would limit benefit increases for
certain underfunded plans. For a plan where the market value of the plan’s
assets is less than or equal to 80 percent of the funding target, no
amendment increasing benefits would be permitted. If the market value of the
plan’s assets is above 80 percent of the funding target, but was less than
100 percent for the prior plan year, then no benefit increase amendment that
would cause the market value of the plan’s assets to be less than 80
percent of the funding target would be permitted. In either case, the
sponsor could avoid the application of these limits by choosing to
contribute the minimum required contribution and the increase in the funding
target attributable to an amendment increasing benefits.
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Second, the rules would limit lump sum distributions or
other accelerated benefit distributions for certain underfunded plans.
Limits would apply if either the market value of a plan’s assets is less
than or equal to 60 percent of the funding target or the plan sponsor is
financially weak and the market value of the plan’s assets is less than or
equal to 80 percent of the funding target.
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Third, the rules would limit accruals for plans with
severe funding shortfalls or sponsors in bankruptcy with assets less than
the funding target. A plan is considered severely underfunded if the plan
sponsor is financially weak and the market value of the plan’s assets is
less than or equal to 60 percent of the funding target. These plans pose
great risk of plan termination and would effectively be required to be
frozen.
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Lastly, the rules would address an abuse recently seen in
the airline industry – where executives of companies in financial
difficulty have their nonqualified deferred compensation arrangements funded
and made more secure, without addressing the risk to the retirement income
of rank and file employees caused by severely underfunded pension plans. The
rules would prohibit funding such executive compensation arrangements if a
financially weak plan sponsor has a severely underfunded plan. Also, the
rules would prohibit funding executive compensation arrangements less than 6
months before or 6 months after the termination of a plan where the plan
assets are not sufficient to provide all benefits due under the plan. A plan
would have a right of action under ERISA against any top executive whose
nonqualified deferred compensation arrangement was funded during the period
of the prohibition to recover the amount that was funded.
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Plans that become subject to any of these benefit
limitations would be required under ERISA to furnish a related notice to
affected workers and retirees. In addition to letting workers know that
limits have kicked in, this notice will alert workers when funding levels
deteriorate and benefits already earned are in jeopardy.
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The financial health of defined benefit plans must be
transparent and fully disclosed to the workers and their families who rely
on promised benefits for a secure and dignified retirement. Investors and
other stakeholders also need this information because the funded status of a
pension plan affects a company’s earnings and creditworthiness.
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While ERISA includes a number of reporting and disclosure
requirements that provide workers with information about their employee
benefits, the timeliness and usefulness of that information must be
improved.
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For example, the principal Federal source of information
about private sector defined benefit plans is the Form 5500. Schedule B, the
actuarial statement filed with the Form 5500, reports information on the
plan’s assets, liabilities and compliance with funding requirements.
Because ERISA provides for a significant lapse of time between the end of a
plan year and the time when the Form 5500 must be filed, regulatory agencies
are not notified of the plan’s funded status for almost two years after
the actual valuation date. If the market value of a plan’s assets is less
than its funding target, the relevant regulatory agencies need to monitor
whether the plan is complying with the funding requirements on a more
current basis.
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The PBGC does receive more timely information regarding a
limited number of underfunded plans that pose the greatest threat to the
system under Section 4010 of ERISA. Section 4010 data provides
identification, financial, and actuarial information about the plan. The
financial information must include the company’s audited financial
statement. Sponsors also are required to provide actuarial information that
includes the market value of their pension plan’s assets, the value of the
benefit liabilities on a termination basis, and a summary of the plan
provisions for eligibility and benefits.
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However, current law prohibits disclosure, so this
information may not be made publicly available. This makes no sense. Basic
data regarding the funded status of a pension plan is vitally important to
participants and investors. Making information regarding the financial
condition of the pension plan publicly available would benefit investors and
other stakeholders and is consistent with federal securities laws that
Congress has strengthened to require the disclosure of information material
to the financial condition of a publicly-traded company.
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The most fundamental disclosure requirement of a pension’s
funding status to workers under current law is the summary annual report (SAR).
The SAR discloses certain basic financial information from the Form 5500
including the pension plan’s net asset value, expenses, income,
contributions, and gains or losses. Pension plans are required to furnish a
SAR to all covered workers and retirees within two months following the
filing deadline of the Form 5500.
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Information on a plan’s funding target and a comparison
of that liability to the market value of assets would provide more accurate
disclosure of a plan’s funded status. Providing information on a more
timely basis would further improve the usefulness of this information for
workers and retirees.
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The Administration’s proposal would allow information
filed with the PBGC to be disclosable to the public and would provide for
more timely and accurate disclosure of information to workers and retirees.
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Provide broader dissemination of plan information.
Under the Administration’s proposal, the Section 4010 information filed
with the PBGC would be made public, except for the information subject to
Freedom of Information Act protections for corporate financial information,
which includes confidential “trade secrets and commercial or financial
information.”
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Broadening the dissemination of information on pension
plans with unfunded liabilities, currently restricted to the PBGC, is
critical to workers, financial markets and the public at large. Disclosing
this information will both improve market efficiency and help encourage
employers to appropriately fund their plans.
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Provide more meaningful and timely information.
The President’s proposal would change the information required to be
disclosed on the Form 5500 and SAR. Plans would be required to disclose the
plan’s ongoing liability and at-risk liability in the Form 5500, whether
or not the plan sponsor is financially weak. The Schedule B actuarial
statement would show the market value of the plan’s assets, its ongoing
liability and its at-risk liability.
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The information provided to workers and retirees in the
SAR would be more meaningful and timely. It would include a presentation of
the funding status of the plan for each of the last three years. The funding
status would be shown as a percentage based on the ratio of the plan’s
assets to its funding target. In addition, the SAR would include information
on the company’s financial health and on the PBGC guarantee. The due date
for furnishing the SAR for all plans would be accelerated to 15 days after
the filing date for the Form 5500.
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The proposal also would provide for more timely
disclosure of Schedule B information for plans that cover more than 100
participants and that are subject to the requirement to make quarterly
contributions for a plan year (i.e., a plan that had assets less than the
funding target as of the prior valuation date). The deadline for the
Schedule B report of the actuarial statement would be shortened for those
plans to the 15th day of the second month following the close of the plan
year, or February 15 for a calendar year plan. If any contribution is
subsequently made for the plan year, the additional contribution would be
reflected in an amended Schedule B that would be filed with the Form 5500.
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There are two fundamental problems with PBGC premiums.
First, the premium structure does not meet basic insurance principles,
including those that govern private-sector insurance plans. Second, the
premiums do not raise sufficient revenue to meet expected claims. The
single-employer program lacks risk-based underwriting standards. Plan
sponsors face limited accountability regardless of the risk they impose on
the system. As a result, there has been a tremendous amount of cost-shifting
from financially troubled companies with underfunded plans to healthy
companies with well-funded plans.
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This excessive subsidization extends across industry
sectors – to date, the steel and airline industries have accounted for
more than 70 percent of PBGC’s claims by dollar amount while covering less
than 5 percent of the insured base.
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The PBGC also needs better tools to carry out its
statutory responsibilities in an effective way and to protect its ability to
pay benefits by shielding itself from unreasonable costs. Recent events have
demonstrated that the agency’s ability to protect the interests of
beneficiaries and premium payers is extremely limited. This is especially
true when a plan sponsor enters bankruptcy or provides plant shutdown
benefits -- benefits triggered by a plant closing or other condition that
are generally not funded until the event occurs. Currently, the agency has
few tools at its disposal other than to move to terminate plans in order to
protect the program against further losses.
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The Administration’s proposal would reform the PBGC's
premium structure. The flat per-participant premium will be immediately
adjusted to $30 initially to reflect the growth in worker wages since 1991,
when the current $19 figure was set in law. This recognizes the fact that
the benefit guarantee continued to grow with wages during this period, even
as the premium was frozen. Going forward, the flat rate premium will be
indexed for wage growth.
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In addition to the flat-rate premium, a risk-based
premium will be charged based on the gap between a plan’s funding target
and its assets. Because the funding target takes account of the sponsor’s
financial condition, tying the risk based premium to the funding shortfall
effectively adjusts the premium for both the degree of underfunding and the
risk of termination. All underfunded plans would pay the risk based premium.
The PBGC Board – which consists of the Secretaries of Labor, Treasury and
Commerce – would be given the ability to adjust the risk-based premium
rate periodically so that premium revenue is sufficient to cover expected
losses and improve PBGC’s financial condition. Charging underfunded plans
more gives employers an additional incentive to fully fund their pension
promises.
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As part of improving PBGC’s financial condition,
additional reforms are needed. Plan sponsor bankruptcies and plant shutdown
benefits increase the probability of plan terminations and impose
unreasonable costs on the PBGC. The proposal would freeze the PBGC guarantee
limit when a company enters bankruptcy and allow the perfection of liens
during bankruptcy by the PBGC for missed required pension contributions. The
proposal also would prospectively eliminate the guarantee of certain
unfunded contingent liability benefits, such as shutdown benefits, and
prohibit such benefits under pension plans.
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The Bush Administration is committed to working with
Congress to ensure that the defined benefit pension reforms included with
the President’s Budget – strengthening the funding rules, improving
disclosure, and reforming premiums – are enacted into law.
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As I noted earlier, the primary goals of the
Administration’s proposal are to improve pension security for workers and
retirees, to stabilize the defined benefit pension system, and to avoid a
taxpayer bailout of the PBGC. This can be achieved by strengthening the
financial integrity of the single-employer defined benefit system and making
sure that pension promises made are promises kept. We look forward to
working with Members of this Committee to achieve greater retirement
security for the millions of Americans who depend on defined benefit plans.
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