December 14, 2005
JS-3047

Remarks by Randal K. Quarles
Under Secretary of the Treasury for Domestic Finance
to the Exchequer Club

Thank you for inviting me to speak before the Exchequer Club today. I am pleased to continue the long standing tradition of Treasury officials discussing key financial and economic policy issues before this distinguished group.

As we at the Treasury consider some of the specific economic and financial challenges the country needs to address, we are certainly heartened that we do so against the backdrop of one of the strongest economies in many years. Third quarter growth in the Gross Domestic Product was 4.3 percent, good for any quarter, but quite remarkable in a period that followed a devastating natural disaster. It marks the 10th straight quarter that GDP growth has exceeded 3 percent. Job growth continues with 215,000 new jobs added in November and a total of 1.8 million new jobs this year--almost 4.5 million since May 2003. And this strong job creation has not come at the expense of productivity growth. Productivity grew 4.7 percent in the third quarter and current unemployment is only 5 percent. We have built a strong foundation for future growth based upon low taxes, restrained government spending, legal reform, and incentives for saving and investment. All this is particularly good news for American workers.

In spite of all the encouraging economic reports, there are some issues of great importance to America's workforce that need to be addressed. I would like to talk about one of those issues today, the current state of the country's defined benefit pension system. I think that the complex issues surrounding the funding and administration of our pension and pension guarantee will be among the most challenging and consequential that our society will face over the next several years. The Administration has made pension reform one of its key legislative priorities. The federal government has an interest in defined benefit pension plans for four key reasons.

First, the government has an interest in ensuring simple fairness. The administration wants to make sure that pension plan sponsors deal fairly with their employees by meeting their pension obligations. It's an elementary principle, really: a promise made ought to be a promise kept.

Second, pension benefits are guaranteed by a federal government corporation, known as the Pension Benefit Guaranty Corporation or the PBGC. When a company with an underfunded pension plan reorganizes, liquidates, or demonstrates according to strictly defined statutory standards that it cannot continue operations with its pension plans, the PBGC takes over those pension plans' assets and liabilities and becomes the plan trustee. Once it takes over a plan, PBGC assumes the responsibility of making benefit payments to all employees and retirees who have earned pensions under the plan. Because the PBGC guarantee is limited to a fixed dollar amount, workers and retirees can often lose retirement benefits when such pension terminations occur; benefits that they have earned through long years of service to the sponsoring company.

Third, when the PBGC takes over a pension plan it is often one of the largest unsecured creditors. As a sponsoring company works its way through the bankruptcy reorganization, PBGC can end up with a significant equity interest in the new company. The federal government being a large equity holder in any private company – however that stake may have arisen – is inconsistent with the fundamental principles of a market economy. The continued operation of private sector companies in our economy should not depend on whether the U.S. government holds or maintains an equity stake in the company, but rather it should be based on financial market participants' willingness to invest in the on-going business operations of such companies.

Finally, the rules for funding pension plans are defined in federal law and are jointly enforced by the Department of Labor and the Internal Revenue Service. Pension plan contributions and investment returns are tax-advantaged, which means that government has an interest in ensuring that such advantages are not abused.

Status of the Defined Benefit Pension System

I am sure that many you have read in the newspapers that pension plans and the pension insurance system are in difficult financial straits. Although most companies do make benefit payments when due and fund their plans responsibly, an increasing number in recent years have not. Underfunding in pension plans increased from $164 billion to $450 billion between 2001 and 2005. During that same five-year period, PBGC has seen its net financial position decline from a $7.7 billion surplus to a $22.8 billion deficit. The increase in PBGC's deficit has come about primarily because of the failure of a number of very large pension plans including those of United Airlines, US Airways, LTV Steel, and Bethlehem Steel. Claims against the single employer guarantee fund from these and other pension plans that failed over the past five years totaled $34.1 billion.

Some recent high profile pension plan terminations illustrate the magnitude of problems in the defined benefit pension system.

• United Airlines: At the time PBGC moved to terminate United's four pension plans it estimated that there were sufficient assets to cover only 42 percent of total obligations. Assets were $7.0 billion while liabilities were $16.8 billion. PBGC guarantees will cover $6.6 billion of the $9.8 billion shortfall. The remaining $3.2 billion represents lost benefits to plan participants. At this time PBGC is still litigating the size of its claim for unfunded liabilities in the bankruptcy court.
• U.S. Airways: U.S. Airways' plans that terminated in 2003 and 2005 had sufficient assets to cover only 37 percent of liabilities. At the time of termination assets were $2.9 billion while liabilities were $7.9 billion PBGC's guarantee covered $2.9 billion of the $5.0 billion shortfall. The remaining $2.1 billion represents benefit losses.
• Bethlehem Steel: Plans terminated in 2002 had assets sufficient to cover only 45 percent of liabilities. Assets at the time of termination were $3.5 billion and liabilities $7.8 billon. PBGC's guarantee will cover $3.7 billion of the $4.3 billion funding shortfall. The difference of $600 million will be lost to participants.

How is it that the pension system finds itself in this situation? While there are a number of factors, one of the key reasons is that the current funding rules have not adequately ensured that companies fund their pension plans and keep the promises they have made to employees.

One of the key deficiencies in the current funding rules is that it is difficult to get an accurate measure of the degree of pension plan underfunding. A significant reason is that current pension funding rules are designed to make contributions even and as predictable as possible while the plan sponsor funds to a target that represents its long run benefit payment obligations. Today's funding rules allow pension plan assets and liabilities to be measured on a smoothed rather than a current basis. Liabilities are averaged over a four-year period while assets may be averaged for up to five years. Smoothed measures that delay recognition of asset and liability value changes make plans appear to be much better funded than they are on a current basis when asset values are declining and liability values rise. This has occurred most recently when stock prices and interest rates both fell at the beginning of the 2001 bear market.

While the idea of making contributions even and predictable may sound appealing, one consequence of smoothing rules is that pension plans are permitted to remain seriously underfunded for years at a time. A convenient way to think of pension underfunding is to consider it a loan from employees to employers. Accrued pension benefits are part of an employee's compensation for work already performed. To the extent that employers are permitted to make less than the contribution required to fully fund their pension promises the plan is essentially extending credit to the employer – and employers that take such loans from their pension plans are shifting some of the risk of meeting pension obligations from themselves to their employees. In the United States, with its pension guaranty system, a significant portion of that risk is then transferred to the guarantor, the PBGC. If a pension sponsor encounters financial trouble while underfunded it is likely to default on its pension loans resulting in lost benefits to participants and losses to PBGC's guaranty fund.

Another serious measurement problem is that pension liabilities are measured using a single, long-term interest rate to discount future benefit payments. Under normal conditions – that is when the yield curve slopes upward – the use of a single long-term discount rate systematically understates the liabilities of plans with a large ratio of retirees to active workers. This is especially problematic in the many plans of older industrial companies that have more retirees than active workers.

In addition to measurement problems, the current funding rules also provide a mechanism – called credit balances – that while allowing for the greater predictability of contributions also can lead to chronic underfunding. Credit balances, an accounting construct that may be unfamiliar to those outside of the pension community, may be used by pension plans in lieu of required cash contributions. Credit balances are created when pension sponsors make contributions that are higher than the minimum required in a given year. Under the current rules the value of such a balance, once created, increases each year with an interest credit that is chosen by the plan and represents the expected long-run return on pension plan assets. The interest credit is applied each year even if the value of plan assets declines. These balances may be used instead of cash contributions even in plans that are very seriously underfunded. It should be noted that credit balances allowed Bethlehem to avoid making any cash contributions to its plans for three years before its termination. At the time that PBGC took over the plan, assets equaled only 45 percent of termination liabilities. Likewise US Airways was not required to make any cash contributions to its pilots' plans for the four years preceding its termination even though the plan's assets covered only 33 percent of accrued benefits at the time of termination.

Some other problems in the current pension funding rules are that the funding targets are set at 90 percent of current liability, which is a smoothed measure that is well below the level of outstanding obligations. Also payments for new benefits can be amortized for up to 30 years, which provides incentives to increase benefits today since most of the funding expense only comes due years in the future.

The current funding rules are not the only problem with today's defined benefit pension system. Some other problems with the current system include:

• Pension plan financial disclosures to participants are inadequate. The data supplied to participants is out of date and consists only of smoothed asset and liability measures. Participants are unable to monitor how well their plans are funded with this information. For example, the participants of Bethlehem steel were told the year before the plan terminated that it was 84 percent funded based on smoothed asset and liability measures and the current law funding target. When the plan terminated the next year, however, participants were surprised to learn that plan funding would only cover about 45 percent of earned benefits.
• The pension insurance system creates moral hazard. The existence of insurance provides the incentive for employees to accept future promises of pension benefit as a substitute for current wage increases even if it appears unlikely the sponsoring firm will be able to fund such promises.
• Premium rates are set below the level needed for PBGC to regain solvency. PBGC's premium structure includes two parts. The first is a flat rate premium of $19 per plan participant that has not been increased since 1991 even though maximum insurance coverage automatically increases every year. Between 1991 and 2005, PBGC's maximum guarantee for an individual who retires at age 65 increased from $27,000 to $45,613. PBGC also charges a variable premium of $9 per $1,000 of underfunding. This premium rate has not been updated since 1996.
• All plan sponsors pay the same flat premium rate and the same variable premiums for underfunding regardless of the risk that they will terminate underfunded plans. This creates a set of cross subsidies from stronger to weaker plan sponsors that results in adverse selection in the pension system. Strong sponsors have an incentive to leave the system to avoid paying subsidies; weak sponsors have an incentive to remain to receive those subsidies.

It has become apparent to nearly all interested parties that the defined benefit pension system is not sustainable in its present form and that action is needed to protect both pension plan participants and the pension guaranty system.

The Administration's Pension Reform Proposal

In order to encourage the continuation of financially sound pension plans, the Administration unveiled a comprehensive reform proposal in January of this year. This proposal, if adopted would change the focus of pension funding rules from smoothing contributions to ensuring that plans have adequate assets to meet their accrued obligations. By promoting sound funding the Administration's proposal will protect employee's benefits and place the pension guaranty system on a firm financial footing.

The Administration has proposed the following changes to pension rules.

• Assets and liabilities would be measured at current, market values. Accurate and current measurement is necessary both as a basis for implementing sound funding rules and for making the disclosure of pension plan's financial status transparent to employees, retirees, and financial market participants.
• Liabilities would be valued using a yield curve of high quality (AA) corporate bonds rather than with a single interest rate in order to capture the time structure of the underlying benefit payments.
• Pension funding targets for most plans will be set at 100 percent of accrued benefits. Sponsors that are financially weak and pose the highest risk of terminating underfunded plans would fund to a higher target.
• Plans would be required to eliminate increases in underfunding within seven years. This amortization period will apply to new benefits, as well as to other causes of underfunding such as investment losses. A short amortization period will help ensure that plans do not remain underfunded for extended periods of time.
• The use of credit balances would be eliminated. Plans would be required to make cash contributions to satisfy their funding obligations in the future.
• Plans that are underfunded would be restricted in their ability to increase benefits. This will prevent plans that are already underfunded from making their situations worse.
• Plans will be required to provide new and meaningful financial disclosures to plan participants.
• PBGC's per capita premiums will be increased and rise in the future at the same rate as PBGC's maximum coverage levels. Risk based premiums that will reduce the cross subsidies in the current premium system will be introduced.

Congress has responded to the Administration's call for reform by undertaking important pension legislative initiatives. The Senate, under the leadership of Chairman Grassley of the Finance Committee and Chairman Enzi of the Health, Education, Labor and Pensions Committee passed the Pension Security and Transparency Act of 2005 on November 16. The House may bring legislation to the floor as early as this week. Similar versions of The Pension Protection Act of 2005 have been reported out of the Education and Workforce Committee under Chairman Boehner and the Ways and Means Committee under Chairman Thomas.

And yet, although the House and Senate bills are both modeled after the Administration proposal, both in their current form might actually result in a weakening of pension plan funding and the pension guaranty system. The fundamental goal of any pension reform proposal should be to reduce claims on the pension insurance system, reduce benefit losses to plan participants, and increase plan funding, all with the goal of ensuring that pension promises are kept. The Administration does not consider any bill that fails to improve upon current law as an acceptable legislative outcome. Likewise, the Administration opposes temporary fixes –such as extending the corporate bond rate as the discount factor – that do not comprehensively address the problems in the current system. However, we believe that we can work with the Congress to strengthen current legislation in conference. Together the Congress and the Administration can produce a bill that will improve protection for the pension benefits of employees and retirees.