November 10, 1999
The Working Group Report, submitted to the ERISA
Advisory Council on November 10, 1999, was approved by the full body and
subsequently forwarded to the Secretary of Labor. The Advisory Committee
on Employee Welfare and Pension Plans, as it is formally known, was
established by Section 512(a)(1) of the Employee Retirement Income
Security Act of 1974 to advise the Secretary with respect to carrying out
his/her duties under ERISA.
Members of the 1999 Working Group
Chair: Michael J. Gulotta
Actuarial Sciences Associates, Inc.
Vice Chair: Michael J. Stapley
Deseret Mutual Benefit Association
Rose Mary Abelson
The Northrop Grumman Corporation
J. Kenneth Blackwell
Secretaryof State, State of Ohio
Judith Ann Calder
Abacus Financial Group, Inc.
Michael R. Fanning
Central Pension Fund International Union of Operating
Engineers
and Participating Employers
Neil M. Grossman
William M. Mercer
Janie Greenwood Harris
Mercantile BanCorporation
Patrick N. McTeague
McTeague, Higbee, MacAdam, Case, Watson & Cohen
Thomas J. Mackell, Jr.
Vice Chair of the Advisory Council
MFS Institutional Advisors, Inc.
Rebecca J. Miller
McGladrey & Pullen, L.L.P.
Richard T. Tani, Retired, William M. Mercer
Barbara Ann Uberti
Chair of the Advisory Council
Wilmington Trust Company
The ISSUE
“We are interested in exploring creative proposals to
permit greater pre-funding of retiree health benefits with excess pension
fund assets.”David A. Smith, Director of Public Policy
AFL-CIO
July 13, 1999
“Since retiree health care is an intrinsic part of
retirement security, we see no reason not to permit the use of over-funded
pension plans to help guarantee retiree health coverage….…policy
should allow the pension asset transfer to fully fund the retiree health
benefit obligations for current retirees and active employees as well.”Morton
Bahr, President
Communications Workers of America
June 8, 1999“We believe making excess pension assets
more freely available for other constructive purposes would encourage more
companies to voluntarily sponsor defined benefit pension plans and
encourage companies to enhance participants’ security by funding these
plans at a higher level.”Michael J. Harrison, Human Resources Vice
President
Lucent Technologies Inc.
July 13, 1999“If rigid and irrational legal
restrictions “trap” these surplus assets in the defined benefit plan
and prevent them from being used productively for other retirement
security purposes:Employers will be even more reluctant to adopt defined
benefit plans, ....
Employers will naturally be reluctant to contribute any
more to their plans than the law requires, ....
It will be harder for employers to fund other post
retirement benefits, ... and finally,
Many employees who may need or want to move into phased
retirement…..will find it harder to do so.”Mark J. Ugoretz, President
The ERISA Industry Committee
July 13, 1999
CONTENTS
Executive Summary
Introduction
Laying the Groundwork
Chapter 1: Funded Status of Pension Plans
Chapter 2: Retiree Health Benefits
Chapter 3: Accessibility of Surplus Assets
Chapter 4: Policy Considerations
Chapter 5: Findings and Recommendations
Appendix: Summary of Testimonies of Expert
Witnesses Attached
EXPERT WITNESSES:
Dallas L. Salisbury (April 6, 1999)
President & CEO
Employee Benefit Research Institute
Morton Bahr (June 8, 1999)
President
Communications Workers of America
Richard P. Hinz (May 5, 1999)
Director of the Office of Policy and Research
Employee Benefits Security Administration
David A. Smith (July 13, 1999)
Director of Public Policy
AFL-CIO
Ron Gebhardstbauer (May 5, 1999)
Senior Pension Fellow
American Academy of Actuaries
Mark J. Ugoretz (July 13, 1999)
President
ERISA Industry Committee
Dr. Sylvester J. Schieber (May 5, 1999)
Director of Research and Information
Watson Wyatt Worldwide
Michael J. Harrison (July 13, 1999)
HR Vice President
Lucent Technologies Inc.
John M. Vine (June 8, 1999)
Partner
Covington & Burling
Cheryl L. Harwick (July 13, 1999)
Tax Counsel – Employee Benefits
Marathon Oil Company - USX Corp
Kenneth W. Porter (June 8, 1999)
Chief Actuary
The DuPont Company
Howard E. Winklevoss (July 13, 1999)
President & CEO
Winklevoss Consultants, Inc.
David Certner (June 8, 1999)
Senior Coordinator
American Association of Retired Persons
Dr. Irwin Tepper (September 8, 1999)
Founder and President
Irwin Tepper Associates, Inc.
Congressman Earl Pomeroy (September 8, 1999)
United States House of Representatives
SURPLUS PENSION ASSETS:
SECURING THE RETIREE HEALTH BENEFIT PROMISE
Executive Summary:
The subject of surplus pension assets has been a
controversial issue for many years. Favorable market conditions have
created large surpluses in the amount of assets held in defined benefit
plans. Specifically, it is estimated that U.S. pension surplus currently
exceeds a quarter trillion dollars. Simultaneously, a growing elderly
population in this country faces rapidly escalating medical costs,
advanced life expectancies, and a shortage of funds set aside to meet
their substantial post-retirement health needs. This Working Group of the
ERISA Advisory Council was assembled to determine whether it is feasible
to make use of surplus pension assets to strengthen and secure the retiree
health benefit promise.
Our activities focused around verifying the funded
status of the U.S. private pension system, examining current and future
trends in the retiree health benefits field, reviewing the accessibility
to surplus assets under current law, and surveying the landscape of
informed opinion to garner insight from experts representing a myriad of
backgrounds and viewpoints.
Over a six month period, 15 expert witnesses from the
Department of Labor, corporations and organized labor, think tanks and
academia, and legislators and advocacy groups testified on issues related
to the use of surplus pension assets for securing retiree health benefits.
Their testimony and accompanying evidence, which is cited throughout this
report, serve as the backbone for the Working Group’s findings and
recommendations.The testimony and data we collected supports the premise
that there continues to be a gradual but certain decline in traditional
defined benefit plans as measured by the number of plans sponsored, the
number of employees covered, and the growth of assets available to secure
such plans as compared to the growth of assets contributed to defined
contribution plans. In addition, only a small and declining proportion of
American workers are covered by employer-sponsored post-retirement medical
plans, and these plans are themselves, in general, underfunded. Current
law restricts access to surplus pension assets for purposes of securing
retiree benefits other than pensions.
With the exceptions noted, the Working Group
unanimously makes the following recommendations regarding the use of
surplus pension assets to fund retiree health benefits:
Extend permanently the provisions of IRC Section 420,
otherwise scheduled to expire at the end of 2000. Continue allowing for
transfers of surplus pension assets to fund current year medical
obligations when pension assets exceed the greater of the Full Funding
Limit and 125% of current liability.
Replace the five-year Maintenance of Benefit
requirement in the current Section 420 with a five-year Maintenance of
Cost requirement. While a majority of the working group voted in favor of
this recommendation, a significant minority felt strongly that the
maintenance of benefits provision should be preserved. The minority was
concerned that a substitution of a maintenance of cost provision would
effectively permit or encourage a reduction in retiree health benefits
over time, particularly considering anticipated higher health care costs
in the future.
Expand Section 420 to allow for prefunding of medical
obligations up to the present value of postretirement medical benefits for
current retirees when pension assets exceed the greater of the Full
Funding Limit and 135% of the current liability.
Approximately 50% of the Working Group would also favor
an expansion of the group for which retiree medical benefits may be
prefunded by including active employees who are eligible to retire.
Allow the use of future health care inflation in
determining the present value of post-retirement medical benefits.
(Agreement on this recommendation was nearly unanimous.)
Require a qualified actuary to certify that the present
value of post-retirement medical benefits was determined using sound
actuarial assumptions and methods.
Allow surplus pension assets to be transferred either
to a special 401(h) sub-account within the pension plan or to a VEBA
established under Section 419 of the Internal Revenue Code. Stipulate that
investment income on surplus pension assets transferred to a VEBA will not
be subject to Unrelated Business Income Tax.
Refer the following issues to a future Working Group or
other forum for additional study:
Current law provisions on funding of retiree health
benefits and their effect on the security of retiree health plans.
The current full funding limits for defined benefit
pension plans and their impact on the level of employer contributions to
pension plans.
The remainder of this report highlights pertinent
testimony and sets forth in greater detail the Working Group’s findings
on the use of surplus pension assets to secure the retiree health benefit
promise.Introduction - Laying the Groundwork:
The subject of Surplus Pension Assets has been a
controversial issue for many years. Employers that sponsor defined benefit
plans have expressed frustration with the simultaneous requirement to
assume the risk of plan underfunding and gain the benefit of a very
limited ability to utilize “surplus” assets for other retiree
benefits.The purpose of the Working Group on Surplus Pension Assets is to
study and/or make recommendations in the following areas: the funded
status of pension plans, the prevalence of retiree health benefits and the
extent of retiree health funding, accessibility of surplus pension assets
to secure other retiree benefits, policy considerations with respect to
the use of surplus pension assets, and alternate approaches and safeguards
for the use of surplus assets. This report summarizes the insight the
group has gathered from the testimony of expert witnesses called to share
their experience and opinions on these important topics.
Chapter One discusses trends in the funded status of
privately held pension plans in this country. How much overfunding exists?
What are the prevailing trends in funded status? How do these patterns
vary by industry, unionization, and number of participants? The Working
Group grappled with these and many other questions as it listened to
testimony from representatives of the Department of Labor, Watson Wyatt
Consultants, and the American Academy of Actuaries.
In the second chapter, the state of retiree health
benefits is brought to the forefront. The Working Group turned to a noted
authority on the subject to cite the trends in coverage, describe the
funding issues associated with retiree health plans, and discuss the
potential impact of health care reform initiatives on employer actions
with respect to retiree health benefit design and funding.
The third chapter describes the current level of
accessibility to surplus pension assets, the provisions of Section 420 of
the Internal Revenue Code and the experiences of some employers who have
made Section 420 asset transfers or intend to do so. Since employers will
continue to play an important role in providing for retired Americans’
income and health care needs, the Working Group asked senior
representatives of three large companies to provide their views on the use
of surplus pension assets for providing retiree health benefits.Policy
considerations are addressed in the fourth chapter of this report. What to
do with surplus pension assets is a complex question. In order to surface
and evaluate the many issues affecting policy considerations in this
matter, the Working Group obtained testimony from leaders representing a
wide variety of backgrounds and perspectives.
Chapter Five of the Report provides the Work Group's
findings and recommendations.
Chapter 1 - Funded Status of Pension Plans
“The slowdown in pension funding is directly
attributable to reluctance on the part of plan sponsors to tie up excess
assets that can never be accessed at reasonable cost even if there are
wildly excess assets in the plan.”Dr. Sylvester J. Schieber
Director of Research and Information
Watson Wyatt Consultants
BACKGROUND AND ANALYSIS—TRENDS IN FUNDED STATUSAny
policy debate on the subject of surplus pension assets should take note of
the enormous magnitude of the aggregate amount of overfunding (i.e.,
difference between current assets and current liabilities) in the private
pension system. As of 1996, single and multiemployer pension plans were
overfunded by some $251 billion in this country (Attachment 1). Given the
extraordinary recent performance of the capital markets, the amount of
overfunding has probably increased substantially since that estimate was
made. Not surprisingly, single employer plans with over 100 lives account
for the vast majority of the overfunding.
This Working Group was established to investigate the
issue of surplus pension assets and make recommendations on how to
productively utilize these funds to meet the future needs of the American
people. The following analysis is based on the testimonies of expert
witnesses called to contribute their valuable insight and opinions.
To obtain data regarding the funding patterns of
defined benefit pension plans, the Working Group obtained testimony from
the Department of Labor (DOL), Watson Wyatt Consultants and the American
Academy of Actuaries. Individuals who provided testimony were Richard Hinz,
Director of the Office of Policy and Research of the Employee Benefits
Security Administration of the Department of Labor; Sylvester Schieber,
Director of Watson Wyatt’s Worldwide Research and Information Center,
and Ron Gebhardtsbauer, Senior Pension Fellow at the American Academy of
Actuaries.Testimony provided by witnesses from the Department of Labor and
Watson Wyatt offers insight into the trends in the funded status of
private sector defined benefit pension plans and factors contributing to
those trends.
The DOL measured funded status by examining the funded
ratio, defined as the ratio of current assets (fair market value) to
current liabilities (OBRA 87 liabilities). Both of these items are
reported on Schedule B of the Form 5500, which defined benefit pension
plans must file annually with the DOL. The aggregate funding ratio defined
as the ratio of total current assets to total current liabilities for all
plans, dropped steadily from 1990 to 1994 and then turned upwards in 1995
and 1996. The aggregate funding ratio was 1.35 in 1990 and 1.19 in 1996
(Attachment 2).
Wyatt examined a subgroup of the universe of defined
benefit pension plans (those with over 1000 active employees) but reviewed
a longer period of time, the years between 1988 and 1998. Wyatt’s
analysis corroborates Department of Labor findings and shows that the
funded status of these plans declined from 1.45 in 1988 to 1.23 in 1998
(Attachment 3).Another indicator of the trend in funding status is the
percentage of plans with assets greater than a certain percentage of
liabilities at different points of time. Wyatt data indicates that the
percentage of plans with assets greater than 125% of accrued benefits
declined from 67% in 1988 to 47% in 1998 while the percentage of plans
with assets greater than 150 % of accrued benefits dropped from 47% to 24%
in the same period (Attachment 3). DOL data shows a similar trend. During
the period 1990 to 1996, the number of plans that were 100% funded
(current assets greater than current liabilities) declined from 83% to 65%
while the number of plans that were 150% funded went down from 36% to 15%.
Although declining interest rates and maturing plan
populations were two of the factors that led to lower funded status, the
most significant contributing factor was the slowdown in contributions to
pension plans. DOL analysis indicates that in each of the years 1990
through 1995, payments to pension beneficiaries and plan expenses exceeded
contributions to pension plans.
Experts believe that public policy, directly as well as
inadvertently, played a major role in the slowdown of pension
contributions. Dr. Schieber, for example, asserted that a major reason for
the decline in contributions was the new full funding limit legislated in
1987, which prohibits employer contributions if assets exceed 150% of the
current liability. Dr. Schieber presented data that convincingly supported
his thesis. Wyatt data shows a steady decline in plans with assets greater
than 150% of accrued benefits as well as plans with assets greater than
125% of accrued benefits beginning in 1988, when the restrictive full
funding limit became effective, and ending in 1996 (Attachment 3).
Contrary to what some believe, asset reversions did not
lead to depletion of pension assets and lower funding ratios. Dr. Schieber
noted that high excise taxes imposed on asset reversions by the Omnibus
Budget Reconciliation Act of 1990 (OBRA 90) virtually put a stop to asset
reversions. However, according to Dr. Schieber, OBRA 90 did adversely
impact plan sponsor willingness to make large pension contributions. “The
slowdown in pension funding is directly attributable to reluctance on the
part of plan sponsors to tie up assets that can never again be accessed at
reasonable cost even if there are wildly excess assets in the plan,”
according to Dr. Schieber.VARIATIONS IN FUNDED STATUS
Are there inherent differences in the funded status of
pension plans with different characteristics?
In different industries?
Single versus multi-employer?
Small versus large?
Collectively bargained versus non-collectively
bargained?
DOL and Wyatt data provided answers to the above
questions.
The DOL examined funding ratios over the period 1990
through 1996 for different industries. Funding ratios were studied for the
following six industries: Construction, Retail, Manufacturing, Finance and
Insurance, Communications and Utilities and Services. Manufacturing showed
the lowest funding ratios while Finance and Insurance tied with
Communications and Utilities for the highest funding ratios. The trend in
funding ratios for each of the industries was remarkably similar. Funding
ratios declined steadily from 1990 through 1996.
DOL data indicated that multi-employer plans had lower
funding ratios than single employer plans and that the trend in funding
ratios was downward between 1990 and 1996 for both single employer and
multi-employer plans. The difference in funded status for single employer
and multi-employer plans in the DOL analysis is probably due to the fact
that the data included both pay-related and non-pay related single
employer plans. Multi-employer plans are usually non-pay related. Wyatt
examined the ratios of assets to accrued benefits for non pay-related
single and multi-employer plans and found them to be very similar.
Wyatt studied the funded status of accrued benefits for
plans of different sizes (1,000 to 4,999 actives, 5,000 to 9,999 actives,
10,000 to 24,999 actives, or 25,000 and more actives). In 1998, the funded
status for each of the groups was very similar (Attachment 4). Each of the
groups showed a decline in funded status from 1988 to 1998.
The DOL studied the funding ratios for collectively
bargained plans versus non-collectively bargained plans. Funding ratios
for collectively bargained plans were lower than for non-collectively
bargained plans. The funding ratio declined between 1990 and 1996 for each
category of plans.
WHAT IS SURPLUS ANYWAY?
Broadly speaking, surplus is the excess of assets over
plan obligations. Different definitions can be provided for plan
obligations as well as plan assets. Many different definitions of surplus
have been constructed based on different schools of thought. Since the
fundamental purpose of pension plans is to provide pension benefits to
participants, in defining surplus and allowing plan sponsors to utilize
surplus for other retiree benefits, the basic question that must be
answered is “How much surplus is necessary to ensure benefit security?”Mr.
Gebhardtsbauer of the American Academy of Actuaries noted that the
following questions should be considered before allowing access to pension
surplus:
“Will the pension benefits of workers be protected?
Is PBGC adequately protected?
Does it (the policy) maintain or improve incentives to
save for retirement?
Is it part of a consistent retirement income policy?
Will the advantages from the alternative uses of the
surplus outweigh the disadvantages from a policy perspective?”
This report considers alternate definitions of surplus
and explores briefly the implications of using these definitions. Chapter
4 addresses the potential policy implications of alternate approaches to
accessing pension surplus in greater detail.
The plan obligation may be defined as the amount that
needs to be held in the pension fund to ensure the benefit security of its
participants. The amount that needs to be held in the pension fund to
ensure benefit security of plan participants has also been defined in
different proposals in terms of the following actuarial terms:
Current liability
Termination liability
Full funding limit
Actuarial accrued liability
Current liability, termination liability and actuarial
accrued liability are measures of plan liabilities that vary in value
based on the actuarial assumptions used; prominent among which are the
interest and mortality assumptions. Current liability is the present value
of accrued benefits based on current interest rates prescribed by the IRS.
The termination liability is the amount that the plan would owe plan
participants if it were to terminate at that point in time. Many believe
that this is the minimum that should be held in the plan if the plan
sponsor is to be allowed to utilize surplus for securing other retiree
benefits. The actuarial accrued liability is determined under the plan’s
actuarial funding method and for the same interest assumption would
provide a larger value than the current liability. The full funding limit
is defined under the Internal Revenue Code as the lesser of the actuarial
accrued liability and the applicable percentage of the current liability.
The applicable percentage is 150% for years until 1998, 155% for 1999 and
2000, and increases gradually to 170% for 2005 and succeeding years.Since
the full funding limit is the point beyond which the IRS does not allow
deductible contributions, an intuitive definition of surplus would be
assets in excess of the full funding limit. However, the full funding
limit may be lower than the termination liability since it is based on
interest assumptions that are often higher than the conservative
assumptions used to determine the termination liability. Also, for non-pay
related plans, the full funding limit does not reflect the long term plan
obligation since it does not include updating of the benefit formula. It
is therefore necessary to seek alternate definitions of surplus.
Defining surplus assets as those in excess of the
current liability presents the same problems as defining the threshold as
the full funding limit. The interest assumptions and methods used to
calculate the current liability often produce a number lower than the
termination liability. One could get around this obstacle by defining the
surplus as the excess of assets over termination liability. However, this
creates additional work for the plan sponsor since unlike the current
liability, the termination liability is not a number required to be
calculated and reported each year.
Another approach, establishing the threshold simply as
100% of the current liability or 100% of the termination liability,
creates some additional problems. While a plan with assets equal to one of
these measures might be considered to be adequately funded at a moment in
time, it may become inadequately funded fairly quickly. A market decline
may cause asset losses; equally troublesome would be a decline in interest
rates or an increase in retirements, either of which could cause
liabilities to increase. Conservatism requires that the threshold include
a margin above the current liability or termination liability. For non-pay
related plans a margin is required because neither the current liability
nor the termination liability for these plans takes into account the
benefit enhancements that are customarily made in each bargaining cycle.
Mr. Gebhardtsbauer pointed out that benefit security is
a function not only of how wide the margin is but also of future funding
actions of the employer. He suggested that lower margins might be
appropriate for immunized portfolios, plans holding annuities, or plans
with a greater retiree proportion. On the other hand, a higher margin may
be required for plans with poor credit ratings. He also suggested that
different margins (and excise taxes) might be applied for different uses
of the surplus assets.
Under current law, the threshold above which employers
can withdraw surplus pension assets for funding of retiree health benefits
has been established as the greater of the full funding limit and 125% of
the current liability. According to Mr. Gebhardtsbauer, under certain
conditions, this threshold would produce a figure lower than the plan’s
termination liability. This could occur in a period of declining interest
rates, if the current liability calculation was based on an outdated
mortality table, or in the event that the current liability calculation
did not take into account valuation of contingent events such as plant
shutdowns. Assuring that benefit security of plan participants is
protected is not only a matter of defining the appropriate threshold. It
is also a function of the plan sponsor’s ability to fund the plan. Mr.
Gebhardtsbauer suggested that the PBGC would be protected if companies in
bankruptcy were not allowed to withdraw surplus pension assets or if such
companies were required to give PBGC advance notice of a planned surplus
withdrawal.Fluctuations in plan asset performance can affect benefit
security. Chapter 4 of this report will address what margin level may
provide adequate protection against future investment losses. For now, it
is appropriate to note the amount of overfunding of private pension plans
in this country and to observe the difficulties associated with getting to
the heart of the matter from an actuarial perspective.
Chapter 2 - Retiree Health Benefits
“Since the cost of health care during the later years
of life may well exceed many individuals’ family income, financing
health care for the elderly is an important issue.”Dallas L. Salisbury
President and CEO
Employee Benefit Research InstituteBACKGROUND
Americans, as citizens of the wealthiest nation in the
world, have come to expect adequate and reasonably affordable health care.
However, the expected expansion in the number of retirees over the next
decade coupled with increased life expectancy will put a major strain on
employers and the government as both seek to control the skyrocketing
costs of health care. A solution to this problem must be found if we are
to continue to provide appropriate care to our nation’s elderly
population without placing an undue burden on the younger generations. In
order to get a comprehensive view of the trends affecting employer
sponsored retiree health plans, the Working Group turned to Dallas
Salisbury, President and CEO of the Employee Benefit Research Institute (EBRI).TRENDS
IN COVERAGE
Employer-sponsored health care plans can deliver
retiree health benefits in a uniquely tax-effective manner that alternate
solutions, such as raising the pension benefit, cannot match. While
pension plan payments are taxable to retirees, disbursements made from
retiree health plans for the purchase of health care are not. Mr.
Salisbury’s testimony shows that despite this fact, since 1990, the
proportion of employers in America sponsoring retiree health care plans
has shrunk, while the proportion of employers requiring retiree premium
sharing has increased. The following points are summarized from Mr.
Salisbury’s testimony.- The Bureau of Labor Statistics (BLS) gathers
data on employers with 100 or more employees while consultant surveys base
findings on employers with at least 500 employees or on their own data
base of clients. BLS statistics show the percentage of employers offering
retiree health coverage in 1995 as 35% and 41% for Medicare-eligible and
under 65 retirees respectively (Attachment 6). These figures are similar
to those provided by a Mercer survey that indicates that in 1998, 30% of
large employers offered retiree health benefits to Medicare-eligible
retirees while 36% of these employers offered such benefits to retirees
who were under age 65 (Attachment 7).
- The numbers above belie the true extent of retiree
health care coverage in the private sector. Employers that do provide this
benefit typically exclude their part-time employees and small employers,
who constitute about 45% of the employer body, generally do not provide
any retiree health benefits at all. It is reasonable to estimate that
provide health coverage is available to between 16% to 23 % of the total
private sector workforce.
- Statistics for retiree health coverage are available
for a number of years and tell a story of erosion of coverage. While
retiree health benefits have never been as prevalent as pension benefits,
BLS statistics and consultant surveys both show that coverage was broader
in the late 80s and early 90s than is currently the case as we approach
the millennium (Attachments 5 and 6). Furthermore, merely examining the
proportion of employers offering retiree health coverage does not provide
a true picture of the depth of coverage. Employers have started requiring
greater premium sharing from retirees and have begun to phase out
postretirement coverage entirely for new workers.
- The move to reduction of employer-provided retiree
health coverage began in 1990 when the Financial Accounting Standards
Board released FAS 106. FAS 106 required employers, beginning with fiscal
years starting after December 15, 1992, to measure the obligation for
retiree health liabilities, to post a measure for the unfunded
postretirement health expense in the balance sheet and to disclose the
unfunded liability in the footnotes to the financial statements.
- In response to FAS 106 and increases in health care
costs, companies made numerous changes to their retiree health benefit
programs. 1995 survey data from Buck Consultants demonstrates that the
most common retiree health plan redesign features require employee cost
sharing premiums, followed by capping of employer contributions and annual
adjustments to retiree contribution amounts (Attachment 7). Even the 16%
-23% of private sector labor force that currently enjoys employer provided
retiree health coverage is likely to be required to make significant
out-of-pocket contributions as a condition of coverage in the future.
- Data suggests that employers are not eliminating
retiree health plans altogether, although some new employers have decided
not to offer the benefit in the first place. Instead, employers who
provide for some retiree health coverage are phasing out the benefit for
new workers so as to gradually eliminate the program
FUNDING OF RETIREE HEALTH PLANS
There are currently no requirements for companies to
pre-fund retiree health benefits. Under current tax law provisions,
tax-effective funding measures are available only for collectively
bargained retiree health plans. Unions in the private as well as public
sectors have made retiree health a priority issue in their collective
bargaining with employers. However, the effect on overall funding levels
for retiree health plans has been limited.
Recent data available from Buck Consultants indicates
that 33% of private-sector retiree health plans are funded. The prevalence
of funding varies widely by industry, ranging from a high of 86% among
utilities to lows of 23% in manufacturing and 0% in the retail industry
(Attachment 8). Unlike pension plans that have had a long history of
substantial funding and have enjoyed the run-ups in pension assets from
the bull market beginning in the early 1980s, funding levels for retiree
health plans are low. Indeed, only 9% of the plans that are funded have a
funding ratio of 81% or higher.
Some attempts to solve the growing problem were made in
the early 1990s when various legislative bills proposed the introduction
of tax-effective retiree health funding mediums. Unfortunately for
would-be reformers, these bills were accompanied by the requirement of
vesting of retiree health benefits, which the employer population saw as
an unacceptable trade-off. The bills subsequently died from lack of
support. Mr. Salisbury believes that if an acceptable funding compromise
had been reached at the time, we could currently be looking at a different
picture of retiree health coverage. Employers would have begun funding the
retiree health benefit obligation and enjoyed the big stock market gains
of this decade. Since asset returns reduce the FAS 106 expense, there
would have been less pressure to reduce the employer commitment and shift
costs to retirees. Consequently, benefit coverage and funding levels would
have been stronger than they are today.
FUTURE DIRECTION OF EMPLOYER HEALTH PLANS
Recent legislative proposals have sought to raise the
Medicare eligibility age concurrently with an increase in the eligibility
age for Social Security. Mr. Salisbury asserts that reform proposals that
reduce Medicare coverage will impact employer decisions and lead to
further decline in employer provided coverage. On the other hand, other
bills propose adding prescription drug coverage to Medicare or allowing
early retirees to buy in to the Medicare program. Reforms such as these
that increase Medicare benefits will decrease costs but are not likely to
lead employers to add the benefit.
In the next few years, many of the companies that
installed defined benefit retiree health caps will see their claim levels
reach the caps. Mr. Salisbury believes that at this point companies will
turn to other approaches for containing costs such as defined contribution
plans and greater use of Medicare-risk HMOs and Medicare-plus-choice
plans. In general, Mr. Salisbury sees a trend towards more defined
contribution plans for those employers that retain retiree medical
coverage.
Another major factor contributing to the decline of
retiree health plans is the lack of tax-effective funding vehicles that
would allow employers to put aside funds to back the promised benefits.
Except for collectively bargained plans for which unions were able to get
special treatment, the government has discouraged such funding measures in
order to focus on raising tax revenues and closing the deficit. Mr.
Salisbury believes that if tax-effective funding vehicles are made
available without vesting requirements, more employers will pre-fund the
benefits which would lead to greater security for plan participants.
Chapter 3 - Accessibility of Surplus Assets
“We believe making excess pension assets more freely
available for other constructive purposes would encourage more companies
to voluntarily sponsor defined benefit pension plans and encourage
companies to enhance participant’s security by funding these plans at a
higher level.”Michael J. Harrison
HR Vice President
Lucent Technologies Inc.BACKGROUND
In Chapter 1 of this report we defined surplus pension
assets as the excess of plan assets over plan obligations. By
accessibility of surplus we mean the employer’s ability to use pension
plan assets for a purpose other than providing traditional pension
benefits. Let us start out by stating that surplus is not presently very
accessible. Current law properly discourages use of plan assets for
purposes other than payment of plan benefits and plan administration
expenses. ERISA and the Internal Revenue Code allow access to surplus
pension assets only in certain restricted circumstances. One such
situation is covered under Section 420 of the Internal Revenue Code.John
Vine, Partner in Covington and Burling, a law firm that specializes in
ERISA matters, testified at our request regarding the provisions of the
law that regulate employer access to surplus pension assets. In addition,
the Working Group heard the testimony of representatives of three large
employers with well-funded defined benefit pension plans who provided a
corporate perspective on the accessibility of surplus pension assets.
Kenneth Porter, Chief Actuary at DuPont, Michael Harrison, HR Vice
President at Lucent Technologies and Cheryl Harwick, Tax Counsel at
Marathon Oil – a subsidiary of USX Corporation provided testimony based
on their experiences with large employer-sponsored plans.PLAN TERMINATION
AND EXCISE TAXES
A pension plan may be terminated and excess assets may
revert back to the employer after payment of plan obligations and taxes.
However, legislators have developed laws and regulations to make
reversions administratively difficult and financially unattractive in
order to discourage plan sponsors from viewing pension funds as a ready
source of cash.
A reversion is only possible if the pension plan
contains language authorizing reversion of surplus assets to the employer
after a plan termination. Moreover, the plan language must be adopted at
least five years before plan termination. Once a plan is terminated, all
of the plan’s obligations to plan participants must be satisfied and any
residual assets attributable to employee contributions must be distributed
to participants. Any excess amount left over may revert back to the
employer but is subject to both income and excise taxes.The Omnibus Budget
Reconciliation Act of 1990 (OBRA 90) raised excise taxes on pension plan
asset reversions. The excise tax can be as high as 50% but is reduced to
20% if part of the surplus is used to provide qualified pension benefits
to participants. The 20% excise tax applies if the plan transfers 25% of
the surplus to a qualified replacement plan or if at least 20% of the
surplus is used to increase the benefits of the participants in the plan
before it is terminated. According to testimony given to the Working Group
by Dr. Schieber of Watson Wyatt, the higher excise tax virtually put a
stop to asset reversions.
INTERNAL REVENUE CODE SECTION 420
Section 420 was enacted by Congress in 1990 to allow an
employer added flexibility in the funding of retiree health benefits by
permitting surplus pension assets to be used for payment of retiree
medical expenses. Under Section 420, surplus is defined as the excess of
plan assets over the greater of the full funding limitation and 125% of
the current liability. Such surplus may be transferred to a 401(h)
sub-account for payment of retiree medical expenses as long as the
transferred amount does not exceed the amount to be paid from the 401(h)
account for retiree medical benefits for pension plan participants during
the current year. An employer that makes a 420 transfer must meet certain
additional requirements. All pension benefits must vest immediately. Plan
participants, any union representing the employees, and the Labor
Department must be notified of the transfer. The employer must also
maintain essentially the same retiree medical benefit, under the
Maintenance of Benefit provision of Section 420, for the five years
following the transfer. The original Section 420 provision contained a
five-year Maintenance of Cost provision, which was amended later to a
Maintenance of Benefit provision.
Section 420 is a revenue raiser for the government.
Employers that make the Section 420 transfer use existing pension assets
for payment of retiree medical expenses in the year of transfer.
Therefore, they do not take the tax deduction they otherwise would for
payment of retiree medical expenses. Originally the Section 420 provision
was scheduled to expire at the end of 1995; Congress later extended its
life to the end of the year 2000. A Section 420 extension was included in
many of the bills introduced this year. Most of these included a five-year
maintenance of cost requirement instead of the current maintenance of
benefit requirement.
OTHER USES OF SURPLUS PENSION ASSETS
After payment of income and excise taxes, not much is
left to make the exercise of plan termination and reversion financially
worthwhile to employers. Instead of plan termination, employers have
developed various other legally acceptable strategies for use of surplus
pension assets. Mr. Vine provided the following list of strategies
currently being used by employers:
Contribution holiday
Merging a strongly funded pension plan with a less
well-funded pension plan
In connection with a sale, spinning off part of surplus
assets and transferring them to the buyer’s planExpanding the group of
plan participants
Providing enhanced benefits to a subclass of the plan’s
current participantsProviding disability, incidental death, layoff or
plant closing benefits
Amending the plan to provide enhanced window pension
benefits for retirement within a designated window period
Providing increased pension benefits instead of health
care or savings plan benefits
EMPLOYER EXPERIENCES WITH SURPLUS ASSETS
Although the three employers whose representatives
testified have distinct cultures and employee demographics, all sponsor
defined benefit pension plans with significant surpluses. In addition to
the strategies for use of surplus pension assets described above, these
employers have transferred pension assets under Section 420 and have
useful insights regarding the aspects of Section 420 that work well. In
addition, they shared their thoughts on those aspects that need
improvement.
Commitment to Defined Benefit Pensions
DuPont, Marathon Oil and Lucent are all companies with
long histories of defined benefit pension plans. DuPont’s first final
pay plan was adopted in 1904. Marathon Oil was once a part of Standard Oil
and now is part of USX Corporation, and began its Retirement Plan in 1936.
The Lucent pension plan was spun-off in 1996 from the long-standing
AT&T pension plan and inherited plan assets that made Lucent’s
pension fund one of the largest in the U.S.In their testimony, all three
companies affirmed their commitment to the defined benefit pension system.
Mr. Harrison’s view that defined benefit pension plans have played a
major role in contributing to a better standard of living and a more
dignified retirement for a significant number of the nation’s retirees
was shared by the two other employer representatives who gave
testimony.Committed as they are to the defined benefit pension system,
these three employers believe that the system needs some change. The three
testimonies echoed the common sentiment that even though they were
committed to the defined benefit system, they sought greater flexibility
in the use of surplus pension assets. Ms. Harwick stated, “In today’s
environment…it is essential that all underutilized and available assets
be used productively…Even a modest transfer amount of an otherwise
underutilized asset may help to free up other capital to help finance a
project or keep jobs or create new jobs.” Mr. Porter believes that the
fiduciary responsibility that DuPont management bears to its shareholders
requires a balancing of needs and resources. He stressed that, “As we
attempt to properly allocate corporate resources, pension funding
represents a particular challenge…If the plan is significantly
overfunded, … there is no way to directly rectify a grossly underfunded
situation under ERISA. In this respect the law is not balanced.” Mr.
Harrison also recognized the need to explore other options, “We believe
there are opportunities to create greater flexibility for sponsoring
companies while maintaining benefit security.”Experience with Section
420 TransfersDuPont and Marathon Oil have both made asset transfers under
Section 420 almost every year since 1990 when the provision became
effective. DuPont has made asset transfers for seven of the ten possible
years. Marathon’s first Section 420 transfer occurred in 1991, and
Marathon has completed a Section 420 transfer each year since. Lucent has
not made pension asset transfers under Section 420 since its divestiture
from AT&T in 1996. However, Lucent is very familiar with the
experience of AT&T, which made four Section 420 asset transfers for
the years 1990 through 1993. Lucent intends to make Section 420 transfers
of $360 million each year from 1999 until the expiration of the Section
420 provision.EMPLOYER AND EMPLOYEE ADVANTAGES FROM USE OF SECTION 420
Section 420 offers each of the companies that testified
the unique opportunity to tap excess pension assets and enhance retiree
medical benefit security at the same time. Both the Marathon plan and the
DuPont plan have been fully funded since 1984 and have not made any
pension contributions since then. All three company-sponsored plans remain
extremely well funded in spite of the measures to utilize surplus assets.
These companies depend on Section 420 to allow use of surplus pension
assets.
DuPont, Lucent and Marathon have benefitted from the
high asset returns of the 1980s and 90s. Each of the companies has used
some of the other means described in this chapter to absorb the excess
assets generated by these high returns. DuPont has taken action to enhance
pension benefits and has offered several open window retirement programs.
Both these actions resulted in the utilization of significant amounts of
surplus assets. A Section 420 asset transfer offers DuPont an appealing
means of dealing with the problem of “runaway pension assets”.Marathon
has made many amendments to the Retirement Plan in an effort to
productively utilize surplus pension assets. These have included enhanced
early retirement benefits, cost-of-living adjustments for existing
retirees, early retirement window programs, improved lump sum benefits and
improved pre-retirement survivor benefits.
Lucent and many other companies have discovered that
benefit security for retiree health benefits is particularly low due to
the lack of tax-advantaged funding, a strong deterrent to pre-funding for
retiree health plan sponsors. For example, although it boasts a $14
billion surplus in its USA pension plans, Lucent has a $4.7 billion
shortfall in its retiree health plans. All three companies made note that
the 420 transfer enhances retiree medical benefit security. Since the
companies have this available cash flow to meet their retiree health
commitments, they are less likely to reduce coverage or increase retiree
contributions. Section 420’s Maintenance of Benefit provision provides
benefit security for retirees for the four years following the transfer.
The provision allows some retirees to receive a more direct benefit than
would otherwise be provided. Marathon retirees received a premium holiday
for part of 1995 thanks to this clause. In addition, new pension
participants enjoy full vesting in their pension benefits on account of
the 420 transfer.
In summary, all three companies felt that the Section
420 transfer provision benefits both employer and employee.PROPOSED
REVISIONS TO SECTION 420
The current provision expires in year 2000. The three
employers are unanimous in recommending that the provision be extended.
However, to maximize its usefulness they would like to see expansion of
the provision and some technical changes.
a. Use of Surplus Assets for Defined Contribution(DC)
Plans
Marathon and Lucent both propose that Section 420 allow
surplus assets to be used for employer contributions to DC pension plans
in addition to retiree health benefits. Assets would only be transferred
for allocation to accounts of participants who also participate in the
defined benefit plan containing the surplus assets. The employer could be
required to maintain the same level of contributions to the DC plan for a
period of five years or be allowed to use accelerated vesting for the DC
plan. If there are sufficient surplus assets, both the retiree health
transfer and the DC plan transfer should be permitted in a given year.
b. Use of Surplus Assets for Non-qualified Benefits
Lucent suggests an alternate proposal in which surplus
assets could be used to pay for pension benefits in excess of qualified
plan limits (such as the 415 and 401(a)(17) limits). Both of these
proposals would raise revenues for the IRS since previous tax-deductible
pay-as-you-go benefits will now be financed with excess assets.
c. Section 420 Funding Cushion
DuPont believes that the use of the conservative
interest requirement for the current liability calculation combined with
the 25% cushion creates too great a margin for their final pay plan, which
has a mature population and a track record of high investment returns.
DuPont believes that public policy makers should recognize that the rules
they create impact different plans in disparate ways.
d. Maintenance of Cost
The lack of guidance surrounding the current
maintenance of benefit standard makes it difficult to gauge whether
compliance has been achieved, particularly in overlapping maintenance
periods. Marathon recommends switching back to a Maintenance of Cost
standard.
Chapter 4 - Policy Considerations
“We are interested in exploring creative proposals to
permit greater pre-funding of retiree health benefits with excess pension
fund assets.”David A. Smith
Director of Public Policy
AFL-CIO
BACKGROUND
Accessing surplus pension assets for purposes other
than paying pension benefits involves several major policy considerations.
The Working Group focused on the desirability of encouraging defined
benefit pension plans, the appropriate level of funding for pension plans,
and the utilization of surplus assets (with an emphasis on retiree health
benefits). In order to surface and evaluate these issues, the Working
Group obtained testimony from Congressman Earl Pomeroy, David A. Smith of
the AFL-CIO, Mark J. Ugoretz of the ERISA Industry Committee, David
Certner of AARP, Howard E. Winklevoss of Winklevoss Consultants, Inc.,
Irwin Tepper of Irwin Tepper Associates, Inc., Ron Gebhardtsbauer of the
American Academy of Actuaries, Morton Bahr of the Communications Workers
of America, Michael J. Harrison of Lucent Technologies, Kenneth W. Porter
of the DuPont Company and Cheryl L. Harwick of Marathon Oil Company, a
subsidiary of USX Corporation.
DESIRABILITY OF ENCOURAGING DEFINED BENEFITS PLANS
Defined benefit plans are those which provide a benefit
upon termination or retirement which is defined by its plan terms. The
plan sponsor makes contributions into a trust which, together with assumed
investment returns, is anticipated to be adequate to provide the defined
benefit for plan participants. If the assumed investment returns are
insufficient to be adequate to provide the defined benefit, the plan
sponsor must make additional contributions. Therefore, under defined
benefit plans, the investment risk is borne by the plan sponsor.
In contrast, the plan sponsor’s commitment under a
defined contribution plan is a specified contribution amount – usually
expressed as a percentage of the participant’s pay. The ultimate benefit
varies with investment performance. Therefore, the investment risk is
borne by the plan participant. Furthermore, defined benefit plans are
insured by the Pension Benefit Guaranty Corporation while defined
contribution plans are uninsured.Congressman Pomeroy questioned the
ability of defined contribution plans to provide a secure retirement for
Americans. He noted that participation rates in defined contribution plans
were too low, investment choices of employees were too conservative and
that the typical defined contribution plan balance was too low to provide
for a comfortable retirement income.
While several other witnesses, like Mr. Certner of the
AARP, supported the use of both defined benefit plans and defined
contribution plans, all witnesses who addressed the issue asserted that
public policy should attempt to reverse the decline in the number of
defined benefit pension plans and encourage their growth. Mr. Certner
elaborated on his view stating: “What we have tried to do is to try to
make both plans as equitable as possible to cover, to essentially extend
coverage and provide as much security in either kind of plan that the
company adopts. Obviously, it seems to work out best when a company has
both.”Mr. Smith, representing the AFL-CIO affirmed the value of defined
benefit plans in his remarks: “Four in five union members are covered by
a retirement plan at work. The overwhelming majority of the workers have a
defined benefit plan as the primary private source of income protection in
old age. We believe that defined benefit plans are the best way to provide
retirement income security for workers.” Mr. Bahr, President of the
Communications Workers of America, described how his colleagues have
profited from the existence of such plans, especially of late, stating
that, “American workers have been among the greatest beneficiaries of
the recent stock market success – through their pension funds.”Unions
were not alone in their support of defined benefit pension plans. Mr.
Harrison of Lucent Technologies went so far as to say that he supports
“…all legislation which promotes the expansion of the defined benefit
pension plans in ways that make voluntary programs more attractive to both
plan participants and sponsoring companies.”While there is apparent
broad based support for defined benefit plans, since the passage of ERISA
in 1974 the number of defined benefit pensions plans and the number of
participants covered by such plans have actually decreased
substantially.What, then, can be done to encourage defined benefit plans?
One way is to provide access to excess pension plan assets while
maintaining or enhancing the overall benefit security of plan
participants. According to Ron Gebhardtsbauer of the American Academy of
Actuaries, “Giving employers greater access to pension funds will
improve the flexibility of DB [Defined Benefit] plans from the employer’s
perspective and add to the attractiveness of that form of retirement
arrangement and encourage their adoption and maintenance.”All the plan
sponsor witnesses reaffirmed this message. Representative among the plan
sponsor’s point of view was that of Mr. Harrison who stated that, “…making
excess pension assets more freely available would encourage more companies
to voluntarily sponsor defined benefit pension plans and enhance
participant’s security by funding these plans at a higher level.”WHAT
ARE APPROPRIATE LEVELS OF FUNDING?If it can be agreed that accessing
excess pension plan assets to secure retiree health benefits is desirable,
the question then becomes “What is the appropriate level of pension plan
funding?” Without the answer to this question, we have no benchmark to
evaluate excess plan assets.Currently, Section 420 of the Internal Revenue
Code defines excess plan assets for purposes of determining amounts
available to pay postretirement health benefits as the excess of (A) over
(B) where:
(A)= the lesser of market or actuarial value
of plan assets
(note: the actuarial value is often less than the
market value of plan assets)
(B)= the greater of the plan’s Full
Funding Limit or 125% of current liabilityDr. Winklevoss of Winklevoss
Consultants, Inc. performed pension plan asset/liability modeling for the
purpose of testing whether or not the Section 420 definition of excess
assets is sufficiently large to maintain the financial integrity of the
pension plan. Dr. Winklevoss projected the relationship between pension
plan assets and liabilities using simulation techniques to determine how
frequently assets could fall below liabilities. He compared the current
Section 420 definition of excess assets (125% of current liability) to a
150% of current liability benchmark and found that: “…transferring
assets down to 125% of the OBRA ’87 current liability might be somewhat
too liberal … A 150% funding limit … may be somewhat too conservative
… I believe that a funding limit in the 135% range would represent a
reasonable compromise if assets in excess of the current year’s retiree
health care payments are allowed to be transferred out of the pension
plan.”Dr. Tepper also analyzed the appropriateness of different
threshold levels for purposes of defining excess pension assets under
Section 420 by performing stochastic projections. Dr. Tepper concluded
that a threshold level of 135% was adequate to remove most of the risk of
future unfunded liabilities over time frames up to five years. In Dr.
Tepper’s words: “….By the time you get to 135% (funded ratio), most
of the risk of unfunded current liability over 5 years gets reduced. If
you raise the threshold to 145% you’ve done about as much as you can to
reduce the risk.”In Dr. Tepper’s view the financial condition of the
sponsoring corporation is an important consideration in determining
whether the pension asset level provides reasonable security. He noted
that the funded status falling below 100% was not a significant concern if
the sponsoring corporation could afford to make ongoing contributions,
since this would bring the plan to a surplus position again. Dr. Tepper
did not, however, recommend a Section 420 threshold that was different for
more solvent versus less solvent companies, since this would lead to too
complex a system and one that might be open to gaming.The adequacy of
pension plan surplus can vary with demographic characteristics of plan
participants. Mr. Porter testified that at DuPont, for example,
liabilities for retired and terminated employees dominate the pension
plan. Furthermore, active employees at DuPont have long service.
Therefore, little of the surplus assets are needed to finance future
benefit accruals under the plan. In fact, for DuPont the level of pension
plan surplus may continuously grow if pension plan assets are not
accessible for other purposes.
Mr. Ugoretz of the ERISA Industry Committee expressed
eloquently the sentiments of the employer community when he testified
that: “…because employees are not required to provide retirement plans
to their workers, it is imperative that federal law create and maintain an
environment that is conducive to plan formation, continuation, and
expansion. If rigid and irrational legal restrictions ?trap’ these
surplus assets in the defined benefit plan and prevent them from being
used productively for other retirement security purposes – employers
will be even more reluctant to adopt defined benefit plans.”UTILIZATION
OF SURPLUS ASSETSNaturally, different witnesses have different
perspectives on how surplus assets should be applied. Mr. Bahr of the CWA
believes that: “There should be no means by which an employer can garner
any value from the plan it sponsors, other than by delivering benefits to
participants. The funds should be used solely to secure dignity in
retirement.”Mr. Certner of AARP said: “…Our feeling generally is,
the funds are put into the pension trust for the exclusive benefit of the
participants. And for the purpose of providing current and future pension
benefits.”On the other hand, Mr. Porter declared that: “As a publicly
traded company, DuPont has a fiduciary responsibility to its owners. We
have been entrusted with the owners’ assets with the expectation that we
will allocate our resources efficiently and appropriately to provide for
all of our corporate obligations. We pay taxes, and invest in research,
plans, properties, employees, the community, the environment and a host of
other business needs. Balance is important. To the extent one area gets
out of balance, we have an obligation to our owners to rectify that
situation. As we attempt to properly allocate corporate resources, pension
funding presents a particular challenge…a unilateral increase in benefit
levels necessarily results in a dilution of reported earnings, even when
surplus pension assets are used to finance those benefits. Accordingly,
business competitiveness issues, not pension asset values, dictate when
and whether benefits levels are changed.”Congressman Pomeroy indicated
that the first priority should be to “conclusively and positively
guarantee the solvency of the defined benefit”. Second should be the
prudent enhancement of the defined benefit from surplus funds, and third,
should be the enhancement of collateral benefits to employees such as
post-retirement medical.Mr. Gebhardtsbauer of the American Academy of
Actuaries testified that, “Strengthening employer solvency can create
more security for the pension plan … surplus assets could be helpful to
strengthen a company at an important time … the best insurance is a
strong employer.”Most witnesses asserted their view that the use of
excess assets to pay postretirement health benefits under Section 420
encouraged the continuance of defined benefits and improved the overall
benefit security of plan participants. Many witnesses also supported the
expansion of Section 420.Some witnesses supported the expansion of Section
420 to improve the funding of postretirement health benefits. For example,
Mr. Smith of the AFL-CIO declared that: “We are interested in exploring
creative proposals to permit greater pre-funding of retiree health
benefits with excess pension fund assets. The proposal would have to
contain sufficient assurances about worker pension security and employer
commitment to continuing both health and retirement plan coverage. We
believe there may be room to craft a proposal to encourage greater
commitment to retiree health benefits.” Mr. Bahr of the CWA expressed
this view even more strongly: “…it is time to forcefully encourage
employers who have excess assets in their pension funds to utilize some of
those assets to secure that guarantee….Since retiree health is an
intrinsic part of retirement security, we see no reason not to permit the
use of over-funded pension plans to help guarantee retiree health
coverage.”Other witnesses supported the expansion of Section 420 to
allow excess pension benefits to pay other employee benefits as well. Mr.
Vine of Covington and Burling, said: “A strong case can be made, for
example, that surplus pension assets should also be available to provide
other types of retirement benefits for pension plan participants, such as
allocations to a defined contribution plan … Permitting surplus assets
to be transferred to a defined contribution plan for those employees who
participate in both plans will help … make more efficient use of pension
assets.”Different witnesses had different views on the current five year
Maintenance of Benefit requirement of Section 420 and the alternate
Maintenance of Cost clause that has been suggested. Congressman Pomeroy
believes that asking employers to maintain benefits for five years is
entirely reasonable given the advantage they gain from the Section 420
asset transfer. However Ms. Harwick of Marathon Oil feels that the
Maintenance of Benefit clause is unclear, especially when a company makes
transfers in multiple years and would strongly favor a Maintenance of Cost
requirement.SUMMARY OF POLICY CONSIDERATIONS
The expert witnesses unanimously support the continued
encouragement of defined benefit plans. Their testimony generally asserts
that providing access to excess pension assets to enhance the overall
benefit security of pension participants is a significant step towards
encouraging defined benefit plans. Internal Revenue Code Section 420
currently allows access to excess pension plan assets to pay current
retiree health benefits. Many experts stated that retiree benefit security
can be further enhanced by the expansion of Section 420 to allow the
transfer of excess pension assets in order to pre-fund postretirement
health benefits.
Chapter 5 - Findings and Recommendations
Over a period of six months, the Working Group heard
testimony from the Department of Labor, corporations, organized labor,
consulting firms, think tanks, legislators and advocacy groups on issues
related to the use of surplus pension assets for securing retiree health
benefits. Based on the testimony heard and the information that was
submitted, the Working Group has reached the following conclusions:
There continues to be a gradual but certain decline in
traditional defined benefit plans as measured by the number of plans
sponsored, the number of employees covered, and the growth of assets
available to secure such plans as compared to the growth of assets in
defined contribution plans.
Current law restricts access to surplus pension assets
for purposes of securing retiree benefits other than pensions.
There has been a consistent decline in the funded
status of defined benefit plans from 1990 to 1996 which has resulted in a
significant reduction in current liability funding ratios. This decline in
funding ratios, which is reasonably similar across all industries, has
occurred in spite of strong asset returns in the 1990's. Analysis of data
indicates that employers are contributing less to guarantee retirement
security than they did a decade before.
There is some indication that the new Full Funding
Limitation, legislated in 1987, has prevented employers from making
contributions to their pension plans and thus has negatively impacted
funding ratios.
A small proportion of American workers are covered by
employer-sponsored post-retirement medical plans.
There is currently a small percentage (about 16%-23%)
of American workers that have such protection.
The proportion of workers with employer sponsored
post-retirement medical coverage has declined. The decline is attributed
by many to new Financial Accounting Standards Board rules (FAS 106)
implemented in 1993.
Compared to pension plans there is very little funding
of retiree health plans. Data indicates that only a minority of private
sector retiree health plans are funded. In addition, funding has been
discouraged by the tax law provisions of the Deficit Reduction Act of 1984
(DEFRA).
Retiree health benefits are less secure than pension
benefits on account of lack of vesting and PBGC protection, as well as tax
law provisions which discourage funding.
Testimony supports the premise that if surplus pension
assets could be used to secure post-retirement medical benefits, it might
encourage some employers to offer such benefits and encourage others to
continue rather than eliminate them.
Testimony also supports the premise that Internal
Revenue Code Section 420, legislated in 1990 under the Omnibus Budget
Reconciliation Act of 1990 (OBRA 90), has provided some limited
flexibility in the use of surplus pension assets and has had some measure
of impact in preserving post-retirement medical plans and improving
retirement security.
The Working Group heard testimony from both
corporations and organized labor in favor of expanding the provisions of
the current Section 420 of the Internal Revenue Code.
It is difficult to define what level of surplus is
adequate to responsibly secure future pension obligations. However, based
on expert testimony before the Working Group, 125% of current liability
was recommended to be adequate for transfers provided for under the
current provisions of Section 420. If changes are made to allow for a
transfer of assets to support more than a single year of retiree health
benefits, experts suggested that the threshold be higher.
Current provisions of Section 420 benefit the employer,
the retiree, and the federal government. The employer is provided
flexibility to use surplus pension assets to meet employee benefit
obligations, retirees receive greater security of post-retirement medical
obligations, and greater tax revenues are generated for the federal
government.
Recommendations
The fact that a small and declining proportion of
American workers are covered by employer sponsored post-retirement medical
plans is a serious public policy concern. Furthermore, this decline in
coverage is not likely to be reversed without some legislative
intervention. The Council concurs that surplus pension assets should be
used for securing retiree health benefits to a greater extent than
permitted by current law. With the exceptions noted, we unanimously make
the following specific recommendations:
Extend permanently the provisions of IRC Section 420,
otherwise scheduled to expire at the end of 2000. Continue allowing for
transfers of surplus pension assets to fund current year medical
obligations when pension assets exceed the greater of the Full Funding
Limit and 125% of current liability.
Replace the five-year Maintenance of Benefit
requirement in the current Section 420 with a five-year Maintenance of
Cost requirement. While a majority of the working group voted in favor of
this recommendation, a significant minority felt strongly that the
maintenance of benefits provision should be preserved. The minority was
concerned that a substitution of a maintenance of cost provision would
effectively permit or encourage a reduction in retiree health benefits
over time, particularly considering anticipated higher health care costs
in the future.
Expand Section 420 to allow for prefunding of medical
obligations up to the present value of postretirement medical benefits for
current retirees when pension assets exceed the greater of the Full
Funding Limit and 135% of the current liability.
Approximately 50% of the Working Group would also favor
an expansion of the group for which retiree medical benefits may be
prefunded by including active employees who are eligible to retire.
Allow the use of future health care inflation in
determining the present value of post-retirement medical benefits.
(Agreement on this recommendation was nearly unanimous.)
Require a qualified actuary to certify that the present
value of post-retirement medical benefits was determined using sound
actuarial assumptions and methods.
Allow surplus pension assets to be transferred either
to a special 401(h) sub-account within the pension plan or to a VEBA
established pursuant to Section 419 of the Internal Revenue Code.
Stipulate that investment income on surplus pension assets transferred to
a VEBA will not be subject to Unrelated Business Income Tax.
Refer the following issues to a future Working Group or
other forum for additional study:
Current law provisions on funding of retiree health
benefits and their effect on the security of retiree health plans.
The current full funding limits for defined benefit
pension plans and their impact on the level of employer contributions to
pension plans.
SUMMARY OF TESTIMONY BEFORE THE ERISA ADVISORY COUNCIL
WORKING GROUP ON EXPLORING THE POSSIBILITY OF USING
SURPLUS PENSION ASSETS TO SECURE RETIREE HEALTH
BENEFITS
WORKING GROUP MEETING
April 6, 1999
DALLAS L. SALISBURY, President and CEO, Employee
Benefit Research Institute
(Summary prepared by Neil Grossman)
Mr. Salisbury testified about trends in retiree health
coverage and financing. He warned, at the outset, that the surveys and
news reports tend to overstate the availability of retiree health coverage
for two reasons: (1) they often sample only larger employers, which are
more likely to offer coverage, and (2) they often ignore part-time
workers, who are less likely to have coverage. His bottom line: Today,
fewer employers provide retiree health benefits than in the past, due in
large part to short-term job tenures and the increasing exclusion of new
employees from retiree medical plans. Only between 16 and 23 percent of
the private sector workforce can expect to receive some employer
contribution toward retiree health coverage.
Legislation, including Medicare reform, should not have
a profound impact on coverage trends, according to Mr. Salisbury. These
trends are driven by three overriding factors: (1) the growth in health
care costs, (2) Financial Accounting Standard (FAS) 106, which requires
companies to incur a current charge on the balance sheet for future
retiree medical obligations, and (3) the lack of a tax-favored vehicle for
pre-funding retiree medical liabilities. However, Mr. Salisbury noted that
an increase in the eligibility age for Medicare is likely to reduce
coverage, because of its immediate impact on corporate net worth under FAS
106.
When asked about the potential effect of tax-favored
pre-funding, Mr. Salisbury thought that pre-funding opportunities would
not necessarily increase retiree health coverage, as long as the ability
to pre-fund was contingent on vesting employees retiree medical benefits.
He also thought that the use of surplus pension plan assets for this
purpose could encourage employers to offer retiree medical coverage in a
defined contribution (but not a defined benefit) arrangement and encourage
them to continue, rather than eliminate, retiree medical plans in some
circumstances.
WORKING GROUP MEETING
May 5, 1999
SYLVESTER J. SCHIEBER, Director of Research and
Information Watson Wyatt Worldwide
(Summary prepared by Richard Tani)
The slowdown in pension funding is directly
attributable to reluctance on the part of plan sponsors to tie up assets
that can never again be accessed directly at reasonable cost even if there
are wildly excess assets in the plan.
For plans which become excessively overfunded, there
ought to be some kind of provision to allow employers to take back some of
the money in one way or another.
I think you would actually encourage more pension
funding if you had some flexibility in having access to these assets than
we have under current rules.
I believe that if we don’t secure (retiree medical)
benefits in some way, we are ultimately going to see these benefits
vanish. I do not believe employers are in situations where they can carry
large unfunded liabilities, especially liabilities that have such
potential variability.Mr. Schieber noted a reduction in pension
contributions starting in the early 1980's. He also noted a reduction in
the funded status of pension plans (based on a Wyatt survey). Part of this
is due to adding the 150% of Current liability to the full funding limit
(if assets exceed the full funding limit no contributions may be made to
the plan). He feels that this 150% limit is artificial and causes a
deferral of funding, which may cause employers to cut back pension
benefits when later funding costs become higher.
He described an analysis his firm did on the 1995 House
Ways and Means Committee proposal that allowed plan sponsors to transfer
excess assets out of pension plans to be used for other purposes. The
transfer would be subject to regular income tax plus an excise tax. (There
was to be a brief window in which no excise tax would apply). Excess
assets were defined as assets in excess of the greater of the full funding
limit or 125% of current liability. He compared various scenarios where
the actuarial accrued liability (the old full funding limit and the normal
measure for ongoing funding of a plan) was less than 125% and 150% of
current liability and over 150% of current liability. The point was that
the combination of the 150% of current liability portion of the full
funding limit and the 125% of current liability portion of the definition
of excess assets caused disparate results in relationship to excess assets
relative to the actuarial accrued liability. He felt that it also caused
much confusion among non-actuaries. (Editor’s note: I feel that the 150%
of current liability limit could easily be eliminated from the full
funding requirement with little adverse impact but that the 1995 House
Ways and Means Committee proposal makes a lot of sense).When asked at what
level assets would be considered excessive, he said if assets exceed the
full funding limit, the rules do not allow any contributions. This implies
that any assets above this level is excessive. (Editor’s note: I do not
see an inconsistency in having a small buffer zone where contributions may
not be made, but assets cannot be taken out).He also noted the public
policy issue that tax laws have restricted employers ability to fund
retiree health obligations. One reason may be that retiree health benefits
are not taxable when received as pension benefits are. Funding retiree
health benefits through excess pension assets is a backdoor method of
funding something that can’t be funded directly. In other words we need
to review the funding vehicles and tax laws that affect retiree medical
benefits.Background on Mr. Schieber
Mr. Schieber has a Ph.D in Economics from the
University of Notre Dame. He has been with Watson Wyatt since 1983. Prior
to that he was the first research director of EBRI. Prior to that he was
deputy director of the office of Policy Analysis in the Social Security
Administration. He has served on the board of directors of EBRI
(1991-1996) and on the Pension Research Council at the Wharton School
(University of Pennsylvania) since 1985. He was also a member of the 1994
to 1996 Social Security Advisory Council.
WORKING GROUP MEETING
May 5, 1999
RICHARD HINZ, Director of the Office of Policy and
Research of the Employee Benefits Security Administration of the
Department of Labor (Summary prepared by Rebecca Miller)
Mr. Hinz, Director of the Office of Policy and Research
of the Pension and Welfare Benefits Administration of the Department of
Labor provided detail from the Form 5500 reports covering the funded
status of plans. For our briefing, he and three other members of his
office (Daniel Beller, David McCarthy and Steve Donahue) analyzed data
from the 1990 through 1995 database of actuarial information available
from the Schedule B of the Forms 5500 filed for those plan years. The 1996
data is not yet available for analysis. In looking at all of this data,
Mr. Hinz emphasized that this is beginning of the plan year information.
Thus, the most recent year included in his information would include
December 1, 1995. With the majority of plans having calendar year ends,
most of the data would be as of January 1, 1995. All plans filing Form
5500 were included. 10 percent of small plans filing Form 5500 C/R were
also included.
The database was edited to take out forms that were
missing material data or had internally inconsistent data. The data was
not adjusted for keypunch errors. These were assumed to be offsetting, but
the assumption was not tested. The data was not adjusted for changes in
the methods of valuing plan assets or actuarial estimates.
The most significant consideration when attempting to
draw any conclusions from the data is to recognize that the Schedule B
changed in 1995 in response to a change in the law. Also, 25 percent of
the 1994 Schedule B’s are missing from the database.The decision was
made to test the plan’s funding ratio rather than dollars, as that was
concluded to present a better tool for measuring across plans of varying
sizes. Mr. Hinz described how that concept is constructed. It is the ratio
of the plan’s current assets divided by the plan’s liabilities.
Current assets are the reported investments at the beginning of the plan
year plus earnings and contributions, less any expenses and distributions.
The liabilities are the current liabilities reported on the Schedule B
including new accruals and adjustments for changes in interest rate
assumptions.From this background the analysis demonstrated the following
patterns:
Total assets in defined benefit plans increased about
15 percent from 1990 to 1995
Plan liabilities increased substantially over the same
period.
The aggregate funding ratio decreased from 1.35 in 1990
to 1.19 in 1996.
Funding for plans when separated between single
employer and multi-employer showed the same pattern, though the
multi-employer plans had lower funding ratios overall.
The same pattern is reflected when the data is analyzed
by industry with the exception of the retail industry whose mean funded
status appears to have increased substantially for 1995 and 1996, though
the median stays within the pattern of the group.
When analyzed by the plan size, plans with fewer than
100 participants have improved their funding position relative to 1994,
but it is still lower than 1990. Larger plans show a consistent decrease
in the mean funding ratio. As in the industry analysis for retail, when
looking at median ratios the apparent improvement disappears and the small
employer group shows a consistent pattern of declining ratios, along with
larger employers.
To provide further information about what was happening
with these plans, Mr. Hinz and his staff looked at the pattern of behavior
of certain key components of a plan’s funding ratio.The rate of return
over this period was fairly dynamic, ranging from something less than 5
percent in 1990 and 1994 to around 20 percent in 1991 and 1995 with a
geometric means of roughly 10.6 percent.
Employer contributions were steadily increasing over
this period.
Expenses and other cash flows were both positive and
negative for this time frame. The positive side includes additions to plan
assets from consolidations and other transfers.
Benefit payments also consistently increased over the
period and were nearly 3 times the level of contributions.
The conclusion is that net cash flows without earnings
are negative for every year during this period. When earnings are added,
net cash flows were negative for 1990 and 1994 and positive in 1991
through 1993 and 1995. For this purpose, unrealized appreciation or
depreciation in asset values is included in cash earnings.
During this same period the median interest rate
assumptions declined from 8 percent to 7.4 percent. This increases the
liability for future benefits. Total liabilities rose from just over $700
billion to just approximately $1,100 billion.
Other issues to be taken into account is reviewing this
information include:
For all plans the ratio of retired participants to
active participants is increasing from 28 percent to 35 percent for all
plans. (This is 28 retired employees for every 100 active participants.)
The number of plans that are 100 percent funded or 150
percent funded are declining from 83 to 65 percent and 36 to 15 percent,
respectively.
Of the plans that are more than 100 percent funded, the
number of sponsors making a contribution for the plan year is declining.
During the question and answer part of his testimony,
the following additional points came to light:
The analysis does not take into account any amendments
that might have been made to the well funded plans that increased
liabilities.
Some feeling for the size of the surplus and how that
has been changing was requested.
Also, data was requested regarding the asset allocation
of plan’s with a surplus.The data does not readily highlight the impact
of plan mergers.
WORKING GROUP
May 5, 1999
RON GEBHARDTSBAUER, American Academy of Actuaries,
(Summary prepared by Janie Greenwood Harris)
Mr. Gebhardtsbauer’s testimony covered the advantages
and disadvantages of giving employers access to pension plan surplus. One
advantage discussed was that of reward and risk. The sponsor of a defined
benefit plan bears the risk of investment returns. If the plan experiences
poor returns, the employer has to fund the loss. If the returns are great
the plan becomes overfunded and the only reward to the employer is a
funding holiday. The employer would have to terminate the plan to access
the surplus. Since the employer bears the risk of investment return, the
reward to it should be commensurate with the risk taken. Mr.
Gebhardtsbauer thinks that plans would be better funded if employers knew
that surplus could be reached later and would also discourage plan
termination as a means of access. He also thinks that the ability to use
plan surplus will strengthen the employer who has a few bad years.The
disadvantage of taking money out of a plan is that the security of the
employees benefits will be affected, particularly in the case of weak
companies. A second disadvantage is that the PBGC would be concerned
because the company could have bad experiences and terminate, causing the
PBGC to pay benefits.
Mr. Gebhardtsbauer suggested three approaches that
could be used to determine the threshold for accessing plan surplus: 1)
termination liability; 2) current liability; and 3) actuarial liability.
He discussed the differences between the three approaches and the problems
with each: termination liability goes up and down; current liability
excludes certain benefits and the retirement assumption used for
determining actuarial liability are not very good. He pointed out that in
some situations current liability is less than termination liability and
could result in a shortage at termination. Mr. Gebhardtsbauer suggested
that the Council might consider recommending a margin and possibly
different margins for different plans.
In closing, Mr. Gebhardtsbauer pointed out that the
employers are using their surplus and avoiding the 50 percent or 20
percent excise tax by acquiring a company with an underfunded plan and
funding that plan with the surplus. While this helps the employees of the
underfunded plan, the funds do not benefit the employees for whom the
funds were originally intended.
WORKING GROUP MEETING
June 8, 1999
JOHN M. VINE, Attorney Covington and Burling, (Summary
prepared by Judith Ann Calder)
A. ERISA’S FIDUCIARY STANDARDS 1) General
requirements
-Plan assets must be held for
the exclusive purposes of providing benefits to plan
participants and beneficiaries and defraying reasonable
plan administration expenses.
-Transfer of plan assets to a
party in interest, such as the employer, may also be a prohibited
transaction.
2) Key exceptions
-After the termination of a
pension, and after all the plan’s liabilities to participants and
beneficiaries have been
satisfied, residual assets may be distributed to the employer if the
plan so provides and if the
distribution does not violate any law. (Residual assets
attributable to employee
contributions must be distributed to participants and their
beneficiaries, and plan
provisions calling for a reversion must be adopted at least five
years before the plan’s
termination.)
B. INTERNAL REVENUE CODE’S APPLICABILITY 1) Key
restrictions
-Before all of the plan’s
liabilities have been satisfied, plan assets may be used only for the
exclusive benefit of employees or their
beneficiaries.
-Pension plans, under Treasury
Department regulations, may not provide benefits not
customarily included in a
pension plan, e.g., layoff benefits or sickness, accident, and
medical benefits (except as permitted by IRC Section
401(h)). 2) Tax consequences
-A reversion may be included in
the employer’s gross income and subject to income tax.
-A reversion may also be
subject to an excise tax as high as 50%, but can be reduced to
20% if the plan transfers 25%
of the surplus to a qualified replacement plan or if 20% or
the surplus is used to increase
the benefits of the participants in the plan before it is
terminated.C.OTHER ERISA AND
INTERNAL REVENUE CODE CONSIDERATIONS
1) ERISA and IRC regulations do not prevent surplus
assets from being used for a number of purposes; they do not prevent
employers from:
Merging a strongly funded pension plan with a less
well-funded pension plan.
In connection with a sale, spin-off, or other
disposition, spinning off all or part of the plan’s surplus assets and
transferring them to the buyer’s plan.Amending a strongly funded plan to
provide benefits to employees who had not previously participated in the
plan.
Amending a strongly funded plan to provide enhanced
pension benefits to a subclass of the plan’s current participants (e.g.,
the employer’s executives) as long as the plan complies with the Code’s
nondiscrimination rules.Amending the plan to add disability and incidental
death benefits.
Amending the plan to provide layoff and plant closing
benefits as long as the benefits are offered in the form of a Social
Security supplement or a life annuity.
Amending the plan to provide early retirement window
benefits that are available to employees who retire within a designated
window period and execute a release in favor of the employer.
Amending the plan to increase pension benefits while
reducing other important benefits, such as health care or savings plan
benefits.
Terminating a plan and recovering, after taxes, all or
part of the plan’s surplus assets.2) Internal Revenue Code Section
401(h) allows pension plans to provide medical benefits only if the plan
meets certain requirements, most significantly.
The benefits are provided through a separate account.
The employer’s contributions to the account do not
exceed 25% of the total contributions to the plan (other than the
contributions to fund past service costs) after the 401(h) account is
established.
NOTE: These restrictions indicate that only new
contributions--not existing plan assets can be used to fund a 401(h)
account.
D. INTERNAL REVENUE CODE SECTION 420 adopted by
Congress in 1990; currently scheduled to expire in 2000; recently
reapproved by the Senate Finance Committee to run through Sept. 30, 2009)
1) Key Benefits
Permits surplus assets to be transferred to a 401(h)
account to pay for current retiree medical costs. However, it does not
allow for advance funding of retiree health liabilities.
Permits excess pension assets to be used productively,
since it allows pension assets to be used for current retiree health care
expenses.
Raises federal tax revenues, since it relieves
employers of the need to make tax-deductible payments for retiree health
benefits.
2) Requirements for making a 420 transfer
Transferred amount may not exceed the excess of the
value of the plan’s assets over the greater of the plan’s termination
liability or 125% of the plan’s current liability.Transferred amount may
not exceed the amount reasonably estimated to be what the 401(h) account
will pay out during the year to provide current health benefits on behalf
of retired employees who are also entitled to pension benefits under the
plan. Key employees are not included.
The pension plan must provide that the accrued pension
benefits must become nonforfeitable for any participant or beneficiary
under the plan as well as for any participant who separated from service
during the year preceding the transfer.
The employer must maintain the same level of retiree
health benefits during the five years following the transfer.
The plan administrator must notify each participant and
beneficiary, as well as the Labor Department and any plan participants
union, or each amount to be transferred.
NOTE: The Senate Finance Committee recently voted to
extend Section 420 and to replace the benefit-maintenance requirement with
a pre-1994 cost-maintenance provision requiring the employer to maintain
the same retiree health costs for the five years following the 420
transfer.
V. FUTURE ISSUES
A strong case can be made that surplus pension assets
should be available to provide other types of retirement benefits for
pension plan participants (e.g., allocations to a defined contribution
plan). This would make surplus assets use consistent with the purpose
underlying the pension assets original accumulation: to provide retirement
benefits to participants and beneficiaries.
Existing barriers between defined benefit and defined
contributions plans deny employers the flexibility to use accumulated
pension assets efficiently to provide benefits that employees desire and
employers want to provide. Permitting surplus pension assets to be
transferred to a defined contribution plan for those employees who
participate in both plans could help to break down those barriers and to
make more efficient use of assets.
WORKING GROUP
June 8, 1999
KENNETH W. PORTER, Chief Actuary and Manager, DuPont
Finance, (Summary prepared by Rose Mary Abelson)
Good afternoon! My name is Ken Porter. I am Chief
Actuary at The DuPont Company. I wish to express my appreciation for the
opportunity to meet with you today and share some of our experiences
regarding the use of Section 420 of the Internal Revenue Code.
Background
(Exhibit 1) DuPont has financed a portion of its share
of retiree health costs for seven of the ten years for which such
financing has been permissible. This includes an asset transfer scheduled
for later this month with respect to 1999 retiree health costs. In those
seven years, DuPont will have financed nearly $1.6 billion of its retiree
health costs this way. During this same period, DuPont has granted a
number of open-window-type retirement programs that have also utilized a
significant amount of surplus pension assets. Nevertheless on an ERISA
funding basis our principal retirement plan is still more than 50%
overfunded.
As a result of our Section 420 transfers, DuPont will
have cumulatively contributed about half a billion dollars in additional
Federal revenue. For 1999 alone, DuPont is expected to contribute nearly
$100 million in additional Federal revenue through this means.
Let me put this in perspective. A few weeks ago the
Senate Committee on Finance considered a proposal to extend Section 420
through the year 2009. The Committee mark scored this extension at $136
million over the first four years of that extension ($348 million for the
remaining five years). Assuming DuPont is able to continue making Section
420 transfers, our contribution to Federal revenue would more than triple
the Senate Finance mark for that period.
During the mid-1970's DuPont embarked on an aggressive
funding program designed to fully fund its principal U.S. pension plan.
The resulting large asset base was ripe for the huge returns of the early
1980's. That plan became fully funded by 1984, and DuPont has not made
contributions for any subsequent year. The surplus quickly became
sufficient to not only cover all future normal costs of the pension plan,
but for comparison it was also sufficient to cover all our projected
future retiree medical costs. Since then, asset growth has materially
outpaced the growth in plan liabilities.
As a publicly traded company, DuPont has a fiduciary
responsibility to its owners. We have been entrusted with the owner’s
assets with the expectation that we will allocate our resources
efficiently and appropriately to provide for all of our corporate
obligations. We pay taxes, and invest in research, plants, properties,
employees, the community, the environment and a host of other business
needs. Balance is important. To the extent one area gets out of balance,
we have an obligation to our owners to rectify that situation. As we
attempt to properly allocate corporate resources, pension funding presents
a particular challenge.If a pension plan is underfunded, the plan sponsor
can make additional contributions. If it is grossly underfunded, the plan
sponsor must make more significant contributions. If the plan is modestly
overfunded, the sponsor can simply suspend contributions to rectify that
situation. If, however, the plan is significantly overfunded, a simple
suspension of contributions may be inadequate to bring the plan into
balance. In that event, there is no way to directly rectify a grossly
overfunded situation under ERISA. In this respect, the law is not
balanced.
Certainly, plans can use surplus assets to finance
enhanced pension benefits, as we have on several occasions. But this only
makes sense if there is a business need to do so. From a stockholder
perspective, the SEC requires (through GAAP accounting standards
promulgated by the FASB) that corporate earnings reflect the benefits
actually promised in the plan document. Thus, a unilateral increase in
benefit levels necessarily results in a dilution of reported earnings,
even when surplus pension assets are used to finance those benefits.
Accordingly, business competitiveness issues, not pension asset values,
dictate when and whether benefits levels are changed.
As mentioned above, our funded status became excessive
in the mid-1980's. At that time some of us at DuPontbecame concerned about
the potential of what we referred to as runaway assets. That is, a surplus
that could grow in perpetuity. Effective for 1990, Section 420 was enacted
to allow transfers of surplus assets each year to finance that year’s
retiree health costs. This change in law eased our situation somewhat. As
illustrated above, however, we have suspended contributions for 15 years,
enhanced pension benefits, and made Section 420 transfers. Nevertheless,
our surplus has continued to grow.Demographics Considerations
The subject of overfunding is only part of our story.
Plan design and participant demographics are also important. DuPont
maintains a single, final pay-related defined benefit pension plan that
covers essentially all parent-company employees throughout the United
States. The same formulas that apply to senior management also apply to
our workers at the plants, including both represented and non-represented
employees. Our first final-pay pension plan was adopted in 1904, and
actuarially based funding of that plan commenced in 1919. We are proud of
our long history of providing quality retirement benefits with sound
funding.
As you might expect from this lengthy history, retired
and terminated employee liabilities now dominate our pension plan. As you
are aware, the monthly pension for retired participants is no longer
subject to pay increases or future service accruals. By contrast, the
smaller portion of our liability that is attributable to active employees
does grow with future accruals. Our active participants, however, tend to
be longer-service employees with, on average, fewer than ten years
remaining to reach eligibility for an unreduced pension (generally age 58
in this plan). Thus, taken as a percent of total plan assets, the expected
future accruals for active participants is fairly small. That is,
relatively little of the surplus assets can be expected to be used to
finance future accruals under the plan. Let me show you the numbers.
(Exhibit 2) Barely 30% of our pension liability is
attributable to active participants. When measured on a going-concern
ERISA funding basis, this represents about 20% of plan assets. In
addition, only about 45% of our assets are needed to cover our inactive
liability. Thus, on a funding basis, only about 65% of plan assets are
needed to cover the accrued liability of the plan. Because our plan is a
final salary-related plan, the ERISA funding valuation includes the
effects of assumed future salary increases for active employees. Thus,
even fewer assets are needed to cover the value of benefits accrued to
date. Importantly, as measured for funding purposes the surplus assets in
this plan are nearly four times the present value of future normal cost.
Stated differently, more than 25% of our assets are
redundant to all current and future accruals under the plan. If the fund
earns 9% per year, the surplus is expected to grow in perpetuity even with
annual Section 402 transfers.
Even the ERISA funding basis, however, can be viewed as
somewhat conservative. A 60-year history of investment results suggests a
middle-of-the-road investment return assumption in excess of 10% over the
very long term. For comparison, our pension trust has earned a compound
annual rate of return in excess of 12% since the early 1980's. Thus, the
plan remains robustly funded.
Section 420 Measurement Requirements
In spite of this, Section 420 requires us to calculate
liabilities as if we could earn rates only 10% above those offered for
30-year Treasury Bonds. And then we must gross up those liabilities by
25%. As shown earlier, however, 70% of our pension plan liability relates
to pensioners and survivors, while 30% of our liability relates to active
employees. The ultimate question is whether the 25% gross-up is
appropriate for the plan as a whole. We believe these requirements provide
more than sufficient safeguards with respect to the DuPont plan.
We will start with a review of retiree liability. Taken
in isolation, the 25% gross up is not necessary. There are no future
accruals for these participants, so the monthly income related to this
liability is essentially fixed. By definition, the current liability for
this group (as defined in ERISA) equals the present value of all future
benefits. The only actuarial risks, therefore, are mortality and
investment return. There is, however, little reason to suspect major
volatility in our mortality experience. Accordingly, the only meaningful
risk is investment return. If investment return is the only meaningful
variable for inactive participants, the requirement to use rates only 10%
above the risk-free investment return assumptions is sufficiently
conservative for the retired liability. The additional requirement to
gross up the resulting liability by 25% can only be justified in the
broader context of the total plan, but has no theoretical basis when
viewed solely by the context of the inactive liability. This will be
demonstrated on the next exhibit.
(Exhibit 3) On a stand-alone basis for the retired
liability, it is possible to quantify the extent by which the 25% gross up
redundantly overcompensates against investment risk. For a pensioner age
65, 125% of the current liability produces the same value as would be
determined using only a 4% discount rate! This is nearly 2 percentage
points BELOW the riskless 30-year Treasury bond rate and 75 basis points
lower than the current 6-month T-bill rate. The situation gets worse for a
75 year-old pensioner. Here, 125% of the current liability is equivalent
to valuing the liability at only about 3%. When looking in isolation at
the retired population of any plan, it is difficult to justify using
implicit rates that are substantively below what the U.S. Government is
willing to pay for funds.
The active employee liability, however, does present a
different picture. Some commentators have discussed the need to protect
against a variety of plan types and circumstances. In contrast to the
retired liability, where the flat 25% gross-up is redundant, the same
gross up for the active liability may or may not be appropriate, depending
on plan design and employee demographics. It is my understanding that some
concerns have been raised with respect to flat-dollar-type plans and plans
with relatively young employee populations. Neither of those two issues
exist in the DuPont plan. As mentioned above, we have a final pay plan
where the typical employee is within 10 years of full retirement
eligibility.
Because, as illustrated above, a 25% gross up is
theoretically unnecessary for the retired liability, and because the
retired liability accounts for 70% of our total liability, it is clear
that when applied in the aggregate the current 25% gross up requirement
substantially protects all plan participants against any reasonable risk.
Historically, lawmakers have not been eager to enact
laws that reflect real-world differences among plans--including
demographics, plan provisions and funding policies. As a result, there is
sometimes a tendency to design laws to protect the public against the most
egregious situations. In addition, because the focus is frequently on
active liabilities, the substantive impact of inactive liabilities is not
always given proper consideration. We believe public policy should provide
rules that equitably protect plan participants while recognizing that
those rules impact different plans in disparate ways. For large, mature,
final pay pension plans like the DuPont plan, the current protection in
Section 420 are already more than adequate.
WORKING GROUP
June 8, 1999
DAVID CERTNER, Senior Coordinator, Economics Team,
Federal Affairs Department, American Association of Retired Persons,
(Summary prepared by Michael Stapley)
Mr. Certner testified regarding the use of surplus
pension assets for the purpose of funding post-retirement medical
obligations or for any other purpose other than to pay pensions. He stated
that the basic position of AARP was that using pension funds for any other
purpose than the payment of current and future pension benefits was not a
good idea.
As a part of his testimony, Mr. Certner reviewed the
history of pension funding beginning with 1983 guidelines from the DOL,
PBGC, and IRS which broke with past history in permitting pension plan
reversions. He indicated that up until that time money was considered to
be held in trust to pay pension benefits. Reversions began to be more
common place in the 1980's. He indicated a number of legislative efforts
to halt this practice, including the 10 percent excise tax in 1986. He
reviewed several failed efforts for greater curbs in the next few years
which culminated in restricted legislation adopted in 1990. Mr. Certner
summarized information relating to pension reversions during the 1980s
indicating that over 2,000 plans terminated affecting over 2 million
participants with reversions in excess of $20 billion dollars.
Mr. Certner then reviewed the 1990 legislation which
restricted pension reversions. He indicated that the legislation provided
for increased excise taxes to 50 percent (or 20 percent under certain
circumstances). This was coupled with provisions for limited retiree
health benefit transfers. He indicated that the inclusion of language
which allowed limited retiree health benefit transfers was a compromise,
and the reversions were the main concern of the legislation. Reversion
opponents did not favor transfers but compromised in the end in order to
get legislation passed that would provide some restriction. The
compromised legislation resulted in section 420. It included tough strings
on retiree health transfers.
Mr. Certner then reviewed 1995 legislative activity in
both the House and Senate indicating that a Senate Finance Committee
proposal was overwhelmingly rejected (94-5) by the full Senate and that a
House provision was ultimately dropped in conference.
Mr. Certner then reviewed the basis for AARP’s
opposition to using pension funds for any purpose other than funding
pension benefits. He indicated that funds were put into a pension trust
for the exclusive benefit of participants and that trust funds were to be
used to ensure payment of current and future pension benefits. He stated
very strongly that funds should not be put at risk; that to do so was bad
public policy because there would be a temptation to skim off excess funds
in good times risking short falls in bad times. He indicated that changes
in the economy, interest rates or market returns can quickly impact the
pension funds ability to pay benefits and that the strong market we have
experienced the last few years should not cause people to think that
surplus pension assets might not be needed in the future. He further
indicated that putting funds at risk puts the PBGC and individuals at risk
because PBGC does not cover all plan benefits. The failure of pension
plans can result in plan participants receiving lesser benefits in the
future. He also indicated that reducing plan funding reduces the
opportunity for benefit improvements which he felt were consistent with
retirement plan goals and purposes. Benefit improvements might include
providing ad hoc COLAs and the improvement of other plan benefits,
including early retirement, enhanced benefit formulas, etc.Mr. Certner
also indicated that reducing plan funding is bad savings policy because
pensions are the largest source of personal savings and capital in the
country and that consuming pension assets exacerbates the problem with the
national savings rate. He also indicated that reducing plan funding
circumvents pension tax policy because the tax incentives provided for
pension funding are for pension income and retirement; that diverting
money to other uses converts plans into a more general corporate checking
account allowing tax deductions for benefits that otherwise may not be tax
preferred.
Mr. Certner then spoke specifically to the current 420
provisions indicating that retiree health is an important retirement
benefit and one that AARP is concerned about. He indicated that the
current limited transfer provisions has not threatened the pension system,
but it should not be expanded. He emphasized that it is important to
maintain a cushion to ensure the ability to pay projected benefits and
that it is important to have maintenance in benefit provisions to ensure
protection to retiree health benefits in the future. While opposing any
expansion, Mr. Certner indicated that AARP had not taken a position with
respect to the specific extension of Section 420. He also indicated the
importance of the defined benefit system in guaranteeing a safe retirement
for American workers, but indicated that from AARP’s perspective they
did not favor one form of retirement program over another and that AARP
generally sought to improve upon the benefits and adequacy of the pension
system under both DB and DC plans.WORKING GROUP
June 8, 1999
MORTON BAHR, President, Communications Workers of
America, (Summary prepared by Michael J. Gulotta)
Mr. Bahr indicated his pleasure to testify on
retirement plan benefits on behalf of the Communications Workers of
America which represent 630,000 workers nationwide.
"Defined benefit plans are the foundation of
security for retired workers," said Mr. Bahr. He went on to add that
retiree health care coverage was a critical element of retirement income
and that policies to strengthen commitments and funding for retiree health
care was in workers’ best interests. Making use of surplus pension plan
assets to secure retiree health benefits is a laudable goal in the CWA’s
opinion.Mr. Bahr argued that pension plans were established to pay
benefits to plan participants and that funds should be used solely to
secure dignity in retirement.
He indicated that the major telecommunications
companies with which the CWA deals have pension plans with assets of
approximately $190 billion and that assets were 40% more than the
liabilities of these pension plans.
Mr. Bahr indicated that high levels of funded status
have not resulted in any appreciable increase in pension benefits and that
bargaining over retirement benefits has been contentious. He further
commented that while certain corporations were prefunding retiree health
benefits, the liabilities for the benefits were significantly in excess of
assets.
Mr. Bahr expressed the view that a continuation of the
practice of pension asset transfers is supported by the CWA. In fact, he
went on to say that "it is time to forcefully encourage employers to
guarantee health coverage to their retirees and to enable those employers
who have excess assets in their pension funds to utilize the assets to
secure that guarantee". In permitting the use of excess assets, he
cited two key principles which must be adhered to. First, there must be a
pension plan asset cushion and while the current level of a 25% cushion
has served a good purpose, a slightly lower one might be acceptable.
Second, the surplus assets must be put aside in a trust to fund retiree
health coverage.
Mr. Bahr indicated that "policy should allow the
pension asset transfer to fully fund the retiree health benefit
obligations for current retirees and active employees". This policy
would amend current policy which permits the use of excess pension assets,
but only to finance current year’s retiree health costs.WORKING GROUP
July 13, 1999
David Smith, AFL-CIO, Director of Public Policy,
American Federation of Labor-Congress of Industrial Organizations (Summary
prepared by Janie Greenwood Harris)
Mr. Smith began his testimony by providing the Council
background on trade unionists and retirement issues. Almost 80% of trade
unionists are covered by a retirement plan. A majority are in a defined
benefit plan which in conjunction with social security will constitute
their primary source of retirement income. Union plans make up about half
of all workers who are represented by defined benefit plans and their
accounts represent over half of all assets in defined benefit plans.
It is his opinion that defined benefit plans, on top of
social security, are the best and most appropriate way to provide
retirement security for the following reasons:
a) they provide defined, predictable
benefits for life
b) they place investment risk and
management with employers and professional asset managers
c) they provide a collective savings
mechanism and appropriate risk spreading
d) they are protected by the PBGC
Mr. Smith stated that almost 40% of union retirees are
covered by retiree health care while only one in five other retirees are
protected. With this background, the AFL-CIO is very concerned about the
inappropriate use of surplus pension assets. Retirement plan assets
represent deferred compensation and belong to the workers. This principle
underlies any discussion of the use of plan assets.
The Revlon and Pacific Lumber plans were cited as two
examples of the undermining of retirement security for workers in the
'80s. The plans were terminated and the funds invested in an insurance
company that failed. Thousands of workers' promise of retirement security
was never realized. He cautioned against opening the door to a repeat of
that experience.
Mr. Smith stated that the AFL-CIO clearly supports the
provisions of IRC 420. The way in which the use of plan surpluses is
constrained by 420 and the confinement of the utilization is appropriate.
He emphasized their position that the surpluses of defined benefit plans
should only be used to provide retirement health security for current
retirees and active employees.
Between 1991 and 1998, the number of large employers
providing health care coverage to retirees declined by 13 percent. Between
1960 and 1996, personal health care expenditures rose by over 10 percent
and now make up almost 12 percent of GDP. The pressure on firms providing
retiree health care coverage will get worse. Section 420 will become even
more important. Mr. Smith reiterated that the AFL-CIO's support of the
continuation of 420 is not unconditional. The law represents a careful
balance between health coverage for retirees and the security of the
assets that represent future retirement resources for today's workers. Any
proposals to change the existing provisions would be met with great
suspicion and concern.
During the question and answer session, Mr. Smith was
asked whether he thought prefunding of retiree health benefits could have
prevented the erosion in retiree health coverage. It was his opinion that
if pre-funding had been accomplished with the same safeguards as contained
in 420, the downside would have been very low.
Mr. Smith indicated that he is uncomfortable endorsing
the wholesale transfer of pension surplus. Health care is a special case.
The use of surpluses for other purposes would need to be vigorously
analyzed and should meet a strict test for actually enhancing retirement
security.
WORKING GROUP
July 13, 1999
Mark J. Ugoretz, President, ERISA Industry Committee
(Summary prepared by Michael J. Gulotta)
Mr. Ugoretz made three basic points in his testimony.
His first point was that retirement security interests of workers make the
promotion of voluntary defined benefit plans imperative and that such
plans have also been the basis of increasing health security in
retirement. Secondly, he pointed out that retirement security cannot be
complete without postretirement health security. Lastly, he indicated that
extending the ability to transfer excess pension plan assets pursuant to
Section 420 of the Internal Revenue Code promotes defined benefit plans
and retiree health benefit security.
Expanding on his position supportive of encouraging
defined benefit plans, Mr. Ugoretz indicated that Federal law should
encourage strong funding of defined benefit plans. He went on to testify
that if rigid and irrational legal restrictions trap surplus assets in the
defined benefit plan and prevent such assets from being used for other
retirement security purposes, then employers will be unwilling to adopt or
maintain plans. In addition, strong funding of plans would be discouraged
and benefit security would suffer.
In implementing IRC Section 420, Mr. Ugoretz said
Congress recognized that the use of surplus pension assets was appropriate
because such use was consistent with the retirement security objectives of
a defined benefit plan, consistent with the purposes for which such assets
were accumulated and consistent with the needs of employees for retiree
benefit security.
He argued that the reasons for enacting 420 are no less
compelling today than they were when 420 was enacted. Finally, Mr. Ugoretz
noted that alternative uses of surplus pension assets had been identified
by ERIC but that the industry group had not reached any conclusions yet on
the desirability of such alternatives.
WORKING GROUP
July 13, 1999
Michael J. Harrison, Human Resources Vice President for
Compensations & Benefits, Lucent Technologies (Summary prepared by
Neil Grossman)
Mr. Harrison discussed the historical use of Internal
Revenue Code section 420 by Lucent Technologies (Lucent), a former
subsidiary of AT&T and now an independent company with about 280,000
past and current employees covered by defined benefit plans in the United
States. Today, these plans have a surplus of approximately $14 billion,
while the company’s retiree medical obligations are underfunded by $4.7
billion.Code Section 420 authorizes certain transfers of excess pension
assets to pay for retiree medical benefits. Lucent has made no Section 420
transfers since its divestiture from AT&T in 1996. However, AT&T
used section 420 while Lucent was still a subsidiary and Lucent plans to
do so in the future.
Lucent considers section 420 transfers to be
advantageous to both the company and plan participants. The company’s
cash flow improves, because it does not have to pay retiree medical
expenses out of current cash. Participants benefit because Lucent is less
likely to cut back retiree medical coverage or require greater
contributions from retirees, significant issues for the company’s
unions. Participants also become vested in their pensions as a result of
the transfers.Lucent believes adequate excess assets should remain in
pension plans after section 420 transfers to maintain the security of
participants retirement income and assure no more than negligible risks to
PBGC. The present 125% of current liability cushion is appropriate,
according to Mr. Harrison; but he suggests the real focus should be on the
probability of meeting benefit commitments in future years. He noted that
AT&T sought to retain pension assets sufficient to produce at least a
90% probability of 100% funding after 5 years and a 75% probability of
100% funding after 10 years. For Lucent, this approach yields results
close to the present 125% cushion.
Lucent favors expanding the uses of surplus pension
assets beyond paying for retiree medical coverage, so long as these uses
benefit plan participants. One example cited by Mr. Harrison: using
surplus to make matching contributions under section 401(k) plans, perhaps
coupled with faster vesting of plan accounts. Another: using surplus to
fund pensions in excess of qualified plan limits, which would give
corporate executives a bigger stake in the qualified plan. Both of these
options raise tax revenues and have cash flow advantages for companies.
WORKING GROUP
July 13, 1999
Cheryl Harwick, Tax Counsel, Marathon Oil, Subsidiary
of USX Corporation (Summary prepared by J. Kenneth Blackwell)
Marathon Oil Company completed its first IRC Section
420 transfer in 1991 (relating to 1990 retiree medical expenses). The
second transfer occurred later that year relating to 1991 retiree medical
expenses, and there has been a Section 420 transfer each year since.
Transfer amounts range from approximately $9.9 million to 14.3 million,
and the total of transfers to date is approximately $101.5 million.
It is Marathon's opinion that Section 420 transfers
have worked very well for both the Company and the Retirement Plan
participants. From the Company's perspective, it has been able to derive
some additional value from an underutilized asset. From the participant's
perspective there have been several positives: 1) the cost maintenance or
benefit maintenance standard provides participants with a level of
security related to their retiree medical benefits; 2) approximately 5,000
"premium payers" shared in a direct benefit of cost savings of
approximately $650,000 during a 3-month premium holiday needed to comply
with the cost maintenance standard; 3) participants with relatively short
service enjoy full vesting in the Retirement Plan at the time of a
transfer, even if they have not completed the 5 years of service normally
required for vesting; and 4) the notice requirements provide an additional
reminder of the value of the participant's retirement benefit. Marathon is
in favor of the legislative proposal to revert to the cost maintenance
standard, and believes that the bright line or certainty that it provides
is better for all concerned. Marathon believes that the other Section 420
safeguards, including the funding cushion, provide adequate security and
remain appropriate.
Marathon noted that the Retirement Plan ratio (assets
divided by current liabilities) has grown since the first Section 420
transfer occurred in 1991--a function of good investment strategy. It
believes that a distinction should be made between plans with
"some" surplus assets and plans with such a large surplus that
under any realistic forecast the surplus will never be fully used for
pension benefits, even taking into account Section 420 transfers. Marathon
believes that the Retirement Plan falls into the latter category.
Marathon believes that it is essential that employers
be permitted responsible access to surplus pension assets, and that
providing access, with safeguards, will benefit plan participants as well
as employers. Marathon would like to see Section 420, with minor
modifications, continue well into the future, and believes that the law
should permit certain other acceptable uses of surplus pension assets.
Marathon suggests that it is appropriate to use surplus assets to provide
other types of benefits to active or retired participants in the pension
plan (contributions to a defined contribution plan, welfare benefits,
tuition reimbursement, employer FICA tax obligations, etc.). Currently,
Marathon is actively seeking legislation that would permit transfers of
surplus assets to a qualified defined contribution plan (sometimes
referred to as the "414(v) proposal"). This use of surplus
assets is consistent with the purpose behind the establishment of the
Retirement Plan, i.e. providing retirement benefits to participants and
beneficiaries. The proposal establishes a new IRC Section 414(v) that
contemplates annual transfers under rules similar to the current IRC
Section 420 transfers, including a commitment that the defined
contribution plan will maintain the same level of contributions for a
minimum of five years. Assets could only be transferred for allocation to
accounts of participants who also participate in the plan containing the
surplus assets. Section 414(v) would exist in addition to IRC Section 420,
and not as an alternative to it. Either or both transfers could be made in
a given year.
WORKING GROUP
July 13, 1999
Howard E. Winklevoss, President and CEO, Winklevoss
Consultants, Inc. (Summary prepared by Richard Tani)
Notable Quotes
"I have to applaud the people who formulated that
420 proposal. It's pretty thoughtful in my view."
"I would like to have it on the record that I feel
very comfortable about 420 transfers up to the current retiree
liability." (one year's costs)
"I'd feel a little more comfortable with
135%." (minimum liability funded ratio) if plans transferred more
than one year's retiree medical costs.
"By and large, corporate America is reasonably
conservative with regard to their pension plans. I have not experienced
situations where the corporation wanted to abuse the pension plan in any
way."
Mr. Winklevoss analyzed the funded status of pension
plans by doing stochastic projections. Under a stochastic projection,
inflation and investment return are random events following statistical
patterns.
The correction between stocks and bonds was 60%.
(Editor's note: These assumptions seem reasonable over long periods of
time, but the past may not be a good prediction of the future).
Under the stochastic projections, 2000 samples were
taken and Mr. Winklevoss presented the results after 5 years and 10 years.
The funded status represents the ratio of market value
of assets to current liability, where market value of assets to current
liability is the value of benefits earned using a discount rate equal to a
4 year weighted average of 30 years Treasury Bill rates. Mr. Winklevoss
felt that current liability is conservative (a high measure of the
liability) based on a reasonable expectation of investment return.
However, termination liability measured by the PBGC would produce higher
liabilities.
The projections included employer contributions when
required based on minimum funding rules. He noted that in the worst case
scenarios where the funded status dropped below 90%, the law requires
additional contributions, which in some cases might exceed 30% of covered
payroll, a very high amount.
In the case where assets were stripped down to 125% of
current liability, the chart above shows (by interpolating) that there is
about a 20% probability that assets will drop to below 100% in 5 years,
and a 40% probability that assets will drop below 100% in 10 years.
In the case where assets were stripped down to 150% of
current liability, the probabilities that assets drop below 100% are about
10% in 5 years and 30% in 10 years.
Mr. Winklevoss noted that, as long as the sponsoring
company was healthy, funded ratios below 100% were not a major concern,
because over time the funded status would improve as a result of
additional funding. However, there is a positive correlation between
bankruptcies and falling markets.
Mr. Winklevoss' bottom line was that the current 420
rules were fine, since under these rules only a few plans would be
stripped down to 125%. If more assets were allowed to be transferred (e.g.
total future liability of retiree medical benefits for current retirees),
he felt more comfortable with a 135% minimum funded status, since more
plans might be brought down to the minimum.
WORKING GROUP MEETING
September 8, 1999
Earl Pomeroy, Congressman (Summary prepared by Michael
J. Stapley)
Congressman Pomeroy expressed appreciation for the
ERISA Advisory Committee. He indicated it was reassuring to know that
somewhere in this town [Washington, D.C.] there are dedicated, smart
people with appropriate backgrounds that are considering important
questions relative to employee benefits. Congressman Pomeroy then outlined
the following two issues that might be considered for future study by the
ERISA Advisory Council.
A review of FASB Accounting Principle [106] which
requires surplus to be reported as earnings.
Whether or not the congressional efforts to stop
pension plan reversions should be extended to nonprofit entities.
The Congressman then shared several different pieces of
information with respect to defined contribution plans raising questions
with respect to their adequacy in securing retirement for Americans.
Specific questions raised included:
Participation rates. He expressed concern that
participation rates were low and that the amount of money being paid was
not adequate to guarantee a secure retirement.
Investment choices. He raised concerns that employees
were too conservative in their investment choices and that greater
participation in equity markets would help guarantee a better retirement.
Leakage. He indicated that 55% of workers who received
a lump sum distribution did not roll over any of it into a qualified plan.
47% of all 401(k) plans have less than $10,000; 70% have less than
$30,000. He indicated these levels of savings were not sufficient to
provide retirement income security.
Speaking directly to the issue of surplus pension
assets and securing post-retirement medical benefits, Congressman Pomeroy
raised the following four questions:
Who owns surplus assets in the pension fund?
Are the solvency thresholds in existing 420 adequate to
insure the solvency of the defined benefit plan?
Should the legislation be maintained as it is presently
which requires maintenance of benefits when transfers are made or should
maintenance of cost provision be adopted?
Should 420 be expanded to allow surplus funds to
prefund post-retirement medical obligations?
Mr. Pomeroy then indicated that the first priority
should be to "conclusively and positively guarantee the solvency of
the defined benefit". Second, should be the prudent enhancement of
the defined benefit from surplus funds, and third, would be the
enhancement of collateral benefits to employees such as post-retirement
medical. He indicated this would include the current provisions of Section
420 and the maintenance of benefit requirement. Mr. Pomeroy indicated he
felt that replacing the maintenance of benefit requirement with
maintenance of cost would not be appropriate.
Finally, Congressman Pomeroy indicated that he had not
come to a conclusion with respect to the prefunding of post-retirement
medical benefits through an expanded Section 420. He did indicate that
prefunding was a legitimate, important strategy for employers to meet the
increasing of their retiree health benefits. At that point he then
concluded his comments and considered questions from the Working Group.
WORKING GROUP MEETING
September 8, 1999
Irwin Tepper, President, Irwin Tepper Associates, Inc.
(Summary prepared by Richard Tani)
Notable Quotes
"We conclude that by the time you get to 135%
(funded ratio), most of the risk of unfunded current liability over 5
years gets reduced. If you raise the threshold to 145% you've done about
as much as you can to reduce the risk."
"The funding rules are very good. They seem to
work pretty darn well."
Mr. Tepper analyzed the funded status of pension plans
by doing stochastic projections very similar to Howard Winklevoss (see
July 13, 199 testimony). His asset assumptions were a little different
from Winklevoss'.
His methodology was slightly different also, in that he
assumed that assets were taken down to the threshold level in any year
that assets exceeded that level and he looked at the probability that the
funded status would drop below certain levels in any year during the
projection (Winklevoss brought assets down to the threshold level only in
the first year and looked at the funded status at the end of the
projection period).
Because of his methodology assumptions, his
probabilities are slightly higher than Winklevoss (numbers in parenthesis
above).
Mr. Tepper said in his analysis, contribution levels
remained manageable, even under the worst scenarios. He noted that in a
typical plan, liabilities will grow about 13% per year (less benefit
payments) which is about 6% for benefit accrual and 7% for discounting
(interest). This does not take into account fluctuations due to changing
interest rates. Therefore, a 25% surplus could be wiped out in 2 years if
assets did not grow. (In practice, assets do earn a return, and more
contributions make up any short falls if assets do not perform as
expected).
Tepper notes (same as Winklevoss) that a funded status
below 100% was not a significant concern if the sponsoring corporation was
healthy. Over time, contributions will bring the plan to a surplus
position again. However, he did not feel that the law should take into
account the financial condition of the company, since it would add too
much complexity.
Tepper also explained that having a heavier retiree mix
in the population reduces the volatility of the liability to interest rate
fluctuations. Again, he said that to incorporate any rules relating to
retiree mix would be too complicated and not workable.
Tepper's conclusion was that a threshold of 145% funded
status was conservative, and 135% was adequate to remove most of the risk
of future unfunded liabilities over time frames up to 5 years.
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