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Pension Pain: The Other Social Insurance Crisis

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Tags Big GovernmentLegal SystemU.S. EconomyInterventionismMonopoly and CompetitionProduction Theory

06/17/2004Carl F. Horowitz

Private pensions in this country date back more than 100 years, that is to say, to a time when most people didn't live long enough to collect them. Nowadays Americans take living comfortably to 75 and beyond to be an entitlement. Not that longevity in itself is something to complain about, but it does have a few downsides—like a gradually sinking pension system.   

Pension Benefit Guaranty Corporation (PBGC) is a federal agency whose responsibility is to protect current and future retirees—as of now about 44 million—in the event of a meltdown of their employer-sponsored pension plan. The Washington, D.C.-based entity was chartered as part of the Employee Retirement Income Security Act of 1974 (ERISA).  

Congress intended PBGC to insure traditional, or "defined-benefit," plans. Under such a plan, an employer or employee representative (e.g., labor union) makes periodic contributions to an investment fund whose managers promise to pay all participating workers their vested benefits upon retirement or departure. The worker's benefit level is determined by a formula based on earnings and length of service. Benefits are paid as a monthly stream of income, known as an "annuity," or as a lump sum.

It's a fact of life that pension funds can and do fail. Indeed, the collapse of Studebaker a decade earlier, more than any one event, led to the ERISA law. When that auto manufacturer shut down its assembly plant in South Bend, Ind. in 1964, only 3,600 of 10,500 workers and retirees—those aged 60 or older who had put in at least 10 years of service—received their promised benefits. Some 4,000 others, aged 40–59, received only 15 percent, while 2,900 remaining persons under age 40, got nothing. In creating PBGC, lawmakers were confident that no employee would ever get burned like this again. As the law stipulated that a pension plan's assets must be sufficient to cover liabilities, intervention by the corporation would be a last resort.

Looking Great on Paper

Pension Benefit Guaranty Corp., on paper anyway, is a purely self-financing edifice with sturdy firewalls against failure. As an insurance agency, it derives much of its income through premiums—around $800 million annually in recent years. It also invests in financial markets, especially fixed-income funds, and the result has been the buildup of a trust fund now worth $35 billion. PBGC receives no tax dollars and is not backed by the full faith and credit of the U.S. government. There also is an adjustable per-worker ceiling on claims payouts. The maximum guaranteed annual pension at age 65 for participants in plans terminating in 2003 was $43,977, lower for those who retire earlier or elect to receive survivor benefits. Certain early retirement subsidies and benefit increases made within the most recent five-year period may not be fully guaranteed.

Perhaps the most important safeguard of all is that PBGC does not step in whenever an employer pulls the plug on a sound plan. The vast majority of defined-benefit plan terminations are precautionary measures rather than reactions to actual or pending bankruptcies. In such instances—and there have been more than 160,000 of them since ERISA's passage—assets are sufficient to cover accrued liabilities.

It's when plans are chronically and severely troubled that PBGC enters the picture. When an employer goes bankrupt or otherwise cannot make good on its pension promises, the agency takes over the plan, in some cases going to court to get a termination order. At that point, PBGC covers all outstanding pension liabilities, provided the employer meets at least one of four ERISA-defined distress tests.

Two examples of a PBGC takeover, both from this March, illustrate the extent to which pension funds often fall short of delivering on their promises. The Columbus, Ga.-based Johnston Industries, a maker of household and industrial fabrics, had two plans collectively funded at only 40 percent, with $23 million in assets covering $58 million in promised benefits (i.e., liabilities). And Top-Flite Golf Co., a Chickopee, Mass.-based manufacturer of golf balls, was only a little better off, with $26 million in assets covering $56 million in liabilities.

The 800-member staff of Pension Benefit Guaranty Corp. is finding itself busy these days handling such hard cases. In 2003 the agency reimbursed plans to the tune of $2.5 billion, a figure representing roughly 1 million workers and retirees in about 3,200 terminated defined-benefit plans. Agency officials expect claims payments to rise to $3 billion this year. Granted, that's still a small portion of the total $1.5 trillion worth of liabilities that PBGC currently insures, but the real story is that many plans not taken over (yet) are dangerously, and deceptively, underfunded. And because of that, a sharp economic downturn could be a calamity, not simply a problem.

Insured single-company plans by the end of 2003 had amassed a cumulative deficit of about $350 billion, down somewhat from the $400 billion figure from a year earlier, but still way up from the $50 billion-to-$100 billion range of the 90s. PBGC, for its part, seems less than prepared to handle a deluge of fund collapses. During FY 2002 the agency's balance sheet went from a $7.7 billion surplus to a $3.6 billion deficit, a loss of $11.3 billion, more than five times larger than any previous one-year loss. The deficit since has slid further (as of March 31, 2004) to $9.7 billion.

Sources of System Instability

There are four key explanations as to why a seemingly healthy insurance system suddenly has entered such precarious straits.    

First, during the 1980s employers began to discard the defined-benefit in favor of the "defined-contribution" approach, prime examples of the latter being 401(k), 403(b) and Keogh plans. Under a defined-contribution plan, the participating employee, within prescribed employer-sponsored limits (and occasionally with matching employer contributions), makes the decisions as to where and how much to invest retirement funds. The employee, by virtue of this, bears all the risks. These plans exist outside the federal pension insurance system.

The switch was an adaptation to some emerging realities: 1) contributions to defined-contribution plans are tax-deductible; 2) the long-stagnant stock market had begun a long swing upward starting in 1982; and 3) the habit of lifelong loyalty to a single company was yielding to a view of career planning that allowed for, and to an extent encouraged, changing jobs several times, and with it a greater incentive to insist on plan portability.

Labor Department data reveal the extent to which defined-benefit plans have fallen out of favor. Whereas 39 percent of all U.S. workers in 1980 were covered by a traditional plan, this figure less than two decades later had dropped to 22 percent—and a good two-thirds of the latter had consisted of defined-benefit/defined-contribution hybrid plans. The shift in the share of defined-contribution participants was nearly the reverse, rising from 8 percent to 27 percent. (A little over half of all workers in either case lacked any retirement plan).

From its 1985 peak of 114,400, the number of defined-benefit plans in force has shrunk to its current level of around 31,000. One result of all these terminations has been PBGC's loss of potential income from premiums. Another consequence is a "creaming" effect. Because companies voluntarily leaving the system tend to be the most solvent, the ones remaining are those posing the greatest risks.   

A second reason for underfunding has been the double-whammy in the stock and bond markets for much of this decade. A sharp decline in stock prices during 2000–02 diminished the assets of company pensions and the PBGC alike. Over the course of the 1980s, according to Ibbotson Associates, annual real equity returns averaged 11.9 percent, rising to 14.8 percent during the 90s.

By contrast, during the 2000s (through August 2003) equities incurred an annual average loss of 10.8 percent. Meanwhile, low bond interest rates inadvertently have raised funding requirements. In a pension plan, liabilities are calculated by adding up the value of promised future benefits and then discounting that sum to obtain a present value. For years, plan sponsors reluctantly have had their liabilities tied to 30-year U.S. Treasury bonds, which offer interest rates about as low as possible. Using these rates as the basis for a formula inadvertently had inflated liabilities, thus heightening the appearance of plan underfunding and triggering higher funding requirements. That the government stopped issuing new 30-year Treasuries in 2001 only added to the demand for those remaining in circulation, further driving up prices and driving down interest rates.

Third, the ERISA law enables companies with chronically underfunded plans to receive an implicit subsidy from companies with sound plans. When a company gives employees a pay raise, it pays for the raise immediately. But when the company hikes the employees' pension, it can defer the cost for up to 30 years. Deferral is an especially attractive strategy for companies short on assets—in other words, for the ones that aren't doing well in the first place. Since PBGC is legally obligated to make timely payments on all promised benefits, this increases the pressure to raise premiums on everyone else.

And annual premiums have gone up. In the original legislation Congress set the rate at a mere $1 per worker, so as to encourage maximum participation. Lawmakers in 1987 raised that to $19, adding a variable-rate premium of 0.9 percent of a plan's underfunded sum to be measured on a "current-liability" rather than a "termination" basis.

A highly unsound plan can avoid this surcharge by showing (in most cases) that it is 90 percent or more fully funded on a current-liability basis. That's why Bethlehem Steel, whose $3.9 billion claim was the largest in PBGC history, paid no variable-rate premiums in the five years prior to termination (the firm declared bankruptcy in October 2001). In its last filing prior to termination, the company was 84 percent-funded on a current liability basis, but only 45 percent-funded on a termination basis.

It is little surprise, then, that many companies with sound pension plans, already paying higher premiums because of the bad apples in the system, are either freezing or terminating their plans. Why contribute to them when severely underfunded plan operators can get away with paying the same premium? The situation is analogous to one in which safe drivers, already resentful over having to pay higher premiums to cover claims created by accident-prone drivers, discover that the high-risk drivers pay no more!

Fourth and finally, organized labor has exerted a major influence in getting private-sector employers (though not to the extent that they've corralled employers in the public sector) to retain pensions and raise contributions. According to the U.S. Bureau of Labor Statistics' National Compensation Survey, 74 percent of all unionized private-sector workers in 2003 participated in a defined-benefit plan, as opposed to 15 percent of their nonunion counterparts.

This huge difference is no coincidence. Labor officials generally disdain defined-contribution plans as an attempt by employers to weasel out of their commitments, shifting risks to individual workers. The AFL-CIO's Web site describes defined-benefit plans as "real pensions." The problem is that union intransigence has created some real problems. The pension woes at the Big Three automakers, for example, can be traced back to the United Auto Workers' success a few decades ago in winning ample pension concessions, and fending off company efforts to curb such spending.

The legacy of such union activism is being felt today. Last October GM announced it had diverted an extra $13.5 billion toward its employee pension funds, with another $6 billion likely soon to follow. Maintaining high-cost pension plans show up in production costs, and ultimately showroom sticker prices. A recent article in the Detroit Free Press reported that pension, retiree health and other benefits cumulatively account, on average, for $1,360 of every GM vehicle rolling off the assembly line. The respective figures for Ford and Chrysler are $734 and $631. By contrast, the per-vehicle benefit cost for Honda and Toyota vehicles assembled at U.S. plants amount to a scant $107 and $180, respectively.

As much as private-sector unions have an inherently adversarial relationship with employers, both have been partners in pushing pension liabilities as far into the future as possible. This is especially true for employers faced with the unpleasant choice of downsizing or bankruptcy. On the asset side as well, unions often stand with management. They view stocks as better investments than bonds, as stocks over the long run are likely to produce larger returns. The downside, as the unions and everyone else discovered during the two and a half years starting in March 2000, is that the stock market is an escalator that can go down—way down—as well as up.

Remedial Action: Symbol or Substance? 

PBGC officials are the first to admit to the system's structural flaws. The agency's then-executive director, Steven A. Kandarian, offered the following summary in prepared testimony before the U.S. Senate Special Committee on Aging in October 2003:

Pension insurance creates moral hazard, tempting management and labor at financially troubled companies to make promises that they cannot or will not fund. . . . In exchange for smaller wage increases today, companies often offer more generous pension benefits tomorrow, knowing that if the company fails the plan will be handed over to PBGC. These companies are using their pension plans to unfairly shift their labor costs to responsible companies and their workers. At some point, these financially strong companies may exit the defined benefit system, leaving only those companies that pose the greatest risk of claims.

To set PBGC on the right track, Congress recently passed temporary two-year legislation, the Pension Funding Equity Act, which President Bush signed into law this April. The law's key feature, worth about $80 billion, would switch the basis for calculating pension plan liabilities from ostensibly risk-free, 30-year Treasury bonds to long-term, high-yield corporate bonds. Employers, seeking to reduce levels of mandatory contributions, had been clamoring for this. Call it what one will, but this provision is a loan by any other name. Employers, in effect, will be borrowing from their pensioners. And in the event their pension plans default, taxpayers ultimately will be liable.

The law also provides $1.6 billion in special relief to the airline and steel sectors by waiving special funding requirements normally imposed upon troubled pension plans. These two industries accounted for nearly three-fourths of the dollar value of all claims paid out during FY 1975–2002. Early in the 90s PBGC found itself having to manage the pension plans of the bankrupt Eastern and Pan American Airlines, with respective liabilities of $600 million and $800 million. Those sums seem modest in comparison to the plan liabilities PBGC has inherited from steel-industry bankruptcies:  National Steel ($1.3 billion), LTV Steel ($1.9 billion), and Bethlehem Steel ($3.9 billion). One dreads what would happen if the auto manufacturers went this route.

Many companies, seeking to avoid having to freeze or terminate their defined-benefit pensions, have converted them to "cash-balance" plans. While formally a defined-benefit plan, and thus eligible for PBGC insurance, a cash-balance plan is a hybrid, and functions much like a 401(k). Each worker is given a portable account credited with a percentage of pay, with interest buildup, each year. When the employee retires or leaves the company, he gets the accumulated balance, usually in the form of a lump sum.

Dozens of Fortune 500 companies have adopted this type of arrangement. At present, cash-balance plans account for 25 percent of all participants in defined-benefit plans, and 40 percent of all defined-benefit-held assets. But this option is in real jeopardy due to union opposition and especially a misguided court decision last summer. In Cooper et al. vs. IBM, a federal judge (Southern District of Illinois) ruled that IBM's cash-balance funding plan illegally discriminated against older employees. The company is appealing the decision. Should it lose, the shift by U.S. companies toward 401(k) plans almost without question will be that much more pronounced.

Transforming the Pension System

Attacking the competence or integrity of Pension Benefit Guaranty Corp. misses the larger point, as does denouncing the new pension law as "corporate welfare."  PBGC is trying to cope with a broad mandate set forth by Congress 30 years ago with consequences few could foresee at the time.

The root of the problem is the inherent unsoundness of State-granted guarantees to firms (and unions) against market failure. Protecting workers from a pension meltdown seems a stabilizing and decent thing to do. But in retrospect, it is clear that "stability" has been achieved by inviting the likelihood of a far greater crisis down the road. By substituting a government guarantee for a market test of profit and loss, the PBGC created a moral hazard that ended up subsidizing instability and today threatens to impose huge costs on taxpayers.

Congress, under the new two-year law, is required to study the nature and extent of pension underfunding. Under pressure to maintain the solvency of the system, the final report may recommend several courses of action: better measurement of liabilities, improvement of information availability, and revision of actuarial assumptions about mortality and retirement. Though welcome, such measures would avoid addressing the urgency of transforming the federal pension insurance system into one in which risk and reward are in sync. In the end, only full privatization of PBGC, thus putting the corporation on the same footing as other insurers, can do that. The program would then need to take its own shape according to the dictates of the market.

Such action hardly could be more imperative in an era when people retire earlier and live longer. PBGC data show that American men who retired during the period 1950–55 could expect to collect their pension for 11.5 years; for men who left the work force during 1995–2000, the figure had lengthened to 18.1 years. The strains on the nation's entire elderly-support system, not simply on traditional pensions, have grown enormous. Back in 1935, when Social Security was established, U.S. life expectancy, though already having risen substantially, was roughly 65 (even less for men).

Life expectancy today is about 80 for women and 75 for men, one result of which has been a declining ratio of active workers to beneficiaries. Most current workers sense, properly, that Social Security checks alone won't ensure a comfortable retirement. The program provided persons retiring in 2003 at age 65 with an average benefit level of 41.3 percent of immediate pre-retirement earnings. This "replacement rate," as it is known, dropped to only 38.5 percent after factoring in payment of Medicare Part B premiums.

Convincing young workers to support a population of retirees steadily growing proportionally as well as numerically is a tough political sell. Labor Department data for defined-benefit pension plans show that the ratio of contributors to recipients, which had exceeded 3 to 1 in 1980, now stands even at 1 to 1, and will dip even lower over the next several years.

Even if Congress, the administration and new PBGC Executive Director Bradley Belt can resolve this dilemma, they will be faced with another reality: Social Security, Medicare and other retirement-support programs collectively now account for about 40 percent of the federal budget, up from 30 percent in 1980. This proportion should rise further, thanks to the Medicare drug-prescription "reform" package passed by Congress and signed by President Bush last fall, which the White House admits will raise the program's total cost by an additional $534 billion over the next 10 years.

In light of the Census Bureau's projection that the number of Americans aged 65 and over will nearly double between now and 2030, we may wind up like Europe and Japan sooner than we think.


Image source: commons.wikimedia.org


Crenshaw, Albert B. "A System Going Under?" Washington Post, October 19, 2003.

Crenshaw, Albert B. "The Retirement-Funding Debate." Washington Post. October 19, 2003.

Edmister, Robert O. Financial Institutions:  Markets and Management. New York:  McGraw-Hill, 1980, pp. 171–87.

Kandarian, Steven A., PBGC Executive Director, testimony before the Special Committee on Aging. U.S. Senate, October 14, 2003.

Lindeman, David C. "Underfunding and Bankruptcy:  Pensions' Plagues and the PBGC." The American Enterprise March/April 1993, Vol. 4, No. 2, pp. 72–80.

Munnell, Alicia H. "Future Retirees at Risk." The American Prospect. May 2004, pp. 54–56.

Salisbury, Dallas and Nora Jones, eds., Retirement in the 21st Century:  Ready or Not. Washington, D.C.:  Employee Benefit Research Institute, 1994.

U.S. General Accounting Office, Pension Plans:  Hidden Liabilities Increase Claims Against Government Insurance Program. GAO/HRD-93-7, Washington, D.C.:  U.S. General Accounting Office, December 1992.

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