Pension Reform: Defined Benefit Plans - What's Wrong? What Needs Fixing?

Citing a February 2006 report by Charles Morris, of The Century Foundation, "The first realization that [Defined Benefit plan] pension promises were not ironclad may have come when the Studebaker Co. folded in 1963 and defaulted on its pension obligations. Congress eventually responded with the Employee Retirement Income Security Act (ERISA) of 1974. ERISA established financing and accounting standards for defined benefit pensions and created the federal Pension Benefit Guarantee Corporation (PBGC) to insure private defined benefit pension commitments."

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Under ERISA, rather than having to fund current pension benefit payments out of current cash flow, companies having a Defined Benefit plan are required to set aside invested assets to fund their future pension liabilities. Morris' report continues: "If the actuarially determined present value of pension liabilities exceeds that of pension fund assets, the shortfall is subtracted from the company's net worth as if it were a debt... As of mid-2005, private companies have amassed $1.8 trillion in assets to support their defined benefit pension obligations, against future liabilities valued at about $2.2 trillion [a projected $700 billion shortfall]...During the 1990s market boom, stock returns were so high that many plans became over-funded, and pension funds actually became an important driver of company earnings. When the markets reversed after 2000, pension fund underperformance hammered plan profits, at the same time as falling operating earnings reduced companies' ability to increase plan contributions. Just as important...the steady fall in interest rates after 2001 greatly ratcheted up the book value of future pension liabilities."

To shed some light on the magnitude of this problem and how it has grown, lets turn the clock back approximately eighteen months. In August of 2004, Rep. John Boehner, chairman of the House Education & the Workforce Committee, released the following statement:

"The recent decision by United Airlines to suspend contributions to its under-funded pension plan, at least in the interim during bankruptcy proceedings, is another very visible symptom of a broken defined benefit pension system that needs significant reform. It's an issue Washington cannot afford to ignore. The retirement security of millions of American workers - and the interest of millions of American taxpayers - is at stake.

The Pension Benefit Guaranty Corporation (PBGC), which assumes responsibility for and guarantees retirement benefits should a company falter, is concerned about the pensions of United's workers and retirees - and rightly so. Unfortunately, it's become an all too familiar problem. In recent years, the PBGC has become liable for hundreds of pension plans and accumulated an $11.2 billion deficit. Although the agency has enough resources to pay benefits in the near future, the possibility of a taxpayer bailout of the PBGC could be necessary if the financial condition of the agency continues to deteriorate."

Now to understand how the problem has grown, lets fast-forward to Charles Morris' report: "...Analysts at Credit Suisse/First Boston (CSFB) recently published a list of twenty major companies with pension liabilities that equal or exceed the company's market value; the list includes Delta Airlines (which has since declared bankruptcy), with pension obligations 13 times higher than its market value; General Motors, 4.7 times higher; Ford, 2.7 times higher; Lucent, 1.9 times higher; and U.S. Steel, 1.4 times higher. Mounting deficits at the PBGC are creating the potential for a federal bailout on the scale of the 1980s Savings and Loan crisis...More likely, companies will accelerate the process of extracting themselves from their pension obligations. One path is the strategic bankruptcy. Shedding pension obligations has become practically a standardized financial engineering tool in the hands of private equity buyout managers - in steel companies, auto parts companies, and more recently, a string of airline bankruptcies. Collectively, it appears that United, Delta, and Northwestern airlines, and the auto parts maker Delphi will be relieved of some $32 billion in pension liabilities through the bankruptcy process. The last four companies on that list have not yet officially requested a PBGC takeover, but that seems inevitable."

It doesn't take a "rocket scientist" to see how bad things are for these plans. But trust this, it will take more than a few of them to solve this problem and don't count on it going away on its own. So much for Defined Benefit plans.