Will the Bough Break?

The agency that insures pensions is being battered by bankruptcies

Like a boxer who keeps landing punch after punch, a series of big corporate bankruptcies is pounding the quasi-governmental agency that insures the pensions of 44 million Americans. In just one year, the blows have turned a $7.7 billion surplus in the Pension Benefit Guaranty Corp.'s main insurance program into a $3.6 billion deficit.

The steel industry threw the first one, as $7.1 billion in claims landed in the PBGC's lap in 2002 after the failures of LTV, National Steel, and Bethlehem Steel. Now, airline reorganizations are pummeling the agency. On Apr. 1, the PBGC, which insures old-fashioned "defined benefit" plans that pay retirees a pension based on their years of service, took over the pilots' plan at US Airways Group Inc. That added $600 million in claims. Next could be United Airlines Inc., which filed for Chapter 11 in December and has $6.4 billion in unfunded pension obligations that management wants to unload. "It's very unlikely United will emerge from bankruptcy without having the [pension] programs terminated," says Mark Oline, managing director at Fitch Ratings.

The situation looks bleak as far as the eye can see. In all, the PBGC estimates that it could be on the hook for $35 billion more in claims, about half from airlines and steelmakers. Already, debate is raging over whether some employers should pay higher premiums to the PBGC and whether the agency should require companies to fund their plans at higher levels. "We expect that our deficit may increase dramatically," PBGC Executive Director Steven A. Kandarian told the Senate Finance Committee in mid-March.

No retired steelworkers or airline pilots are in immediate danger of seeing their checks cut off -- though some are getting much less than their companies' plans promised because PBGC benefits are capped at $43,977 a year, and less for those under 65. With more than $25 billion in assets and $800 million in annual premium income, the agency has enough cash to keep paying benefits for years. But that could change if its liabilities mushroom fast. "One big bankruptcy could wipe out [the PBGC's] positive cash flow quickly," warns Zvi Bodie, a finance professor at Boston University School of Management.

The PBGC, founded in 1975, has hit rough patches before, but today's troubles are of a different magnitude. The agency estimates that corporate pension underfunding now exceeds $300 billion. The previous high-water mark, in 1993, was $109 billion. Offenders are typically Old Economy companies that, unlike high-tech outfits, offer generous pensions and may have far more retirees than workers. General Motors Corp. ended 2002 with a $19.3 billion shortfall in its pension fund. And Ford Motor Co.'s plan went from a $600 million surplus to a $7.3 billion deficit in the past year alone. Factor out some of the optimism built into pension-funding assumptions and the true gap for Corporate America could be much greater, some experts say. Ronald J. Ryan, president of bond-market research firm Ryan Labs Inc., pegs it at more than $500 billion. "Companies have a pension problem that's beyond belief," says Ryan.

The mess companies are in is partly of their own making. Even though pension liabilities are akin to bonds -- essentially promises to pay a set amount at a future date -- employers have invested roughly 60% of plan assets in stocks and 40% in bonds. That mix fattened returns during the stock-market boom but wreaked havoc once the double whammy of falling stock prices and unusually low interest rates set in. Pension-accounting rules that rely on the interest rate of the 30-year Treasury bond to compute liabilities made matters worse: The lower the rate, the larger the liability, and the 30-year rate has been especially depressed since the Treasury Dept. stopped issuing long bonds in 2001. The upshot: In the past three years, pension assets have fallen 19.3%, while liabilities have soared 48.5%, according to Ryan.

Employer groups, eager to avoid higher premiums, contend that the problem will ease as stocks and interest rates rebound. "There is no crisis," says Janice M. Gregory, vice-president of the ERISA Industry Committee, which lobbies on pension issues for big companies. "It's a situation that requires monitoring but not action at this time."

The PBGC doesn't agree. It figures it will need 12 years' worth of premiums just to cover claims from 2002. And the agency's premium base is shrinking as employers drop traditional plans in favor of employee-directed 401(k)s. Even though the system isn't in acute danger, "there are structural problems that need to be addressed," says the PBGC'S Kandarian.

To tackle them, Kandarian is considering reforms. The most controversial is a radical shift in the way premiums are calculated. The PBGC has always levied a flat annual fee on most companies. Since 1991, that has been $19 per person covered. But Kandarian is mulling a change based on two elements of risk: a company's credit rating and the asset mix in its pension plan. A PBGC study of its 27 largest claims found that nearly 90% came from companies that had junk-bond ratings on their debt for a decade before the agency had to take over their plans. And heavier investments in equities over bonds introduces more volatility into plan returns, says Boston University's Bodie. "Premiums ought to be based on the mismatch [between assets and liabilities] as well as the strength of the sponsor," Bodie says.

Kandarian also wants to require underfunded companies to add cash to their plans. Under current law, a company can boost benefits without additional funding as long as its plan is at least 60% funded. Kandarian wants to raise that threshold, though he hasn't said to what level. And he would partly close the loophole that allows companies with shortfalls in their plans to avoid adding cash if they contributed more than the minimum required in past years.

Such steps require congressional approval and are likely to meet stiff resistance from business. Just complying with the current rules is forcing many companies to divert cash into their pension funds. Switching to risk-adjusted premiums "would hit the companies that can least afford it," says Mark Beilke, director of employee benefits at consultant Milliman USA.

Employers want Treasury to switch the benchmark for calculating pension liabilities from the 30-year bond to a blend of corporate-bond indexes. That rate would be higher, which would shrink liabilities -- and funding requirements. Business also wants Congress to repeal the cap on tax-deductible contributions so companies can stash away more in good times. "It's a perverse system that says you can't save when you're flush but you must save when things are tight," says John C. Scott, director of retirement policy for the American Benefits Council.

Such changes might work, but it could take years for Congress to pass them. That might be too late. True, the PBGC is solvent now. But no one expected bankruptcies to drain more than $11 billion in a single year, either.

By Amy Borrus, with Mike McNamee, in Washington, and David Henry in New York

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