Operating a pension protection fund - the US experience

When a plan is terminated and taken over by the PBGC, all additional benefit accruals, vesting and other regular plan obligations come to an end. The PBGC will then pay benefits according to the documentation of the pension plan concerned, subject to the maximum guarantee (see below).

The system ensures that there is no interruption to current pension payments, with pensioners being given estimated benefit payments while their plan is examined. Payments of these estimated benefits may occasionally result in over- or underpayments. In the case of underpayments the PBGC will reimburse pensioners with interest. In the case of overpayments pensioners must reimburse the PBGC, but without interest, and any resulting reduction is usually limited to 10% of each future monthly benefit payment.

If a PBGC-insured multi-employer plan is unable to pay guaranteed benefits when due, the PBGC will provide the pension plan with a loan to enable the payments to continue.

The pension guarantee

There is a statutory limit on the pension entitlement that can be guaranteed by the PBGC.

In the case of the singe-employer program, the limit is adjusted annually for new terminations, but remains unchanged for any particular plan once it has been set on its termination. For existing pensioners, the age used to determine the maximum guarantee is their age as at the date of plan termination. For non-pensioner members, the maximum guarantee depends on their age when they retire.

For plans terminating in 2003, the maximum guarantee is $43,977.24 pa in the case of a single non-pensioner member aged 65. This maximum is reduced for pensions coming into payment to members under 65, so that for a member aged 55, the maximum guarantee is $19,789.80 pa.

There is also an adjustment when a survivor's pension is to be payable, which reflects both the cost of the additional survivor's benefit and the difference in ages between the two partners. For example, if a pension is to become payable to a member aged 65 and a 50% survivor's pension is to become payable on the member's death to a spouse who is currently aged 60, the maximum pension for the member of $43,977.24 would be reduced to $37,600.56 pa.

Benefit increases and new benefits are not fully covered by the PBGC's guarantee if they have been awarded less than five years before the plan's termination. In such cases, the PBGC will guarantee up to a maximum of (a) 20% of the increase for each whole year since the benefit increase was awarded, and (b) $360 pa. Benefit increases awarded less than one year before the plan's termination are not generally guaranteed. Benefit increases awarded more than five years before the plan's termination are guaranteed up the maximum total amount.

There are circumstances where pensioners can actually receive more than the maximum guaranteed benefit. Such circumstances might include a situation where a plan has sufficient assets to pay non-guaranteed benefits when funds are recovered in excess of those needed to pay guaranteed benefits.

Before a multi-employer plan can receive financial assistance from the PBGC, it must suspend payment of all benefits in excess of the guaranteed level. The PBGC guarantees a portion of the accrued pension up to a maximum of $429 for each year of credited service.

Premiums

Insurance premiums are paid to the PBGC by about 32,500 pension plans and premium revenue totalled about $812 million in 2002. In the case of the multi-employer program, each multi-employer plan pays the PBGC an annual insurance premium currently set at $2.60 per participant.

All single-employer pension plans pay a basic flat-rate premium of $19 per participant a year. In addition, these pension plans are required to pay an additional variable-rate charge of $9 per $1,000 of unfunded vested benefits.

When originally established in 1974 only a basic flat-rate premium was charged (initially set at $1 per participant!). By 1988, the rate was $16 per participant. Because of the growing concern that good employers were subsidising the reckless, the variable-rate premium was introduced for underfunded schemes at that time. The sum of the basic flat-rate and variable premium was initially capped in 1988 at $50 per participant. The cap was gradually raised until legislation enacted in 1994 phased it out altogether. The PBGC comments that the effect of the cap weakened the financial incentive on the most seriously underfunded plans to fund their pension plans properly. By that time, although plans whose premiums were limited by the cap accounted for 80% of all the underfunding in the single-employer program, they were the source of just 25% of the PBGC's premium revenues.

Raising the interest rate

The calculation of the variable-rate premiums depends on the setting of a suitable interest rate to discount the plan liabilities - the higher the interest rate set, the lower the premiums companies have to pay. This interest rate was increased from 80% to 85% of the yield on 30-year Treasury securities in July 1997. This rate was further temporarily increased to 100% for plan years beginning in 2002 and 2003 as a result of the Job Creation and Worker Assistance Act of 2002. The interest is to remain permanently at this rate once the Secretary to the Treasury agrees a new mortality table to calculate plan liabilities.

The PBGC also points out that asset valuations will change at the same time to a "fair market value" basis and comments that this is likely further to decrease the variable-rate premium revenues it receives. In a more recent development, the Portman-Carter Bill, currently before the US Congress, will further cut the PBGC's revenues if it is adopted, by switching the interest rate used from that applicable to 30-year Treasury bonds to the rate achieved by corporate bonds. The rate for corporate bonds is higher because of their inherent greater risk.

Strong incentive

Companies will certainly seek to avoid the liability to pay the uncapped variable premium that becomes payable if there are unfunded vested benefits. For example, the equity research department of financial firm Raymond James published a research note on 14 November 2002 on the Ford Motor Company following a conference call given by the automaker to analysts. At that time Ford was projecting its UK pension plan would end the year underfunded to the tune of $6.2 billion.

The analysts commented: "From a practical standpoint, Ford plans to make at least the minimum contributions required under ERISA standards and to avoid paying higher insurance premiums to PBGC . . . Under ERISA, Ford expects to make required cumulative contributions of between $1.1 billion and $1.2 billion between 2002 and 2007. To avoid PBGC penalty premiums during that same time frame, Ford would need to contribute between $1.6 billion and $3.6 billion."

Compliance evaluation

The PBGC runs a pension compliance evaluation program to help ensure that pension plans pay the appropriate level of premium. The system works on a self-assessment basis, whereby each individual scheme calculates its own premium and supplies the PBGC with the information on which it is based. In general, the PBGC accepts this information without further verification. However, it selects some plan "filings" for additional review either randomly, or as a result of an electronic data screening process that can identify errors in the premium calculation or any anomalies in the data.

The PBGC will normally send the plan administrator a letter of inquiry to resolve any query. If there is prima facie evidence of non-compliance, the PBGC has power to conduct limited reviews and on-site evaluations. Its draft findings are then normally discussed with the administrator before a determination is issued. The plan administrator then has 30 days to submit a request for reconsideration. If this happens the matter is decided by a senior PBGC official.

All unpaid premium amounts are subject to a late payment interest charge. Also a monthly penalty rate set at 5% of the outstanding unpaid premium can be levied; but the total penalty paid cannot exceed the amount of the unpaid premium.

Early warning program

The PBGC operates an "early warning program", which in its own words "allows PBGC to prevent losses before they occur, rather than waiting to pick up the pieces when a company goes bankrupt and its financial resources are limited". In its Technical Update 00-3, issued in July 2000, the PBGC explained the circumstances in which it may contact companies, the transactions likely to cause it concern, the situations in which it may seek protection for the pension insurance program and the types of protection it may seek.

The PBGC gathers intelligence on companies in order to identify potential commercial transactions that could jeopardise its insurance services. To do so, it uses financial information services and news databases, as well as relying on information sharing between the Department of Labor, the Internal Revenue Service and the Securities and Exchange Commission. Once the PBGC has identified a potential transaction that could jeopardise the stability of its insurance program, it will meet with the company to negotiate any additional contributions or security that it feels is needed because of the proposed transaction.

Transactions that cause the PBGC concern include the break-up of a controlled company group, a transfer of significantly underfunded pension liabilities in connection with a business sale, or a leveraged buy-out. All these can substantially weaken the financial support of pension plans.

2002 - a challenging year

The PBGC's single-employer insurance program swung from a $7.73-billion surplus in 2001 to a $3.64-billion deficit in 2002. That $11.37-billion net loss is the biggest in the PBGC's 28-year history. In the Federal agency's 2002 annual report, executive director Steven A. Kandarian spoke of the opening years of the 21st century as possibly being the most challenging in the PBGC's history and paid tribute to its staff, who coped with an "unprecedented flood of terminating plans". During the fiscal year 2002, the PBGC absorbed a $1.85-billion loss from the underfunded pension plans of the LTV steel industry group, its largest pension plan termination ever. All told, the steel industry accounted for $7.57 billion of the $9.31 billion in losses from completed and probable pension plan terminations.

Kandarian added: "On the bright side, even though our single-employer deficit totalled about $3.6 billion at fiscal year-end, we recorded a small investment gain, and we still have on hand more than $25.4 billion of assets to meet our benefit obligations." The table summarises PBGC's financial and operational position over the past two years.

Source: Pension Benefit Guaranty Corporation 2002 annual report.

Learning from PBGC's experience

The Pension Protection Fund to be set up in the UK bears many similarities to the present day PBGC. What lessons can we in the UK learn from studying the PBGC and its history? Tim Keogh, European Partner at Mercer Human Resource Consulting comments:

"The strength of PBGC is that . . . it has provided an effective safety net for US pension fund members. Its weakness is that it has been used as a mechanism for companies in weak industries to divest themselves of liabilities at the expense of strong companies, steel and airlines having been notable examples. The Pension Protection Fund is exposed to the same risks unless it adopts a robust approach to setting its levies, and there are other safeguards to avoid liability dumping."