The Protection of Pension Benefits: The UK and US Pension Benefit Insurers

Ron GebhardtsbauerAmerican Academy of Actuaries

John TurnerAARP Public Policy Institute

10th International Pension SeminarTokyo, November 22, 2005

The Pension Protection Fund

• Started in April 2005 in the United Kingdom• Provides a major improvement in retirement

income security for pension participants and beneficiaries

• The bankruptcy of a firm will no longer cause a middle- or lower-income participant in a defined benefit pension scheme who is near retirement or who is retired to lose a substantial portion of their retirement benefits. Higher-income participants may still be affected.

Contracting Out

• The PPF insurance is particularly important in the context of contracting out, where social security benefits are replaced by privately-provided benefits through defined benefit plans or through individual accounts.

• It replaces the guarantee implicitly provided through state pensions.

Pension Benefit Guaranty Corporation

• The US Pension Benefit Guaranty Corporation (PBGC) has 30 years of experience, starting in 1975.

• Much has been learned during that time concerning the functioning of pension benefit insurance

PBGC

• Insurance premiums set by Congress

• Premiums based on number of participants and amount of underfunding

• The insurance is mandatory

• It covers most workers in private sector defined benefit plans

• 100% of benefits accrued at termination insured up to a maximum

PBGC (cont.)

• Plan sponsor and all members of its controlled group (related companies) liable for the pension plans liabilities

• Fundamental principle that the PBGC attempts to be fully funded, taking in revenue annually at least equal to the growth of its liabilities

Record Deficits

• At the end of fiscal year 2003, the PBGC had a deficit of $11.2 billion, which was a record at that time.

• At the end of fiscal year 2004, the deficit was $23.3 billion, more than double the previous record.

PBGC’s Trust Fund Overfunding Takes a Dive

• 2000 $9.7 billion• 2001 $7.7 billion• 2002 ($3.6 billion)• 2003 ($11.2 billion)• 2004 ($23.2 billion)

() indicates a deficitSince 2000, a decline of nearly $33 billion.

Bethlehem Steel

• An example of PBGC’s problems

• In its last filing before termination, it reported it was 84% funded on a current liability basis.

• At termination, PBGC calculated that it was 45 percent funded on a termination basis, with underfunding of $4.3 billion.

Causes of Decline

• Deterioration in assets due to decline in the stock market

• The “current liability” measure of liabilities uses smoothed interest rates, which with declining interest rates overstated the current interest rate

• Greater number of subsidised early retirements due to decline of firm.

PBGC’s Need for Reform

• Better measure of pension liabilities, so that the measures used for determining required contributions are closer to the measures used to determine liabilities at plan termination

• Stricter rules for pension plan funding to require higher funding levels

Basic Principles for Evaluating the PPF

• Adequate funding of pension schemes

• Dealing with moral hazard

Adequate Funding: The Problem

• For tax-paying firms, there are tax incentives to fund pension plans

• For firms in financial distress, the incentives are to fund to the minimum amount allowable because the pension benefit insurer may ultimately pay the benefits

Adequate Funding (2)

• Requiring adequate funding rather than placing too much burden in the incentive effects for funding of risk-based premiums limits the premium costs of employers.

Critique of the UK’s PPF

• Moral hazard

• Funding requirements for schemes

• Risk-based premium

• Level of benefits insured

Moral Hazard

• For most types of insurance, moral hazard is not a serious problem

• For pension benefit insurance, moral hazard is a very serious problem

• This point is the most important point of the presentation.

Moral Hazard

• For most types of insurance, moral hazard weakens the incentive of those who are insured to avoid loss.

• For pension benefit insurance, moral hazard leads to aggressive steps by financially distressed firms in the “end game” who attempt to increase the loss because that will save money for cash compensation for executives.

Moral Hazard (2)

• For most types of insurance, moral hazard is limited by countervailing motivations – people with medical insurance don’t want to get sick.

• For some types of voluntary insurance, those purchasing insurance are risk averse and take other steps to minimize loss.

• For most employers, concern about reputation in the labor market limits moral hazard in pension benefit insurance.

Moral Hazard (3)

• With the PPF and PBGC, the existence of insurance reduces the concern of employers for reputation because their workers are protected.

• It reduces the incentive for workers to pressure employers to adequately fund the pension scheme.

Distressed Firms Minimize Funding

• They pressure actuaries for favorable actuarial assumptions

• They contribute the minimum required

• They skip required contributions

• They invest in riskier portfolios

Distressed Firms Deplete their Pension Schemes’ Assets

• Workers are fired – increasing the retirement benefit payouts

• Executives fully transfer their benefit rights out of the scheme to avoid the loss of benefits when the firm bankrupts

Distressed Firms Increase Scheme Liabilities

• They raise promised benefits rather than giving wage increases for workers because the PPF or PBGC will have to pay for the future benefits rather than the firm.

Risk-Based Premiums

• Provide appropriate incentives for funding schemes

• Avoid subsidization of declining industries by financially healthy ones

• Avoids a healthy firm subsidizing its weaker competitors

• Reduce problem of adverse selection

Determinants of Risk: A Complex Problem

• Financial stability of firm

• Degree of underfunding of scheme

• Extent of immunization of portfolio and risk of assets in portfolio

• Age structure of workforce

Underfunding, a Good Proxy

• Extremely difficult to calculate “ideal” premium• Premium based on underfunding is a good proxy• Because underfunded plans tend to be found in

firms with financial problems, underfunding proxies for the financial weakness of the sponsoring firm

• Underfunding is a simple way to determine a risk-related premium

Level of Benefits PPF Insures

• 90% of termination benefits for those less than the scheme’s normal pension age with a cap, but not full protection of indexation in schemes with generous indexation

• 100% at the scheme’s normal pension age and above with no cap, but not full protection of past or future indexation in schemes with generous indexation

Criticisms

• The PPF insurance is important in that it fully insures the contracted out benefit for most people below the normal pension age, but it provides little protection for supplementary benefits above the contracted out benefit.

Low Level of Protection

• The termination benefit, which is based on the worker’s wage at termination, is considerably lower than the worker’s ongoing benefit, which is based on the worker’s full career wage at retirement.

• Thus, the protection of ongoing benefits is far lower than the 90% level protection for termination benefits.

Political Risk

• There is a need to protect the PPF from two types of political risk

• 1. The risk that the government will set the ceiling on allowable funding at too low a level, leading to funding problems during economic downturns

• 2. The risk that weak firms will exert political pressure to enact funding and insurance rules favourable to themselves.

Suggestions – Regulating Scheme Benefits

• Benefit generosity increases not permitted in underfunded schemes

• Lump sum benefit payments and full transfer out of benefit rights not permitted in schemes that have a funding ratio below a certain level

Suggestions– Levy

• PPF levy should be risk-based from the start to minimize cross subsidization, to avoid political risk that there would be delays in an attempt to develop an “ideal” risk-based levy, and to establish the principle that the PPF finances its future liabilities as they accrue

• Risk-based part of levy should be tied to underfunding

Suggestions – Measurement of Liability

• PPF liability for underfunded terminated schemes should extend to former owners and to controlled group (other firms owned by same owners)

• Measured liability for required funding and for termination insurance should be the same

Suggestions – Funding Rules

• Consideration in UK should be given to mandating minimum actuarial assumptions or to tieing them to fixed benchmarks, such as Government bonds

• Specific rules should be established to determine the minimum funding requirement

• Firms with underfunded schemes should be required to make an annual disclosure to their employees and shareholders

CONCLUSIONS

• The PPF and PBGC provide important protections to British and American pension participants

• Consideration should be given in both the UK and US to reducing the problem of moral hazard and strengthening required funding of defined benefit pension plans.