You would need to be asleep at the wheel to not know we are in a pension funding crisis. Hardly a day goes by when we do not hear about a pension plan that reduces or freezes future benefit accruals to lessen its funding shortfall, or that is predicted to become insolvent in the foreseeable future notwithstanding such benefit adjustments. Participants in these underfunded plans naturally worry that they will lose their hard-earned pension benefits. If the plan is in the private sector, they will be somewhat protected by a pension insurance system established in 1974 under ERISA [the Employee Retirement Income Security, which covers most non-governmental pension plans] and administered by a governmental agency known as the Pension Benefit Guaranty Corporation (PBGC).
The PBGC actually runs two pension insurance programs: one for single-employer plans; the other for multiemployer plans. The single-employer program covers pension plans that are sponsored by one employer. The multiemployer program covers pension plans created and funded through collective bargaining agreements between a union and a group of employers (usually in related industries). The two programs are financially separate, meaning the assets of one program may not be used to pay the obligations of the other.
Under both programs, the plans pay premiums to the PBGC to insure that pension benefits will be paid if, (i) in the case of a single-employer plan, the employer goes bankrupt or out of business and can no longer afford to keep the plan going, or (ii) in the case of a multiemployer plan, the plan becomes insolvent (i.e., has no money). The PBGC receives no tax dollars. It’s operations are financed solely by these insurance premiums, investment income from assets in plans it has taken over, and any recoveries it is able to obtain from the companies formerly responsible for the plans.
Because the PBGC pays multiemployer program benefits only after the plan is out of money, the PBGC’s main source of revenue under that program is the insurance premiums. But premiums under the multiemployer program have historically been much lower than those under the single-employer program. These factors have contributed to the multiemployer program having fewer resources to pay benefits than the single-employer program. However, an even bigger factor has limited, and is now straining, the resources of the PBGC’s multiemployer program.
Over the past ten years, there has been an alarming increase in the number of multiemployer pension plans that have become insolvent. And this is despite Congress’s passage in 2014 of the Multiemployer Pension Reform Act (MPRA), which permits multiemployer pension plans to cut pension benefits for all but the disabled and those age 80 and older IF the plan is in “critical and declining” status (i.e., if the plan is less than 65% funded and its funded percentage is declining) and certain other conditions are met. A key impetus behind the MPRA was the hope that, with benefit cuts, fewer multiemployer plans would become insolvent, thereby extending the resources of the PBGC’s multiemployer insurance program. Unfortunately, even with cuts under the MPRA, the PBGC’s multiemployer insurance program is predicted to run out of money by the end of 2025!
While a great many single-employer pension plans are also underfunded, most are not as underfunded as the multiemployer plans. Additionally, the PBGC’s single-employer program has more sources of revenue than its multiemployer program (discussed above); its financial condition (currently in a deficit) is expected to steadily improve over the next decade; and it is anticipated that the program will be able to pay PBGC benefits for many years. Still, participants in both programs risk losing a portion of their vested benefits due to statutory limits on how much the PBGC can pay.
For participants in a single-employer pension plan, the 2017 maximum age-65 PBGC benefit is $5,369.32/month. For participants in a multiemployer pension plan, it is $1,430/month if the participant has 40 years of service; $1,072.50/month if the participant has 30 years of service; $715.00/month if the participant has 20 years of service; and $357.50/month if the participant has 10 years of service. Clearly, participants in multiemployer pension plans that have become insolvent are at greater risk of losing a portion of their hard-earned pension benefits than participants in single-employer pension plans where the employer had gone bankrupt or out of business.
Many governmental pension plans are also underfunded; some, seriously so. However, because governmental pension plans are not covered by ERISA, the participants in those plans receive NO PBGC benefit protections. Therefore, if the governmental body sponsoring their plan goes bankrupt, their benefits may be cut in the bankruptcy proceedings, as occurred a few years ago with the City of Detroit and its two retirement systems.
So, what the heck got us into this underfunded pension mess? The reasons vary from plan to plan, but here are some of the main ones:
1. Weaker than predicted investment returns. Investment markets are volatile, making it difficult to accurately predict investment returns. That said, many plans plainly over-state their expected vestment returns.
2. Erroneous assumptions regarding the amount and length of time future benefits are payable under the plan (e.g., anticipated pay is too low; expected length of work is too short; predicted mortality is understated). Again, many plans use overly optimistic assumptions regarding the relevant factors for determining pension amounts and how long they will be paid.
3. Changing demographics. People are living longer and are, therefore, eligible to collect benefits longer, which creates additional expense for all plans. Multiemployer plans face additional demographic challenges. In multiemployer plans, employer contributions are based on the number of hours worked by active plan participants, but these plans have been experiencing declining active participant populations and growing retiree populations. Therefore, even if collective bargaining leads to higher hourly contribution rates, this increasing demographic imbalance creates ever greater cash flow challenges for multiemployer plans.
4. The employer’s inability to make additional contributions to the plan. If the employer’s business is struggling, it will have limited ability to make contributions to the plan.
5. External events. A higher funded percentage should be expected during periods of strong economic growth and investment returns. Conversely, a lower funded percentage can be expected during a recession or years of poor investment returns. The Great Recession of 2009 is one from which plans are still recovering.
6. Over-promised pension benefits in light of the foregoing factors. This is especially true with a great many multiemployer plans and governmental plans that have promised very generous pension benefits as compared to those promised to similar pay scale employees in single-employer plans in the private sector. Given the additional expense of these relatively generous benefits, it is no surprise that most of these plans are experiencing serious funding shortfalls. While some have taken steps to stem the bleeding by making their benefit formulas less generous on a going forward basis, it will take years for this strategy to markedly improve their funded percentage, and for some it is already too late to prevent insolvency.
7. All other things being equal, low interest rates used to discount the present value of future benefit obligations under the plan. A plan’s funded status is generally based on a comparison of (i) the value of the plan’s assets as of a specified date (or averaged over a period of time not to exceed 24 months), and (ii) the value of the plan’s current and future pension liabilities.
While plan sponsors have some flexibility in the discount rate used to compute the present value of future benefits payable under their plan, single-employer pension plans must select a rate derived from monthly U.S. corporate bond yield rates published by the IRS. Those rates have been at historical lows since the Great Recession of 2009. As of December 31, 2016, the discount rate for that index was 4.0%.
Multiemployer pension plans, on the other hand, may use a discount rate that matches their assumed investment return. Most multiemployer pension plans have been using a discount rate of between 7.0% and 7.5%. Use of this higher discount rate improves a multiemployer plan’s funded status relative to what it would be if the lower corporate bond rates were utilized. However, pension actuaries generally agree that the lower corporate bond rate would provide a more realistic picture of a multiemployer plan’s funded status. Stated otherwise, they believe multiemployer plans are in even worse shape than what appears in their annual funding notices.
Because even a small change in the discount rate will make a relatively large difference in a plan’s funded percentage (all other things being equal), if and when discount rates rise, we can expect the funded status of pension plans to improve. Many financial experts and advisors are, in fact, predicting a gradual rise in discount rates over the next few years. For plans, that will certainly be a welcome change and something to cheer about.*
To read more about the impact of interest rates on a pension plan’s funded status, please go to my Facebook Page – www.facebook.com/PensionJustice4You – and read Posts 13, 17, 27, and 31. You do not need a Facebook account to read these Posts.