EVENTS

Date:	Wednesday, October 10, 2007
Time:	10:30 AM -- 12:30 PM
Location:	Wohlstetter Conference Center, Twelfth Floor, AEI 1150 Seventeenth Street, N.W., Washington, D.C. 20036

October 2007

Pension Protection Act of 2006: What Do We Know about What We Did to Defined Benefit Plans?

 

In August 2006, President George W. Bush signed the Pension Protection Act of 2006 (PPA), legislation intended to improve the funding of defined-benefit pension plans, improve the measurement of assets and liabilities, and require plan sponsors to face stricter requirements regarding their funding targets. The old rules were incredibly complex, but the new rules are best described as complex in new and different ways.

Speakers at this conference examined the effects of the recent legislative changes. They will also focus on the tools necessary and available for analyzing legislative changes and for analyzing the risks posed by the current system. Those risks affect employees, employers, and--importantly--taxpayers, who insure these plans through the Pension Benefit Guaranty Corporation (PBGC).

Mark Warshawsky, director of retirement research at Watson Wyatt Worldwide, discussed the changes enacted in PPA and present results from his firm's proprietary model on the likely effects of the new law on a typical pension plan. David Gustafson, director of policy, research, and analysis at the PBGC; and Alex Brill, a research fellow at AEI, discussed these results and other approaches for analyzing the consequences of reforms to the defined-benefit pension system.

Bill Thomas
AEI

While defined-benefit plans are not the most exciting of topics, they nevertheless touch upon some very important issues. These issues are occasionally revisited by Congress and by other organizations, as should be the case. The PPA was passed in 2006 to correct certain weaknesses in defined-benefit plans and in their oversight. Opportunities might appear down the road for further modifications, and examination of how the PPA bill has worked thus far can help guide future changes. The PPA bill initially came out of the House, and the bill the Senate eventually proposed was difficult to reconcile with the original House version. In the end, the House bill was plowed through the Senate and was signed into law.

Mark Warshawsky
Watson Wyatt Worldwide

The PPA was touted, variously, as putting a brake on pensions, boosting 401(k) plans, and adding volatility to the pension funding market. None of these claims had any merit to them, and none of them came to pass.

Throughout the late 1990s, defined-benefit plan contributions were relatively small, a period which is referred to as a "pension holiday." With the drop in interest rates and the onset of the stock market decline, employers began making massive contributions to pension plans. Some of these contributions--tens of billions of dollars worth in all--were made on a volunteer basis, while others were required by law.

Under the old law, two different measures of pension liability were used-a current liability measure as well as an actuarial liability measure. A new measure of liability was needed, as with the two separate measures, there were two different funding regimes operating at the same time. In addition, the old measure of current liability failed to include numerous items and understated the total liability amount, despite using an unreasonably low discount rate. The passage of the PPA has brought with it a new system for measuring pension liability. A single measure of liability is now used, and this indicator is far more accurate than what was used previously. The new measure also sets the corporate bond rate as the discount rate. This is far more appropriate than setting the discount rate to the thirty-year bond rate, a feature of the previous system

One major problem with the old defined-benefit rules was contribution volatility. The cliff scheme in place meant that corporations could go from having no contribution requirements to having massive obligations. It was difficult for businesses to handle this sort of volatility. The PPA has provided a very important and meaningful improvement in this category, partly as a result of an increase in maximum deductible contributions to 150 percent of target liability.

With the new law in place, if a defined-benefit plan is less than 60 percent funded, it must be frozen and lump sump payouts from it must be forbidden. This sort of punishment is important as it provides an important incentive for an employer to keep a plan funded. An employer would certainly wish to avoid the profound embarrassment that would befall it should its plan be frozen. Above a certain level of funding, there are no benefit limitations. The new law is meant to get away from credit balances, and it partly succeeds in this. The PPA has also introduced "at-risk," the credit worthiness of a plan sponsor. This new notion has proven to be very controversial. Its introduction, however, may actually be worthwhile, as the nature of a liability really does change as the financial condition of a plan sponsor changes. This measure of at-risk is nonetheless imperfect. Finally, under the new law, lower rates of funding set off higher PBGC premiums, in addition to various other payout restrictions.

One possible consequence of the new law is an improvement in benefit security. There has already been an improvement in funding status, which shows that the new law has already been of use. Moreover, under the PPA, sponsors will have an incentive to get to 100 percent funding as soon as possible, because they will want to minimize benefit restrictions as well as ensure more flexibility for themselves. Under the new law, there is less room for systemic abuses and for the moral hazard problems that were previously of concern. As a result of the new regulation, the PBGC's own situation should improve, and a slowing in plan freezes should take place. 

One weakness of the new regulations manifests itself should a plan become well-funded and the plan sponsor wants to withdraw extra assets. In this case, the sponsor has to pay 50 percent excise taxes on the withdrawn assets, in addition to income taxes. These excise taxes should be reduced to 20 percent, especially since no taxes are being collected with the 50 percent rate in place.

David Gustafson
PBGC

The PPA should reduce contribution volatility. It must be noted that volatility was not pervasive under the old system, and instead primarily affected companies contributing the bare minimum required by law. Regardless, the PPA's increase in the maximum deductible contribution is a major improvement. More improvement on volatility can be achieved, in part through the elimination of the excise tax on extra assets withdrawn.

According to some of the modeling done, the PPA may have not significantly strengthened minimum funding rules or significantly improved premium rules. Models also suggest that the PBGC's deficit is unlikely to change much over the next ten years, despite the enactment of the new regulations.

Finally, there is a terrible cost to giving one industry relief over another industry, as far as defined-benefit plans are concerned. The airline sector, one industry receiving favor, will make bigger claims as a result of this industry-wide relief in the event that any given airline terminates its plan.

Alex Brill
AEI

Defined-benefit plans are difficult to model precisely. Nevertheless, models happen to provide valuable insight into the implications of changes in law. This is particularly true in the case of the PPA. When Congress was debating the bill, it did not have access to models such as the proprietary scheme presented by Mark Warshawsky. As a result, elected officials and staffers were often flying blind when considering the various subtleties of this legislation.

The PPA is a significant piece of legislation that has brought with it a significant impact. Had the changes enacted through the PPA been insignificant, they would have been easier to make than they actually were. The introduction of at-risk rules was particularly significant as well as difficult to achieve

Having access to modeling tools is important when making economic policy changes. While plenty of public and private models are available for tax and Social Security issues, there are few pension models. In fact, it can be said that the PBGC currently has a monopoly on pension models. The fact that few competitors exist is a problem. As a result of the PBGC's quasi-monopoly, transparency, consultation, and third-party review are critical. It is good that the PBGC is moving in this direction.

AEI intern Boris Vabson prepared this summary.