The “tax extenders” bill, which yesterday I relabeled The Hypocrisy Act of 2010, contains some little-discussed provisions that would allow certain firms to further underfund their employee pensions. Advocates for the legislation promote this as a virtue, continuing a longstanding bipartisan trend of Congress rewarding bad pension behavior by both management and labor bosses in firms with a certain type of pension plan. These provisions are irresponsible and should be removed from the bill.

I’m going to use this as an opportunity to provide a crash course in a few aspects of pension policy. Let’s begin with some background on defined contribution and defined benefit pension plans.

In a defined contribution (DC) pension plan, an employer commits to contributing specific dollar amounts into an employee’s pension account. The employee then makes investment decisions for the funds in his account. The employee has both the upside and downside investment risk: if he invests well, he will have more for retirement. If he invests poorly, he will have less. The employer usually contracts out to a private investment firm (like Fidelity) for the account and investment management.

In a defined benefit (DB) pension plan, an employer commits to pay the employee a specific benefit amount at retirement. The employer owns both the upside and downside investment risk.

If a worker is risk averse toward investment, then the advantage goes to the DB plan. If he thinks he can manage his investments better than his employer can, then the advantage goes to the DC plan. Many workers are risk averse with their retirement planning. Also, if you hate private investment firms (as some on the left do), then you probably don’t like that aspect of a DC plan.

In a defined contribution plan, the employer deposits funds regularly (often with each paycheck) into each employee’s account. While the final pension benefit at retirement is uncertain because of investment risk, the current existence of the employer’s contributions is not. We say this account is fully funded or that the future benefit, while uncertain in amount because of investment risk, is prefunded. The employee is often required to match a portion of the employer’s regular contributions.

In a defined benefit plan, the employer contributes a lump sum regularly to the pension plan in the aggregate. The contribution amount is at the discretion of the employer, but the law establishes rules that determine a minimum contribution. In theory, a well-designed law should require the employer to regularly contribute enough cash to keep all the pension promises made by the employer fully prefunded. That way, if the employer goes bankrupt, there are enough funds already set aside to pay all the retirement promises previously made. There is a significant opportunity cost for firm management to making pension plan contributions: every dollar contributed to the pension plan is a dollar that cannot be used to pay current wages and benefits, or invest in new capital, or pay dividends to firm owners.

But the calculation of “How much does firm management need to contribute to its DB plan to keep it fully funded?” depends on the key discount rate used to calculate the future cost of those pension promises. If this discount rate is low, then the present value of future pension promises will be high, and the present value of pension plan assets (assuming certain investment returns) may be insufficient to cover those promises. The plan will be underfunded. If the discount rate for liabilities is high, then the plan will be fully funded and the employer could appear to responsibly offer employees new pension promises, thinking that enough money has been set aside to pay past promises.

The discount rates that employers must use are defined by law. Employers and labor leaders lobby Congress to set an artificially high discount rate, so that the pension plan looks healthy and the firm management doesn’t have to contribute as much cash each quarter to the DB pension plan. This allows management to chronically underfund the pension plan while honestly stating that they are complying with pension law. And it allows labor bosses to prioritize in their negotiations with management current wages and benefits over funding past pension promises.

Since DC plans are by design always fully funded and DB plans often are not, the advantage here goes to DC plans. The employees and retirees in DB plans often don’t know this, however, because their funds are comingled and therefore obscured, and because the accounting rules are deceptive, the result of lobbying by management and labor. This strategy collapses if the firm goes bankrupt and the underfunding becomes real.

In a defined contribution plan, the employee legally owns the funds in his account. In a defined benefit plan, he owns a (legally binding) promise from his employer that the funds will be there when the employee retires. This has two effects:

  1. A DC plan is portable, a traditional DB plan is not. If the worker changes jobs, he can take his DC account balance with him.
  2. If the employer goes bankrupt:
    • The worker with the DC plan sees no effect on the pension he has earned so far, since he legally owns the funds in his account.
    • The worker with the DB plan sees his employer “dump” the pension plan onto the government-run defined benefit plan insurance company, called PBGC: the Pension Benefit Guaranty Corporation.
      • PBGC takes all the assets in the pension plan, and all the pension promises made up to that point.
      • PBGC then pays all the previously-earned pension promises, up to a ceiling (which in 2010 is $54,000 per year for someone retiring at 65).
        • If there aren’t enough assets in the plan to pay the promises up to the ceiling, then PBGC makes up the difference.
        • If there are enough assets to pay up to the ceiling, but not all the promises above the ceiling, then retirees with pension promises above the ceiling get a “haircut” (proportional reduction) in their pension benefit. They lose part of their pension because their employer underfunded the promise and went bankrupt.

The legal ownership, portability, and elimination of bankruptcy risk are advantages of DC plans over DB plans.

The PBGC is funded by insurance premiums, charged to firms with DB pension plans. Those premiums are again determined by law, again subject to lobbying, and are therefore in many cases lower than an actuarially fair premium. When a firm dumps its plan on PBGC, other firms with DB plans are hurt since their premiums are more likely to increase. In the extreme, experts fear that at some point PBGC will run out of money and come to Congress for a taxpayer bailout. As we all now know, that kind of risk should not be ignored.

The further problem is that most firms that offer DB pension plans are in industries with a high risk of bankruptcy. Several large steel manufacturers dumped their DB plans on the PBGC years ago, and airlines often flirt with it. Workers and retirees shafted by bankruptcy is therefore a real risk. Low wage and short-time employees are generally protected by PBGC’s insurance, but those who have worked long enough or had high enough wages to earn pension benefits above the PBGC ceiling lose out.

This is a textbook case of moral hazard. The presence of government insurance with artificially low premiums encourages firm managers and labor union bosses to cooperate and shift some of the costs of future employee pensions onto the PBGC and maybe onto taxpayers. Management and labor agree to pay employees higher wages and benefits now, to increase the promised future retirement benefit promises from that plan, but to underfund those promises. They are, in effect, gambling workers’ pensions on the firm’s ability to avoid bankruptcy.

Defined Benefit Pension Reform

President Bush and his team pushed for defined benefit pension reform, based on five principles:

  1. Keep your promises, in advance: If an employer makes a pension promise, he or she should fully prefund that promise.
  2. Don’t disguise your underfunding: Plans should be required to accurately measure their pension plans using a conservative discount rate for liabilities (like Treasuries or a AAA corporate bond rate).
  3. Don’t hide your underfunding: That information should be transparent to current employees, retirees, investors, and everyone else. Don’t hide your underfunding.
  4. Get to full funding ASAP: Firms that have underfunded DB pension plans should be required to, over time, bring those plans up to full funding.
  5. We’ll negotiate on a reasonable definition of ASAP: A reasonable transition time for (4) can be negotiated, balancing firms’ current needs for revenues with a policy desire to get to full funding as quickly as possible.

Unlike many economic policy issues, DB pension reform involves a three-sided interest battle, among management, labor leaders, and workers+retirees. The problem is that management and labor leaders team up as described above to protect their own interests, jeopardizing the interests of workers+retirees. (An economist would say that labor leaders have an “agency problem” here, where their interests differ from those of the workers they claim to represent.) Novice policy observers get confused because they’re used to Republicans siding with management and Democrats siding with labor. They see bipartisan agreement with just a few outliers (from both parties) who are complaining loudly about some nebulous risk of future harm to workers and retirees. This is an example of where interest-group driven bipartisanship drives irresponsible policy.

A few members of Congress withstood the pressure from management and labor and pushed policies along the lines of President Bush’s. Notable for their admirable and responsible behavior were Rep. John Boehner and Senators Grassley and Baucus. Their leadership led to President Bush signing a DB pension reform law in 2006.

This law made progress on the above goals but was far from perfect. At the time, we looked on it as an incremental improvement over current law. In particular, we thought it phased up to full funding far too slowly.

One medium-sized policy victory in that law was a restriction that firms with severely underfunded DB plans could not make any new pension promises until they had fully funded their previous promises. While I hope this seems inherently reasonable and responsible to you, we met with (and overcame) fierce resistance to it at during the legislative process.

Hypocritical pension funding “relief”

The new House version of the extenders bill would undo much of that good work by providing “temporary pension funding relief” to firms offering DB pension plans.

The argument seems reasonable on its face: We’re in the early stage of an economic recovery, and our firm needs to use all its available resources to survive and eventually grow and hire more workers. The government should therefore relax the onerous requirements that management contribute large amounts of cash now to the firm’s DB pension plan.

But there is always an excuse not to contribute to your employees’ pension plan. When times are tough, the firm needs those resources to grow or even to survive. When times are good, the markets are doing well, the assets in the pension plan look healthy, and the firm managers argue they don’t need to contribute to the plan. The plans remain chronically underfunded, and retiree pensions are at perennial risk of firm bankruptcy.

I won’t go into the details of each of the four provisions affecting “single employer” DB plans, or the others affecting “multi-employer” DB plans. While the forms of the changes are different, each has a similar result: firms would be required to contribute less to their employees’ pension plans over the next year or two.

One particularly egregious provision (in section 303 of the draft House bill) would begin to weaken the “no new promises until you fully fund old promises” rule. Even worse, it would do so through an accounting change to make plans whose asset values declined significantly appears as if they had not lost as much value. The market losses of 2008 and 2009 were damaging and real, and the lost value in DB pension plans needs to be rebuilt through new employer contributions. To pretend these losses did not happen while allowing new pension promises to accrue is irresponsible.

Like so many other changes in this bill, these are drafted as temporary changes. Experience strongly suggests that if these provisions are enacted once into law, they will become “extenders” in the future, resulting in a permanent weakening of the funding of DB pension plans.

This is like planting a time bomb, with future retirees as potential victims. Years from now, when a firm goes bankrupt, the press will run heart-rending stories of retirees forced by the PBGC rules to take haircuts to their pensions, in which they receive less than they were promised over a lifetime of work. The reporter will wonder, “Why didn’t anyone object at the time, when Congress weakened the requirements that employers fully prefund the promises they make to their retirees?”

I am objecting. Will anyone in a position of power say no?

Tip for reporters: These legislative provisions are almost always driven by 1-4 specific firms. There’s a story waiting for the reporter who can uncover which firms benefit from each provision, and which Members of Congress are responsible for the insertion of those provisions into the draft House bill.

(photo credit: Airline workers on the tarmac by ellenm1)