pension fund perspective: major redesign of the pension insurance program

CFA Institute

Pension Fund Perspective: Major Redesign of the Pension Insurance ProgramAuthor(s): Patrick J. ReganSource: Financial Analysts Journal, Vol. 34, No. 5 (Sep. - Oct., 1978), pp. 10-11+58Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4478172 .

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PENSION FUND

by Patrick J. Regan, BEA Associates, Inc.

Major Redesign of the Pension Insurance Program On June 30, 1978, the Pension Bene- fit Guaranty Corporation sent two reports to Congress "suggesting a major redesign of the present federal insurance program for private defined benefit pension plans." If adopted, the PBGC recommendations will have major investment implications for the capital markets.

The first report, entitled "Multiem- ployer Report Required by P.L. 95-214," deals with the financial problems faced by multiemployer pension plans. In a multiemployer plan, a number of employers con- tribute amounts negotiated in collec- tive bargaining to a joint fund admin- istered by a board of trustees that in- cludes representatives of both the employer companies and the unions. There are approximately 2,000 such plans in the United States, involving some eight million workers and re- tirees protected by total plan assets of $25 to $30 billion.

Unfortunately, many multiemployer plans are financially weak; the PBGC estimates that 160 plans with total gross unfunded guaranteed pension liabilities of $8.3 billion may have to terminate over the next 10 years. If this should happen, the PBGC would assume this obligation, in accordance with the provisions of ERISA, then attach a lien of up to 30 per cent of net worth on the employers' assets. The PBGC estimates that it could recover $3.5 billion in this fashion, leaving it with a net obligation of $4.8 billion. The report dis- cusses several alternative methods of strengthening the financial condition of multiemployer plans, including a two-tiered system that would boost employer contributions and limit or reduce benefit increases for troubled plans.

CELI Status Report

The other report is entitled "Contin- gent Employer Liability Insurance:

Status Report to the Congress." Sec- tion 4023 of ERISA called for the es- tablishment of a program of "contingent employer liability insurance" (CELI) by September 1977, with coverage effective September 1979. Such insurance would prevent the PBGC from reaching a sponsor's assets in the event of a plan termination, thereby removing the potential 30 per cent of net worth claim.

A review of the legislative history of ERISA reveals that the House did not originally impose an employer net worth limitation, although the Senate originally limited employer liability to 50 per cent of net worth, then re- duced the limitation to 30 per cent of net worth by an amendment in September 1973. At this point, the Senate Finance Committee intro- duced the forerunner of CELI, whereby an employer could pay an increased premium and be afforded relief if he did not continue in business. The Conference Committee later drafted Section 4023 of ERISA, but left it up to the PBGC to develop a detailed CELI program.

Congress originally intended that CELI coverage be offered by the PBGC, by private insurers or through a joint program. However, after private insurers expressed no interest in the program, the PBGC had to develop its own. In January 1977, the PBGC Advisory Committee appointed a CELI panel of 17 pension experts to advise it on the establish- ment of such a program. This culmi- nated in the June 30, 1978 report, which states that: "The PBGC, the Advisory Committee to the PBGC, and a special subcommittee appointed by the Advisory Committee (CELI Panel) have concluded that it is not feasible to implement a CELI program as contemplated by Section 4023 of ERISA. Rather, it may be desirable to alter the present structure of employer liability within the basic guarantee program."

The report lists five reasons why a full coverage CELI program is not feasible.

1. CELI is not insurance: For a risk to be insurable, the potential loss must be beyond the control of the insured, a cri- terion that is absent if an employer can initiate a voluntary termination of the plan.

2. CELI poses philosophical problems: If CELI is mandatory, it would re- quire some employers to subsidize the business decisions of others. Also, there is no reason why employers should be re- lieved of their obligation to fund their pension plans if they are financially able to do so.

3. CELI would create incentives to terminate pension plans: If employer liability was removed, employers might voluntarily terminate, jeopardizing the entire program. The fact that CELI-in- duced terminations could deplete the basic benefits fund is termed the "spill- over effect."

4. CELI itself would be expensive and would increase the costs of the basic program as well: The CELI Panel report showed that, of $22.4 billion of unfunded vested benefits owed by large corporations, $2.8 billion is currently covered by the basic benefits program and $19.6 billion would be insured by a full- coverage CELI program. Obviously, the CELI premiums would have to be several times the basic benefit premium, which itself would have to be increased if CELI resulted in more terminations.

5. CELI would be difficult to ad- minister: If employers, rather than the plan, have to pay the premiums, CELI would entail a costly and cumbersome separate insurance program.

Given these problems, the PBGC report concluded that: "The fundamental conceptual problems associated with full-coverage CELI would undermine the workability of any CELI program. A CELI program offering full or nearly full coverage is unsound and could cripple the basic insurance program as well."

10 G FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1978



CELI Alternatives

The PBGC staff and CELI Panel offered some suggestions for restruc- turing employer liability. The Panel suggested limiting the potential abuses of voluntary termination by making "business hardship" a condition of relief. In contrast to the present law, which requires terminating sponsors to pay off their unfunded liability with a single lump-sum payment, going concerns would be required to continue making payments until their unfunded pension liability was completely amortized. If a small company is suffering business hardship, the first $10,000 of the next annual payment would be waived. If a larger company is in a Chapter X or XI bankruptcy, up to one million dol- lars per year would be waived. Only on liquidation of the business would the 30 per cent of net worth limitation be applied.

The PBGC staff proposed a modifi- cation of the Panel's approach. Under their alternative, "the obligations of the pension plan would become a direct liability of the sponsor." Plan termination would occur only when liabilities were fully discharged or liquidated. If the employer ceased oper- ations, or there was a bankruptcy re- organization, the pension claim would be assigned creditor status and share in the liquidated assets of the business, with the PBGC covering only the unfunded guaranteed benefits.

The interesting thing is that both proposals could effectively remove the 30 per cent of net worth limitation on employer liability for going concerns, thus making the employer lia- ble for the entire unfunded obligation. The report states that this re- flects: "a shift in attitude that has taken place with respect to pension obligations. Before ERISA, most pension plan sponsors could terminate a pension plan unilaterally and, in many cases, with im- punity. ERISA is evidence of the evolu- tion that has taken place in the attitude toward pensions within the United States.

continued on page 58

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FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1978 D 1



be precise. Under straight-line depreciation, for example, the asset is written off faster than a level series of payments reduces the amount of the capitalized debt. (In any amortization schedule for a debt with level payments, the interest payments in the early years exceed those in the later years, while the payments reducing principal are smaller in the early years than in later years.) Thus a more precise adjust- ment would be to add the amount of the lease debt to liabilities, to add some smaller amount to assets and to reduce owners' equity by the difference between the first two numbers. We have simulated the ratio of asset book value to debt book value for financing leases with various interest rates and lease terms. We find that the implied reduction in owners' equity is not likely to be larger than 10 per cent of the amount of the lease capitalization, about $30 million for Pen- ney's.

8. See, for example, Patrick J. Regan, "Potential Cor- porate Liabilities under ERISA," Financial

A nalysts Journal, March/April 1976, 26-32 or the book by Jack L. Treynor, Patrick J. Regan and William W. Priest, Jr., The Financial Reality of Pension Funding Under ERISA (Homewood, Ill.: Dow Jones-Irwin, 1976).

9. Lee J. Seidler suggests that the information filed by companies with the I.R.S. and the Labor Department on Schedule B of Form 5500 is likely to be of higher quality.

10. The range of betas for the Dow Jones Industrials is relatively small, from 0.70 to 1.15 in a market where betas range from near zero to over three. Note that two securities can have the same beta while having very different financial structures. Consider, for example, two companies both with reported betas of 1.00. The first has no debt. The second would have a beta of 0.60 if it had no debt, but since it has debt, its measured beta increases to 1.00. Still it is true that, ceteris paribus, the more debt, the more risky the company.

PENSION FUND...

continued from page 11

Increasingly, pensions are viewed as part of the wage package, rather than a gift from the employer. Many plan sponsors have already taken the step of regarding pension obligations as a liability, both morally and from a balance sheet point of view."

Potential Investment Implications The PBGC reports could have major investment implications. Dropping the proposed CELI coverage and removing the net worth limitation for going concems will come as a blow especially to those five per cent of companies with large unfunded liabilities. Companies contributing to multiemployer plans could find them- selves faced with greater contribution requirements or increased claims on net worth.

Since the PBGC estimates that it could recover $3.5 billion in net worth from contributors to 160 troubled multiemployer plans, many large companies must be involved. Yet how many analysts are aware of the contributions that companies make to multiemployer plans, let alone their potential liability in the event of termination? Wall Street's merger and acquisition people cer- tainly consider such items. For example, the syndicates that bid for Pea- body Coal knew that the company was a major contributor to the mine workers' pension fund, and they must

have utilized actuarial estimates of the likelihood of plan termination and the potential contingent liability in formulating their bids.

The PBGC reports offer construc- tive suggestions for overhauling the federal insurance program for the private pension system. As soon as specific policies are formulated, we can expect the credit rating agencies to begin making whatever ratings ad- justments they consider necessary. Moody's, which recently studied this issue (see "ERISA-A Bond Rater's View" in the February 20, 1978 issue of Moody's Bond Survey) found

that: "The ratios of unfunded past service costs to stockholders' equity, the debt ratios after adjusting for pension debt equiva- lents, and the unfunded past service costs per employee clearly weaken as we move to the lower rating categories. From a sta- tistical perspective, Moody's bond ratings reflect the credit implications of pension plans."

A future column will discuss the specifics of incorporating pension costs and liabilities into a credit analysis, which will, of course, de- pend on which, if any, of the PBGC approaches is adopted. U

wHjn1 R.JReynolds Industries, Inc.

Common Stock Dividend

A quarterly dividend of 87 1/2 cents per share has been declared on the Common Stock of the Company, payable September 5, 1978 to stockholders of record atthe dose of business August 10, 1978.

C. F. BENBOW Senior Vce President and Secretary Winston-Salem, N. C., July20, 1978

Seventy-Eight Consecutive Years of Cash Dividend Payments

Tobacco Products Aluminum Products Food Products Packaging Materals Fruit Beverages Petroleum Containerized Freight Transportation

58 0 FINANCIAL ANALYSTS JOURNAL / SEPTEMBER-OCTOBER 1978



pension fund perspective: major redesign of the pension insurance program

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