Pension ‘Savings’ in Transportation Bill May Be Costly

Robert C. Pozen

The transportation bill that Congress passed this summer is financed, in part, with a budget gimmick: Lawmakers changed the funding rules for corporate pension plans. These changes help the federal budget in the short term by reducing the tax deductions that corporations take for contributing to these plans — thereby reportedly increasing their taxable income.

These changes, however, encourage companies to contribute less to pensions, which raises the long-term risk that a governmental insurer will need to step in to pay benefits. Under the new funding rules, the required pension contributions for public U.S. companies could drop in one year from $58 billion to approximately $33 billion, says accounting expert Chris Senyek.

To understand these accounting changes, consider how corporate pension plans calculate their future obligations to plan beneficiaries. Actuaries begin by projecting the number of current and future employees and their life expectancy to estimate a total plan obligation. The actuaries then reduce this total by applying a “discount rate,” which should represent the risk-free return that plans could be certain of earning on their investments.

The lower the discount rate, the higher the estimated pension obligation. And if the plan has a gap between this amount and its current assets, the company must make up the difference through regular contributions.

The discount rate, then, is an important factor to businesses. Under the old funding rules, companies used a discount rate based on the interest rate for high-quality bonds, averaged over the past two years. Under the new rules, companies may use an alternative discount rate, based on the interest rate for the same bonds but averaged over the past 25 years. Because interest rates today are near historic lows, this new alternative discount rate is likely to be at least 1 percentage point higher than the prior discount rate and, therefore, to lead to much lower required contributions by companies with underfunded pension plans.

Estimates by David Zion of Credit Suisse show that a 1 percentage-point increase in the discount rate would require Lockheed Martin to contribute $1.4 billion to its pension fund in 2013, instead of $2.4 billion under the old rules. According to the same estimates, UPS’s required contributions would drop to $47 million in 2013, compared with $1.6 billion under the old rules.

Unfortunately, these substantial “savings” to companies pose a substantial risk to the Pension Benefit Guaranty Corp. (PBGC), the federal agency that guarantees up to $56,000 per year in benefits for each pension participant. The PBGC would assume the obligations of a pension plan if participating companies filed for bankruptcy or their plans otherwise became insolvent.

These companies pay annual premiums to the PBGC, but what is paid in is insufficient to finance the agency’s ongoing obligations. In 2011, it reported a deficit of $26 billion. Although the new legislation would also increase corporate premiums paid to the PBGC by $9.6 billion over the next decade, this increase would be grossly inadequate to pay for the agency’s overall exposure to risk from underfunded pension plans.

Some argue that the “artificially” low interest rates engineered by the Federal Reserve in the past two years do not accurately reflect expected risk-free returns over the long term. While there is some validity to these arguments, using the 25-year average is similarly unrealistic, since it includes the high interest rates of the early 1980s that were “artificially” engineered by then-Federal Reserve Chairman Paul Volcker.


Fortunately, this reform effectively phases out in a few years. By 2016, the alternative discount rate is scheduled to drop to 70 percent of the 25-year average rate (down from 90 percent in 2012). Moreover, the high rates of the late 1980s will fall out of the 25-year average by 2016, further reducing that alternative discount rate. Since lower discount rates result in larger calculated funding gaps, the supposed “pension relief” produced by this legislation will quickly disappear.

The transportation legislation is, in short, another example of Congress kicking the can down the road. The esoteric changes in funding rules will not actually improve the financial condition of corporate pension plans; instead, the new rules will allow companies with deeply underfunded plans to avoid the day of reckoning when they must deliver on their promises to plan beneficiaries.