Sensible Funding Rules to Stabilize Pension Benefits Christian

Sensible Funding Rules to Stabilize Pension Benefits Christian E. Weller, Ph. D. Senior Economist Center for American Progress www. americanprogress. org

Overview § Current funding rules are counter-cyclical. § The administration’s proposal would exacerbate countercyclicality, raise uncertainty for employers and beneficiaries. § Alternative funding rules could reduce counter-cyclicality. § Everybody could win: employers would gain predictability and employees and PBGC would see greater benefit security.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 3 The Basics of Pension Funding § Pension funding depends on the ratio of assets to current liabilities. § Current liabilities are projected benefit payments discounted to the present. The lower the interest rate is, the higher liabilities will be. § Many employers use fair market value to value their assets. When asset prices fall, pension plans quickly lose money and vice versa. § During periods of overfunding, employers have disincentives to contribute more.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 4 Counter-Cyclical Regularities § Interest rates fell in 11 out of 12 recessions. § Stock prices tend to be lower just prior to a recession. § Underfunding is typical for recessions and overfunding is typical for expansions. § The magnitude of the declines was especially pronounced in the recent recession. Thus, reserves built up during the expansion quickly evaporated.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 5 Administration Proposal Will Exacerbate Problems § Administration has proposed use of yield curve, with smoothing over 90 days, and fair market valuation. § Greater use of fair market value increases asset volatility. § Yield curve raises costs for firms with older work force in mature industries. EPF estimates cost would rise by 2 -4 percent. § Yield curve would magnify counter-cyclicality. Short-term interest rates fall more than long-term interest rates in a recession.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 6 Alternative Rule Change No. 1: More Smoothing of Liabilities § Instead of using a 4 -year weighted average, use a 20 -year average. § Instead of using 30 -year treasury rate use 10 -year treasury rate. § 10 -year treasury rate is below 30 -year rate and thus provides a safety cushion.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 7 Alternative Rule Change No. 2: More Smoothing on Asset Side § Stock prices are tied to long-term P/E ratio. It is assumed that asset prices adjust over 20 years to their long-term average. § When prices are high, they are discounted, and when they are low they are increased. § Asset valuation has to stay within 80 -120% of fair market value.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 8 Alternative Rule Change No. 3: Required Funding § Required funding levels up to 120% of current liabilities. § Administration has proposed to allow for funding up to 130%, but not require it. Given recent research, this is likely not to have a large impact.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 9 Simulation Results § More funding holidays during the recent recession because funds would have been better prepared. § More funding adequacy, while maintaining average contribution levels. There is no free lunch, but timing matters. § All funding rule changes would have reduced counter -cyclicality after the 1980 s. Greatest effect comes from asset funding rule changes.

Sensible Funding Rules to Stabilize Pension Benefits October 8, 2004 10 Conclusion § Pension funding rules are counter-cyclical. § Administration proposal would exacerbate countercyclicality, especially for plans in manufacturing. § Alternative funding rule changes, which allow for more smoothing, would reduce counter-cyclicality and improve funding adequacy.