Case 3-8 Corporate Governance Implications of the Pension Benefit Guaranty Corporation In 1974, Congress created the Pension Benefit Guaranty Corporation (PBGC) as part of the Employment Retirement Income Security Act to protect workers from pension failures. The PBGC protects the pensions of American workers and retirees in private single-employer and multiemployer defined benefit pension plans. The PBGC receives no funds from general tax revenues. Operations are financed by insurance premiums set by Congress and paid by sponsors of defined benefit plans, investment income assets from pension plans trusteed by PBGC, and recoveries from the companies formerly responsible for the plans. The PBGC collects premiums from U.S. pension plans and uses the money to pay partial retirement benefits if a plan cannot meet its pension obligations to workers. A 2009 study of the solvency of the Pension Benefit Guaranty Corporation (PBGC) by the Brookings Institute points out that the deficit in the fund is $22 billion. This may be just the tip of the iceberg. Back in May of 1995, United Airlines was granted permission by the bankruptcy court to terminate its $9.8 billion in pension obligations. The PBGC will cover about $6.6 of the shortfall with retirees bearing the burden of reduced benefits of about $3.2 billion. The agency estimates that total underfunding of all traditional pensions is about $450 billion, including $96 billion for defaults it calls reasonably possible. There is a statutory limit on the amount that PBGC can guarantee. Under the single-employer program, the limit is adjusted annually based on changes in the Social Security contribution and benefit base and is permanently established for each pension plan based on the date the plan terminates except for cases in which termination occurs during a plan sponsor's bankruptcy or for certain airline industry plans. For plans with a 2009 termination date, the maximum guarantee is $54,000.00 yearly ($4,500.00 monthly) for a single life annuity beginning at age 65. The maximum is adjusted downward for retirees younger than age 65. For example, the maximum guarantee for a participant who retires at age 62 is $42,660.00 yearly ($3,555.00 monthly) for a single-life annuity. There are three main reasons for the PBGCs financial troubles. First, it has structural problems with its finances that date back to its inception in 1974. Its premium levels, which are set by legislation, have never been high enough to cover the risks it has faced over the long term, which are themselves largely determined by pension funding rules that are also legislated. This problem has been mitigated over the years by increases in premiums and tighter rules on corporate pension funding, but the deficit continues to get worse. Premium levels are not sufficient to hold the deficit steady; they would have to go up considerably further still to fill in the existing financial hole. Second, the PBGC insures against corporate bankruptcies, so it is no surprise that a period of severe economic distress would cause claims on the PBGC to soar. The problem would have been worse still for the PBGC, by a considerable ways, if the government had not rescued GM and Chrysler. (The state of the economy is not the only explanation, of course, since the PBGC had deficits of $11 billion and up during the bubble period of the mid-2000s.) In addition to the actual claims hitting the PBGC as a result of this recession, there is also a much higher potential level of claims over the next few years. Third, corporate pension funds have about three-fifths of their money invested in the stock market. There is an unfortunate tendency for bankruptcies to occur during periods when the stock market has also been hammered, since both are tied to the overall state of the economy. This gives the PBGC a large, indirect stake in the performance of the stock market, which is one reason why economists with pension expertise virtually unanimously have opposed increases in the PBGCs holdings of stock in its own portfolio. The stock market declined precipitously during the years 2007 through 2008, which directly reduced the value of the PBGCs stock holdings to a modest extent and raised the likely cost of bankruptcies that resulted in PBGC takeovers of pension funds. Even more importantly is the estimated cost in todays dollars of paying all future pension claims that have gone up sharply. For example, the PBGC provides an estimate of the pension underfunding at financially weak companies. The 2008 report showed a figure of $47 billion for this exposure. Pension liabilities are measured by estimating the future pension payments, based on such things as life expectancies, and then calculating the cost in todays dollars of making those payments. The dramatic reduction in interest rates over the time period through 2010 makes the cost in todays dollars significantly higher, since there is less assumed investment income over the years due to the lower interest rates. Thus, the mismatch between the poor performance of the stock market and the large increase in estimates of the pension liability due to declines in interest rates was quite harmful to pension plans and to the PBGC. In sum, the past few years have been bad ones for the PBGC. But, the results should not be dismissed as simply the sign of another victim of the financial crisis. There are serious structural problems with the PBGCs finances that will keep it on a long-term downward trend unless corrected. There will be periods when the cancer at its core seems to be in remission, especially during boom periods in the economy and markets, but the inevitable economic declines will show that the problem is still there, getting worse. Questions 1. What are the ethical obligations of a company to meet its pension obligations to its employees? Should companies be allowed to walk away from their commitments if it is the only reasonable step to forestall bankruptcy? Use ethical reasoning to answer this question. 2. What are the corporate governance implications of having a pension plan that fails to meet its employee obligations? Consider the various elements of corporate governance and evaluate the role of each group. 3. In late April of 2009, Lockheed Martin said its first-quarter earnings for 2009 fell 8.7% because rising pension costs outweighed an increase in sales. Is it right for a company to absorb pension costs so high that it exceeds sales revenue? Consider your answer to question 1 in responding to this