When Congress passed a transportation bill in July, it included important changes to rules governing corporate pensions. Unfortunately, these changes will allow companies to underfund their pension plans, which will cost taxpayers down the road.
As usual with bad pension policy, the rules involve a complex accounting issue. In this case it’s “discounting,” the process by which a pension actuary determines how many assets a fund must have today to cover payments that come due in the future.
For example, imagine that a pension fund owes a payment of $105 in one year. If the fund applies a discount rate of 5 percent, it must hold $100 today for that obligation to be fully funded.
Pension funds use discount rates matched to yields on high quality corporate bonds in order to simulate the risk experienced by corporate pensioners. As with a bond, corporations are generally obligated to make their pension payments in full unless they go bankrupt.
Corporate bond yields, like most interest rates, have fallen drastically in recent years. Low bond yields mean low pension discount rates; and the lower the discount rate, the more money a corporation must set aside to cover its pension promises.
Corporations seeking to duck that responsibility found an ally in Congress. Because pension contributions are deductible from taxable income, higher pension contributions mean lower corporate income tax collections for the U.S. Treasury.
So Congress changed the discounting rules, allowing companies to choose discount rates based on a 25-year average of corporate bond yields instead of using an average of just two years. In other words, companies may now calculate their pension funding needs in part based on bonds that traded in the early 1990s, even though similar yields are unavailable today.
Today’s low bond yields have made corporate pension promises more expensive to keep. Allowing companies to ignore this fact simply allows them to hide their pension costs and create funding gaps. If a company remains financially healthy, it will have to make bigger payments in later years to catch up, which also means the corporate tax collections boosted by this policy today will be lower in later years.
Meanwhile, companies that go bankrupt will tend to have accrued larger unfunded liabilities. The bulk of those liabilities are covered by the Pension Benefit Guaranty Corp., a federal agency backstopped by taxpayers.
The pension legislation also raised the premiums that companies pay into the agency, which, in theory, should offset costs to taxpayers. But Congress counted the increased premiums as funds available to pay for highway construction, essentially double-counting the money.
This relief of pension funding obligations will undermine the solvency of pension funds in part to address a problem that doesn’t exist. Companies protest that they can’t afford to adjust to sharply falling discount rates. The costs they face, however, are a mix of costs they should have been able to control and costs they do control.
In the first category is any increase in unfunded pension liabilities due to lower discount rates. It’s true: Given the crashing bond yields of recent years, without relief, pension funds would be told to start holding many more assets. But the flip side of falling yields is that bond prices have risen significantly.
If a pension plan invested in bonds with maturities matching its obligations -- that is, enough 10-year bonds to cover the payments due in 10 years, and so forth -- the value of its holdings should have risen enough to cover its added asset needs. Only companies that chose not to properly match their maturities are left closing a gap.
In the second category is the increase in the cost of benefits that employees accrue going forward. Lower discount rates will force companies to set aside more money as workers earn benefits. That reflects a real rise in the cost of promised pension benefits. Companies that find those costs excessive can cut the benefits employees earn in the future. They may decide that they prefer not to change pension terms but, as with any other benefit, they should be prepared to pay more as costs rise.
The Pension Protection Act and its predecessor, the Employee Retirement and Income Security Act, were major improvements to the security of retirement systems. The core of these laws is the requirement that companies adequately fund their plans so that workers and taxpayers are protected when companies go bankrupt.
By weakening such requirements, Congress weakened employee retirement security and increased the risk that taxpayers will be on the hook to bail out underfunded pension plans. Congress made a mistake. It’s not too early to begin drafting legislation to fix it.
To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at email@example.com.