Sensible Funding Rules
to Stabilize Pension Benefits
Christian E. Weller, Ph.D.
Senior Economist
Center for American Progress
www.americanprogress.org
Sensible Funding Rules to Stabilize Pension Benefits
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
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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
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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
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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
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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
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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
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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
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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 1980s. Greatest effect
comes from asset funding rule changes.
Sensible Funding Rules to Stabilize Pension Benefits
October 8, 2004
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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.