The Pension Benefit Guaranty Corporation’s Real Crisis

On February 1, American Airlines—which declared bankruptcy last November—announced plans to end defined benefit pensions as part of its Chapter 11 restructuring plan. If approved by bankruptcy court, the airline would turn over its defined benefit pension plans to the Pension Benefit Guaranty Corporation (PBGC), a federally chartered agency that insures private sector pensions.

Offloading pension liabilities would help American Airlines’ restructuring efforts, but it would place enormous strain on the PBGC, which last year reported a $26 billion deficit. If the agency takes on American Airlines’ pensions, that deficit could grow to $35 billion, according to recent congressional testimony by PBGC Director Joshua Gotbaum.

The PBGC is funded through premiums paid by insured companies, not by federal dollars. But taxpayers should still worry; while they aren’t directly on the hook for the PBGC’s unfunded liabilities, that could well change. The agency’s massive, mounting deficit makes for a very likely target for a federal bailout.

In fact, some politicians have already proposed such a bailout. A bill introduced in the last Congress by Sen. Robert Casey (D-Penn.) sought to make the federal government liable for multiemployer plans under the PBGC’s purview. Thankfully, the bill failed, but similar schemes could come to the fore if the PBGC’s deficit were to get much worse.

Unlike a viable, private sector insurer, the PBGC acts like the political animal it is. Its premiums are woefully inadequate to cover its payouts because they are set by politicians in Congress. But this undermines the very purpose of premiums: pricing risk, as determined by market signals.

Moreover, the politicized premium-setting regime practically guarantees that premiums will tend to be too low. As Gotbaum recently told the House Subcommittee on Health, Employment, Labor, and Pensions (HELP), “Our premiums are not set by us; they’re set by law. They’re set too low.” Indeed—and they will almost certainly remain too low as long as unions and companies have an incentive to lobby keep rates low.

It gets worse. As American Airlines’ move to offload its pensions illustrates, the PBGC is a prototypical moral hazard. American, like many large firms, has suffered from chronically underfunded pensions for years. Without a federal guarantee, they would have had a greater incentive to reform their pension systems long ago, perhaps by paying out existing commitments and phasing out defined benefit pensions for new employees.

The PBGC is effectively propping up an institution that is becoming increasingly anachronistic: defined benefit pensions. These plans pay out a fixed amount, regardless of the value of the pension fund. The job of defined benefit fund managers is to project the returns they need make to pay out pension obligations and determine what investments they need to stay afloat. But as any investor knows, projecting future returns is an inexact science, at best. All the while, liabilities keep growing. In 2011, the Department of Labor sent out “critical” status notices to the managers of 131 union pension funds that are underfunded by 35 percent or more.

In recent years, defined contribution plans have been steadily replacing defined benefit plans across most industries. Why have defined benefit pensions survived for so long? Because they could. Today, defined benefit pensions are largely confined to government employers—and private sector unions. Interestingly, the major industries that have unloaded their pensions onto the PBGC—airlines, steelmakers, and automakers—once had something in common with government: They all once operated in an environment of very little competition. The implication is clear: Defined benefit pensions thrive in stasis. In a highly competitive economy, however, they are extremely risky.

The PBGC last fall requested Congress to give it greater latitude in setting premiums to reflect actual market risk. Such a move would be a positive step, but more reform is needed. If the defined benefit pensions that remain in the private sector are to pay out their obligations without taxpayers getting soaked, pension insurance premiums need to be liberalized to reflect the real risks they face, as signaled by real prices communicated through a free market.

In a recent congressional hearing, HELP subcommittee ranking member Robert Andrews (D-N.J.) stated that he and his Republican colleagues agreed on one thing—“no more bailouts.” Amen. If Congress is serious about ending the bailout culture it cultivated, it needs to fundamentally reform how the PBGC sets premiums. Until then, the agency will continue to face funding problems well into the future, and taxpayers will remain at risk of having to pick up the tab.