Committee on Ways and Means, Subcommittee on Oversight, 6-20-02 Testimony

Statement of Mark Beilke, Director, Employee Benefits Research,
Milliman USA, Vienna, Virginia, on behalf of the American Benefits Council

Testimony Before the Subcommittee on Oversight
of the House Committee on Ways and Means

Hearing on Retirement Security and Defined Benefit Pension Plans

June 20, 2002

Chairman Houghton, Ranking Member Coyne, thank you very much for the opportunity to appear before you today on this critically important topic. I am Mark Beilke, Director of Employee Benefits Research for Milliman USA. Milliman USA is a firm of consultants and actuaries with more than 30 offices in the U.S., more than 1600 employees, and over 5,000 employee benefits clients, most of which sponsor defined benefit pension plans. I am appearing today on behalf of the American Benefits Council, where Milliman serves on the board of directors. The American Benefits Council (Council) is a public policy organization representing principally Fortune 500 companies and other organizations that assist employers of all sizes in providing benefits to employees. Collectively, the Council’s members either sponsor directly or provide services to retirement and health plans covering more than 100 million Americans.

Background on Defined Benefit Plans

Mr. Chairman, I want to thank you for calling this hearing to examine the state of our nation’s defined benefit pension system. Such an examination is urgently needed. While the private-sector defined benefit system helps millions of Americans achieve retirement income security, it is not a system in good health. The total number of defined benefit plans has decreased from a high of 170,000 in 1985 to 59,000 in 1997 (the most recent year for which official Department of Labor statistics exist), and most analysts believe there are fewer than 50,000 plans in the U.S. today.^[1] There has been a corresponding decline in the percentage of American workers with a defined benefit plan as their primary retirement plan from 38% in 1980 to 21% in 1997. Looking at the decline in defined benefit plans from one year to the next makes this unfortunate downward trend all the more stark. The Pension Benefit Guaranty Corporation (PBGC) reports that it insured 39,882 defined benefit plans in 1999 but only 38,082 plans just one year later in 2000. This is a decrease of almost two thousand defined benefit plans in a single year. Furthermore, based on what we are seeing throughout my firm, there is more plan termination activity in 2002 that we have seen in recent years.

These numbers are particularly sobering because defined benefit plans offer a number of features that are effective in meeting employee needs – benefits are funded by the employer (and do not typically depend upon employees making their own contributions to the plan), employers bear the investment risk in ensuring that earned benefits are paid, benefits are guaranteed by the federal government through the PBGC, and benefits are offered in annuity form. The stock market conditions of recent years (and the corresponding decline in many individuals’ 401(k) balances), as well as the national retirement policy discussions spurred by the bankruptcy of the Enron Corporation, have once again demonstrated to many the important role that defined benefit plans can play in an overall retirement strategy.

So, with these advantages for employees, what has led to the ill-health of the defined benefit system? Several factors have played a role. First, the statutory and regulatory landscape has not been friendly to defined benefit plans and the companies that sponsor them. Throughout the 1980’s and early 1990’s, frequent changes were made to the statutes and regulations governing defined benefit pensions, often in the name of promoting pension “fairness.” Yet the result was that these plans became increasingly expensive and complicated to administer and the plan design flexibility so important to employers was impaired. During the same period, and motivated by a desire to raise federal revenue, Congress repeatedly reduced the benefits that could be earned and paid from defined benefit plans, undermining the personal commitment to these voluntary plans by senior management and other key decision-makers.

Defined benefit plans also require very significant -- and often unpredictable -- financial commitments from employers, something that many companies found more difficult to maintain in light of intense business competition from domestic and international competitors, many of which did not offer defined benefit plans and so did not have the corresponding pension expense. In addition, employees have not tended to place great value on defined benefit pension benefits offered by employers, preferring “shorter-horizon” and more visible benefits such as 401(k) and other defined contribution plans, stock option or stock purchase programs, health insurance and cafeteria plans. So ironically, while defined benefit plans have been complicated for employers to administer and expensive for them to maintain, they have not resulted in a significant increase in employee satisfaction, which is one of the core reasons for an employer to offer a benefit program in the first place.^[2]

The Pension Achievements Contained in the 2001 Tax Law

The Council is very gratified that in recent years Congress has recognized these disturbing trends and has begun to establish a more supportive policy environment for defined benefit pensions. This change of direction was initiated by Representatives Rob Portman and Ben Cardin and began in earnest with passage of the Portman/Cardin pension reforms contained in the Small Business Job Protection Act of 1996 and the Taxpayer Relief Act of 1997.

Representatives Portman and Cardin continued their efforts with the Comprehensive Retirement Security and Pension Reform Act (H.R. 1102 in the 106^th Congress; H.R. 10 in the 107^th Congress), which was ultimately enacted as part of the 2001 tax law. This legislation contained a number of very positive changes to the rules governing defined benefit plans. Correcting a series of past revenue-driven restrictions enacted by Congress, the Portman/Cardin legislation repealed an artificially low cap on pension funding that had complicated pension budgeting and financing. It also increased the benefits that can be earned under -- and paid from -- qualified defined benefit pension plans so that these plans remain an attractive vehicle for employers to sponsor in our voluntary pension system. The Portman/Cardin legislation also simplified a number of the most complex rules applicable to defined benefit plans, making these plans somewhat easier to administer, particularly in the context of mergers and acquisitions.

Mr. Chairman, you played a leading role in advancing these pension reforms through the Ways & Means Committee and many members of this Subcommittee worked to see these reforms enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. Thank you for these efforts, and thank you, of course, to Representatives Portman and Cardin for their leadership in drafting and advancing a series of reforms that have put our nation’s defined benefit pension policy on a new and more productive course.

Making the 2001 Pension Reforms Permanent

We understand that this week the House of Representatives will consider legislation introduced by Representatives Portman and Cardin -- H.R. 4931, the Retirement Savings Security Act of 2002 -- which will make the pension changes of the 2001 tax law permanent. In the Council’s view, this is one of the most important steps Congress can take to continue to encourage and support defined benefit pension plans. Sound pension policy depends upon truly long-range planning and budgeting, for both employees and employers, and this is difficult to achieve given that all of last year’s positive reforms are scheduled to evaporate come 2011. Consistency and supportiveness have too often been lacking in our nation’s policy toward defined benefit pension plans, but by making the 2001 pension changes permanent Congress can realize these goals and help to restore the health of our nation’s defined benefit system.

Unfinished Pension Reforms from the Portman/Cardin Legislation

Additional changes to our pension laws that would aid defined benefit pensions were contained in the Portman/Cardin pension legislation approved by the House (H.R. 10) but were not enacted as part of the final 2001 tax law due to anticipated application of the Byrd Rule in the Senate. Representatives Portman and Cardin have gathered these reforms in H.R. 3918, the Pension Improvement Act of 2002 and nearly all of these reforms were included in the Pension Security Act (H.R. 3762) passed by the House of Representatives on April 11, 2002.

These reforms would make defined benefit plans a more attractive vehicle for small employers through pension insurance premium relief and simplified reporting. They would create fairness for defined benefit plan sponsors by allowing the PBGC to pay interest on premium overpayments. Finally, they would help to simplify and rationalize defined benefit plan administration through a number of regulatory reforms, such as providing a limited safety valve from mechanical testing rules, encouraging electronic dissemination of plan documents, and modernizing plan notice regimes.

The provision providing for a limited safety valve from the mechanical pension testing rules has come under criticism from some quarters. The Council believes that this criticism is unfounded and that the safety valve provision is needed to ensure the rationality of the rules governing our pension system. The provision has been thoroughly vetted and debated and has been approved by the House of Representatives five times, often by overwhelming margins. The provision merely provides a limited safety valve so that fair pension plans that may be tripped up by mechanical testing rules can, under limited circumstances, demonstrate the equity of their plan to Treasury Department officials.

We encourage you to enact these important remaining items from the Portman/Cardin pension legislation this year in order to take another important step to support and encourage defined benefit pensions.

Pension Interest Rate Reform

Another area in which Congress has been tremendously helpful in recent months is in addressing the very serious repercussions for defined benefit pension plans of the decline in 30-year Treasury bond rates.^[3] If one puts aside the necessary follow-up work to enact the unfinished Portman/Cardin pension changes and to make the 2001 pension reforms permanent, clearly the action most urgently needed to stem the increasing number of defined benefit plan terminations is for Congress to enact permanent and comprehensive reform of the interest rates used for pension calculations. To highlight the urgency of this task, the Council has recently learned of several large employers that have concluded they must freeze their defined benefit plans. In each instance, the financial ramifications stemming from the low 30-year Treasury bond rates has been a primary factor.

Under current law, employers that sponsor defined benefit pension plans are required to use 30-year Treasury bond rates for a wide variety of pension calculations. Yet the Treasury Department’s buyback program and subsequent discontinuation of the 30-year bond has driven rates on these bonds to a level significantly below other conservative long-term bond rates. The result has been an artificial inflation in pension liabilities, often by more than 20 percent. As a result of these inflated liabilities, employers confronted inflated required pension contributions and inflated variable premium payments to the PBGC. Due to the nature of the pension funding rules, a number of employers faced dramatic increases in their pension funding obligations. I personally saw plans that had been overfunded for several years, requiring no cash contributions, which required substantial funding. Others that had modest and predictable contribution levels in the past saw funding requirements at multiples of what had been required in recent years.

Congress recognized that these unwarranted funding and premium obligations could not have come at a worse time. Such requirements would drain away hundreds of millions of dollars at a time when employers needed all the resources they could muster to keep workers on the payroll and to make the purchases and investments necessary to return the nation to economic growth. Congress also recognized that unreasonably inflated liabilities discourage employers from maintaining strong pension programs for their employees.

To correct for these inflated liabilities, Congress included short-term pension interest rate relief in the Job Creation and Worker Assistance Act of 2002, which President Bush signed into law on March 9, 2002. This short-term relief helped to remedy the artificially inflated funding and premium obligations faced by employers for the 2002 and 2003 plan years. It did so by allowing employers to use a higher interest rate for pension purposes (120 percent of the 30-year bond rate for funding purposes and 100 percent of the 30-year bond rate for premium purposes). This relief has made a meaningful difference to employers around the nation who have seen artificial liabilities corrected and precious resources freed up for maintaining payrolls and keeping businesses strong. This helped salvage employer commitment to these plans so as to ensure that employees will continue to build defined benefit pension benefits.

Four members of the Ways & Means Committee -- Representatives Sam Johnson, Rob Portman, Ben Cardin and Earl Pomeroy -- led the effort to secure this relief, and the Council wishes to extend its sincere appreciation for their leadership on this issue. These same Members are now working hard to apply the relief to the final 2001 payment that defined benefit plan sponsors must make by September 15, 2002 and to make a number of technical corrections to the relief provided in the stimulus legislation. These additional reforms were included in the House-passed Pension Security Act (H.R. 3762) and the Council looks forward to working with the Ways & Means Committee to identify an appropriate legislative vehicle that can carry these additional reforms to the President’s desk in a timely fashion.

Once short-term relief has been achieved, the Council believes it will be imperative for Congress to turn its attention to developing and enacting permanent and comprehensive pension interest rate reform. This effort must involve selection of a substitute long-term interest rate for use by pension plans in lieu of the 30-year Treasury bond rate. The effort must also involve correction of the rate not only for pension funding and premium purposes (the areas addressed by the short-term relief) but for all pension purposes currently dependent on the 30-year rate, such as the valuation of maximum benefits and lump sums payable from defined benefit pensions.

The low 30-year Treasury bond rates have had the same inflationary effect on lump sum payments from defined benefit plans that they have had on the funding and premium obligations of these plans. In other words, the low rates have produced artificially inflated lump sum payments to departing employees. While these inflated lump sums may appear to redound to the benefit of the affected employees, the reality is that the drain of cash from plans as a result of these artificially inflated payments has led a number of plan sponsors to freeze or terminate their defined benefit plans. This is clearly a very unfortunate result for the employees at these firms. Artificially inflated lump sums also deter employees from taking their benefit in an annuity form of payment, which would often be the preferable choice from a retirement income security and retirement policy perspective. Clearly, any change to the interest rate used for lump sum valuation purposes will need to include significant transition relief for participants nearing retirement age, but making this change is critical to the future of defined benefit plans.

We cannot over-emphasize the urgency of developing this permanent, comprehensive reform nor the degree to which achieving this reform is related to stemming the decline in defined benefit plans. The Council is committed to working with Congress and with groups from across the ideological spectrum to craft the permanent, comprehensive pension interest rate reform so necessary for defined benefit plans to remain viable.^[4]

Hybrid Plan Clarification

One notable bright spot in the defined benefit plan landscape in recent years has been the development of what are known as hybrid defined benefit plans, the most common variety of which is the cash balance plan.^[5] These plans have proven popular with employees and employers alike. While they offer the benefits of a traditional defined benefit plan (employer funding and risk-bearing, federal guarantees, the option of annuity benefits), they do so in an individual account form that is more easily understood and therefore more easily integrated into the employee’s overall retirement planning. Cash balance plans also offer the benefit of portability since benefits can be rolled over to an employee’s next workplace retirement plan or to an Individual Retirement Account. In addition, they offer a more even accrual pattern than traditional defined benefit plans (where significant benefit accruals are dependent on long service, producing disappointing results for employees who switch jobs several times during their careers). The bottom line is that the individual accounts, portability and level accruals of cash balance plans often make these hybrid defined benefit plans a better fit for the retirement needs of today’s mobile workforce than the traditional defined benefit pension.^[6]

Unfortunately, the laws and regulations applicable to defined benefit plans have not been updated to reflect the development and adoption of cash balance plans over the last fifteen years. These defined benefit rules were constructed entirely around the model of a traditional defined benefit plan, where the typical formula is tied to years of service and final pay and the benefit is paid in an annuity form at age 65. As a result, the rules are ill-suited to account-based cash balance plans, which have more level accruals and typically pay lump sums at whatever age employees depart. The awkward application of the traditional defined benefit rules to cash balance plans has left a number of pressing legal and compliance issues regarding these hybrid plans unresolved.

To give one example, some uncertainty exists regarding whether the value of the cash balance account constitutes the employee’s accrued benefit in a cash balance plan. This is clearly what is intended under a cash balance plan such that when an employee departs they are paid the balance in their account. Yet some have argued that application of the traditional defined benefit rules yields a different result. This theory holds that, in determining an employee’s lump sum distribution from a cash balance plan, the plan must project the cash balance account value forward to normal retirement age using the plan’s interest crediting rate and then discount the resulting figure to a present value using the statutorily prescribed 30-year Treasury bond rate. When the plan’s interest crediting rate is higher than the 30-year bond rate, this process produces an amount higher than the value of the cash balance account. This has been dubbed the “whipsaw” theory. While such a theory might appear to benefit the affected employee, the result is that employers must lower the cash balance plan’s interest crediting rate for all employees to the low 30-year Treasury bond rate in order to avoid whipsaw, substantially impairing the growth in cash balance accounts that would result from payment and compounding at a higher interest rate.

The federal agencies with jurisdiction over defined benefit plans -- led by the Treasury Department -- have been engaged for several years in an effort to resolve some of these legal and compliance uncertainties. The Council understands that this effort is nearing fruition and that proposed guidance on some of these questions may be issued later this summer. Yet it appears that the regulatory guidance will not address all of the outstanding issues, and the agencies may well conclude that they do not have statutory authority to reach all of the open questions. The Council believes that, whether through regulatory guidance or statutory change, it is imperative that we resolve the remaining uncertainties surrounding cash balance plans. These plans are the only real source of vitality in our defined benefit system today and have proven themselves to be the most effective way to deliver defined benefit plan advantages and protections in a way that meets the needs of today’s mobile employees. The statutory and regulatory climate should encourage these plans through clear rules that acknowledge their unique design features. Thus, we hope to work with Congress in the wake of the issuance of regulatory guidance later this year to complete the task of establishing a stable and supportive legal environment for cash balance plans.

The Next Generation of Pension Reform

With the enactment of the many positive Portman/Cardin pension reforms as part of the 2001 tax law, the Council has spent a good deal of time over the past year developing additional recommendations to further strengthen and expand the employer-sponsored retirement system. A number of these recommendations focus on ways to revitalize our defined benefit system and many of the defined benefit reforms I have already discussed today top our list of recommendations. Thus, we believe making the 2001 pension reforms permanent, enacting the unfinished Portman/Cardin pension changes, achieving permanent and comprehensive pension interest rate reform, and clarifying the rules applicable to cash balance plans are the most important steps Congress can take to improve the health of our defined benefit system.

Yet there are other reforms that the Council believes would help strengthen defined benefit pensions and let me share a few with you today.

First, the Council believes it is appropriate to consider reducing the per participant pension insurance premiums that employer sponsors of defined benefit plans pay to the PBGC. The premium discounts contained in the original Portman/Cardin bill and included in recent House-passed pension legislation (H.R. 3762) benefit only small employers or those firms that have never had a defined benefit plan. We believe modest premium relief would also be appropriate for employers to help restrain this significant cost that accompanies sponsorship of a defined benefit pension.
Second, the Council believes Congress should help to make defined benefit pension benefits a more useful mechanism for the financing of retiree medical coverage. Pension benefits are often used to meet health costs in retirement and we believe certain tax changes would help employees do this more efficiently. At many companies today, employees are asked to bear a share of the cost of retiree medical coverage. Yet if these employees are receiving a pension benefit and wish to pay their retiree medical premium with these funds, the position of the Internal Revenue Service appears to be that these workers must pay tax on the pension benefit and then pay the premium with after-tax dollars. We recommend that Congress allow employees to direct the appropriate portion of these pension payments to pay retiree medical premiums on a pre-tax basis (as active employees may do with salary to pay health premiums). This will allow employees to pay these premiums with pre-tax dollars, helping to alleviate one of the primary financial pressures faced by many older Americans.
Third, the Council recommends adoption of legislation introduced by Representatives Roy Blunt and Earl Pomeroy (H.R. 3012), which allows employers to “pick up” employee contributions to a contributory defined benefit plan so that these employee contributions may be treated as pre-tax contributions. This “pick-up” pre-tax treatment is permitted for contributory defined benefit plans of state or local governments but not for the contributory defined benefit plans maintained by some private-sector firms. Allowing this pre-tax treatment will encourage employers and employees alike to remain committed to these contributory defined benefit plans rather than abandoning them for exclusively defined contribution arrangements (where employee contributions are typically pre-tax).
Fourth, the Council believes that a legislative solution is necessary to address the growing administrative burdens attributable to “lost participants”, i.e., participants with relatively small benefits who cannot be located by plans. The cost for plans of maintaining records of these benefits and searching for the participants is significant, and a solution needs to be found. The Council believes that one option to explore is a material expansion of PBGC’s missing participant program to apply to plans that have not terminated.
Fifth, the Council recommends further simplification of the many complex rules governing defined benefit plans, many of which achieve little from a policy perspective but can make pension plan administration both more complicated and more costly.^[7]

The Council hopes to work with Representatives Portman and Cardin, with you Chairman Houghton and Ranking Member Coyne, and with other leaders in Congress to see these additional defined benefit reforms included in the next generation of pension reform legislation.

Conclusion

Mr. Chairman, I want to thank you once again for calling this hearing on what the Council believes to be one of the most important components of our nation’s retirement system and for examining some of the most important retirement policy questions we as a nation face today. The Council feels strongly that we must ensure that both traditional and hybrid defined benefit plans remain viable choices for employers so that companies can select the pension plan design most suited to the needs and wishes of their workforce. Defined benefit plans offer unique advantages for employees, but without prompt action by Congress we fear these plans will increasingly disappear from the American pension landscape.

Thank you very much for the opportunity to appear today and I would be pleased to answer whatever questions you and the members of the Subcommittee may have.

[1] The decline in sponsorship of defined benefit plans is in stark contrast to the increase in sponsorship of defined contribution plans, such as 401(k)s. According to the same official Department of Labor statistics, the number of defined contribution plans has increased from 462,000 in 1985 to 661,000 in 1997.
[2] Employee preference for account-based and more portable benefits has been a prime factor in the development of hybrid defined benefit plans, which are discussed below.
[3] The decline in these rates is attributable to the Treasury Department program of the last four years to buy back 30-year bonds from the public and was capped off by the outright discontinuation of the 30-year bond on October 31, 2001.
[4] The Council is currently developing our recommendations regarding the appropriate permanent, comprehensive solution to the pension interest rate problem and will be pleased to share our thoughts with Congress when we complete this process.
[5] The cash balance design combines features of a traditional defined benefit pension with those of a defined contribution plan such as a 401(k), hence the term “hybrid.” In a traditional defined benefit plan, an individual's pension is generally determined by a formula incorporating the employee's years of service and pay near retirement. The benefit in this traditional pension is expressed in the form of a lifetime annuity (stream of income) beginning at normal retirement age, which is typically 65. In a cash balance plan, an individual's pension is generally determined by an annual benefit credit (typically a percentage of pay) and an annual interest credit (an annual rate of interest that is specified by the plan). These benefit and interest credits are expressed as additions to an individual's cash balance account. These accounts grow over time as the benefit and interest credits accumulate and compound. Benefits in a cash balance plan are ultimately paid out in the form of a lifetime annuity or a lump sum.
[6] Congress devoted significant attention to conversions from traditional defined benefit plans to cash balance plans during the 106^th Congress. It was understandably concerned about the information employees received regarding these conversions and how certain, discrete groups of workers were affected by the change in plan design. These concerns led to enactment of an expanded notice requirement as part of the 2001 tax law, which will ensure that all employees receive the information they need to understand these conversions and the effect on their pension benefits.
[7] What follows are several examples of defined benefit plan complexity in need of reform and simplification. Today when a defined benefit plan obtains from a participant a waiver of the qualified pre-retirement survivor annuity (QPSA) (with spousal consent) and the participant is younger than 35 years old, the plan must seek another waiver from the same participant (again with spousal consent) after he or she has attained age 35. Another example of needed reform is legislation to further facilitate the use of new technology in plan administration. This use reduces costs and improves accuracy, thereby clearly improving administrative efficiency. A final example is legislation that reduces unnecessary burdens on the many defined benefit plans that use base pay (or rate of pay) in their benefit formula. Current law requires such plans to perform complex testing not otherwise necessary. The Council would be pleased to share with interested Members of the Subcommittee our other recommended regulatory simplifications in the defined benefit area.