At the eleventh hour, the US Senate has voted to keep federal money flowing to highways, but rejected the bill's funding source. This $10.8 billion package was to be paid for through a budget maneuver called temporary pension smoothing. As a budgetary matter, this is just a gimmick. Yet as a pension matter, it makes perfect sense—if it is permanent. Regardless of what one thinks about the highway bill, as far as pensions are concerned, Congress should stop the gimmickry and enshrine this change in permanent law.
When Congress wants to increase spending, it must come up with the funds. This is called a "pay-for." Two years ago, Congress "paid-for" the Highway Bill with a temporary pension smoothing amendment. More recently, the Senate attempted to use pension smoothing as a pay-for to extend unemployment benefits, but that bill never passed the House of Representatives.
Pension smoothing is a sensible way to allow corporations to maintain and fund their pension plans. It allows plan sponsors to align their funding to the long-term horizon of their liabilities, not the short-term nature of market volatility. Pensions value their liabilities using a discount rate similar to the rate of interest paid on high-grade corporate bonds—essentially, those rated AA. Even though pension liabilities are paid out over decades, current rules require that they be valued with a two-year average discount rate.
Since 2005, US corporations have terminated 5,000 pension plans. Two million fewer Americans are covered by a defined benefit plan.
Interest rates have been very low for years. The lower the interest rate, the higher the present value of the liabilities. Corporations are required to pay down approximately one-seventh of their underfunded pension liabilities each year. They are not, however, required to have pension plans in the first place. And after years facing this volatility, fewer of them do. Since 2005, the year before current pension legislation was passed, corporations in the United States have terminated 5,000 pension plans. Today, two million fewer Americans are covered by a defined benefit plan.
If Congress would like to keep the remaining pensions plans in place, it must make pension smoothing permanent. As the name suggests, this would smooth the burden (and pain) of funding plans across all rate environments rather than concentrating it on low-rate periods. Over time, it will make pension funding would become more predictable. That will allow more corporations to keep their plans intact.
Some argue that the only way to value liabilities is by marking them sharply to market. For the security of members’ retirements, these liabilities must be fully funded. But think about this: If interest rates were to rise by less than two points, almost every pension in America would be "fully funded." Would we want corporations to forego any pension contributions in those years? What we should want—if we want to keep the defined benefit system alive—are predictable contributions that rise and fall over the long term (just like the liabilities they are responsible to meet).
Unfortunately, Congress has used temporary pension smoothing as a sort of budgetary piggy bank. Need to fund a $10 billion project? Bingo! Pension smoothing. The fact is, lower near-term contributions mean higher ones in coming years. When Congress only counts the budgetary effect in the next few years, it is hiding the long-term reality instead of addressing it. But many plan sponsors—desperate for stability—won’t fall in line if only offered temporary smoothing.
Two years ago, the Congressional Budget Office’s “pay-for” revenue estimate proved too high thanks to pension smoothing. Many corporations chose not to take advantage of it, due to the short timeframe and Congress’ unreliability and unpredictability. This year, the office has lowered its estimate. Lawmakers know that temporary pension smoothing will not deliver the long-term funding stability corporations need to keep their pensions in place. So lawmakers should act.
Charles Millard is the global head of pension relations at Citigroup. He also served as the director of the US Pension Benefit Guaranty Corporation (2007-2009) in the administration of President George W. Bush.