An Empirical Analysis of Risk-Related Insurance Premiums for the PBGC

Abstract

Abstract In 1986, one component of the single-employer plan termination insurance program was altered in an attempt to assure its financial integrity. A year later, the Pension Benefit Guaranty Corporation proposed that the basis for computing premiums for plan sponsors also be changed and the basic philosophy of the proposal was incorporated in the Omnibus Budget Reconciliation Act of 1987. This article develops probability and severity models for large single-employer defined benefit sponsors. Estimates of the liability that underfunded plans impose on the PBGC are obtained from combining the results of the two models and calculations of insurance premiums are presented. Introduction In 1974, the Employee Retirement Income Security Act (ERISA) established a plan termination insurance program for the majority of defined benefit pension plans in the United States to ensure that at least a certain level of participants' benefits would be paid without regard to the funded status or continued existence of the sponsor's pension plan. The extant literature is replete with articles pointing out the preverse financial incentives created by this program (e.g., Sharpe, 1976; Treynor, Regan and Priest, 1976; Treynor, 1977; and Harrison and Sharpe, 1983) and, since its inception, the deficit generated by the single-employer component of this system had grown to as much as $3.8 billion. In 1986, one of the major defects associated with the original design was corrected when the Single Employer Pension Plan Amendments Act (SEPPAA) changed the insured event from that of, in essence, any plan termination to a termination accompanied by a specified event for the plan sponsor. [1] This change effectively limited the insurable event to an insufficient [2] termination due to bankruptcy by the sponsor, thereby virtually eliminating the opportunity of an ongoing sponsor to exchange the unfunded vested liabilities of the plan for 30 percent of its net worth (an option existing under the original provisions of (ERISA). However, it did nothing to change the premium structure from a flat dollar amount per participant. Congress recently redressed this shortcoming in part by enacting a variable rate premium structure that will relate the sponsor's annual premium to the plan's underfunding (as measured on a termination basis). Although this change will factor the plan's potential severity into the determination of the annual premium, it falls short of a risk-related premium structure that would characterize the insurance if it were written in the private sector. Such a structure would base annual premiums not only on the potential severity but also the probability of an insured event taking place (i.e., bankruptcy of a sponsor with an underfunded plan). The new premium system also differs from a free market approach in that it includes a maximum charge of $50 per participant. The idea of risk-related premiums for the plan termination insurance program is not new. In his seminal work on the establishment of a guaranty fund for pension plan benefits insurance, McGill (1970, p. 76) made a provision to reflect the probability of plan termination in the premium rate if the burden appeared to be consequential. Congress, however, initially set the PBGC premium rates at $1.00 per participant. [1] Although PBGC was provided the opportunity under ERISA Section 4006 to modify this initial premium structure, no action was taken until Congress mandated under SEPPAA that PBGC investigate alternative premium bases upon which some or all projected future program costs could be allocated on a variable rated or risk-related computation. In response, the PBGC (1987, p. 55) produced a proposal for a variable rate premium structure that provided the basic structure of the legislative changes under the Omnibus Budget Reconciliation Act of 1987 (OBRA). [4] The new single-employer plan termination insurance program increased the flat rate premium to $16. …