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September 29, 2014
Pension Smoothing Risks Losing Money, but Few Alternatives Seen
by Luca Gattoni-Celli

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Despite its use as an offset in the recently enacted bill replenishing the Highway Trust Fund, policy analysts say that pension smoothing does not ultimately increase tax revenue and risks costing money, but even those who question its legitimacy see few politically viable alternative offsets.

Pension smoothing reduces the minimum required level of tax-deductible contributions to single-employer defined benefit pension plans. It allows employers to use higher, historic interest rates in their funding calculations, resulting in lower required contributions, increased taxable business income, and thus greater projected revenue.

Firms may contribute less each year, but must still ultimately meet their obligations, counteracting an initial revenue bump. The short-term nature of the gains has led some to call the practice a gimmick or worry that resulting pension defaults could ultimately create government liabilities.

Pension smoothing's unpredictability raises questions about its use as a pay-for by the top House and Senate taxwriters, who previously opposed the practice. In June negotiations over this year's highway funding bill, Senate Finance Committee Chair Ron Wyden, D-Ore., criticized seeking revenue from "accounting gimmicks," and though he demurred when asked if that included pension smoothing, he has opposed it in the past. Similarly, numerous congressional staff members say House Ways and Means Committee Chair Dave Camp, R-Mich., despises pension smoothing.

A Senate tax staffer said Congress's constant reliance on pension smoothing signals dysfunction, and that the offset is depletable and should be discarded.

Thomas Barthold, Joint Committee on Taxation chief of staff, said pension smoothing does not increase revenue overall and that the JCT's revenue estimates for pension smoothing proposals show annual revenue losses late in the official 10-year budget window used to score tax bills, as firms increase pension contributions.

Pension smoothing is probably a wash for the budget, said Marc Goldwein, senior policy director of the Committee for a Responsible Federal Budget, though he added that it potentially loses a little revenue because of the time value of money. Moreover, any resulting pension defaults guarantee increased total government liabilities, Goldwein said, calling pension smoothing "absolutely, 100 percent" a gimmick.

Pension smoothing-related defaults would create new liabilities for the Pension Benefit Guaranty Corp., an independent government agency that collects premiums from employers, to insure at least the partial value of insolvent pension plans, according to Judy A. Miller, director of retirement policy at the American Society of Pension Professionals & Actuaries. Typically, most employers exceed minimum pension contributions, but pension smoothing puts a limited number of underfunded plans at risk of default, if the financially troubled firms that support them go under, Miller said.

Miller said the argument that pension smoothing poses nominal risk given the long-term time frame of pension liabilities breaks down if companies fail in the next few years and are unable to meet their liabilities.

The PBGC's 2013 Projections Report estimated that the agency's program for insuring single-employer pension programs would run a $7.6 billion total deficit through 2023, said an agency official. The PBGC estimated that the pension smoothing measure enacted under the Highway and Transportation Funding Act of 2014 (H.R. 5021) would add $2.3 billion to that $7.6 billion figure, all in present-value dollars, an increase of more than 30 percent. The PBGC had not estimated the cost of additional years of pension smoothing, the official added.

This year's round of pension smoothing made retroactive changes to law after 2012 that delay for five years an adjustment in the formula used to determine minimum contributions.


How It Works

Miller and a second Senate staff member said the current round of pension smoothing puts some plans at significant risk of underfunding if interest rates remain depressed, because the diminished contributions to those plans would have a lower real rate of return and would not sufficiently increase in value to meet pension obligations. If low rates reduce the returns of compound interest, the opportunity cost of reducing initial contributions would be significant, Miller said.

Pension smoothing was first used as an offset in July 2012, for another extension of transportation infrastructure funding. (Prior coverage .) But the Senate staffer said the arguments for pension smoothing in 2012 do not apply to the second round enacted this year, because interest rates are no longer near zero and, as shown by recent Treasury bond rate trends, cannot be predicted.

Responding to the financial crisis, the Federal Reserve pushed interest rates to a historical low in July 2012, which increased minimum pension contribution requirements, forcing firms with well-funded pensions to lock tens of billions of dollars into pension plans, money that can only legally be re-purposed for worker health benefits, the staffer said.

The near-zero interest rates had dragged down the 24-month moving average of high-quality corporate bond rates that dictated minimum required pension contributions. Under the 2012 highway bill, single-employer PBGC premium levels and pension contributions' maximum deductibility remained tied to the 24-month moving average, the staffer said. Miller said the full value of the minimum required contribution is tax deductible by law.

Interest rates and minimum required contributions are inversely related because if an employer is obliged to assume that pension contributions accumulate more interest and grow in value faster, it is allowed to contribute less. The 2012 highway bill's pension smoothing provisions weakened the link between historically low short-term interest rates and minimum required contributions, reducing the requirements to give companies greater access to their own capital, the staffer said.

The 2012 highway bill created a corridor of minimum and maximum interest rates along a broader, 25-year moving average that reflected interest rates' higher historical levels. The corridor gradually widens with the lower bound falling to accommodate interest rates' expected rise to historical norms, the staffer said.

Under the bill, the pension smoothing corridor used to determine minimum and maximum required contributions started at plus or minus 10 percent of the 25-year moving average in 2012, widening to 15 percent in 2013, increasing by 5 percent annually until it reached 30 percent in 2016, after which the corridor would hold steady.

If the 24-month average falls below the pension smoothing corridor, the corridor's lower bound is the interest rate used to determine minimum required contributions, the staffer said. The 24-month average is used to determine minimum contribution levels if it falls within the corridor, according to the staffer. The corridor's upper bound would be used to determine maximum allowable contributions in the unexpected event that the 24-month moving average exceeded it, the staffer said.

As an example, if the 24-month moving average interest rate for 2012 (0.1 percent) were below the product of the 25-year moving average (1.5 percent) and 90 percent (0.9), that second, pension smoothing corridor (1.35 percent) would be used to calculate minimum required contributions.

The Senate staffer said pension smoothing's creators expected interest rates would eventually exceed the lower bounds of the corridor they created, allowing the 24-month moving average to once again determine minimum required pension contributions. The staffer said this crossover would have probably occurred a year or two from now -- if not for the second round of pension smoothing in this year's highway bill.

The 2014 highway bill holds the pension smoothing corridor at plus or minus 10 percent for five additional years, until 2017, after which it would widen plus or minus 5 percentage points per year until reaching 30 percent in 2021, after which it would hold steady.

Miller said stakeholders and tax observers who argue pension smoothing has little opportunity cost are assuming that rates will remain low for a few years then gradually rise to historical norms, an argument she characterized as more a rationalization than a policy justification. And the Senate staffer's point about recent interest rate movements defying market expectations illustrates the fundamental difficulty of forecasting such financial metrics.


Slippery-Smooth Politics

Despite their previous opposition, both chief taxwriters included pension smoothing in their respective plans to replenish the Highway Trust Fund when negotiations had broken down, with Camp first proposing $6.4 billion worth and Wyden proposing $2.7 billion in response. Camp's plan reached President Obama after the House rejected, and the Senate retracted, Senate-passed amendments to adopt Wyden's offsets, minus the pension smoothing.

So why the change? Simple politics can turn even critics into apologists. A House tax staffer said pension smoothing is relatively popular because it lacks tangible, concentrated political opposition. Many businesses like having less capital locked up in pensions, at least temporarily, and many congressional members like that revenue within the budget window technically increases without angering any constituency or affecting government programs, the staffer said.

The House tax staffer added that pension smoothing's complexity muddles critiques: "Of course budget hawks don't like it, but I don't think they've developed a succinct enough explanation of the policy to get deficit-minded interests fired up."

Told the general public might call pension smoothing a gimmick if it understood the provision, Camp responded that his bill's offsets had received bipartisan support in the past. Former Congressional Budget Office Director Douglas Holtz-Eakin said pension smoothing's bipartisan acceptability, vital to an offset's adoption in the current political environment, has been established by repeated vetting, dating back to the 2010 Simpson-Bowles fiscal commission.

Holtz-Eakin said he thinks "the gimmick label is used too casually," though he added that "pension smoothing has been used to pay for essentially unrelated policy actions. There is no particular virtue in that."

A House tax staffer agreed that policy actions should be meaningfully and directly linked to their funding sources; he said determining alternatives is difficult because it requires knowing the usually unrelated activity that pension smoothing is being applied to.

One obvious choice to pay for highway funding, the Senate tax staffer argued, is highway user fees. The staffer suggested a gas tax increase, as proposed this year by Sens. Christopher Murphy, D-Conn., and Bob Corker, R-Tenn. That plan died, however, signaling the political difficulty of any alternatives.

But pension smoothing may soon run dry as a funding source, so alternatives will need to be explored. The second Senate staffer said further delaying the corridor's expansion could generate more revenue within the budget window but emphasized that doing so would be risky.

Barthold said such additional revenue would result from simply pushing some of the collection reversals beyond the budget window. But he could not predict how much more official revenue pension smoothing could generate. "We have not estimated any specific proposal" to extend pension smoothing another year or two, Barthold said.

The PBGC spokesperson also said the agency had not evaluated how it would be affected by additional years of pension smoothing.

Though Holtz-Eakin didn't know how to estimate how much more official revenue pension smoothing could conceivably provide, he said that "there is very little left."

As for alternatives, "the key dynamic will be the degree to which the discretionary [spending] stakeholders drive Republicans and Democrats to take on the entitlement spending," Holtz-Eakin said. "Stay tuned."

Follow Luca Gattoni-Celli (@TheGattoniCelli) on Twitter for real-time updates.


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