The valuation of PBGC insurance contracts

Research output: Working paper

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DateIn preparation - 2012
Original languageEnglish

Abstract

The PBGC is a federal agency that insures the payment of pension benefits for
44.1 million American workers, which amount to 30,330 private sector defined
benefit pension plans. These types of pension plans promise to pay specific
monthly cash-flows to the employees upon retirement. The corresponding cashflows
are normally based on a combination of salary and years of service and
are independent from the pension plan assets. The risk of default is thus very
high.
If a sponsoring firm undergoes financial distress, it can apply for voluntary
termination of the pension plan. It must however prove to a bankruptcy court
or to the PBGC that such termination is necessary for the purpose to remain in
business. Alternatively, the pension plan might be terminated directly by the
PBGC (distress termination) so as to protect the interests of its participants.
This happens for instance whenever the pension plan can no longer afford the
benefits due at a particular time. In both cases, the PBGC takes over the
pension plan as a trustee, paying the accrued benefits by using the pension plan
assets as well as its own funds.
If the pension plan is fully funded, on the other hand, it can be terminated
(standard termination) by an employer, who demonstrates his ability to pay in
full all the benefits that are due. In such a case, the employer may choose an
insurance company that provides an annuity to the plan participants, or may
pay all the benefits directly as a lump sum.
Since the PBGC is not funded by general tax revenues, its only source of
income, apart from its own investments, are the premia paid by the sponsoring
firms that participate in the insured pension plans.
In recent years, the problem of determining the correct amount of premia to
be paid by the sponsoring firms has become extremely relevant.
Currently, premia paid by the PBGC are characterized by a flat rate premium
consisting of $19 per participant, plus a variable rate premium paid by
under-funded single employer plans at rate of merely $ 9 per $ 1,000 of underfunding.
Clearly, this rule for determining risk premia fails to consider the risk
of default on the part of the sponsoring firm.
Another crucial aspect to be taken into account is the incentive for the
sponsoring firm to cheat and temporarily transfer corporate assets to the pension
plan. This strategy ensures that two goals are simultaneously achieved. First
of all, high tax status firms receive tax benefits from overfunding (see Thomas
1988). Secondly, they avoid paying for the variable rate premium based on the
level of underfunding of the pension plan.

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