Report of the Working Group Studying Exploring the Possibility of Using Surplus Pension Assets to Secure Retiree Health Benefits

November 10, 1999

The Working Group Report, submitted to the ERISA Advisory Council on November 10, 1999, was approved by the full body and subsequently forwarded to the Secretary of Labor. The Advisory Committee on Employee Welfare and Pension Plans, as it is formally known, was established by Section 512(a)(1) of the Employee Retirement Income Security Act of 1974 to advise the Secretary with respect to carrying out his/her duties under ERISA.

Members of the 1999 Working Group

Chair: Michael J. Gulotta

Actuarial Sciences Associates, Inc.

Vice Chair: Michael J. Stapley

Deseret Mutual Benefit Association

Rose Mary Abelson

The Northrop Grumman Corporation

J. Kenneth Blackwell

Secretaryof State, State of Ohio

Judith Ann Calder

Abacus Financial Group, Inc.

Michael R. Fanning

Central Pension Fund International Union of Operating Engineers

and Participating Employers

Neil M. Grossman

William M. Mercer

Janie Greenwood Harris

Mercantile BanCorporation

Patrick N. McTeague

McTeague, Higbee, MacAdam, Case, Watson & Cohen

Thomas J. Mackell, Jr.

Vice Chair of the Advisory Council

MFS Institutional Advisors, Inc.

Rebecca J. Miller

McGladrey & Pullen, L.L.P.

Richard T. Tani, Retired, William M. Mercer

Barbara Ann Uberti

Chair of the Advisory Council

Wilmington Trust Company

The ISSUE

“We are interested in exploring creative proposals to permit greater pre-funding of retiree health benefits with excess pension fund assets.”David A. Smith, Director of Public Policy

AFL-CIO

July 13, 1999

“Since retiree health care is an intrinsic part of retirement security, we see no reason not to permit the use of over-funded pension plans to help guarantee retiree health coverage….…policy should allow the pension asset transfer to fully fund the retiree health benefit obligations for current retirees and active employees as well.”Morton Bahr, President

Communications Workers of America

June 8, 1999“We believe making excess pension assets more freely available for other constructive purposes would encourage more companies to voluntarily sponsor defined benefit pension plans and encourage companies to enhance participants’ security by funding these plans at a higher level.”Michael J. Harrison, Human Resources Vice President

Lucent Technologies Inc.

July 13, 1999“If rigid and irrational legal restrictions “trap” these surplus assets in the defined benefit plan and prevent them from being used productively for other retirement security purposes:Employers will be even more reluctant to adopt defined benefit plans, ....

Employers will naturally be reluctant to contribute any more to their plans than the law requires, ....

It will be harder for employers to fund other post retirement benefits, ... and finally,

Many employees who may need or want to move into phased retirement…..will find it harder to do so.”Mark J. Ugoretz, President

The ERISA Industry Committee

July 13, 1999

CONTENTS

Executive Summary

Introduction

Laying the Groundwork

Chapter 1:  Funded Status of Pension Plans

Chapter 2:  Retiree Health Benefits

Chapter 3:  Accessibility of Surplus Assets

Chapter 4:  Policy Considerations

Chapter 5:  Findings and Recommendations

Appendix:  Summary of Testimonies of Expert Witnesses Attached

EXPERT WITNESSES:

Dallas L. Salisbury (April 6, 1999)

President & CEO

Employee Benefit Research Institute

Morton Bahr (June 8, 1999)

President

Communications Workers of America

Richard P. Hinz (May 5, 1999)

Director of the Office of Policy and Research

Employee Benefits Security Administration

David A. Smith (July 13, 1999)

Director of Public Policy

AFL-CIO

Ron Gebhardstbauer (May 5, 1999)

Senior Pension Fellow

American Academy of Actuaries

Mark J. Ugoretz (July 13, 1999)

President

ERISA Industry Committee

Dr. Sylvester J. Schieber (May 5, 1999)

Director of Research and Information

Watson Wyatt Worldwide

Michael J. Harrison (July 13, 1999)

HR Vice President

Lucent Technologies Inc.

John M. Vine (June 8, 1999)

Partner

Covington & Burling

Cheryl L. Harwick (July 13, 1999)

Tax Counsel – Employee Benefits

Marathon Oil Company - USX Corp

Kenneth W. Porter (June 8, 1999)

Chief Actuary

The DuPont Company

Howard E. Winklevoss (July 13, 1999)

President & CEO

Winklevoss Consultants, Inc.

David Certner (June 8, 1999)

Senior Coordinator

American Association of Retired Persons

Dr. Irwin Tepper (September 8, 1999)

Founder and President

Irwin Tepper Associates, Inc.

Congressman Earl Pomeroy (September 8, 1999)

United States House of Representatives

SURPLUS PENSION ASSETS:

SECURING THE RETIREE HEALTH BENEFIT PROMISE

Executive Summary:

The subject of surplus pension assets has been a controversial issue for many years. Favorable market conditions have created large surpluses in the amount of assets held in defined benefit plans. Specifically, it is estimated that U.S. pension surplus currently exceeds a quarter trillion dollars. Simultaneously, a growing elderly population in this country faces rapidly escalating medical costs, advanced life expectancies, and a shortage of funds set aside to meet their substantial post-retirement health needs. This Working Group of the ERISA Advisory Council was assembled to determine whether it is feasible to make use of surplus pension assets to strengthen and secure the retiree health benefit promise.

Our activities focused around verifying the funded status of the U.S. private pension system, examining current and future trends in the retiree health benefits field, reviewing the accessibility to surplus assets under current law, and surveying the landscape of informed opinion to garner insight from experts representing a myriad of backgrounds and viewpoints.

Over a six month period, 15 expert witnesses from the Department of Labor, corporations and organized labor, think tanks and academia, and legislators and advocacy groups testified on issues related to the use of surplus pension assets for securing retiree health benefits. Their testimony and accompanying evidence, which is cited throughout this report, serve as the backbone for the Working Group’s findings and recommendations.The testimony and data we collected supports the premise that there continues to be a gradual but certain decline in traditional defined benefit plans as measured by the number of plans sponsored, the number of employees covered, and the growth of assets available to secure such plans as compared to the growth of assets contributed to defined contribution plans. In addition, only a small and declining proportion of American workers are covered by employer-sponsored post-retirement medical plans, and these plans are themselves, in general, underfunded. Current law restricts access to surplus pension assets for purposes of securing retiree benefits other than pensions.

With the exceptions noted, the Working Group unanimously makes the following recommendations regarding the use of surplus pension assets to fund retiree health benefits:

Extend permanently the provisions of IRC Section 420, otherwise scheduled to expire at the end of 2000. Continue allowing for transfers of surplus pension assets to fund current year medical obligations when pension assets exceed the greater of the Full Funding Limit and 125% of current liability.

Replace the five-year Maintenance of Benefit requirement in the current Section 420 with a five-year Maintenance of Cost requirement. While a majority of the working group voted in favor of this recommendation, a significant minority felt strongly that the maintenance of benefits provision should be preserved. The minority was concerned that a substitution of a maintenance of cost provision would effectively permit or encourage a reduction in retiree health benefits over time, particularly considering anticipated higher health care costs in the future.

Expand Section 420 to allow for prefunding of medical obligations up to the present value of postretirement medical benefits for current retirees when pension assets exceed the greater of the Full Funding Limit and 135% of the current liability.

Approximately 50% of the Working Group would also favor an expansion of the group for which retiree medical benefits may be prefunded by including active employees who are eligible to retire.

Allow the use of future health care inflation in determining the present value of post-retirement medical benefits. (Agreement on this recommendation was nearly unanimous.)

Require a qualified actuary to certify that the present value of post-retirement medical benefits was determined using sound actuarial assumptions and methods.

Allow surplus pension assets to be transferred either to a special 401(h) sub-account within the pension plan or to a VEBA established under Section 419 of the Internal Revenue Code. Stipulate that investment income on surplus pension assets transferred to a VEBA will not be subject to Unrelated Business Income Tax.

Refer the following issues to a future Working Group or other forum for additional study:

Current law provisions on funding of retiree health benefits and their effect on the security of retiree health plans.

The current full funding limits for defined benefit pension plans and their impact on the level of employer contributions to pension plans.

The remainder of this report highlights pertinent testimony and sets forth in greater detail the Working Group’s findings on the use of surplus pension assets to secure the retiree health benefit promise.Introduction - Laying the Groundwork:

The subject of Surplus Pension Assets has been a controversial issue for many years. Employers that sponsor defined benefit plans have expressed frustration with the simultaneous requirement to assume the risk of plan underfunding and gain the benefit of a very limited ability to utilize “surplus” assets for other retiree benefits.The purpose of the Working Group on Surplus Pension Assets is to study and/or make recommendations in the following areas: the funded status of pension plans, the prevalence of retiree health benefits and the extent of retiree health funding, accessibility of surplus pension assets to secure other retiree benefits, policy considerations with respect to the use of surplus pension assets, and alternate approaches and safeguards for the use of surplus assets. This report summarizes the insight the group has gathered from the testimony of expert witnesses called to share their experience and opinions on these important topics.

Chapter One discusses trends in the funded status of privately held pension plans in this country. How much overfunding exists? What are the prevailing trends in funded status? How do these patterns vary by industry, unionization, and number of participants? The Working Group grappled with these and many other questions as it listened to testimony from representatives of the Department of Labor, Watson Wyatt Consultants, and the American Academy of Actuaries.

In the second chapter, the state of retiree health benefits is brought to the forefront. The Working Group turned to a noted authority on the subject to cite the trends in coverage, describe the funding issues associated with retiree health plans, and discuss the potential impact of health care reform initiatives on employer actions with respect to retiree health benefit design and funding.

The third chapter describes the current level of accessibility to surplus pension assets, the provisions of Section 420 of the Internal Revenue Code and the experiences of some employers who have made Section 420 asset transfers or intend to do so. Since employers will continue to play an important role in providing for retired Americans’ income and health care needs, the Working Group asked senior representatives of three large companies to provide their views on the use of surplus pension assets for providing retiree health benefits.Policy considerations are addressed in the fourth chapter of this report. What to do with surplus pension assets is a complex question. In order to surface and evaluate the many issues affecting policy considerations in this matter, the Working Group obtained testimony from leaders representing a wide variety of backgrounds and perspectives.

Chapter Five of the Report provides the Work Group's findings and recommendations.

Chapter 1 - Funded Status of Pension Plans

“The slowdown in pension funding is directly attributable to reluctance on the part of plan sponsors to tie up excess assets that can never be accessed at reasonable cost even if there are wildly excess assets in the plan.”Dr. Sylvester J. Schieber

Director of Research and Information

Watson Wyatt Consultants

BACKGROUND AND ANALYSIS—TRENDS IN FUNDED STATUSAny policy debate on the subject of surplus pension assets should take note of the enormous magnitude of the aggregate amount of overfunding (i.e., difference between current assets and current liabilities) in the private pension system. As of 1996, single and multiemployer pension plans were overfunded by some $251 billion in this country (Attachment 1). Given the extraordinary recent performance of the capital markets, the amount of overfunding has probably increased substantially since that estimate was made. Not surprisingly, single employer plans with over 100 lives account for the vast majority of the overfunding.

This Working Group was established to investigate the issue of surplus pension assets and make recommendations on how to productively utilize these funds to meet the future needs of the American people. The following analysis is based on the testimonies of expert witnesses called to contribute their valuable insight and opinions.

To obtain data regarding the funding patterns of defined benefit pension plans, the Working Group obtained testimony from the Department of Labor (DOL), Watson Wyatt Consultants and the American Academy of Actuaries. Individuals who provided testimony were Richard Hinz, Director of the Office of Policy and Research of the Employee Benefits Security Administration of the Department of Labor; Sylvester Schieber, Director of Watson Wyatt’s Worldwide Research and Information Center, and Ron Gebhardtsbauer, Senior Pension Fellow at the American Academy of Actuaries.Testimony provided by witnesses from the Department of Labor and Watson Wyatt offers insight into the trends in the funded status of private sector defined benefit pension plans and factors contributing to those trends.

The DOL measured funded status by examining the funded ratio, defined as the ratio of current assets (fair market value) to current liabilities (OBRA 87 liabilities). Both of these items are reported on Schedule B of the Form 5500, which defined benefit pension plans must file annually with the DOL. The aggregate funding ratio defined as the ratio of total current assets to total current liabilities for all plans, dropped steadily from 1990 to 1994 and then turned upwards in 1995 and 1996. The aggregate funding ratio was 1.35 in 1990 and 1.19 in 1996 (Attachment 2).

Wyatt examined a subgroup of the universe of defined benefit pension plans (those with over 1000 active employees) but reviewed a longer period of time, the years between 1988 and 1998. Wyatt’s analysis corroborates Department of Labor findings and shows that the funded status of these plans declined from 1.45 in 1988 to 1.23 in 1998 (Attachment 3).Another indicator of the trend in funding status is the percentage of plans with assets greater than a certain percentage of liabilities at different points of time. Wyatt data indicates that the percentage of plans with assets greater than 125% of accrued benefits declined from 67% in 1988 to 47% in 1998 while the percentage of plans with assets greater than 150 % of accrued benefits dropped from 47% to 24% in the same period (Attachment 3). DOL data shows a similar trend. During the period 1990 to 1996, the number of plans that were 100% funded (current assets greater than current liabilities) declined from 83% to 65% while the number of plans that were 150% funded went down from 36% to 15%.

Although declining interest rates and maturing plan populations were two of the factors that led to lower funded status, the most significant contributing factor was the slowdown in contributions to pension plans. DOL analysis indicates that in each of the years 1990 through 1995, payments to pension beneficiaries and plan expenses exceeded contributions to pension plans.

Experts believe that public policy, directly as well as inadvertently, played a major role in the slowdown of pension contributions. Dr. Schieber, for example, asserted that a major reason for the decline in contributions was the new full funding limit legislated in 1987, which prohibits employer contributions if assets exceed 150% of the current liability. Dr. Schieber presented data that convincingly supported his thesis. Wyatt data shows a steady decline in plans with assets greater than 150% of accrued benefits as well as plans with assets greater than 125% of accrued benefits beginning in 1988, when the restrictive full funding limit became effective, and ending in 1996 (Attachment 3).

Contrary to what some believe, asset reversions did not lead to depletion of pension assets and lower funding ratios. Dr. Schieber noted that high excise taxes imposed on asset reversions by the Omnibus Budget Reconciliation Act of 1990 (OBRA 90) virtually put a stop to asset reversions. However, according to Dr. Schieber, OBRA 90 did adversely impact plan sponsor willingness to make large pension contributions. “The slowdown in pension funding is directly attributable to reluctance on the part of plan sponsors to tie up assets that can never again be accessed at reasonable cost even if there are wildly excess assets in the plan,” according to Dr. Schieber.VARIATIONS IN FUNDED STATUS

Are there inherent differences in the funded status of pension plans with different characteristics?

In different industries?

Single versus multi-employer?

Small versus large?

Collectively bargained versus non-collectively bargained?

DOL and Wyatt data provided answers to the above questions.

The DOL examined funding ratios over the period 1990 through 1996 for different industries. Funding ratios were studied for the following six industries: Construction, Retail, Manufacturing, Finance and Insurance, Communications and Utilities and Services. Manufacturing showed the lowest funding ratios while Finance and Insurance tied with Communications and Utilities for the highest funding ratios. The trend in funding ratios for each of the industries was remarkably similar. Funding ratios declined steadily from 1990 through 1996.

DOL data indicated that multi-employer plans had lower funding ratios than single employer plans and that the trend in funding ratios was downward between 1990 and 1996 for both single employer and multi-employer plans. The difference in funded status for single employer and multi-employer plans in the DOL analysis is probably due to the fact that the data included both pay-related and non-pay related single employer plans. Multi-employer plans are usually non-pay related. Wyatt examined the ratios of assets to accrued benefits for non pay-related single and multi-employer plans and found them to be very similar.

Wyatt studied the funded status of accrued benefits for plans of different sizes (1,000 to 4,999 actives, 5,000 to 9,999 actives, 10,000 to 24,999 actives, or 25,000 and more actives). In 1998, the funded status for each of the groups was very similar (Attachment 4). Each of the groups showed a decline in funded status from 1988 to 1998.

The DOL studied the funding ratios for collectively bargained plans versus non-collectively bargained plans. Funding ratios for collectively bargained plans were lower than for non-collectively bargained plans. The funding ratio declined between 1990 and 1996 for each category of plans.

WHAT IS SURPLUS ANYWAY?

Broadly speaking, surplus is the excess of assets over plan obligations. Different definitions can be provided for plan obligations as well as plan assets. Many different definitions of surplus have been constructed based on different schools of thought. Since the fundamental purpose of pension plans is to provide pension benefits to participants, in defining surplus and allowing plan sponsors to utilize surplus for other retiree benefits, the basic question that must be answered is “How much surplus is necessary to ensure benefit security?”Mr. Gebhardtsbauer of the American Academy of Actuaries noted that the following questions should be considered before allowing access to pension surplus:

“Will the pension benefits of workers be protected?

Is PBGC adequately protected?

Does it (the policy) maintain or improve incentives to save for retirement?

Is it part of a consistent retirement income policy?

Will the advantages from the alternative uses of the surplus outweigh the disadvantages from a policy perspective?”

This report considers alternate definitions of surplus and explores briefly the implications of using these definitions. Chapter 4 addresses the potential policy implications of alternate approaches to accessing pension surplus in greater detail.

The plan obligation may be defined as the amount that needs to be held in the pension fund to ensure the benefit security of its participants. The amount that needs to be held in the pension fund to ensure benefit security of plan participants has also been defined in different proposals in terms of the following actuarial terms:

 Current liability

 Termination liability

 Full funding limit

 Actuarial accrued liability

Current liability, termination liability and actuarial accrued liability are measures of plan liabilities that vary in value based on the actuarial assumptions used; prominent among which are the interest and mortality assumptions. Current liability is the present value of accrued benefits based on current interest rates prescribed by the IRS. The termination liability is the amount that the plan would owe plan participants if it were to terminate at that point in time. Many believe that this is the minimum that should be held in the plan if the plan sponsor is to be allowed to utilize surplus for securing other retiree benefits. The actuarial accrued liability is determined under the plan’s actuarial funding method and for the same interest assumption would provide a larger value than the current liability. The full funding limit is defined under the Internal Revenue Code as the lesser of the actuarial accrued liability and the applicable percentage of the current liability. The applicable percentage is 150% for years until 1998, 155% for 1999 and 2000, and increases gradually to 170% for 2005 and succeeding years.Since the full funding limit is the point beyond which the IRS does not allow deductible contributions, an intuitive definition of surplus would be assets in excess of the full funding limit. However, the full funding limit may be lower than the termination liability since it is based on interest assumptions that are often higher than the conservative assumptions used to determine the termination liability. Also, for non-pay related plans, the full funding limit does not reflect the long term plan obligation since it does not include updating of the benefit formula. It is therefore necessary to seek alternate definitions of surplus.

Defining surplus assets as those in excess of the current liability presents the same problems as defining the threshold as the full funding limit. The interest assumptions and methods used to calculate the current liability often produce a number lower than the termination liability. One could get around this obstacle by defining the surplus as the excess of assets over termination liability. However, this creates additional work for the plan sponsor since unlike the current liability, the termination liability is not a number required to be calculated and reported each year.

Another approach, establishing the threshold simply as 100% of the current liability or 100% of the termination liability, creates some additional problems. While a plan with assets equal to one of these measures might be considered to be adequately funded at a moment in time, it may become inadequately funded fairly quickly. A market decline may cause asset losses; equally troublesome would be a decline in interest rates or an increase in retirements, either of which could cause liabilities to increase. Conservatism requires that the threshold include a margin above the current liability or termination liability. For non-pay related plans a margin is required because neither the current liability nor the termination liability for these plans takes into account the benefit enhancements that are customarily made in each bargaining cycle.

Mr. Gebhardtsbauer pointed out that benefit security is a function not only of how wide the margin is but also of future funding actions of the employer. He suggested that lower margins might be appropriate for immunized portfolios, plans holding annuities, or plans with a greater retiree proportion. On the other hand, a higher margin may be required for plans with poor credit ratings. He also suggested that different margins (and excise taxes) might be applied for different uses of the surplus assets.

Under current law, the threshold above which employers can withdraw surplus pension assets for funding of retiree health benefits has been established as the greater of the full funding limit and 125% of the current liability. According to Mr. Gebhardtsbauer, under certain conditions, this threshold would produce a figure lower than the plan’s termination liability. This could occur in a period of declining interest rates, if the current liability calculation was based on an outdated mortality table, or in the event that the current liability calculation did not take into account valuation of contingent events such as plant shutdowns. Assuring that benefit security of plan participants is protected is not only a matter of defining the appropriate threshold. It is also a function of the plan sponsor’s ability to fund the plan. Mr. Gebhardtsbauer suggested that the PBGC would be protected if companies in bankruptcy were not allowed to withdraw surplus pension assets or if such companies were required to give PBGC advance notice of a planned surplus withdrawal.Fluctuations in plan asset performance can affect benefit security. Chapter 4 of this report will address what margin level may provide adequate protection against future investment losses. For now, it is appropriate to note the amount of overfunding of private pension plans in this country and to observe the difficulties associated with getting to the heart of the matter from an actuarial perspective.

Chapter 2 - Retiree Health Benefits

“Since the cost of health care during the later years of life may well exceed many individuals’ family income, financing health care for the elderly is an important issue.”Dallas L. Salisbury

President and CEO

Employee Benefit Research InstituteBACKGROUND

Americans, as citizens of the wealthiest nation in the world, have come to expect adequate and reasonably affordable health care. However, the expected expansion in the number of retirees over the next decade coupled with increased life expectancy will put a major strain on employers and the government as both seek to control the skyrocketing costs of health care. A solution to this problem must be found if we are to continue to provide appropriate care to our nation’s elderly population without placing an undue burden on the younger generations. In order to get a comprehensive view of the trends affecting employer sponsored retiree health plans, the Working Group turned to Dallas Salisbury, President and CEO of the Employee Benefit Research Institute (EBRI).TRENDS IN COVERAGE

Employer-sponsored health care plans can deliver retiree health benefits in a uniquely tax-effective manner that alternate solutions, such as raising the pension benefit, cannot match. While pension plan payments are taxable to retirees, disbursements made from retiree health plans for the purchase of health care are not. Mr. Salisbury’s testimony shows that despite this fact, since 1990, the proportion of employers in America sponsoring retiree health care plans has shrunk, while the proportion of employers requiring retiree premium sharing has increased. The following points are summarized from Mr. Salisbury’s testimony.- The Bureau of Labor Statistics (BLS) gathers data on employers with 100 or more employees while consultant surveys base findings on employers with at least 500 employees or on their own data base of clients. BLS statistics show the percentage of employers offering retiree health coverage in 1995 as 35% and 41% for Medicare-eligible and under 65 retirees respectively (Attachment 6). These figures are similar to those provided by a Mercer survey that indicates that in 1998, 30% of large employers offered retiree health benefits to Medicare-eligible retirees while 36% of these employers offered such benefits to retirees who were under age 65 (Attachment 7).

- The numbers above belie the true extent of retiree health care coverage in the private sector. Employers that do provide this benefit typically exclude their part-time employees and small employers, who constitute about 45% of the employer body, generally do not provide any retiree health benefits at all. It is reasonable to estimate that provide health coverage is available to between 16% to 23 % of the total private sector workforce.

- Statistics for retiree health coverage are available for a number of years and tell a story of erosion of coverage. While retiree health benefits have never been as prevalent as pension benefits, BLS statistics and consultant surveys both show that coverage was broader in the late 80s and early 90s than is currently the case as we approach the millennium (Attachments 5 and 6). Furthermore, merely examining the proportion of employers offering retiree health coverage does not provide a true picture of the depth of coverage. Employers have started requiring greater premium sharing from retirees and have begun to phase out postretirement coverage entirely for new workers.

- The move to reduction of employer-provided retiree health coverage began in 1990 when the Financial Accounting Standards Board released FAS 106. FAS 106 required employers, beginning with fiscal years starting after December 15, 1992, to measure the obligation for retiree health liabilities, to post a measure for the unfunded postretirement health expense in the balance sheet and to disclose the unfunded liability in the footnotes to the financial statements.

- In response to FAS 106 and increases in health care costs, companies made numerous changes to their retiree health benefit programs. 1995 survey data from Buck Consultants demonstrates that the most common retiree health plan redesign features require employee cost sharing premiums, followed by capping of employer contributions and annual adjustments to retiree contribution amounts (Attachment 7). Even the 16% -23% of private sector labor force that currently enjoys employer provided retiree health coverage is likely to be required to make significant out-of-pocket contributions as a condition of coverage in the future.

- Data suggests that employers are not eliminating retiree health plans altogether, although some new employers have decided not to offer the benefit in the first place. Instead, employers who provide for some retiree health coverage are phasing out the benefit for new workers so as to gradually eliminate the program

FUNDING OF RETIREE HEALTH PLANS

There are currently no requirements for companies to pre-fund retiree health benefits. Under current tax law provisions, tax-effective funding measures are available only for collectively bargained retiree health plans. Unions in the private as well as public sectors have made retiree health a priority issue in their collective bargaining with employers. However, the effect on overall funding levels for retiree health plans has been limited.

Recent data available from Buck Consultants indicates that 33% of private-sector retiree health plans are funded. The prevalence of funding varies widely by industry, ranging from a high of 86% among utilities to lows of 23% in manufacturing and 0% in the retail industry (Attachment 8). Unlike pension plans that have had a long history of substantial funding and have enjoyed the run-ups in pension assets from the bull market beginning in the early 1980s, funding levels for retiree health plans are low. Indeed, only 9% of the plans that are funded have a funding ratio of 81% or higher.

Some attempts to solve the growing problem were made in the early 1990s when various legislative bills proposed the introduction of tax-effective retiree health funding mediums. Unfortunately for would-be reformers, these bills were accompanied by the requirement of vesting of retiree health benefits, which the employer population saw as an unacceptable trade-off. The bills subsequently died from lack of support. Mr. Salisbury believes that if an acceptable funding compromise had been reached at the time, we could currently be looking at a different picture of retiree health coverage. Employers would have begun funding the retiree health benefit obligation and enjoyed the big stock market gains of this decade. Since asset returns reduce the FAS 106 expense, there would have been less pressure to reduce the employer commitment and shift costs to retirees. Consequently, benefit coverage and funding levels would have been stronger than they are today.

FUTURE DIRECTION OF EMPLOYER HEALTH PLANS

Recent legislative proposals have sought to raise the Medicare eligibility age concurrently with an increase in the eligibility age for Social Security. Mr. Salisbury asserts that reform proposals that reduce Medicare coverage will impact employer decisions and lead to further decline in employer provided coverage. On the other hand, other bills propose adding prescription drug coverage to Medicare or allowing early retirees to buy in to the Medicare program. Reforms such as these that increase Medicare benefits will decrease costs but are not likely to lead employers to add the benefit.

In the next few years, many of the companies that installed defined benefit retiree health caps will see their claim levels reach the caps. Mr. Salisbury believes that at this point companies will turn to other approaches for containing costs such as defined contribution plans and greater use of Medicare-risk HMOs and Medicare-plus-choice plans. In general, Mr. Salisbury sees a trend towards more defined contribution plans for those employers that retain retiree medical coverage.

Another major factor contributing to the decline of retiree health plans is the lack of tax-effective funding vehicles that would allow employers to put aside funds to back the promised benefits. Except for collectively bargained plans for which unions were able to get special treatment, the government has discouraged such funding measures in order to focus on raising tax revenues and closing the deficit. Mr. Salisbury believes that if tax-effective funding vehicles are made available without vesting requirements, more employers will pre-fund the benefits which would lead to greater security for plan participants.

Chapter 3 - Accessibility of Surplus Assets

“We believe making excess pension assets more freely available for other constructive purposes would encourage more companies to voluntarily sponsor defined benefit pension plans and encourage companies to enhance participant’s security by funding these plans at a higher level.”Michael J. Harrison

HR Vice President

Lucent Technologies Inc.BACKGROUND

In Chapter 1 of this report we defined surplus pension assets as the excess of plan assets over plan obligations. By accessibility of surplus we mean the employer’s ability to use pension plan assets for a purpose other than providing traditional pension benefits. Let us start out by stating that surplus is not presently very accessible. Current law properly discourages use of plan assets for purposes other than payment of plan benefits and plan administration expenses. ERISA and the Internal Revenue Code allow access to surplus pension assets only in certain restricted circumstances. One such situation is covered under Section 420 of the Internal Revenue Code.John Vine, Partner in Covington and Burling, a law firm that specializes in ERISA matters, testified at our request regarding the provisions of the law that regulate employer access to surplus pension assets. In addition, the Working Group heard the testimony of representatives of three large employers with well-funded defined benefit pension plans who provided a corporate perspective on the accessibility of surplus pension assets. Kenneth Porter, Chief Actuary at DuPont, Michael Harrison, HR Vice President at Lucent Technologies and Cheryl Harwick, Tax Counsel at Marathon Oil – a subsidiary of USX Corporation provided testimony based on their experiences with large employer-sponsored plans.PLAN TERMINATION AND EXCISE TAXES

A pension plan may be terminated and excess assets may revert back to the employer after payment of plan obligations and taxes. However, legislators have developed laws and regulations to make reversions administratively difficult and financially unattractive in order to discourage plan sponsors from viewing pension funds as a ready source of cash.

A reversion is only possible if the pension plan contains language authorizing reversion of surplus assets to the employer after a plan termination. Moreover, the plan language must be adopted at least five years before plan termination. Once a plan is terminated, all of the plan’s obligations to plan participants must be satisfied and any residual assets attributable to employee contributions must be distributed to participants. Any excess amount left over may revert back to the employer but is subject to both income and excise taxes.The Omnibus Budget Reconciliation Act of 1990 (OBRA 90) raised excise taxes on pension plan asset reversions. The excise tax can be as high as 50% but is reduced to 20% if part of the surplus is used to provide qualified pension benefits to participants. The 20% excise tax applies if the plan transfers 25% of the surplus to a qualified replacement plan or if at least 20% of the surplus is used to increase the benefits of the participants in the plan before it is terminated. According to testimony given to the Working Group by Dr. Schieber of Watson Wyatt, the higher excise tax virtually put a stop to asset reversions.

INTERNAL REVENUE CODE SECTION 420

Section 420 was enacted by Congress in 1990 to allow an employer added flexibility in the funding of retiree health benefits by permitting surplus pension assets to be used for payment of retiree medical expenses. Under Section 420, surplus is defined as the excess of plan assets over the greater of the full funding limitation and 125% of the current liability. Such surplus may be transferred to a 401(h) sub-account for payment of retiree medical expenses as long as the transferred amount does not exceed the amount to be paid from the 401(h) account for retiree medical benefits for pension plan participants during the current year. An employer that makes a 420 transfer must meet certain additional requirements. All pension benefits must vest immediately. Plan participants, any union representing the employees, and the Labor Department must be notified of the transfer. The employer must also maintain essentially the same retiree medical benefit, under the Maintenance of Benefit provision of Section 420, for the five years following the transfer. The original Section 420 provision contained a five-year Maintenance of Cost provision, which was amended later to a Maintenance of Benefit provision.

Section 420 is a revenue raiser for the government. Employers that make the Section 420 transfer use existing pension assets for payment of retiree medical expenses in the year of transfer. Therefore, they do not take the tax deduction they otherwise would for payment of retiree medical expenses. Originally the Section 420 provision was scheduled to expire at the end of 1995; Congress later extended its life to the end of the year 2000. A Section 420 extension was included in many of the bills introduced this year. Most of these included a five-year maintenance of cost requirement instead of the current maintenance of benefit requirement.

OTHER USES OF SURPLUS PENSION ASSETS

After payment of income and excise taxes, not much is left to make the exercise of plan termination and reversion financially worthwhile to employers. Instead of plan termination, employers have developed various other legally acceptable strategies for use of surplus pension assets. Mr. Vine provided the following list of strategies currently being used by employers:

Contribution holiday

Merging a strongly funded pension plan with a less well-funded pension plan

In connection with a sale, spinning off part of surplus assets and transferring them to the buyer’s planExpanding the group of plan participants

Providing enhanced benefits to a subclass of the plan’s current participantsProviding disability, incidental death, layoff or plant closing benefits

Amending the plan to provide enhanced window pension benefits for retirement within a designated window period

Providing increased pension benefits instead of health care or savings plan benefits

EMPLOYER EXPERIENCES WITH SURPLUS ASSETS

Although the three employers whose representatives testified have distinct cultures and employee demographics, all sponsor defined benefit pension plans with significant surpluses. In addition to the strategies for use of surplus pension assets described above, these employers have transferred pension assets under Section 420 and have useful insights regarding the aspects of Section 420 that work well. In addition, they shared their thoughts on those aspects that need improvement.

Commitment to Defined Benefit Pensions

DuPont, Marathon Oil and Lucent are all companies with long histories of defined benefit pension plans. DuPont’s first final pay plan was adopted in 1904. Marathon Oil was once a part of Standard Oil and now is part of USX Corporation, and began its Retirement Plan in 1936. The Lucent pension plan was spun-off in 1996 from the long-standing AT&T pension plan and inherited plan assets that made Lucent’s pension fund one of the largest in the U.S.In their testimony, all three companies affirmed their commitment to the defined benefit pension system. Mr. Harrison’s view that defined benefit pension plans have played a major role in contributing to a better standard of living and a more dignified retirement for a significant number of the nation’s retirees was shared by the two other employer representatives who gave testimony.Committed as they are to the defined benefit pension system, these three employers believe that the system needs some change. The three testimonies echoed the common sentiment that even though they were committed to the defined benefit system, they sought greater flexibility in the use of surplus pension assets. Ms. Harwick stated, “In today’s environment…it is essential that all underutilized and available assets be used productively…Even a modest transfer amount of an otherwise underutilized asset may help to free up other capital to help finance a project or keep jobs or create new jobs.” Mr. Porter believes that the fiduciary responsibility that DuPont management bears to its shareholders requires a balancing of needs and resources. He stressed that, “As we attempt to properly allocate corporate resources, pension funding represents a particular challenge…If the plan is significantly overfunded, … there is no way to directly rectify a grossly underfunded situation under ERISA. In this respect the law is not balanced.” Mr. Harrison also recognized the need to explore other options, “We believe there are opportunities to create greater flexibility for sponsoring companies while maintaining benefit security.”Experience with Section 420 TransfersDuPont and Marathon Oil have both made asset transfers under Section 420 almost every year since 1990 when the provision became effective. DuPont has made asset transfers for seven of the ten possible years. Marathon’s first Section 420 transfer occurred in 1991, and Marathon has completed a Section 420 transfer each year since. Lucent has not made pension asset transfers under Section 420 since its divestiture from AT&T in 1996. However, Lucent is very familiar with the experience of AT&T, which made four Section 420 asset transfers for the years 1990 through 1993. Lucent intends to make Section 420 transfers of $360 million each year from 1999 until the expiration of the Section 420 provision.EMPLOYER AND EMPLOYEE ADVANTAGES FROM USE OF SECTION 420

Section 420 offers each of the companies that testified the unique opportunity to tap excess pension assets and enhance retiree medical benefit security at the same time. Both the Marathon plan and the DuPont plan have been fully funded since 1984 and have not made any pension contributions since then. All three company-sponsored plans remain extremely well funded in spite of the measures to utilize surplus assets. These companies depend on Section 420 to allow use of surplus pension assets.

DuPont, Lucent and Marathon have benefitted from the high asset returns of the 1980s and 90s. Each of the companies has used some of the other means described in this chapter to absorb the excess assets generated by these high returns. DuPont has taken action to enhance pension benefits and has offered several open window retirement programs. Both these actions resulted in the utilization of significant amounts of surplus assets. A Section 420 asset transfer offers DuPont an appealing means of dealing with the problem of “runaway pension assets”.Marathon has made many amendments to the Retirement Plan in an effort to productively utilize surplus pension assets. These have included enhanced early retirement benefits, cost-of-living adjustments for existing retirees, early retirement window programs, improved lump sum benefits and improved pre-retirement survivor benefits.

Lucent and many other companies have discovered that benefit security for retiree health benefits is particularly low due to the lack of tax-advantaged funding, a strong deterrent to pre-funding for retiree health plan sponsors. For example, although it boasts a $14 billion surplus in its USA pension plans, Lucent has a $4.7 billion shortfall in its retiree health plans. All three companies made note that the 420 transfer enhances retiree medical benefit security. Since the companies have this available cash flow to meet their retiree health commitments, they are less likely to reduce coverage or increase retiree contributions. Section 420’s Maintenance of Benefit provision provides benefit security for retirees for the four years following the transfer. The provision allows some retirees to receive a more direct benefit than would otherwise be provided. Marathon retirees received a premium holiday for part of 1995 thanks to this clause. In addition, new pension participants enjoy full vesting in their pension benefits on account of the 420 transfer.

In summary, all three companies felt that the Section 420 transfer provision benefits both employer and employee.PROPOSED REVISIONS TO SECTION 420

The current provision expires in year 2000. The three employers are unanimous in recommending that the provision be extended. However, to maximize its usefulness they would like to see expansion of the provision and some technical changes.

a. Use of Surplus Assets for Defined Contribution(DC) Plans

Marathon and Lucent both propose that Section 420 allow surplus assets to be used for employer contributions to DC pension plans in addition to retiree health benefits. Assets would only be transferred for allocation to accounts of participants who also participate in the defined benefit plan containing the surplus assets. The employer could be required to maintain the same level of contributions to the DC plan for a period of five years or be allowed to use accelerated vesting for the DC plan. If there are sufficient surplus assets, both the retiree health transfer and the DC plan transfer should be permitted in a given year.

b. Use of Surplus Assets for Non-qualified Benefits

Lucent suggests an alternate proposal in which surplus assets could be used to pay for pension benefits in excess of qualified plan limits (such as the 415 and 401(a)(17) limits). Both of these proposals would raise revenues for the IRS since previous tax-deductible pay-as-you-go benefits will now be financed with excess assets.

c. Section 420 Funding Cushion

DuPont believes that the use of the conservative interest requirement for the current liability calculation combined with the 25% cushion creates too great a margin for their final pay plan, which has a mature population and a track record of high investment returns. DuPont believes that public policy makers should recognize that the rules they create impact different plans in disparate ways.

d. Maintenance of Cost

The lack of guidance surrounding the current maintenance of benefit standard makes it difficult to gauge whether compliance has been achieved, particularly in overlapping maintenance periods. Marathon recommends switching back to a Maintenance of Cost standard.

Chapter 4 - Policy Considerations

“We are interested in exploring creative proposals to permit greater pre-funding of retiree health benefits with excess pension fund assets.”David A. Smith

Director of Public Policy

AFL-CIO

BACKGROUND

Accessing surplus pension assets for purposes other than paying pension benefits involves several major policy considerations. The Working Group focused on the desirability of encouraging defined benefit pension plans, the appropriate level of funding for pension plans, and the utilization of surplus assets (with an emphasis on retiree health benefits). In order to surface and evaluate these issues, the Working Group obtained testimony from Congressman Earl Pomeroy, David A. Smith of the AFL-CIO, Mark J. Ugoretz of the ERISA Industry Committee, David Certner of AARP, Howard E. Winklevoss of Winklevoss Consultants, Inc., Irwin Tepper of Irwin Tepper Associates, Inc., Ron Gebhardtsbauer of the American Academy of Actuaries, Morton Bahr of the Communications Workers of America, Michael J. Harrison of Lucent Technologies, Kenneth W. Porter of the DuPont Company and Cheryl L. Harwick of Marathon Oil Company, a subsidiary of USX Corporation.

DESIRABILITY OF ENCOURAGING DEFINED BENEFITS PLANS

Defined benefit plans are those which provide a benefit upon termination or retirement which is defined by its plan terms. The plan sponsor makes contributions into a trust which, together with assumed investment returns, is anticipated to be adequate to provide the defined benefit for plan participants. If the assumed investment returns are insufficient to be adequate to provide the defined benefit, the plan sponsor must make additional contributions. Therefore, under defined benefit plans, the investment risk is borne by the plan sponsor.

In contrast, the plan sponsor’s commitment under a defined contribution plan is a specified contribution amount – usually expressed as a percentage of the participant’s pay. The ultimate benefit varies with investment performance. Therefore, the investment risk is borne by the plan participant. Furthermore, defined benefit plans are insured by the Pension Benefit Guaranty Corporation while defined contribution plans are uninsured.Congressman Pomeroy questioned the ability of defined contribution plans to provide a secure retirement for Americans. He noted that participation rates in defined contribution plans were too low, investment choices of employees were too conservative and that the typical defined contribution plan balance was too low to provide for a comfortable retirement income.

While several other witnesses, like Mr. Certner of the AARP, supported the use of both defined benefit plans and defined contribution plans, all witnesses who addressed the issue asserted that public policy should attempt to reverse the decline in the number of defined benefit pension plans and encourage their growth. Mr. Certner elaborated on his view stating: “What we have tried to do is to try to make both plans as equitable as possible to cover, to essentially extend coverage and provide as much security in either kind of plan that the company adopts. Obviously, it seems to work out best when a company has both.”Mr. Smith, representing the AFL-CIO affirmed the value of defined benefit plans in his remarks: “Four in five union members are covered by a retirement plan at work. The overwhelming majority of the workers have a defined benefit plan as the primary private source of income protection in old age. We believe that defined benefit plans are the best way to provide retirement income security for workers.” Mr. Bahr, President of the Communications Workers of America, described how his colleagues have profited from the existence of such plans, especially of late, stating that, “American workers have been among the greatest beneficiaries of the recent stock market success – through their pension funds.”Unions were not alone in their support of defined benefit pension plans. Mr. Harrison of Lucent Technologies went so far as to say that he supports “…all legislation which promotes the expansion of the defined benefit pension plans in ways that make voluntary programs more attractive to both plan participants and sponsoring companies.”While there is apparent broad based support for defined benefit plans, since the passage of ERISA in 1974 the number of defined benefit pensions plans and the number of participants covered by such plans have actually decreased substantially.What, then, can be done to encourage defined benefit plans? One way is to provide access to excess pension plan assets while maintaining or enhancing the overall benefit security of plan participants. According to Ron Gebhardtsbauer of the American Academy of Actuaries, “Giving employers greater access to pension funds will improve the flexibility of DB [Defined Benefit] plans from the employer’s perspective and add to the attractiveness of that form of retirement arrangement and encourage their adoption and maintenance.”All the plan sponsor witnesses reaffirmed this message. Representative among the plan sponsor’s point of view was that of Mr. Harrison who stated that, “…making excess pension assets more freely available would encourage more companies to voluntarily sponsor defined benefit pension plans and enhance participant’s security by funding these plans at a higher level.”WHAT ARE APPROPRIATE LEVELS OF FUNDING?If it can be agreed that accessing excess pension plan assets to secure retiree health benefits is desirable, the question then becomes “What is the appropriate level of pension plan funding?” Without the answer to this question, we have no benchmark to evaluate excess plan assets.Currently, Section 420 of the Internal Revenue Code defines excess plan assets for purposes of determining amounts available to pay postretirement health benefits as the excess of (A) over (B) where:

 (A)= the lesser of market or actuarial value of plan assets

(note: the actuarial value is often less than the market value of plan assets)

 (B)= the greater of the plan’s Full Funding Limit or 125% of current liabilityDr. Winklevoss of Winklevoss Consultants, Inc. performed pension plan asset/liability modeling for the purpose of testing whether or not the Section 420 definition of excess assets is sufficiently large to maintain the financial integrity of the pension plan. Dr. Winklevoss projected the relationship between pension plan assets and liabilities using simulation techniques to determine how frequently assets could fall below liabilities. He compared the current Section 420 definition of excess assets (125% of current liability) to a 150% of current liability benchmark and found that: “…transferring assets down to 125% of the OBRA ’87 current liability might be somewhat too liberal … A 150% funding limit … may be somewhat too conservative … I believe that a funding limit in the 135% range would represent a reasonable compromise if assets in excess of the current year’s retiree health care payments are allowed to be transferred out of the pension plan.”Dr. Tepper also analyzed the appropriateness of different threshold levels for purposes of defining excess pension assets under Section 420 by performing stochastic projections. Dr. Tepper concluded that a threshold level of 135% was adequate to remove most of the risk of future unfunded liabilities over time frames up to five years. In Dr. Tepper’s words: “….By the time you get to 135% (funded ratio), most of the risk of unfunded current liability over 5 years gets reduced. If you raise the threshold to 145% you’ve done about as much as you can to reduce the risk.”In Dr. Tepper’s view the financial condition of the sponsoring corporation is an important consideration in determining whether the pension asset level provides reasonable security. He noted that the funded status falling below 100% was not a significant concern if the sponsoring corporation could afford to make ongoing contributions, since this would bring the plan to a surplus position again. Dr. Tepper did not, however, recommend a Section 420 threshold that was different for more solvent versus less solvent companies, since this would lead to too complex a system and one that might be open to gaming.The adequacy of pension plan surplus can vary with demographic characteristics of plan participants. Mr. Porter testified that at DuPont, for example, liabilities for retired and terminated employees dominate the pension plan. Furthermore, active employees at DuPont have long service. Therefore, little of the surplus assets are needed to finance future benefit accruals under the plan. In fact, for DuPont the level of pension plan surplus may continuously grow if pension plan assets are not accessible for other purposes.

Mr. Ugoretz of the ERISA Industry Committee expressed eloquently the sentiments of the employer community when he testified that: “…because employees are not required to provide retirement plans to their workers, it is imperative that federal law create and maintain an environment that is conducive to plan formation, continuation, and expansion. If rigid and irrational legal restrictions ?trap’ these surplus assets in the defined benefit plan and prevent them from being used productively for other retirement security purposes – employers will be even more reluctant to adopt defined benefit plans.”UTILIZATION OF SURPLUS ASSETSNaturally, different witnesses have different perspectives on how surplus assets should be applied. Mr. Bahr of the CWA believes that: “There should be no means by which an employer can garner any value from the plan it sponsors, other than by delivering benefits to participants. The funds should be used solely to secure dignity in retirement.”Mr. Certner of AARP said: “…Our feeling generally is, the funds are put into the pension trust for the exclusive benefit of the participants. And for the purpose of providing current and future pension benefits.”On the other hand, Mr. Porter declared that: “As a publicly traded company, DuPont has a fiduciary responsibility to its owners. We have been entrusted with the owners’ assets with the expectation that we will allocate our resources efficiently and appropriately to provide for all of our corporate obligations. We pay taxes, and invest in research, plans, properties, employees, the community, the environment and a host of other business needs. Balance is important. To the extent one area gets out of balance, we have an obligation to our owners to rectify that situation. As we attempt to properly allocate corporate resources, pension funding presents a particular challenge…a unilateral increase in benefit levels necessarily results in a dilution of reported earnings, even when surplus pension assets are used to finance those benefits. Accordingly, business competitiveness issues, not pension asset values, dictate when and whether benefits levels are changed.”Congressman Pomeroy indicated that the first priority should be to “conclusively and positively guarantee the solvency of the defined benefit”. Second should be the prudent enhancement of the defined benefit from surplus funds, and third, should be the enhancement of collateral benefits to employees such as post-retirement medical.Mr. Gebhardtsbauer of the American Academy of Actuaries testified that, “Strengthening employer solvency can create more security for the pension plan … surplus assets could be helpful to strengthen a company at an important time … the best insurance is a strong employer.”Most witnesses asserted their view that the use of excess assets to pay postretirement health benefits under Section 420 encouraged the continuance of defined benefits and improved the overall benefit security of plan participants. Many witnesses also supported the expansion of Section 420.Some witnesses supported the expansion of Section 420 to improve the funding of postretirement health benefits. For example, Mr. Smith of the AFL-CIO declared that: “We are interested in exploring creative proposals to permit greater pre-funding of retiree health benefits with excess pension fund assets. The proposal would have to contain sufficient assurances about worker pension security and employer commitment to continuing both health and retirement plan coverage. We believe there may be room to craft a proposal to encourage greater commitment to retiree health benefits.” Mr. Bahr of the CWA expressed this view even more strongly: “…it is time to forcefully encourage employers who have excess assets in their pension funds to utilize some of those assets to secure that guarantee….Since retiree health is an intrinsic part of retirement security, we see no reason not to permit the use of over-funded pension plans to help guarantee retiree health coverage.”Other witnesses supported the expansion of Section 420 to allow excess pension benefits to pay other employee benefits as well. Mr. Vine of Covington and Burling, said: “A strong case can be made, for example, that surplus pension assets should also be available to provide other types of retirement benefits for pension plan participants, such as allocations to a defined contribution plan … Permitting surplus assets to be transferred to a defined contribution plan for those employees who participate in both plans will help … make more efficient use of pension assets.”Different witnesses had different views on the current five year Maintenance of Benefit requirement of Section 420 and the alternate Maintenance of Cost clause that has been suggested. Congressman Pomeroy believes that asking employers to maintain benefits for five years is entirely reasonable given the advantage they gain from the Section 420 asset transfer. However Ms. Harwick of Marathon Oil feels that the Maintenance of Benefit clause is unclear, especially when a company makes transfers in multiple years and would strongly favor a Maintenance of Cost requirement.SUMMARY OF POLICY CONSIDERATIONS

The expert witnesses unanimously support the continued encouragement of defined benefit plans. Their testimony generally asserts that providing access to excess pension assets to enhance the overall benefit security of pension participants is a significant step towards encouraging defined benefit plans. Internal Revenue Code Section 420 currently allows access to excess pension plan assets to pay current retiree health benefits. Many experts stated that retiree benefit security can be further enhanced by the expansion of Section 420 to allow the transfer of excess pension assets in order to pre-fund postretirement health benefits.

Chapter 5 - Findings and Recommendations

Over a period of six months, the Working Group heard testimony from the Department of Labor, corporations, organized labor, consulting firms, think tanks, legislators and advocacy groups on issues related to the use of surplus pension assets for securing retiree health benefits. Based on the testimony heard and the information that was submitted, the Working Group has reached the following conclusions:

There continues to be a gradual but certain decline in traditional defined benefit plans as measured by the number of plans sponsored, the number of employees covered, and the growth of assets available to secure such plans as compared to the growth of assets in defined contribution plans.

Current law restricts access to surplus pension assets for purposes of securing retiree benefits other than pensions.

There has been a consistent decline in the funded status of defined benefit plans from 1990 to 1996 which has resulted in a significant reduction in current liability funding ratios. This decline in funding ratios, which is reasonably similar across all industries, has occurred in spite of strong asset returns in the 1990's. Analysis of data indicates that employers are contributing less to guarantee retirement security than they did a decade before.

There is some indication that the new Full Funding Limitation, legislated in 1987, has prevented employers from making contributions to their pension plans and thus has negatively impacted funding ratios.

A small proportion of American workers are covered by employer-sponsored post-retirement medical plans.

There is currently a small percentage (about 16%-23%) of American workers that have such protection.

The proportion of workers with employer sponsored post-retirement medical coverage has declined. The decline is attributed by many to new Financial Accounting Standards Board rules (FAS 106) implemented in 1993.

Compared to pension plans there is very little funding of retiree health plans. Data indicates that only a minority of private sector retiree health plans are funded. In addition, funding has been discouraged by the tax law provisions of the Deficit Reduction Act of 1984 (DEFRA).

Retiree health benefits are less secure than pension benefits on account of lack of vesting and PBGC protection, as well as tax law provisions which discourage funding.

Testimony supports the premise that if surplus pension assets could be used to secure post-retirement medical benefits, it might encourage some employers to offer such benefits and encourage others to continue rather than eliminate them.

Testimony also supports the premise that Internal Revenue Code Section 420, legislated in 1990 under the Omnibus Budget Reconciliation Act of 1990 (OBRA 90), has provided some limited flexibility in the use of surplus pension assets and has had some measure of impact in preserving post-retirement medical plans and improving retirement security.

The Working Group heard testimony from both corporations and organized labor in favor of expanding the provisions of the current Section 420 of the Internal Revenue Code.

It is difficult to define what level of surplus is adequate to responsibly secure future pension obligations. However, based on expert testimony before the Working Group, 125% of current liability was recommended to be adequate for transfers provided for under the current provisions of Section 420. If changes are made to allow for a transfer of assets to support more than a single year of retiree health benefits, experts suggested that the threshold be higher.

Current provisions of Section 420 benefit the employer, the retiree, and the federal government. The employer is provided flexibility to use surplus pension assets to meet employee benefit obligations, retirees receive greater security of post-retirement medical obligations, and greater tax revenues are generated for the federal government.

Recommendations

The fact that a small and declining proportion of American workers are covered by employer sponsored post-retirement medical plans is a serious public policy concern. Furthermore, this decline in coverage is not likely to be reversed without some legislative intervention. The Council concurs that surplus pension assets should be used for securing retiree health benefits to a greater extent than permitted by current law. With the exceptions noted, we unanimously make the following specific recommendations:

Extend permanently the provisions of IRC Section 420, otherwise scheduled to expire at the end of 2000. Continue allowing for transfers of surplus pension assets to fund current year medical obligations when pension assets exceed the greater of the Full Funding Limit and 125% of current liability.

Replace the five-year Maintenance of Benefit requirement in the current Section 420 with a five-year Maintenance of Cost requirement. While a majority of the working group voted in favor of this recommendation, a significant minority felt strongly that the maintenance of benefits provision should be preserved. The minority was concerned that a substitution of a maintenance of cost provision would effectively permit or encourage a reduction in retiree health benefits over time, particularly considering anticipated higher health care costs in the future.

Expand Section 420 to allow for prefunding of medical obligations up to the present value of postretirement medical benefits for current retirees when pension assets exceed the greater of the Full Funding Limit and 135% of the current liability.

Approximately 50% of the Working Group would also favor an expansion of the group for which retiree medical benefits may be prefunded by including active employees who are eligible to retire.

Allow the use of future health care inflation in determining the present value of post-retirement medical benefits. (Agreement on this recommendation was nearly unanimous.)

Require a qualified actuary to certify that the present value of post-retirement medical benefits was determined using sound actuarial assumptions and methods.

Allow surplus pension assets to be transferred either to a special 401(h) sub-account within the pension plan or to a VEBA established pursuant to Section 419 of the Internal Revenue Code. Stipulate that investment income on surplus pension assets transferred to a VEBA will not be subject to Unrelated Business Income Tax.

Refer the following issues to a future Working Group or other forum for additional study:

Current law provisions on funding of retiree health benefits and their effect on the security of retiree health plans.

The current full funding limits for defined benefit pension plans and their impact on the level of employer contributions to pension plans.

SUMMARY OF TESTIMONY BEFORE THE ERISA ADVISORY COUNCIL

WORKING GROUP ON EXPLORING THE POSSIBILITY OF USING

SURPLUS PENSION ASSETS TO SECURE RETIREE HEALTH BENEFITS

WORKING GROUP MEETING

April 6, 1999

DALLAS L. SALISBURY, President and CEO, Employee Benefit Research Institute

(Summary prepared by Neil Grossman)

Mr. Salisbury testified about trends in retiree health coverage and financing. He warned, at the outset, that the surveys and news reports tend to overstate the availability of retiree health coverage for two reasons: (1) they often sample only larger employers, which are more likely to offer coverage, and (2) they often ignore part-time workers, who are less likely to have coverage. His bottom line: Today, fewer employers provide retiree health benefits than in the past, due in large part to short-term job tenures and the increasing exclusion of new employees from retiree medical plans. Only between 16 and 23 percent of the private sector workforce can expect to receive some employer contribution toward retiree health coverage.

Legislation, including Medicare reform, should not have a profound impact on coverage trends, according to Mr. Salisbury. These trends are driven by three overriding factors: (1) the growth in health care costs, (2) Financial Accounting Standard (FAS) 106, which requires companies to incur a current charge on the balance sheet for future retiree medical obligations, and (3) the lack of a tax-favored vehicle for pre-funding retiree medical liabilities. However, Mr. Salisbury noted that an increase in the eligibility age for Medicare is likely to reduce coverage, because of its immediate impact on corporate net worth under FAS 106.

When asked about the potential effect of tax-favored pre-funding, Mr. Salisbury thought that pre-funding opportunities would not necessarily increase retiree health coverage, as long as the ability to pre-fund was contingent on vesting employees retiree medical benefits. He also thought that the use of surplus pension plan assets for this purpose could encourage employers to offer retiree medical coverage in a defined contribution (but not a defined benefit) arrangement and encourage them to continue, rather than eliminate, retiree medical plans in some circumstances.

WORKING GROUP MEETING

May 5, 1999

SYLVESTER J. SCHIEBER, Director of Research and Information Watson Wyatt Worldwide

(Summary prepared by Richard Tani)

The slowdown in pension funding is directly attributable to reluctance on the part of plan sponsors to tie up assets that can never again be accessed directly at reasonable cost even if there are wildly excess assets in the plan.

For plans which become excessively overfunded, there ought to be some kind of provision to allow employers to take back some of the money in one way or another.

I think you would actually encourage more pension funding if you had some flexibility in having access to these assets than we have under current rules.

I believe that if we don’t secure (retiree medical) benefits in some way, we are ultimately going to see these benefits vanish. I do not believe employers are in situations where they can carry large unfunded liabilities, especially liabilities that have such potential variability.Mr. Schieber noted a reduction in pension contributions starting in the early 1980's. He also noted a reduction in the funded status of pension plans (based on a Wyatt survey). Part of this is due to adding the 150% of Current liability to the full funding limit (if assets exceed the full funding limit no contributions may be made to the plan). He feels that this 150% limit is artificial and causes a deferral of funding, which may cause employers to cut back pension benefits when later funding costs become higher.

He described an analysis his firm did on the 1995 House Ways and Means Committee proposal that allowed plan sponsors to transfer excess assets out of pension plans to be used for other purposes. The transfer would be subject to regular income tax plus an excise tax. (There was to be a brief window in which no excise tax would apply). Excess assets were defined as assets in excess of the greater of the full funding limit or 125% of current liability. He compared various scenarios where the actuarial accrued liability (the old full funding limit and the normal measure for ongoing funding of a plan) was less than 125% and 150% of current liability and over 150% of current liability. The point was that the combination of the 150% of current liability portion of the full funding limit and the 125% of current liability portion of the definition of excess assets caused disparate results in relationship to excess assets relative to the actuarial accrued liability. He felt that it also caused much confusion among non-actuaries. (Editor’s note: I feel that the 150% of current liability limit could easily be eliminated from the full funding requirement with little adverse impact but that the 1995 House Ways and Means Committee proposal makes a lot of sense).When asked at what level assets would be considered excessive, he said if assets exceed the full funding limit, the rules do not allow any contributions. This implies that any assets above this level is excessive. (Editor’s note: I do not see an inconsistency in having a small buffer zone where contributions may not be made, but assets cannot be taken out).He also noted the public policy issue that tax laws have restricted employers ability to fund retiree health obligations. One reason may be that retiree health benefits are not taxable when received as pension benefits are. Funding retiree health benefits through excess pension assets is a backdoor method of funding something that can’t be funded directly. In other words we need to review the funding vehicles and tax laws that affect retiree medical benefits.Background on Mr. Schieber

Mr. Schieber has a Ph.D in Economics from the University of Notre Dame. He has been with Watson Wyatt since 1983. Prior to that he was the first research director of EBRI. Prior to that he was deputy director of the office of Policy Analysis in the Social Security Administration. He has served on the board of directors of EBRI (1991-1996) and on the Pension Research Council at the Wharton School (University of Pennsylvania) since 1985. He was also a member of the 1994 to 1996 Social Security Advisory Council.

WORKING GROUP MEETING

May 5, 1999

RICHARD HINZ, Director of the Office of Policy and Research of the Employee Benefits Security Administration of the Department of Labor (Summary prepared by Rebecca Miller)

Mr. Hinz, Director of the Office of Policy and Research of the Pension and Welfare Benefits Administration of the Department of Labor provided detail from the Form 5500 reports covering the funded status of plans. For our briefing, he and three other members of his office (Daniel Beller, David McCarthy and Steve Donahue) analyzed data from the 1990 through 1995 database of actuarial information available from the Schedule B of the Forms 5500 filed for those plan years. The 1996 data is not yet available for analysis. In looking at all of this data, Mr. Hinz emphasized that this is beginning of the plan year information. Thus, the most recent year included in his information would include December 1, 1995. With the majority of plans having calendar year ends, most of the data would be as of January 1, 1995. All plans filing Form 5500 were included. 10 percent of small plans filing Form 5500 C/R were also included.

The database was edited to take out forms that were missing material data or had internally inconsistent data. The data was not adjusted for keypunch errors. These were assumed to be offsetting, but the assumption was not tested. The data was not adjusted for changes in the methods of valuing plan assets or actuarial estimates.

The most significant consideration when attempting to draw any conclusions from the data is to recognize that the Schedule B changed in 1995 in response to a change in the law. Also, 25 percent of the 1994 Schedule B’s are missing from the database.The decision was made to test the plan’s funding ratio rather than dollars, as that was concluded to present a better tool for measuring across plans of varying sizes. Mr. Hinz described how that concept is constructed. It is the ratio of the plan’s current assets divided by the plan’s liabilities. Current assets are the reported investments at the beginning of the plan year plus earnings and contributions, less any expenses and distributions. The liabilities are the current liabilities reported on the Schedule B including new accruals and adjustments for changes in interest rate assumptions.From this background the analysis demonstrated the following patterns:

Total assets in defined benefit plans increased about 15 percent from 1990 to 1995

Plan liabilities increased substantially over the same period.

The aggregate funding ratio decreased from 1.35 in 1990 to 1.19 in 1996.

Funding for plans when separated between single employer and multi-employer showed the same pattern, though the multi-employer plans had lower funding ratios overall.

The same pattern is reflected when the data is analyzed by industry with the exception of the retail industry whose mean funded status appears to have increased substantially for 1995 and 1996, though the median stays within the pattern of the group.

When analyzed by the plan size, plans with fewer than 100 participants have improved their funding position relative to 1994, but it is still lower than 1990. Larger plans show a consistent decrease in the mean funding ratio. As in the industry analysis for retail, when looking at median ratios the apparent improvement disappears and the small employer group shows a consistent pattern of declining ratios, along with larger employers.

To provide further information about what was happening with these plans, Mr. Hinz and his staff looked at the pattern of behavior of certain key components of a plan’s funding ratio.The rate of return over this period was fairly dynamic, ranging from something less than 5 percent in 1990 and 1994 to around 20 percent in 1991 and 1995 with a geometric means of roughly 10.6 percent.

Employer contributions were steadily increasing over this period.

Expenses and other cash flows were both positive and negative for this time frame. The positive side includes additions to plan assets from consolidations and other transfers.

Benefit payments also consistently increased over the period and were nearly 3 times the level of contributions.

The conclusion is that net cash flows without earnings are negative for every year during this period. When earnings are added, net cash flows were negative for 1990 and 1994 and positive in 1991 through 1993 and 1995. For this purpose, unrealized appreciation or depreciation in asset values is included in cash earnings.

During this same period the median interest rate assumptions declined from 8 percent to 7.4 percent. This increases the liability for future benefits. Total liabilities rose from just over $700 billion to just approximately $1,100 billion.

Other issues to be taken into account is reviewing this information include:

For all plans the ratio of retired participants to active participants is increasing from 28 percent to 35 percent for all plans. (This is 28 retired employees for every 100 active participants.)

The number of plans that are 100 percent funded or 150 percent funded are declining from 83 to 65 percent and 36 to 15 percent, respectively.

Of the plans that are more than 100 percent funded, the number of sponsors making a contribution for the plan year is declining.

During the question and answer part of his testimony, the following additional points came to light:

The analysis does not take into account any amendments that might have been made to the well funded plans that increased liabilities.

Some feeling for the size of the surplus and how that has been changing was requested.

Also, data was requested regarding the asset allocation of plan’s with a surplus.The data does not readily highlight the impact of plan mergers.

WORKING GROUP

May 5, 1999

RON GEBHARDTSBAUER, American Academy of Actuaries, (Summary prepared by Janie Greenwood Harris)

Mr. Gebhardtsbauer’s testimony covered the advantages and disadvantages of giving employers access to pension plan surplus. One advantage discussed was that of reward and risk. The sponsor of a defined benefit plan bears the risk of investment returns. If the plan experiences poor returns, the employer has to fund the loss. If the returns are great the plan becomes overfunded and the only reward to the employer is a funding holiday. The employer would have to terminate the plan to access the surplus. Since the employer bears the risk of investment return, the reward to it should be commensurate with the risk taken. Mr. Gebhardtsbauer thinks that plans would be better funded if employers knew that surplus could be reached later and would also discourage plan termination as a means of access. He also thinks that the ability to use plan surplus will strengthen the employer who has a few bad years.The disadvantage of taking money out of a plan is that the security of the employees benefits will be affected, particularly in the case of weak companies. A second disadvantage is that the PBGC would be concerned because the company could have bad experiences and terminate, causing the PBGC to pay benefits.

Mr. Gebhardtsbauer suggested three approaches that could be used to determine the threshold for accessing plan surplus: 1) termination liability; 2) current liability; and 3) actuarial liability. He discussed the differences between the three approaches and the problems with each: termination liability goes up and down; current liability excludes certain benefits and the retirement assumption used for determining actuarial liability are not very good. He pointed out that in some situations current liability is less than termination liability and could result in a shortage at termination. Mr. Gebhardtsbauer suggested that the Council might consider recommending a margin and possibly different margins for different plans.

In closing, Mr. Gebhardtsbauer pointed out that the employers are using their surplus and avoiding the 50 percent or 20 percent excise tax by acquiring a company with an underfunded plan and funding that plan with the surplus. While this helps the employees of the underfunded plan, the funds do not benefit the employees for whom the funds were originally intended.

WORKING GROUP MEETING

June 8, 1999

JOHN M. VINE, Attorney Covington and Burling, (Summary prepared by Judith Ann Calder)

A. ERISA’S FIDUCIARY STANDARDS 1) General requirements

    -Plan assets must be held for the exclusive purposes of providing benefits to plan

participants and beneficiaries and defraying reasonable plan administration expenses.

    -Transfer of plan assets to a party in interest, such as the employer, may also be a prohibited transaction.

 2) Key exceptions

    -After the termination of a pension, and after all the plan’s liabilities to participants and

    beneficiaries have been satisfied, residual assets may be distributed to the employer if the

    plan so provides and if the distribution does not violate any law. (Residual assets

    attributable to employee contributions must be distributed to participants and their

    beneficiaries, and plan provisions calling for a reversion must be adopted at least five

    years before the plan’s termination.)

B. INTERNAL REVENUE CODE’S APPLICABILITY 1) Key restrictions

    -Before all of the plan’s liabilities have been satisfied, plan assets may be used only for the exclusive     benefit of employees or their beneficiaries.

    -Pension plans, under Treasury Department regulations, may not provide benefits not

    customarily included in a pension plan, e.g., layoff benefits or sickness, accident, and

medical benefits (except as permitted by IRC Section 401(h)). 2) Tax consequences

    -A reversion may be included in the employer’s gross income and subject to income tax.

    -A reversion may also be subject to an excise tax as high as 50%, but can be reduced to

    20% if the plan transfers 25% of the surplus to a qualified replacement plan or if 20% or

    the surplus is used to increase the benefits of the participants in the plan before it is

    terminated.C.OTHER ERISA AND INTERNAL REVENUE CODE CONSIDERATIONS

1) ERISA and IRC regulations do not prevent surplus assets from being used for a number of purposes; they do not prevent employers from:

Merging a strongly funded pension plan with a less well-funded pension plan.

In connection with a sale, spin-off, or other disposition, spinning off all or part of the plan’s surplus assets and transferring them to the buyer’s plan.Amending a strongly funded plan to provide benefits to employees who had not previously participated in the plan.

Amending a strongly funded plan to provide enhanced pension benefits to a subclass of the plan’s current participants (e.g., the employer’s executives) as long as the plan complies with the Code’s nondiscrimination rules.Amending the plan to add disability and incidental death benefits.

Amending the plan to provide layoff and plant closing benefits as long as the benefits are offered in the form of a Social Security supplement or a life annuity.

Amending the plan to provide early retirement window benefits that are available to employees who retire within a designated window period and execute a release in favor of the employer.

Amending the plan to increase pension benefits while reducing other important benefits, such as health care or savings plan benefits.

Terminating a plan and recovering, after taxes, all or part of the plan’s surplus assets.2) Internal Revenue Code Section 401(h) allows pension plans to provide medical benefits only if the plan meets certain requirements, most significantly.

The benefits are provided through a separate account.

The employer’s contributions to the account do not exceed 25% of the total contributions to the plan (other than the contributions to fund past service costs) after the 401(h) account is established.

NOTE: These restrictions indicate that only new contributions--not existing plan assets can be used to fund a 401(h) account.

D. INTERNAL REVENUE CODE SECTION 420 adopted by Congress in 1990; currently scheduled to expire in 2000; recently reapproved by the Senate Finance Committee to run through Sept. 30, 2009)

1) Key Benefits

Permits surplus assets to be transferred to a 401(h) account to pay for current retiree medical costs. However, it does not allow for advance funding of retiree health liabilities.

Permits excess pension assets to be used productively, since it allows pension assets to be used for current retiree health care expenses.

Raises federal tax revenues, since it relieves employers of the need to make tax-deductible payments for retiree health benefits.

2) Requirements for making a 420 transfer

Transferred amount may not exceed the excess of the value of the plan’s assets over the greater of the plan’s termination liability or 125% of the plan’s current liability.Transferred amount may not exceed the amount reasonably estimated to be what the 401(h) account will pay out during the year to provide current health benefits on behalf of retired employees who are also entitled to pension benefits under the plan. Key employees are not included.

The pension plan must provide that the accrued pension benefits must become nonforfeitable for any participant or beneficiary under the plan as well as for any participant who separated from service during the year preceding the transfer.

The employer must maintain the same level of retiree health benefits during the five years following the transfer.

The plan administrator must notify each participant and beneficiary, as well as the Labor Department and any plan participants union, or each amount to be transferred.

NOTE: The Senate Finance Committee recently voted to extend Section 420 and to replace the benefit-maintenance requirement with a pre-1994 cost-maintenance provision requiring the employer to maintain the same retiree health costs for the five years following the 420 transfer.

V. FUTURE ISSUES

A strong case can be made that surplus pension assets should be available to provide other types of retirement benefits for pension plan participants (e.g., allocations to a defined contribution plan). This would make surplus assets use consistent with the purpose underlying the pension assets original accumulation: to provide retirement benefits to participants and beneficiaries.

Existing barriers between defined benefit and defined contributions plans deny employers the flexibility to use accumulated pension assets efficiently to provide benefits that employees desire and employers want to provide. Permitting surplus pension assets to be transferred to a defined contribution plan for those employees who participate in both plans could help to break down those barriers and to make more efficient use of assets.

WORKING GROUP

June 8, 1999

KENNETH W. PORTER, Chief Actuary and Manager, DuPont Finance, (Summary prepared by Rose Mary Abelson)

Good afternoon! My name is Ken Porter. I am Chief Actuary at The DuPont Company. I wish to express my appreciation for the opportunity to meet with you today and share some of our experiences regarding the use of Section 420 of the Internal Revenue Code.

Background

(Exhibit 1) DuPont has financed a portion of its share of retiree health costs for seven of the ten years for which such financing has been permissible. This includes an asset transfer scheduled for later this month with respect to 1999 retiree health costs. In those seven years, DuPont will have financed nearly $1.6 billion of its retiree health costs this way. During this same period, DuPont has granted a number of open-window-type retirement programs that have also utilized a significant amount of surplus pension assets. Nevertheless on an ERISA funding basis our principal retirement plan is still more than 50% overfunded.

As a result of our Section 420 transfers, DuPont will have cumulatively contributed about half a billion dollars in additional Federal revenue. For 1999 alone, DuPont is expected to contribute nearly $100 million in additional Federal revenue through this means.

Let me put this in perspective. A few weeks ago the Senate Committee on Finance considered a proposal to extend Section 420 through the year 2009. The Committee mark scored this extension at $136 million over the first four years of that extension ($348 million for the remaining five years). Assuming DuPont is able to continue making Section 420 transfers, our contribution to Federal revenue would more than triple the Senate Finance mark for that period.

During the mid-1970's DuPont embarked on an aggressive funding program designed to fully fund its principal U.S. pension plan. The resulting large asset base was ripe for the huge returns of the early 1980's. That plan became fully funded by 1984, and DuPont has not made contributions for any subsequent year. The surplus quickly became sufficient to not only cover all future normal costs of the pension plan, but for comparison it was also sufficient to cover all our projected future retiree medical costs. Since then, asset growth has materially outpaced the growth in plan liabilities.

As a publicly traded company, DuPont has a fiduciary responsibility to its owners. We have been entrusted with the owner’s assets with the expectation that we will allocate our resources efficiently and appropriately to provide for all of our corporate obligations. We pay taxes, and invest in research, plants, properties, employees, the community, the environment and a host of other business needs. Balance is important. To the extent one area gets out of balance, we have an obligation to our owners to rectify that situation. As we attempt to properly allocate corporate resources, pension funding presents a particular challenge.If a pension plan is underfunded, the plan sponsor can make additional contributions. If it is grossly underfunded, the plan sponsor must make more significant contributions. If the plan is modestly overfunded, the sponsor can simply suspend contributions to rectify that situation. If, however, the plan is significantly overfunded, a simple suspension of contributions may be inadequate to bring the plan into balance. In that event, there is no way to directly rectify a grossly overfunded situation under ERISA. In this respect, the law is not balanced.

Certainly, plans can use surplus assets to finance enhanced pension benefits, as we have on several occasions. But this only makes sense if there is a business need to do so. From a stockholder perspective, the SEC requires (through GAAP accounting standards promulgated by the FASB) that corporate earnings reflect the benefits actually promised in the plan document. Thus, a unilateral increase in benefit levels necessarily results in a dilution of reported earnings, even when surplus pension assets are used to finance those benefits. Accordingly, business competitiveness issues, not pension asset values, dictate when and whether benefits levels are changed.

As mentioned above, our funded status became excessive in the mid-1980's. At that time some of us at DuPontbecame concerned about the potential of what we referred to as runaway assets. That is, a surplus that could grow in perpetuity. Effective for 1990, Section 420 was enacted to allow transfers of surplus assets each year to finance that year’s retiree health costs. This change in law eased our situation somewhat. As illustrated above, however, we have suspended contributions for 15 years, enhanced pension benefits, and made Section 420 transfers. Nevertheless, our surplus has continued to grow.Demographics Considerations

The subject of overfunding is only part of our story. Plan design and participant demographics are also important. DuPont maintains a single, final pay-related defined benefit pension plan that covers essentially all parent-company employees throughout the United States. The same formulas that apply to senior management also apply to our workers at the plants, including both represented and non-represented employees. Our first final-pay pension plan was adopted in 1904, and actuarially based funding of that plan commenced in 1919. We are proud of our long history of providing quality retirement benefits with sound funding.

As you might expect from this lengthy history, retired and terminated employee liabilities now dominate our pension plan. As you are aware, the monthly pension for retired participants is no longer subject to pay increases or future service accruals. By contrast, the smaller portion of our liability that is attributable to active employees does grow with future accruals. Our active participants, however, tend to be longer-service employees with, on average, fewer than ten years remaining to reach eligibility for an unreduced pension (generally age 58 in this plan). Thus, taken as a percent of total plan assets, the expected future accruals for active participants is fairly small. That is, relatively little of the surplus assets can be expected to be used to finance future accruals under the plan. Let me show you the numbers.

(Exhibit 2) Barely 30% of our pension liability is attributable to active participants. When measured on a going-concern ERISA funding basis, this represents about 20% of plan assets. In addition, only about 45% of our assets are needed to cover our inactive liability. Thus, on a funding basis, only about 65% of plan assets are needed to cover the accrued liability of the plan. Because our plan is a final salary-related plan, the ERISA funding valuation includes the effects of assumed future salary increases for active employees. Thus, even fewer assets are needed to cover the value of benefits accrued to date. Importantly, as measured for funding purposes the surplus assets in this plan are nearly four times the present value of future normal cost.

Stated differently, more than 25% of our assets are redundant to all current and future accruals under the plan. If the fund earns 9% per year, the surplus is expected to grow in perpetuity even with annual Section 402 transfers.

Even the ERISA funding basis, however, can be viewed as somewhat conservative. A 60-year history of investment results suggests a middle-of-the-road investment return assumption in excess of 10% over the very long term. For comparison, our pension trust has earned a compound annual rate of return in excess of 12% since the early 1980's. Thus, the plan remains robustly funded.

Section 420 Measurement Requirements

In spite of this, Section 420 requires us to calculate liabilities as if we could earn rates only 10% above those offered for 30-year Treasury Bonds. And then we must gross up those liabilities by 25%. As shown earlier, however, 70% of our pension plan liability relates to pensioners and survivors, while 30% of our liability relates to active employees. The ultimate question is whether the 25% gross-up is appropriate for the plan as a whole. We believe these requirements provide more than sufficient safeguards with respect to the DuPont plan.

We will start with a review of retiree liability. Taken in isolation, the 25% gross up is not necessary. There are no future accruals for these participants, so the monthly income related to this liability is essentially fixed. By definition, the current liability for this group (as defined in ERISA) equals the present value of all future benefits. The only actuarial risks, therefore, are mortality and investment return. There is, however, little reason to suspect major volatility in our mortality experience. Accordingly, the only meaningful risk is investment return. If investment return is the only meaningful variable for inactive participants, the requirement to use rates only 10% above the risk-free investment return assumptions is sufficiently conservative for the retired liability. The additional requirement to gross up the resulting liability by 25% can only be justified in the broader context of the total plan, but has no theoretical basis when viewed solely by the context of the inactive liability. This will be demonstrated on the next exhibit.

(Exhibit 3) On a stand-alone basis for the retired liability, it is possible to quantify the extent by which the 25% gross up redundantly overcompensates against investment risk. For a pensioner age 65, 125% of the current liability produces the same value as would be determined using only a 4% discount rate! This is nearly 2 percentage points BELOW the riskless 30-year Treasury bond rate and 75 basis points lower than the current 6-month T-bill rate. The situation gets worse for a 75 year-old pensioner. Here, 125% of the current liability is equivalent to valuing the liability at only about 3%. When looking in isolation at the retired population of any plan, it is difficult to justify using implicit rates that are substantively below what the U.S. Government is willing to pay for funds.

The active employee liability, however, does present a different picture. Some commentators have discussed the need to protect against a variety of plan types and circumstances. In contrast to the retired liability, where the flat 25% gross-up is redundant, the same gross up for the active liability may or may not be appropriate, depending on plan design and employee demographics. It is my understanding that some concerns have been raised with respect to flat-dollar-type plans and plans with relatively young employee populations. Neither of those two issues exist in the DuPont plan. As mentioned above, we have a final pay plan where the typical employee is within 10 years of full retirement eligibility.

Because, as illustrated above, a 25% gross up is theoretically unnecessary for the retired liability, and because the retired liability accounts for 70% of our total liability, it is clear that when applied in the aggregate the current 25% gross up requirement substantially protects all plan participants against any reasonable risk.

Historically, lawmakers have not been eager to enact laws that reflect real-world differences among plans--including demographics, plan provisions and funding policies. As a result, there is sometimes a tendency to design laws to protect the public against the most egregious situations. In addition, because the focus is frequently on active liabilities, the substantive impact of inactive liabilities is not always given proper consideration. We believe public policy should provide rules that equitably protect plan participants while recognizing that those rules impact different plans in disparate ways. For large, mature, final pay pension plans like the DuPont plan, the current protection in Section 420 are already more than adequate.

WORKING GROUP

June 8, 1999

DAVID CERTNER, Senior Coordinator, Economics Team, Federal Affairs Department, American Association of Retired Persons, (Summary prepared by Michael Stapley)

Mr. Certner testified regarding the use of surplus pension assets for the purpose of funding post-retirement medical obligations or for any other purpose other than to pay pensions. He stated that the basic position of AARP was that using pension funds for any other purpose than the payment of current and future pension benefits was not a good idea.

As a part of his testimony, Mr. Certner reviewed the history of pension funding beginning with 1983 guidelines from the DOL, PBGC, and IRS which broke with past history in permitting pension plan reversions. He indicated that up until that time money was considered to be held in trust to pay pension benefits. Reversions began to be more common place in the 1980's. He indicated a number of legislative efforts to halt this practice, including the 10 percent excise tax in 1986. He reviewed several failed efforts for greater curbs in the next few years which culminated in restricted legislation adopted in 1990. Mr. Certner summarized information relating to pension reversions during the 1980s indicating that over 2,000 plans terminated affecting over 2 million participants with reversions in excess of $20 billion dollars.

Mr. Certner then reviewed the 1990 legislation which restricted pension reversions. He indicated that the legislation provided for increased excise taxes to 50 percent (or 20 percent under certain circumstances). This was coupled with provisions for limited retiree health benefit transfers. He indicated that the inclusion of language which allowed limited retiree health benefit transfers was a compromise, and the reversions were the main concern of the legislation. Reversion opponents did not favor transfers but compromised in the end in order to get legislation passed that would provide some restriction. The compromised legislation resulted in section 420. It included tough strings on retiree health transfers.

Mr. Certner then reviewed 1995 legislative activity in both the House and Senate indicating that a Senate Finance Committee proposal was overwhelmingly rejected (94-5) by the full Senate and that a House provision was ultimately dropped in conference.

Mr. Certner then reviewed the basis for AARP’s opposition to using pension funds for any purpose other than funding pension benefits. He indicated that funds were put into a pension trust for the exclusive benefit of participants and that trust funds were to be used to ensure payment of current and future pension benefits. He stated very strongly that funds should not be put at risk; that to do so was bad public policy because there would be a temptation to skim off excess funds in good times risking short falls in bad times. He indicated that changes in the economy, interest rates or market returns can quickly impact the pension funds ability to pay benefits and that the strong market we have experienced the last few years should not cause people to think that surplus pension assets might not be needed in the future. He further indicated that putting funds at risk puts the PBGC and individuals at risk because PBGC does not cover all plan benefits. The failure of pension plans can result in plan participants receiving lesser benefits in the future. He also indicated that reducing plan funding reduces the opportunity for benefit improvements which he felt were consistent with retirement plan goals and purposes. Benefit improvements might include providing ad hoc COLAs and the improvement of other plan benefits, including early retirement, enhanced benefit formulas, etc.Mr. Certner also indicated that reducing plan funding is bad savings policy because pensions are the largest source of personal savings and capital in the country and that consuming pension assets exacerbates the problem with the national savings rate. He also indicated that reducing plan funding circumvents pension tax policy because the tax incentives provided for pension funding are for pension income and retirement; that diverting money to other uses converts plans into a more general corporate checking account allowing tax deductions for benefits that otherwise may not be tax preferred.

Mr. Certner then spoke specifically to the current 420 provisions indicating that retiree health is an important retirement benefit and one that AARP is concerned about. He indicated that the current limited transfer provisions has not threatened the pension system, but it should not be expanded. He emphasized that it is important to maintain a cushion to ensure the ability to pay projected benefits and that it is important to have maintenance in benefit provisions to ensure protection to retiree health benefits in the future. While opposing any expansion, Mr. Certner indicated that AARP had not taken a position with respect to the specific extension of Section 420. He also indicated the importance of the defined benefit system in guaranteeing a safe retirement for American workers, but indicated that from AARP’s perspective they did not favor one form of retirement program over another and that AARP generally sought to improve upon the benefits and adequacy of the pension system under both DB and DC plans.WORKING GROUP

June 8, 1999

MORTON BAHR, President, Communications Workers of America, (Summary prepared by Michael J. Gulotta)

Mr. Bahr indicated his pleasure to testify on retirement plan benefits on behalf of the Communications Workers of America which represent 630,000 workers nationwide.

"Defined benefit plans are the foundation of security for retired workers," said Mr. Bahr. He went on to add that retiree health care coverage was a critical element of retirement income and that policies to strengthen commitments and funding for retiree health care was in workers’ best interests. Making use of surplus pension plan assets to secure retiree health benefits is a laudable goal in the CWA’s opinion.Mr. Bahr argued that pension plans were established to pay benefits to plan participants and that funds should be used solely to secure dignity in retirement.

He indicated that the major telecommunications companies with which the CWA deals have pension plans with assets of approximately $190 billion and that assets were 40% more than the liabilities of these pension plans.

Mr. Bahr indicated that high levels of funded status have not resulted in any appreciable increase in pension benefits and that bargaining over retirement benefits has been contentious. He further commented that while certain corporations were prefunding retiree health benefits, the liabilities for the benefits were significantly in excess of assets.

Mr. Bahr expressed the view that a continuation of the practice of pension asset transfers is supported by the CWA. In fact, he went on to say that "it is time to forcefully encourage employers to guarantee health coverage to their retirees and to enable those employers who have excess assets in their pension funds to utilize the assets to secure that guarantee". In permitting the use of excess assets, he cited two key principles which must be adhered to. First, there must be a pension plan asset cushion and while the current level of a 25% cushion has served a good purpose, a slightly lower one might be acceptable. Second, the surplus assets must be put aside in a trust to fund retiree health coverage.

Mr. Bahr indicated that "policy should allow the pension asset transfer to fully fund the retiree health benefit obligations for current retirees and active employees". This policy would amend current policy which permits the use of excess pension assets, but only to finance current year’s retiree health costs.WORKING GROUP

July 13, 1999

David Smith, AFL-CIO, Director of Public Policy, American Federation of Labor-Congress of Industrial Organizations (Summary prepared by Janie Greenwood Harris)

Mr. Smith began his testimony by providing the Council background on trade unionists and retirement issues. Almost 80% of trade unionists are covered by a retirement plan. A majority are in a defined benefit plan which in conjunction with social security will constitute their primary source of retirement income. Union plans make up about half of all workers who are represented by defined benefit plans and their accounts represent over half of all assets in defined benefit plans.

It is his opinion that defined benefit plans, on top of social security, are the best and most appropriate way to provide retirement security for the following reasons:

  a) they provide defined, predictable benefits for life

  b) they place investment risk and management with employers and professional asset managers

  c)  they provide a collective savings mechanism and appropriate risk spreading

  d) they are protected by the PBGC

Mr. Smith stated that almost 40% of union retirees are covered by retiree health care while only one in five other retirees are protected. With this background, the AFL-CIO is very concerned about the inappropriate use of surplus pension assets. Retirement plan assets represent deferred compensation and belong to the workers. This principle underlies any discussion of the use of plan assets.

The Revlon and Pacific Lumber plans were cited as two examples of the undermining of retirement security for workers in the '80s. The plans were terminated and the funds invested in an insurance company that failed. Thousands of workers' promise of retirement security was never realized. He cautioned against opening the door to a repeat of that experience.

Mr. Smith stated that the AFL-CIO clearly supports the provisions of IRC 420. The way in which the use of plan surpluses is constrained by 420 and the confinement of the utilization is appropriate. He emphasized their position that the surpluses of defined benefit plans should only be used to provide retirement health security for current retirees and active employees.

Between 1991 and 1998, the number of large employers providing health care coverage to retirees declined by 13 percent. Between 1960 and 1996, personal health care expenditures rose by over 10 percent and now make up almost 12 percent of GDP. The pressure on firms providing retiree health care coverage will get worse. Section 420 will become even more important. Mr. Smith reiterated that the AFL-CIO's support of the continuation of 420 is not unconditional. The law represents a careful balance between health coverage for retirees and the security of the assets that represent future retirement resources for today's workers. Any proposals to change the existing provisions would be met with great suspicion and concern.

During the question and answer session, Mr. Smith was asked whether he thought prefunding of retiree health benefits could have prevented the erosion in retiree health coverage. It was his opinion that if pre-funding had been accomplished with the same safeguards as contained in 420, the downside would have been very low.

Mr. Smith indicated that he is uncomfortable endorsing the wholesale transfer of pension surplus. Health care is a special case. The use of surpluses for other purposes would need to be vigorously analyzed and should meet a strict test for actually enhancing retirement security.

WORKING GROUP

July 13, 1999

Mark J. Ugoretz, President, ERISA Industry Committee (Summary prepared by Michael J. Gulotta)

Mr. Ugoretz made three basic points in his testimony. His first point was that retirement security interests of workers make the promotion of voluntary defined benefit plans imperative and that such plans have also been the basis of increasing health security in retirement. Secondly, he pointed out that retirement security cannot be complete without postretirement health security. Lastly, he indicated that extending the ability to transfer excess pension plan assets pursuant to Section 420 of the Internal Revenue Code promotes defined benefit plans and retiree health benefit security.

Expanding on his position supportive of encouraging defined benefit plans, Mr. Ugoretz indicated that Federal law should encourage strong funding of defined benefit plans. He went on to testify that if rigid and irrational legal restrictions trap surplus assets in the defined benefit plan and prevent such assets from being used for other retirement security purposes, then employers will be unwilling to adopt or maintain plans. In addition, strong funding of plans would be discouraged and benefit security would suffer.

In implementing IRC Section 420, Mr. Ugoretz said Congress recognized that the use of surplus pension assets was appropriate because such use was consistent with the retirement security objectives of a defined benefit plan, consistent with the purposes for which such assets were accumulated and consistent with the needs of employees for retiree benefit security.

He argued that the reasons for enacting 420 are no less compelling today than they were when 420 was enacted. Finally, Mr. Ugoretz noted that alternative uses of surplus pension assets had been identified by ERIC but that the industry group had not reached any conclusions yet on the desirability of such alternatives.

WORKING GROUP

July 13, 1999

Michael J. Harrison, Human Resources Vice President for Compensations & Benefits, Lucent Technologies (Summary prepared by Neil Grossman)

Mr. Harrison discussed the historical use of Internal Revenue Code section 420 by Lucent Technologies (Lucent), a former subsidiary of AT&T and now an independent company with about 280,000 past and current employees covered by defined benefit plans in the United States. Today, these plans have a surplus of approximately $14 billion, while the company’s retiree medical obligations are underfunded by $4.7 billion.Code Section 420 authorizes certain transfers of excess pension assets to pay for retiree medical benefits. Lucent has made no Section 420 transfers since its divestiture from AT&T in 1996. However, AT&T used section 420 while Lucent was still a subsidiary and Lucent plans to do so in the future.

Lucent considers section 420 transfers to be advantageous to both the company and plan participants. The company’s cash flow improves, because it does not have to pay retiree medical expenses out of current cash. Participants benefit because Lucent is less likely to cut back retiree medical coverage or require greater contributions from retirees, significant issues for the company’s unions. Participants also become vested in their pensions as a result of the transfers.Lucent believes adequate excess assets should remain in pension plans after section 420 transfers to maintain the security of participants retirement income and assure no more than negligible risks to PBGC. The present 125% of current liability cushion is appropriate, according to Mr. Harrison; but he suggests the real focus should be on the probability of meeting benefit commitments in future years. He noted that AT&T sought to retain pension assets sufficient to produce at least a 90% probability of 100% funding after 5 years and a 75% probability of 100% funding after 10 years. For Lucent, this approach yields results close to the present 125% cushion.

Lucent favors expanding the uses of surplus pension assets beyond paying for retiree medical coverage, so long as these uses benefit plan participants. One example cited by Mr. Harrison: using surplus to make matching contributions under section 401(k) plans, perhaps coupled with faster vesting of plan accounts. Another: using surplus to fund pensions in excess of qualified plan limits, which would give corporate executives a bigger stake in the qualified plan. Both of these options raise tax revenues and have cash flow advantages for companies.

WORKING GROUP

July 13, 1999

Cheryl Harwick, Tax Counsel, Marathon Oil, Subsidiary of USX Corporation (Summary prepared by J. Kenneth Blackwell)

Marathon Oil Company completed its first IRC Section 420 transfer in 1991 (relating to 1990 retiree medical expenses). The second transfer occurred later that year relating to 1991 retiree medical expenses, and there has been a Section 420 transfer each year since. Transfer amounts range from approximately $9.9 million to 14.3 million, and the total of transfers to date is approximately $101.5 million.

It is Marathon's opinion that Section 420 transfers have worked very well for both the Company and the Retirement Plan participants. From the Company's perspective, it has been able to derive some additional value from an underutilized asset. From the participant's perspective there have been several positives: 1) the cost maintenance or benefit maintenance standard provides participants with a level of security related to their retiree medical benefits; 2) approximately 5,000 "premium payers" shared in a direct benefit of cost savings of approximately $650,000 during a 3-month premium holiday needed to comply with the cost maintenance standard; 3) participants with relatively short service enjoy full vesting in the Retirement Plan at the time of a transfer, even if they have not completed the 5 years of service normally required for vesting; and 4) the notice requirements provide an additional reminder of the value of the participant's retirement benefit. Marathon is in favor of the legislative proposal to revert to the cost maintenance standard, and believes that the bright line or certainty that it provides is better for all concerned. Marathon believes that the other Section 420 safeguards, including the funding cushion, provide adequate security and remain appropriate.

Marathon noted that the Retirement Plan ratio (assets divided by current liabilities) has grown since the first Section 420 transfer occurred in 1991--a function of good investment strategy. It believes that a distinction should be made between plans with "some" surplus assets and plans with such a large surplus that under any realistic forecast the surplus will never be fully used for pension benefits, even taking into account Section 420 transfers. Marathon believes that the Retirement Plan falls into the latter category.

Marathon believes that it is essential that employers be permitted responsible access to surplus pension assets, and that providing access, with safeguards, will benefit plan participants as well as employers. Marathon would like to see Section 420, with minor modifications, continue well into the future, and believes that the law should permit certain other acceptable uses of surplus pension assets. Marathon suggests that it is appropriate to use surplus assets to provide other types of benefits to active or retired participants in the pension plan (contributions to a defined contribution plan, welfare benefits, tuition reimbursement, employer FICA tax obligations, etc.). Currently, Marathon is actively seeking legislation that would permit transfers of surplus assets to a qualified defined contribution plan (sometimes referred to as the "414(v) proposal"). This use of surplus assets is consistent with the purpose behind the establishment of the Retirement Plan, i.e. providing retirement benefits to participants and beneficiaries. The proposal establishes a new IRC Section 414(v) that contemplates annual transfers under rules similar to the current IRC Section 420 transfers, including a commitment that the defined contribution plan will maintain the same level of contributions for a minimum of five years. Assets could only be transferred for allocation to accounts of participants who also participate in the plan containing the surplus assets. Section 414(v) would exist in addition to IRC Section 420, and not as an alternative to it. Either or both transfers could be made in a given year.

WORKING GROUP

July 13, 1999

Howard E. Winklevoss, President and CEO, Winklevoss Consultants, Inc. (Summary prepared by Richard Tani)

Notable Quotes

"I have to applaud the people who formulated that 420 proposal. It's pretty thoughtful in my view."

"I would like to have it on the record that I feel very comfortable about 420 transfers up to the current retiree liability." (one year's costs)

"I'd feel a little more comfortable with 135%." (minimum liability funded ratio) if plans transferred more than one year's retiree medical costs.

"By and large, corporate America is reasonably conservative with regard to their pension plans. I have not experienced situations where the corporation wanted to abuse the pension plan in any way."

Mr. Winklevoss analyzed the funded status of pension plans by doing stochastic projections. Under a stochastic projection, inflation and investment return are random events following statistical patterns.

The correction between stocks and bonds was 60%. (Editor's note: These assumptions seem reasonable over long periods of time, but the past may not be a good prediction of the future).

Under the stochastic projections, 2000 samples were taken and Mr. Winklevoss presented the results after 5 years and 10 years.

The funded status represents the ratio of market value of assets to current liability, where market value of assets to current liability is the value of benefits earned using a discount rate equal to a 4 year weighted average of 30 years Treasury Bill rates. Mr. Winklevoss felt that current liability is conservative (a high measure of the liability) based on a reasonable expectation of investment return. However, termination liability measured by the PBGC would produce higher liabilities.

The projections included employer contributions when required based on minimum funding rules. He noted that in the worst case scenarios where the funded status dropped below 90%, the law requires additional contributions, which in some cases might exceed 30% of covered payroll, a very high amount.

In the case where assets were stripped down to 125% of current liability, the chart above shows (by interpolating) that there is about a 20% probability that assets will drop to below 100% in 5 years, and a 40% probability that assets will drop below 100% in 10 years.

In the case where assets were stripped down to 150% of current liability, the probabilities that assets drop below 100% are about 10% in 5 years and 30% in 10 years.

Mr. Winklevoss noted that, as long as the sponsoring company was healthy, funded ratios below 100% were not a major concern, because over time the funded status would improve as a result of additional funding. However, there is a positive correlation between bankruptcies and falling markets.

Mr. Winklevoss' bottom line was that the current 420 rules were fine, since under these rules only a few plans would be stripped down to 125%. If more assets were allowed to be transferred (e.g. total future liability of retiree medical benefits for current retirees), he felt more comfortable with a 135% minimum funded status, since more plans might be brought down to the minimum.

WORKING GROUP MEETING

September 8, 1999

Earl Pomeroy, Congressman (Summary prepared by Michael J. Stapley)

Congressman Pomeroy expressed appreciation for the ERISA Advisory Committee. He indicated it was reassuring to know that somewhere in this town [Washington, D.C.] there are dedicated, smart people with appropriate backgrounds that are considering important questions relative to employee benefits. Congressman Pomeroy then outlined the following two issues that might be considered for future study by the ERISA Advisory Council.

A review of FASB Accounting Principle [106] which requires surplus to be reported as earnings.

Whether or not the congressional efforts to stop pension plan reversions should be extended to nonprofit entities.

The Congressman then shared several different pieces of information with respect to defined contribution plans raising questions with respect to their adequacy in securing retirement for Americans. Specific questions raised included:

Participation rates. He expressed concern that participation rates were low and that the amount of money being paid was not adequate to guarantee a secure retirement.

Investment choices. He raised concerns that employees were too conservative in their investment choices and that greater participation in equity markets would help guarantee a better retirement.

Leakage. He indicated that 55% of workers who received a lump sum distribution did not roll over any of it into a qualified plan. 47% of all 401(k) plans have less than $10,000; 70% have less than $30,000. He indicated these levels of savings were not sufficient to provide retirement income security.

Speaking directly to the issue of surplus pension assets and securing post-retirement medical benefits, Congressman Pomeroy raised the following four questions:

Who owns surplus assets in the pension fund?

Are the solvency thresholds in existing 420 adequate to insure the solvency of the defined benefit plan?

Should the legislation be maintained as it is presently which requires maintenance of benefits when transfers are made or should maintenance of cost provision be adopted?

Should 420 be expanded to allow surplus funds to prefund post-retirement medical obligations?

Mr. Pomeroy then indicated that the first priority should be to "conclusively and positively guarantee the solvency of the defined benefit". Second, should be the prudent enhancement of the defined benefit from surplus funds, and third, would be the enhancement of collateral benefits to employees such as post-retirement medical. He indicated this would include the current provisions of Section 420 and the maintenance of benefit requirement. Mr. Pomeroy indicated he felt that replacing the maintenance of benefit requirement with maintenance of cost would not be appropriate.

Finally, Congressman Pomeroy indicated that he had not come to a conclusion with respect to the prefunding of post-retirement medical benefits through an expanded Section 420. He did indicate that prefunding was a legitimate, important strategy for employers to meet the increasing of their retiree health benefits. At that point he then concluded his comments and considered questions from the Working Group.

WORKING GROUP MEETING

September 8, 1999

Irwin Tepper, President, Irwin Tepper Associates, Inc. (Summary prepared by Richard Tani)

Notable Quotes

"We conclude that by the time you get to 135% (funded ratio), most of the risk of unfunded current liability over 5 years gets reduced. If you raise the threshold to 145% you've done about as much as you can to reduce the risk."

"The funding rules are very good. They seem to work pretty darn well."

Mr. Tepper analyzed the funded status of pension plans by doing stochastic projections very similar to Howard Winklevoss (see July 13, 199 testimony). His asset assumptions were a little different from Winklevoss'.

His methodology was slightly different also, in that he assumed that assets were taken down to the threshold level in any year that assets exceeded that level and he looked at the probability that the funded status would drop below certain levels in any year during the projection (Winklevoss brought assets down to the threshold level only in the first year and looked at the funded status at the end of the projection period).

Because of his methodology assumptions, his probabilities are slightly higher than Winklevoss (numbers in parenthesis above).

Mr. Tepper said in his analysis, contribution levels remained manageable, even under the worst scenarios. He noted that in a typical plan, liabilities will grow about 13% per year (less benefit payments) which is about 6% for benefit accrual and 7% for discounting (interest). This does not take into account fluctuations due to changing interest rates. Therefore, a 25% surplus could be wiped out in 2 years if assets did not grow. (In practice, assets do earn a return, and more contributions make up any short falls if assets do not perform as expected).

Tepper notes (same as Winklevoss) that a funded status below 100% was not a significant concern if the sponsoring corporation was healthy. Over time, contributions will bring the plan to a surplus position again. However, he did not feel that the law should take into account the financial condition of the company, since it would add too much complexity.

Tepper also explained that having a heavier retiree mix in the population reduces the volatility of the liability to interest rate fluctuations. Again, he said that to incorporate any rules relating to retiree mix would be too complicated and not workable.

Tepper's conclusion was that a threshold of 145% funded status was conservative, and 135% was adequate to remove most of the risk of future unfunded liabilities over time frames up to 5 years.

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