A Termination Rule for Pension Guarantee Funds

Published date01 March 2018
Date01 March 2018
DOIhttp://doi.org/10.1111/jori.12150
©2016 The Journal of Risk and Insurance. Vol.85, No. 1, 275–300 (2018).
DOI: 10.1111/jori.12150
A Termination Rule for Pension Guarantee Funds
Chunli Cheng
Filip Uzelac
Abstract
A termination rule based on a critical funding ratio is proposed for a pen-
sion guarantee fund (PGF) that considers closing an underfunded pension
plan. This ratio is determined by solving an expected utility maximization
problem on behalf of plan beneficiaries subject to two constraints designed to
preserve the PGF’s viability.The first is an upper bound on the PGF’s annual
intervention probability; the second, a restriction on the expected shortfall of
an underfunded pension plan that is not closed. Both too low and too high
critical funding ratios hurt beneficiaries’ interests, depending on their degree
of risk aversion.
Introduction
A defined benefit (DB) pension plan promises pension beneficiaries (employees) a
specified amount of benefits on retirement, which is determined by a formula that
usually takes into account the beneficiaries’ years of service with the sponsor (the
employer), their salary, and their age. Contributions from the sponsor and future
investment returns constitute the plan’s assets. When assets fall short of accrued pen-
sion liabilities, the plan is underfunded, which exposes beneficiaries to the risk of
failure to receive the full promised pension benefits on their retirement. Underfund-
ing of DB pension plans in the United States and in other countries has been docu-
mented in the empirical literature (see, e.g., Armstrong, 2004; Franzoni and Marin,
2006; Selody, 2007; Severinson, 2008). Moreover, underfunding has been shown to be
Chunli Cheng is at the Bonn Graduate School of Economics, Kaiserstrasse 1, 53111, Bonn,
Germany. Cheng can be contacted via e-mail: chengchunli@live.cn. Filip Uzelac is at the Fed-
eral Financial Supervisory Authority.Uzelac can be contacted via e-mail: flip.uzelac@bafin.de.
We are very much grateful to the two anonymous referees, Lorens Imhof, Harris Schlesinger,
and Peter Zweifel for their insightful suggestions and very valuable corrections. This article
has also benefited from valuable discussions and comments by Stefan Ankirchner, An Chen,
Christian Hilpert, and Jing Li. We also thank the participants of the 18th Spring Meeting of
YoungEconomists, the 17th International Congress on Insurance: Mathematics and Economics
(IME), the 40th Seminar of the European Group of Risk and Insurance Economists (EGRIE),
and seminar audiences in Bonn for helpful discussions. Financial support from the German
Research Foundation (DFG) through the Bonn Graduate School of Economics is gratefully ac-
knowledged.
275
276 The Journal of Risk and Insurance
Table 1
Aggregate Surplus (+)and Deficits ()of the Pension Benefit Guaranty Corporation
(PBGC) in the United States and the Pension Benefits Guarantee Fund (PBGF) in Canada
From 2003 to 2012 (Million)
2003 2004 2005 2006 2007
PBGC (USD$) 11,499 23, 541 23, 111 18, 881 14, 066
PBGF (CAD$) 137.5107.2237.4274.2112 .8
2008 2009 2010 2011 2012
PBGC (USD$) 11,151 21, 946 23, 030 26, 036 34, 379
PBGF (CAD$) 102.247.4+103.36.2+76.2
an equilibrium outcome in an imperfect financial market (see, e.g., Ippolito,1985;
Cooper and Ross, 2002). In an attempt to protect pension beneficiaries against loss
of promised benefits, many developed countries have created a pension guarantee
fund (PGF), also known as pension benefit guarantee insurance.1Examples are the
Pension Benefit Guaranty Corporation (PBGC) in the United States (created in 1974),
the Pension Benefits Guarantee Fund (PBGF) in Ontario, Canada (1980), as well as
the guarantee funds in Sweden (1960), Finland (1962), Germany (1974), Chile (1981),
Switzerland (1985), and Japan (1989).
The PGF charges the sponsor an annual premium, which is specified by law, for in-
suring pension benefits promised to beneficiaries. It can become active in two cases.
In the first case, when the insured DB plan is underfunded while the sponsor is un-
able to salvage the plan without going out of business, the sponsor submits a distress
termination application and waits for an approval by the PGF.In the second case, the
PGF initiates a termination of the underfunded pension fund for protecting pension
beneficiaries, which is known as an involuntary termination in practice. In each type
of termination, the PGF takes over the underfunded DB plan, using its own assets
to pay the benefits of current and future retirees, up to a limit called a maximum
guarantee. The maximum guarantee is set by law and updated periodically,for exam-
ple, annually in the United States). However, under differentmarket scenarios, which
include the decline of stock market prices in 2000, the decrease of interest rates, ex-
cessive risk taking by plan sponsors, and unfavorable demographic and employment
trends, the PGFs have been experiencing difficulty in performing this function (see,
e.g., Armstrong, 2004; Wilcox, 2006; Brown, 2008. Table 1 shows the financial status
of the PBGC in the United States and the PBGF in Ontario, Canada during a recent
decade.2
1According to Jametti (2008), the introduction of pension benefit guarantee insurance was mo-
tivated by the underfunding problem of DB pension plans. The pension guarantee fund is one
of three pension benefit security mechanisms; the other two are solvency requirements and
sponsor support (see Broeders and Chen, 2013.)
2See the PBGC and PBGF’s annual financial reports, http://www.pbgc.gov and http://www.
fsco.gov.on.ca/EN/PENSIONS/Pbgf/Pages/default.aspx.

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