Chip Taylor

Moral hazard

Once you are insured against a loss, you have less incentive to avoid the loss. All insurance companies have to deal with moral hazard among the insured; government insurance funds undoubtedly deal with it more poorly than private insurance companies. The S&L debacle of the 1980s was Exhibit A. The airline pensions insured by the Pension Benefit Guaranty Corporation are shaping up to be Exhibit B.

In an echo of the savings and loan industry collapse of the 1980's, the federal agency that insures company pensions is facing a possible cascade of bankruptcies and pension defaults in the airline industry that some experts fear could lead to another multibillion-dollar taxpayer bailout.

"The similarities are incredible," said George J. Benston, a finance professor at Emory University in Atlanta who has written extensively on the regulatory failures that led to the costly savings and loan bailout.

...

Now experts say they see similar forces gathering in the pension sector, with United Airlines perhaps the first to go down the path. Operating in bankruptcy, United is striving to attract the lenders and investors it needs to survive. It said last month that it would no longer contribute to its pension plans; United also seems intent on shedding some or all of its $13 billion in pension obligations as the only way to succeed in emerging from bankruptcy proceedings.

If United manages to cut itself loose from the costly burden of its pension plans, it might force others determined to keep their costs similarly under control to emulate its move. "Rivals may feel they are at a competitive disadvantage and follow suit, raising the specter of a domino effect in the industry," said Bradley D. Belt, the executive director of the government's Pension Benefit Guaranty Corporation, which insures pensions. If every airline with a traditional pension plan were ultimately to default, the government would be on the hook for an estimated $31 billion. Its insurance coverage is limited, so some employees would have their benefits reduced.

So, how did we get this Pension Benefit Guaranty Corporation?

In 1974, Congress responded to an ugly string of pension failures in the auto industry by passing landmark legislation. From then on, any company that promised pensions to its workers would be required to set aside enough money to pay them. Rules were written to determine how much money was enough. To weave the retirement safety net even more tightly, Congress also created the pension insurance program.

Those protections were hailed as "the greatest development in the life of the American worker since Social Security" by Senator Jacob K. Javits.

If companies that promise pensions are "required to set aside enough money to pay them," how is it that United only has $7 billion of $13 billion covered?

United's pension plan developed its multibillion-dollar shortfall, in part, because pension law allows companies to fund their plans with the assets that any prudent investor would select. Over time, that has meant a shift away from the very conservative bonds that companies used to secure pensions before the 1974 law, in favor of more aggressive investments.

Stocks have become the investment of choice, but today many pension funds seek to bolster their returns even more by adding relatively small amounts of hedge funds, junk bonds and other risky assets. This investment approach can produce attractive returns over time, but can be very volatile and much more dangerous if companies are forced to pay off some of their pension obligations in a down market.

As the pension system has weakened, some specialists have called for measures that would discourage the riskiest investments. As director of the pension agency, Mr. Kandarian proposed charging higher insurance premiums to companies that invested their pension funds in riskier assets, particularly companies that were in bad shape themselves. No one paid attention.

Not only that, but:

Along with Mr. Kandarian, current officials at the pension agency and at the Treasury Department have also been calling for a tightening of the rules requiring pensions to set aside enough money to meet their obligations. In April, Congress loosened the rules instead. The biggest flexibility was given to the most troubled industries, making their pension funds look healthier. [Emphasis added. -- Ed.]

Never underestimate Congress' ability to make a bad situation worse.