|
...estimated trillion assets as security against future benefit payments, and in so doing made a large pool of capital available for efficient deployment through financial markets. (1) Over the thirty-plus years since the founding of the Pension Benefit Guaranty Corporation (PBGC), the government corporation that insures private sector DB plans, more than 168,000 plans have been terminated, but only in about 3,500 of those cases has the PBGC had to step in as trustee; in the other roughly 165,000 cases, plans had sufficient assets on hand to meet accrued obligations. (2) Even the often-cited $23 billion negative net position on the PBGC's balance sheet must be viewed in context, as it represents only a small fraction of total benefits paid since the founding of the insurance program in 1974.
In many respects, however, the system is not working as well as it should. One problem is that the system exposes some workers--those whose benefits exceed the maximum amount guaranteed by the government insurer--to a form of financial risk that they likely are ill positioned to bear and that they may not fully understand. In part the unsuitability of this risk reflects the fact that pensions loom large relative to many workers' financial portfolios. It also reflects the fact that a risky pension generally exposes workers to own-firm risk. (The own-firm nature of the risk inherent in a less-than-fully-secure DB plan arises because one of the preconditions of plan termination is that the sponsor must be in bankruptcy proceedings.) For some workers the downside of this risk has been realized: they have suffered severe blows to their personal financial situation when their employers have terminated their DB plans with assets grossly insufficient to pay accrued benefits, and the PBGC covered only a portion of their loss.
A second problem with the current system is that mispriced PBGC insurance coverage encourages excessive risk taking on the part of both workers and firms. Julia Coronado and Nellie Liang find that "even after controlling for cash availability ... firms closer to bankruptcy have funded their plans much less generously." (3) Anecdotally, other observers have cited cases in which firms in shaky financial condition have granted benefit increases in lieu of wage or salary increases, on the theory that if the fortunes of the firm improved, the firm would be able to meet the newly granted pension obligations, and if not, the government insurance program would step in to fill the gap.
A third problem is that investors seem to have considerable difficulty processing DB-related information accurately. For example, Coronado and Steven Sharpe document that investors seem to be much more sensitive to the smoothed information about pension items currently provided in the body of firms' financial statements than they are to the market-value-based estimates provided in the footnotes. (4) Similarly, Francesco Franzoni and Jose Marin show that firms with severely underfunded pension plans--a publicly observable condition--tend to underperform the stock market? This misvaluation is a matter of macroeconomic concern because it raises the possibility that capital is being misallocated across firms.
A fourth problem with the current system is that it puts taxpayers at risk of providing substantial yet opaque subsidies to the sponsors and participants of DB plans, beyond the $23 billion already reflected on the balance sheet of the federal insurer. In particular, the Congressional Budget Office (CBO) estimates that the insurance provided by the PBGC will be underpriced by $63 billion over the next ten years if current law is left in place . (6) This commitment of resources would come just as other demands on the federal government associated with the retirement of the baby-boom generation are mounting.
A fifth problem is that healthy sponsors confront a real risk that costs will be shifted to them from weaker sponsors. Such a shift would occur if, in an effort to recoup the economic losses already incurred or still in prospect, policymakers were to raise PBGC premiums (which, by construction, are paid only by surviving sponsors) above their economically fair level. A move in this direction would give surviving sponsors an added incentive to bring their plans up to fully funded status and then terminate them, and could therefore deplete the ranks of DB plan sponsors, not because of any inherent flaw in the system or lack of perceived value in DB pensions as a form of compensation, but rather because the costs of sponsorship had been inflated beyond their full and fair level.
One last problem with the status quo is that all sponsors face a regulatory thicket of mind-boggling proportions. One example among many involves the method (which figure 1 attempts to illustrate) that sponsors must use to determine the maximum contribution they will be allowed to deduct against their income taxes. The basic idea is that sponsors should be allowed to deduct the amount that would be required to boost the plan to fully funded status--but not more, because of the losses to the Treasury that would be associated with such "excess" contributions. As the figure makes evident, however, the basic idea is deeply obscured in the current implementation. Needless complexity in the rules governing DB plans adds cost to the system and therefore discourages sponsorship.
[FIGURE 1 OMITTED]
In light of these shortcomings of the current system, this paper puts forward a comprehensive package of reforms with the goal of reviving the existing private DB system.: Given the speed with which that system seems to be shrinking, however, one might well ask, "why bother'?" Fundamentally, two reasons argue for undertaking such a program of reform even at this late date: First, even if conventional DB plans are doomed to extinction, considerable time will be required to unwind the plans still in existence, and the advantages of navigating that unwinding under better rules rather than worse ones could be substantial. Second, the demise of the DB system is hardly a foregone conclusion. Although a number of high-profile freezes and terminations have occurred recently, most large sponsors have preserved their plans thus far. Under streamlined rules, a greater number of firms and workers might decide that a DB plan should be retained as part of the overall compensation package.
The shortcomings described above motivate the adoption of three axioms concerning characteristics that an improved pension system should have. (8) These axioms play a crucial role in the logic of the paper, because the reform proposal that the paper puts forward is derived from them. The first axiom is that workers should be able to view the promise of a DB pension as free of risk. (9) This axiom is intended to address the facts that many workers are not well positioned to bear financial risk on the scale posed by an underfunded pension promise and that a risky pension scheme almost always entails meaningful own-firm risk. (10) If workers understand the nature of that risk, they will offer their employer a lower "price" (in the form of wage and salary concessions) than the capital markets would offer in return for the same cash flow, because, as Lawrence Bader has noted, "employees cannot diversify or hedge this risk in any practical manner," whereas capital markets can do so easily. (11) Zvi Bodie has referred to the difference between what workers and capital markets would offer in return for pension cash flows as "a wedge of dead-weight loss" that the employer can eliminate by making the DB promise free of risk. (12) Another realistic possibility is that workers simply do not understand the nature of the risk they are assuming by accepting a less-than-fully-secure DB plan, and so are not fairly compensated for it. (13)
Some analysts have argued that risky DB promises serve an economically and socially useful purpose, in that they give workers a stake in the economic success of their employer. But the objective of aligning the economic interests of workers with those of their firms can be advanced more directly and more transparently using other forms of compensation, such as employee stock ownership plans and long-dated options, which also have the important advantage of not involving the taxpayer as a third-party guarantor. An alternative argument that might be made in favor of a risk-tolerant approach is that, left to their own devices, workers might reasonably choose a risky pension over a safe one in order to gain some exposure to equity risk. But, again, conventional finance theory suggests that a well-informed worker should have little or no appetite for the particular form of risk exposure inherent in an underfunded DB plan, because it involves a heavy dose of own-firm risk even if the pension trust is invested entirely in a well-diversified portfolio. Moreover, to the extent that workers succeed in capturing the value associated with any upside risk in the net worth of the plan, one might expect employers either to trim other forms of compensation or to arrange the assets of the plan so as to reduce or eliminate that upside risk. If pension plans were to be charged an economically fair insurance premium that reflected the market price of all aspects of risk borne by the insurer, and thus the excess value derived at the expense of the PBGC were to be removed, workers' appetites for pension risk would probably be further diminished. And if general equity exposure is the objective, a 401(k) plan is a more appropriate tool.
The second axiom is that taxpayers should be compensated in full at market-consistent rates for the risk that they shoulder in backstopping the federal pension insurance program. As noted above, failure to assess a rational premium motivates sponsors and workers to take on risks they would not otherwise, exposes taxpayers to considerable financial burden at a time of mounting demands on government, and provides a substantial and opaque subsidy. Again, some analysts have argued to the contrary--that the Congress fully intended to set up a system that would transfer resources to firms in distress. But alternative mechanisms (such as unemployment insurance and various forms of worker education and training) are available that might better serve the purpose of cushioning the economic blow inevitably experienced by some workers and firms in a dynamic economy.
The third axiom is that low-risk sponsors should not have to cross-subsidize the insurance coverage provided to their high-risk counterparts. Sponsorship of a DB plan is voluntary, and low-risk sponsors perceiving a threat that costs might be shifted from distressed firms to them could be moved to terminate plans they might otherwise maintain. Genuine insurance can be provided without cross-subsidization.
Readers who disagree with any of these three axioms,...
NOTE: All illustrations and photos
have been removed from this article.
Looking for additional articles?
Search our database of over 3 million articles.
Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication
name or publication date.
About Goliath
Whether you're looking for sales prospects, competitive information, company
analysis or best practices in managing your organization,
Goliath can help you meet your business needs.
Our extensive business information databases empower business
professionals with both the breadth and depth of credible,
authoritative information they need to support their business
goals. Whether it be strategic planning, sales prospecting,
company research or defining management best practices -
Goliath is your leading source for accurate information.
|
