Creative Destruction in Company Pensions

October 30, 2005 • Commentary

Total underfunding of U.S. defined benefit (DB) pensions is now at a record $450 billion and many believe that the termination of United Airlines’ pension plan earlier this year is only the tip of the iceberg. Those of Delta and Northwest airlines, GM’s spin‐​off Delphi, and other traditional industries are also in trouble. The finances of the Pension Benefit Guarantee Corporation, that partially insures workers against plan terminations, have consequently deteriorated from a $10 billion surplus in the late 1990s to a $23 billion deficit today in its single employer program.

Conventional wisdom has it that the federal government has failed to adequately regulate company pension funding policies. The prospect of more plan failures has prompted the House to pass the Pension Protection Act, which would force employers to achieve full funding earlier and require the PBGC to charge employers higher premiums.

Defined benefit pensions, however, have become unsuitable for the needs of both workers and employers. The decline in the use of these pensions and the emergence of defined contribution plans during the last 25 years reflects a process of creative destruction that promotes economic efficiency and growth. Underfunding in DB pension plans involves more than just insufficient or inefficient regulation. Overcoming it would require a draconian regulatory framework that would hurt rather than help labor markets and the economy. Congress’ policy to date of allowing market forces to play out without additional regulatory interference remains the correct policy.

Rapid technological change is making defined benefit pension plans less desirable for both workers and firms. Because DB pension benefit levels are based on salaries earned during the last few years of service, they impede worker mobility across jobs and occupations. Those who quit their jobs very early accrue zero pension claims and those who divide their careers between multiple employers find their DB pensions significantly reduced.

Pensions that discourage workers from frequently switching jobs would be advantageous to firms that wish to retain experienced workers. However, the value to firms of long worker tenures has declined because speedier technical progress has hastened the depreciation of worker skills. But firms risk acquiring reputations as bad employers if they lay off workers initially hired under promises of sizable future pension accruals. Hence, DB pensions create “job‐​locks,” reducing worker mobility and impede the adoption of new technology.

Both workers and firms now prefer defined contribution (DC) pensions that are portable across jobs, offer wider investment choices, provide retirement benefits commensurate with earlier contributions but unrelated to how long workers stay in particular jobs, and enable the establishment of worker incentives through company matching contributions rather than through implicit promises of future pension accruals.

Those wishing to stem the decline in defined benefit pensions have called for more regulations to enforce full funding. This is motivated by the belief that DB plans expose employees to fewer risks. For example, financial experts oversee DB pension portfolios whereas employees must make investment choices under DC plans themselves, without necessarily having the required expertise. This argument, however, underrates the risks associated with DB plans.

The inherent problem with DB plans is that they are owned by firms but intended to benefit employees. This produces a conflict between increasing pension funding and advancing shareholder value through investing in productive activities — a conflict with no easy solutions. For example, even workers in firms with well‐ or over‐​funded pension plans are not free from the risk of lost pensions. In the 1980s, firms with over‐​funded pension plans often underwent hostile takeovers after which their pension plans were terminated with the capital gains accruing to the new owners. Congress reacted by enacting high taxes on such pension reversions to shareholders. Firms, in turn, responded with minimally adequate plan funding.

Mandating “better funding” sounds like an appropriate policy response but it too could easily backfire. Firms have an incentive to undertake risky investments with pension funds — an incentive that would remain even in the absence of government‐​provided insurance and would be enhanced if such insurance protection were increased. That’s because if pension fund returns turn out to be high, the excess funds would revert to the firm; if they turn out to be low, the plan could be terminated and workers or taxpayers would bear the losses. Taxes on fund reversions to the firm can limit but not eliminate the incentives to undertake risky pension fund investments. But to the extent they are successful, such taxes also reduce managers’ incentives to allocate resources to pension funding rather than to investments that increase the firm’s value.

Defined contribution pensions are better suited to a more dynamic labor market environment. Such plans better align the interests of their owners and beneficiaries because the two are one and the same. Lawmakers should not attempt to sustain defined benefit pensions on artificial life support through regulatory “reform.” Instead of shackling labor markets and the economy with an outmoded system of worker compensation, benign neglect would be growth maximizing.

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