If your company provides you with a pension, chances are it’s underfunded. Although the federal government provides you with some insurance via the Pension Benefit Guarantee Corp., chances are that any future systemic problems will require taxpayers to come to the rescue.
Is there a nifty market-based solution to all of this? While we’d like to think so, we’re skeptical. Defined benefit pensions can’t and shouldn’t be saved.
In defined benefit pension plans, employers save and invest on behalf of workers to pay retirement income that’s typically some percentage of final salary. The latest available data from PBGC show that of the 30,000 employer plans it insures, nearly 60% are underfunded. Total underfunding is $450 billion, and PBGC’s projected excess of outlays over premiums has increased the last five years, shifting from a $10 billion surplus to a $23 billion deficit.
Congress feels the solution is better oversight and tougher regulation, while some economists propose private insurance. They say the problem isn’t with defined benefit plans, but the fact that the plans haven’t been exposed to market discipline.
Proponents claim employers are better able to pool the funds and invest them than individual workers. But that doesn’t appear to be sufficient to guarantee promised pension payouts. Those advantages are neutralized by the fact that most defined benefit plans are underfunded by employers - and by choice. What good are employers’ fund pooling and investment savvy if they repeatedly exaggerate future returns to avoid contributing enough money in the first place?
The main argument for adopting private “funding gap insurance” is that its premiums would provide clear information about the extent of pension underfunding and the true cost of a remedy. Although we agree that insurance markets reveal the true cost of inducing others to bear risk voluntarily, if private pension insurance is such a good idea, why doesn’t it exist already?
Insurance markets have two characteristics that create challenges for companies that sell insurance: “moral hazard” and “adverse selection.” “Moral hazard” exists when an insured party’s behavior can affect the probability that an insured event will occur. “Adverse selection” exists when the only purchasers of pension insurance are the firms (or workers in firms) in industries facing relatively high business uncertainty and those that are more vulnerable to unforeseen shocks - that is, only those who believe they need such insurance.
Combating adverse selection is easy. Proponents argue that such “private insurance” should be mandatory. However, the moral hazard problem is likely to be more challenging to solve. Normally, insurance companies vary premiums, deductibles and co-payments to deter moral hazard, but we doubt that would work in this case.
An insurer would almost certainly want real-time access to an insured party’s financial records and the right to take control of the operation of pensions that became underfunded in the same manner that the FDIC polices deposit insurance. But insurance company requests to assume operation of a pension fund would likely be subject to litigation, and the financial expertise and transaction costs required of the courts in such cases would be paralyzing.
Also, the extent to which pension plans are underfunded varies with the business cycle. Corporate contributions drop when the stock market is down and interest rates low because firms on the edge of survival can put the money to better use elsewhere. Accordingly, insurance firms would be required to constantly oversee and adjust their premiums as business conditions change. The task of monitoring more than 30,000 firms’ financial positions and funding decisions is likely to be too burdensome.
If private insurance won’t work, then what? Unfortunately, no easy alternatives exist, because defined benefit plans are plagued by a conflict of interest: They are intended to benefit workers, but are owned by firms. This produces a tension between alternative uses of available funds: contributing them toward better pension funding vs. investing them in productive activities to increase the firm’s value to shareholders.
We believe that the ongoing shift to defined contribution pensions is the private market’s solution. Defined contribution plans appear more suitable to an environment of accelerating technological change and greater desire for worker mobility - by both employers and employees. Also, defined contribution pension plans align interests and responsibilities properly and in the right entity: the worker.
Congress should try to accelerate the transition to defined contribution pensions rather than applying more stringent regulation and devising stop-gap solutions to shore up an increasingly obsolete system.