Concern over the under-funding of private defined-benefit pensions is at a boiling point. United Airlines was recently allowed to terminate its multibillion-dollar pension plan, and those at Delta, Northwest, American and Continental airlines, as well as GM's spin-off Delphi and steel and other manufacturing industries, appear to be in dire condition. Latest available data show that of the 30,000 employer plans insured by the federal Pension Benefit Guaranty Corporation, almost 60 percent are underfunded. Total under-funding amounts to $450 billion, and plan terminations totaling $108 billion in under-funding are classified as "reasonably possible."
Pension under-funding and prospects of plan terminations have increased considerably since the 2001 recession. As a result, the PBGC's projected excess of outlays over premiums has increased during the last five years, shifting from a $10 billion surplus to a $23 billion deficit. Conventional wisdom says that the federal government has failed to adequately regulate company pension-funding policies. Lately, however, the prospect of more plan failures has prompted some in Congress to introduce legislation that would require employers to achieve full funding and permit the PBGC to charge employers higher premiums.
But reform proposals would also allow employers more time before they must achieve full funding and loosen the criteria for determining fully funded status. The U.S. Congressional Budget Office estimates that the latest proposals would further worsen 10-year federal deficits by as much as $6.5 billion. How will these regulations work? Are they worth the added budgetary cost?
Rapid technical changes during the last 25 years have rendered defined-benefit pensions less suitable for both workers and employers. The main disadvantage for workers arises from the "job lock" they create: Because salaries generally increase during workers' careers, pension benefits based on salaries earned during the last few years at a firm lead to significant pension reductions for those who divide their careers between multiple employers. This impedes workers' mobility whenever pension losses overwhelm the advantage from switching employers.
Speedier technical change has also hastened the depreciation of worker skills, making long-tenured workers less attractive for firms. For the last three decades, both workers and employers at new firms have preferred defined-contribution pensions that are portable across jobs, offer wider investment choices, provide retirement benefits that are commensurate with previous contributions but are unrelated to how long workers stay in particular jobs, and allow borrowing against plan assets to meet emergency spending needs. Moreover, these pensions enable firms to provide rewards and work incentives through company matching contributions, rather than through implicit promises of high but uncertain future defined-benefit pensions.
But what about existing pension promises? Shouldn't companies strive to fully fund those plans and shouldn't Congress adopt stricter regulations to ensure that goal? That's easier said than done. The inherent problem with defined-benefit plans is that they are owned by firms but intended to benefit employees. This produces a conflict between contributing available funds toward better pension-plan funding versus investing them in productive activities to advance the firm's value to shareholders.
Even workers in firms with well- or overfunded pension plans are not free from the risk of lost pensions. In the 1980s, firms with overfunded pension plans were taken over by others interested in dismantling them and terminating their pension plans to capture excess assets. Congress reacted by imposing high taxes on asset reversions to shareholders. But that weakened firms' incentives to fund pension plans beyond minimally adequate levels.
Mandating better funding appears appropriate as a policy response, but it, too, could easily backfire. If forced to deposit more in their defined-benefit pensions, firms may undertake riskier investments with those funds. 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. The incentive to invest pension funds in risky assets would be enhanced if the PBGC's insurance protection were increased, as called for in bills introduced by lawmakers. Taxes on asset reversions to shareholders can limit but not eliminate incentives to undertake risky pension-fund investments. But to the extent they are successful, such taxes also reduce managers' incentives to allocate more resources to pension funding and to invest them conservatively.
The proposed regulations by the Bush administration and Congress appear to be a balanced approach to redress the under-funding in defined-benefit pensions. But the danger in crafting laws that would force firms to fully fund defined-benefit pensions is that they could slow or reverse the process of "creative destruction" in pensions -- i.e., replacing defined-benefit with defined-contribution plans. That's because proposed legislation makes no distinction between protecting the rights of existing pensioners versus providing appropriate pension plans for the next generation of workers. Because defined-contribution plans allow greater labor-market efficiency, laws that make defined-benefit pensions unconditionally more secure could also reduce the economy's future ability to allocate labor resources to their best uses.