Pension Deficits: An Unnecessary Evil

Many companies believe that underfunding pension plans is an inexpensive way to borrow from employees and that mismatching equity investments to bondlike pension promises creates shareholder value. To the contrary, financial economics calls for fully funding and immunizing accrued pensions. For nonguaranteed pensions, inadequate funding magnifies employees' exposure to their employers' financial health—exposure that they cannot diversify. Fully securing the pensions eliminates this inefficiency in employee compensation. Governmental guarantees eliminate the employees' pension risk but invite weak sponsors to extract subsidies from strong ones through underfunding. A statutory requirement of full funding and immunization would eliminate these subsidies. The recent swing from abundant pension surpluses to massive deficits has been an unpleasant surprise worldwide. U.S. pension plans have experienced an adverse shift approaching a half-trillion dollars—a heavy blow to shareholders, the Pension Benefit Guaranty Corporation (PBGC), and to many employees.Pension deficits are commonly viewed as an acceptable risk of efficient long-term funding programs. This article argues, to the contrary, that deficits reflect glaring inefficiencies in employee compensation and the regulatory framework.In the absence of governmental guarantees, a pension promise is economically equivalent to the employer’s issuing its own nontransferable bond to its employees as part of their pay package. Unless the bond is fully collateralized—or the pension is fully funded—its value depends on the plan sponsor’s health. Employees cannot diversify this company-specific risk, to which they are already overexposed through their employment. Informed, rational employees would not pay full market price for a risky employer bond, nor would they give up enough salary to cover the cost of a risky pension. Pensions whose security depends on their sponsors’ creditworthiness are, therefore, inefficient; they cost the sponsors more than they are worth to the employees. A sponsor can eliminate a pension deficit by borrowing in the capital markets to cover the deficit; it can eliminate pension investment risk by exchanging its risky portfolio for an immunizing bond portfolio. In either case, the shareholders suffer no loss. To the contrary, the company improves the efficiency of its employee compensation and tax management. In an unregulated but transparent pension system, the interests of enlightened plan sponsors, companies, and capital providers should lead to a robust version of full funding, in which all accrued pensions are secured by immunizing bond portfolios.The existence of the PBGC changes this full-funding rationale. PBGC guarantees, although limited, shift most pension risk from employees to all plan sponsors jointly. This risk shifting replaces one set of problems with another. Weak companies can make outsized pension promises and then underfund their pensions. In effect, these companies extract involuntary loan guarantees for their risky pension promises from the companies with whom they compete for labor and capital.Two broad legislative solutions to this problem are available: mandatory full funding and risk premiums that accurately reflect each plan’s risk of failure. Only the first solution is feasible. It holds pension plans to standards like those governing other financial intermediaries; that is, it requires them to cover their liabilities at all times with adequate and reasonably well matched assets. A risk-based premium system is appealing because it would give sponsors freedom to manage their plans. But this solution would not hold pension plans to the usual standards for financial intermediaries. Instead, it would leave them dependent on their sponsors’ financial health. To set accurate risk-based premiums, the PBGC would have to monitor not only the pension plans but also the operations of every plan sponsor—a Herculean task in both its difficulty and its unpleasantness.A full-funding requirement would leave the PBGC (apart from legacy costs) covering rare misfortunes rather than inevitable outcomes of widespread risky practices. Successful transition to such a regime would eliminate the remote, but not unimaginable, danger of an assessment spiral among plan sponsors and an eventual taxpayer bailout of the PBGC.Pension risk is inefficiently borne by employees or governmental guarantors. With or without guarantees, full funding is the optimal condition for the pension system.