What Drives Corporate Pension Plan Contributions: Moral Hazard or Tax Benefits?

In testing moral hazard and tax benefit hypotheses regarding defined benefit plan funding and contribution incentives by incorporating sponsors’ bankruptcy risk, the authors proposed that high-bankruptcy-risk sponsors have a strong moral hazard incentive because the put value of the U.S. Pension Benefit Guaranty Corporation guarantee is high. For low-bankruptcy-risk sponsors, the put value is low; maximizing tax benefits associated with pension contributions becomes a powerful incentive. Results based on sponsors’ voluntary contributions support both hypotheses. Underfunding of corporate defined benefit (DB) pension plans has become a prevalent issue among U.S. companies amid the recent financial crisis. A key question that has attracted considerable research interest is what determines a DB plan sponsor’s decisions on pension funding and contributions. Within one unified framework, the authors tested two hypotheses—one on the moral hazard incentive and the other on the tax benefit incentive—with respect to decisions on DB pension funding and contributions by incorporating sponsors’ expected bankruptcy risk, as measured by Moody’s EDF (expected default frequency). The incorporation of expected bankruptcy risk is critical in better understanding a sponsor’s incentives because it relates directly to the put option value derived from U.S. Pension Benefit Guaranty Corporation (PBGC) insurance. The authors hypothesized that sponsors with high expected bankruptcy risk are dominated by the moral hazard incentive because the put option on the PBGC guarantee has the greatest value. In contrast, for sponsors with low expected bankruptcy risk, the PBGC put option value is low; maximizing tax benefits associated with pension contributions becomes a dictating incentive.Unlike earlier researchers who used total pension contributions, the authors decomposed total pension contributions into mandatory and voluntary contributions. They used voluntary contributions as a major measure for sponsors’ incentives regarding pension funding and contributions. Using IRS Form 5500 data for 1990–2010, they calculated sponsors’ voluntary pension contributions on the basis of applicable pension laws and regulations. The results based on sponsors’ voluntary contributions are consistent with the two hypotheses after controlling for potential endogeneity. In particular, sponsors with high expected bankruptcy risk make low voluntary contributions; for those with low bankruptcy risk, voluntary contributions increase with the marginal tax rate. Using the recent financial crisis as a natural experiment on the effects of sponsors’ expected bankruptcy risk, the authors found that both moral hazard and tax benefits have intensified since the crisis.Suggesting that the existing pension regulations do not successfully reduce sponsors’ moral hazard incentive, the authors discuss three important policy implications: (1) The PBGC premium structure should fully reflect the bankruptcy risk that a plan sponsor poses to PBGC, (2) the PBGC claims on unfunded pension liabilities during corporate bankruptcy proceedings should be more strictly enforced, and (3) policymakers should address sponsors’ moral hazard incentive as a critical issue when designing pension regulations to ensure the soundness of the U.S. private pension system.