The politics of pension reform are in full force. Low interest rates, the decline in the stock market (over recent years), and a rising number of retirees are putting a strain on the actuarial calculations used to determine the solvency of many pension plans. Companies with pension plans that are deemed under-funded will have to raise their pension-plan contributions, reducing the available cash for other endeavors.
This under-funding of corporate pension plans produces two different types of problems for the U.S. economy.
For one group of companies, the level of under funding is large enough to potentially push a company into bankruptcy — to the detriment of shareholders and employees. In fact, many companies are doing just that — reneging on their promise to their workers. These companies are walking away from their obligations and forcing the government’s Pension Benefit Guarantee Corp. (PBGC) to take over retirement plans.
Since the PBGC does not pay as much as the pension plans, the workers clearly lose. So do the taxpayers who may be left holding the bag if the PBGC goes under.
But not all companies are choosing to renege on promises to their workers and retirees. For this second group, the level of under-funding is not enough to push these companies into bankruptcy. Theses companies have enough cash flow to stand behind their promises to their workers. But the shareholders shoulder the cost of the under-funding because these companies will have to use part of their cash flow to shore up their pension plans — rather than using it to pursue investment opportunities or pay dividends. In this case, it’s the shareholders who shoulder the burden of the pension plan.
Corporations that, due to their long-term prospects, will be able to provide for their retirees, argue that interest rates and the stock market have been running below the long-run trends. In their view, low interest rates and low returns will only serve to temporarily distort the valuation of their pension plans. The short-term shortfall forces these corporations into a sub-optimal investment path that inevitably leads to lower valuations and decreased employment levels.
But the solution to their problem is fairly straightforward: Use the long-run discount rate and long-run rate of return in actuarial calculations. In doing so, the challenge in only to determine the true and proper estimate for the long-run discount rate and the expected rate of return.
The current set up of corporate retirement plans produces a moral hazard for companies with funded pension plans. These companies have a strong incentive to lobby for a higher discount rate and rate of return on investments. But doing so will only reduce their annual contributions, and could lead to long-run solvency problems if the rates used in the calculations are too high.
And as for the companies that are hopelessly under-funded, they have an added moral hazard: They will have every incentive to shift as much of their compensation to their retirement packages. In doing so they will be able to increase their cash flow in the short-run (they know that they will not have the cash to pay in the future and the PBGC will pick up the tab). But ultimately, either their employees will pay in the form of reduced benefits, or taxpayers will pay by assuming their pension liabilities. In most cases, both the taxpayers and the retirees will shoulder the burden.
Of course, economic growth and rising asset values will cure many of the problems now facing companies that offer pension plans. Yet the current conditions are creating another political battle in an attempt to solve the problem.
There is a debate now in Congress that pits defined-benefit plans against defined-contribution plans. Which way the balance tilts will have significant consequences.
If the pension reforms adopted by Congress allow companies to set aside less money for their defined-benefit (DB) plans — where employees own some amorphous portion of a retirement pie — and, in turn, make it easier for those companies to saddle the PBGC, the balance will tilt in favor of DB plans for at least a few years. In this case, the big winners will be the unions and the dirigistes in Washington.
If, on the other hand, the reforms force companies to set aside more money and to reveal more data to their employees, the movement for defined-contribution (DC) plans — where workers get to keep the upside and downside of their investments — will get an added boost, and so will the investor class.
The Bush administration seems interested in continuing the shift begun by the Reagan administration in favor of the DC plans. If Bush has his way, the economy and the markets will be better off, and the investor class will continue to flourish.