Posted by Pension Info on 12/12/2005, 7:30 pm
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Underfunded Pensions and Perverse Incentives (8/17/05)
By Jonathan Elsberg, CPE staff economist
An incentive is something that motivates a person or organization to do something. It can be a positive incentive like a reward, attracting us to act in a particular way, or a negative incentive like a punishment, convincing us to avoid acting in some way. Economists often focus on incentives to understand why people buy the things they buy or work the way they work. Sometimes an incentive intended to help solve a problem actually ends up making the original problem worse. The looming crisis of underfunded retirement pensions provides an unfortunate example of such ‘perverse’ incentives.
Corporations, which organize and maintain pension funds, are supposed to make sure the funds increase in value, so there will be enough money to pay retired workers the benefits earned over long years on the job. The corporations can do this by putting money directly into the fund or by investing the fund’s money so that it will grow in value. Most pension funds own a lot of stock, and in the late 1990s the growing stock market bubble created an incentive for corporations to stop putting new money into their pension funds, because the funds seemed to be increasing sufficiently in value on their own.
Freed from the need to put money into pension accounts, corporations distributed the surplus to stock owners in the form of dividend checks, or bought up their own stock as a form of investment. These uses of corporate money only helped to push stock market values even higher. In the first case, investors wanted to buy stocks when they thought that those stocks would pay higher dividends. In the second case, the corporations wanted to buy the stock directly. Either way, the growth in demand for stock outstripped the growth in supply, and the result was sky-rocketing prices.
A set of perverse incentives was created: the more the stock market grew, the less corporations felt a need to put money into their pension accounts. The more they used that money for other purposes, the more they helped inflate the stock market bubble. >From the perspective of corporate leaders, the situation must have seemed too good to be true – which it was.
When the stock market bubble finally burst, all that inflated value disappeared from the pension fund accounts. Suddenly, the corporations faced pension bills they were hard pressed to pay. The result is that millions of workers face the real prospect that as they retire, instead of monthly pension checks they’ll be stuck with broken promises.
There has been a rash of pension defaults in recent years, with nearly 600 funds passing off their responsibility for $14.3 billion from fiscal year 2000-2004 to the Pension Benefit Guaranty Corporation. (The PBGC is a government chartered corporation that insures pension plans.) The latest default to make news was in March, 2005, when United Airlines defaulted on pensions for 121,500 employees, the largest default in U.S. pension history. Other airlines are rumored to be looking to follow suit.
The PBGC estimates that 75% of all the corporate pensions it covers are underfunded, and that all together those funds are short by an estimated $95.7 billion. If the problem becomes severe enough, hundreds of billions of dollars in taxpayer money will be needed to bail out the pension system, and even that won’t be enough to fulfill all the retired workers’ expectations. The risk is very high, since already the PBGC is itself underfunded by over $20 billion, making it difficult for the organization to do its job of protecting workers when corporations mismanage their pensions.
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