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Protecting underfunded pensions: the role of guarantee funds

Published online by Cambridge University Press:  15 January 2004

RUSSELL W. COOPER  and
THOMAS W. ROSS
RUSSELL W. COOPER
Affiliation:
Department of Economics, University of Texas, Austin TX 78712, USA
THOMAS W. ROSS
Affiliation:
Sauder School of Business, University of British Columbia, Vancouver, B.C. V6T 1Z2, Canada (e-mail: toms.ross@sauder.ubc.ca)
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Abstract

Employer-related pensions are a common and extremely important component of the compensation paid to workers in both the public and private sectors of developed economies. Many private pensions are insufficiently funded, exposing workers to the risk of a loss should their employer cease operations and not be available to meet pension obligations.

In this paper we study the role of guarantee funds as providers of insurance to workers against the failure of firms with underfunded defined benefit pension plans. Employing a model that predicts pension underfunding, we consider first how private guarantee funds might operate and then explore some potential advantages of public funds.

Overall, we do find that both public and private funds provide insurance benefits. However, private guarantee funds requiring ex ante premia payments may be infeasible in the presence of capital market imperfections, and funds which rely upon ex post contributions may suffer from strategic uncertainty. A public fund can overcome this coordination problem. However, a public fund, such as that administered by the US Pension Benefit Guaranty Corporation, may lead to: (i) greater underfunding of pensions, (ii) distortions in the market participation decisions of firms and (iii) the inclusion of excessively risky assets in the pension portfolio. In some cases, a guarantee fund is not welfare improving.

Type
Research Article
Information
Journal of Pension Economics & Finance , Volume 2 , Issue 3 , November 2003 , pp. 247 - 272
Copyright
© 2003 Cambridge University Press

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Footnotes

The authors gratefully acknowledge extremely helpful discussions with Zvi Eckstein, Richard Ippolito, Owen Lamont and James Pesando, the research assistance of Raul Pacheco-Vega, Liliana Rodriguez, Francisco Salas and Jon Willis and the financial support of the Social Sciences and Humanities Research Council of Canada, the UBC Centre for the Study of Government and Business and the National Science Foundation. Comments and questions from seminar participants at IDEI in Toulouse as well as from two anonymous referees are greatly appreciated. During the preparation of the first draft of this paper, the second author was a visitor in the Institute for Policy Analysis at the University of Toronto and he wishes to express his appreciation to the Institute for its hospitality and support.