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Optimal pension funding strategy and pension insurance reform

The attached model improves our theoretical understanding of corporate pension policies and forecasts the behavioral impact of changes to pension policy. The model calculates optimal pension funding decisions and compares them to the actual decisions companies make. Falkenheim finds that the ability to save money in a tax sheltered account motivates companies to make higher than required contributions, and that the limits on deductible contributions discourage contributions above the maximum. He also finds limited evidence suggesting that companies are deterred from making additional contributions because it would reduce the value of their PBGC insurance. In a surprising result, Falkenheim finds no evidence that companies contribute additional money to reduce their variable rate premium.

Private employment-based defined benefit (DB) pension plans promise payments to retirees based on a formula. For example employees might receive a retirement benefit equal to one percent of their average salary over their tenure at a company for each year that they worked; this benefit would be paid each year that they remain alive in retirement. Based on rules that originated with the Employee Retirement Income Security Act (ERISA) of 1974, companies fund defined benefit pensions by contributing money to trust funds and investing those funds in a mix of investments. Funding rules require companies to contribute an amount equal to the present value of their benefit promises, with penalties for not complying. But sometimes those investments can perform less well than expected and pension funds become insufficient to cover promised benefits. In that situation, the rules require the plan sponsor to remedy the underfunding with additional contributions. If the sponsor goes out of business before remedying the underfunding, workers can lose promised benefits. To avoid these losses, the Pension Benefit Guaranty Corporation (PBGC) takes over the pension fund, pays the funded portion out of the plan assets, and covers the unfunded benefit up to guarantee limits with its own funds, which accumulated from the premiums paid by companies participating in the defined benefit system.

Private pension plans face serious long-term financial challenges. Despite the a trend towards defined contribution plans, private sector defined benefit plans still cover more than 40 million workers and retirees. In recent years, defined benefit plans have been chronically underfunded because of poor asset price performance, lower interest rates, and legislation relaxing the funding rules. The PBGC too is deeply underfunded because historically its premiums have not been adequate given the risks it is required to take.

This study compares actual company decisions about how well to fund their defined benefit pensions to optimal strategies from an infinite horizon model. It develops a Markov Decision Process model to determine optimal funding decisions, and estimates the relationships between those optimal decisions and actual observed decisions using maximum likelihood estimation. The goal of the model is to improve our theoretical understanding of corporate pension policies while also developing a practical tool to forecast how companies will react to policy changes aimed at improving the pension insurance system.

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