Speech

The Role of Self-Regulation and Voluntary Compliance Incentives in the Design of Pension Systems OrganisationforEconomicCo-operationandDevelopment ConferenceonPensionReforminRussia:FromLegislationtoImplementation Moscow,Russia September25,2003 Being in Moscow, a city whose origins officials.Informationrequirementscanalsobe date to Neolithic times, it is easy to extremelyimportant.Companiesmayberequired appreciate how recent is the devel- topublishauditedfinancialreportsontheir opment of pension plans. Although pensionplanassets.Withsuchinformation,for pension-type funds were established in some example,workersmaybelesswillingtoaccept mining communities in Europe as early as the employmentwithafirmthatmaintainsafinan- Middle Ages, it was not until 1889 that the first ciallyweakpensionplan,forfearthatpension national public pension plan was established by benefitswouldnotbeavailableaspromised.Just Germany.Manyothercountriesquicklyfollowed asmaintaininggoodwagesandanattractivework in establishing their own programs, with the environmenthelpsfirmstoattracthigh-quality United States being a relative latecomer. The workers,soalsodoesmaintainingastrongpension U.S. social security program was not enacted plan,providedthatworkershavetheinformation until 1935. In fact, some U.S. companies estab- necessarytodistinguishstrongfromweakpenlished private pension plans well before social sionplans. security. Thefundamentaladvantageofrelyingon Myaimistoprovideabroadoverviewof incentivesisthatcompaniesaremotivatedby self-regulationandcomplianceincentivesinthe profitsandriskoflosstomakesoundbusiness contextofU.S.experience.Whatwemeanby decisions.Companymanagershave,orshould self-regulationandcomplianceincentivesisthat have,theinformationnecessarytopursueeffithegovernmentestablishesfinancialrewardsand cientstrategies,forwhichtheywillberewarded. penalties,andrequiresreleaseofinformation, Regulatoryoversightshouldfocusoncompliance thatencourageprivatefirmstoactinwaysthat withthetaxlaw,forexample,andnotsubstitute servetheinterestsofpensionplanparticipants. theregulators’businessjudgmentforthejudgment Servingtheirinterestssimultaneouslyservesthe offirmmanagers.Otherwise,twoparties—manpublicinterestinasystemthatprovidessecure agerandregulator—arebothmakingthedecisions. pensionsforallcitizens. Atbest,twopeoplearedoingtheworkofone;at Asanexampleofanappropriateincentive, worst,thelackofclarityaboutwhoisincharge thetaxlawmightprovideforreducedtaxeson andwhoisresponsibleforresultsdamagesthe companyincomeifthecompanyprovidespen- qualityofthedecisionsmadeandthefirmissimsionbenefitsthatareavailableforallemployees. plylessproductivethanitotherwisewouldbe. Thetaxbenefitswouldnotbeavailablefora Asanapplicationofthisprinciple,Federal companythatprovidespensionsonlyforsenior Reservebankregulatorsdonottrytosubstitute 1

MISCELLANEOUS theirjudgmentforbankmanagement’sjudgment, BASIC FEATURES OF DEFINEDbutinsteadfocusonthequalityofabank’sinter- BENEFIT AND DEFINEDnalinformationsystemsandrisk-management CONTRIBUTION PENSION practices.Bankexaminersdolookforevidence ofaccountingirregularitiesandfraud,butmore PLANS IN THE UNITED STATES importantlyrequirethatbanksthemselvesmain- Earliersessionsinthisconferencehave tainstronginternalsystemsthatmakefrauddif- focusedonbasiccharacteristicsofpensionplans ficultorimpossible.Thus,regulatorsconcentrate andoninvestmentpolicyissues.Nevertheless, onwhattheydobestandleavebankmanagement I’llreviewthesetopicsalsointheinterestofan tomakebusinessdecisionsdaybyday. orderlypresentationofmytopic. U.S.experiencewithsocialsecurity,with Therearetwobasictypesofpensionplans— privateplansandwiththeregulationofprivate defined-benefitanddefined-contribution.Definedplans,isrelevanttodevelopinganunderstanding benefitplans—whetherpublic,likesocial ofincentivesandcomplianceissuesinthepension security,orprivate—promisepensionbenefits context.Ibelievethattheeconomicprinciples basedonapredeterminedformula.Benefitstypiinvolvedhavebroadapplicability;nevertheless, callyarebasedonlengthofserviceandsalaryin exactlyhowtheyapplytoothercountrieswill thefinalyearsofservice.Mostprivatedefineddependonnumerousmattersofhistoricalexpe- benefitplansarepayableasanannuity.Aworker rience,characteristicsoffinancialmarketsand receivesamonthlyretirementbenefitnomatter howlongheorshelives. knowledgeofparticipants.Ihopethatmyobser- Defined-contributionplansmakenopromises vationsonU.S.experienceprovidesomeinsights regardingfuturepensionbenefits.Rather,this relevantintheRussiancontext. typeofplanspecifiestheannualcontributionto Letmereflectforamomentonmygeneral aretirementsavingsplan;thecontributionis approachtopublicpolicyissuessuchasthe typicallyapercentageoftheworker’ssalaryand designandregulationoftheU.S.pensionsystem. isoftenmatchedtosomedegreebyanemployer Itrytothinkaboutactualexperienceintheconcontribution.Theactualamountavailabletothe textofeconomictheorytoprovideappropriate workeruponretirementdependsupontheaccuanalyticalstructure.Economistscanlearnfrom mulatedcontributionsplustheinvestmentreturn. experiencethewayengineersinthe19thcentury Examplesofdefined-contributionplansinclude learnedfromthecollapsesofrailroadbridges, employeestockownershipplans,profit-sharing whichwerealltoofrequent,ortheexplosionof plans,and401(k)plans.Thelatterarethemost boilersassteamshipsreplacedsailingships. commonandmayincorporateaspectsoftheother Engineersunderstandtheimportanceofdetermintwoplans. ingthesourcesofaccidentsandroutinelystudy Anothersurfacedistinctionbetweenprivate suchevents.Similarly,carefulstudyofeconomic defined-benefitanddefined-contributionplans problemscanhelpmaketheeconomysaferand isthatworkersgenerallydonotcontributeaporthemarketsystemmoreefficient. tionoftheirsalarytotheformerplans.Neverthe- Beforeproceeding,Iwanttoemphasizethat less,pensionsareobviouslyvaluableandthe theviewsIexpressherearemineanddonot rightwaytothinkaboutthesepromisedbenefits necessarilyreflectofficialpositionsoftheFederal isthattheyareaformofworkerpaylikesalary, ReserveSystem.Ithankmycolleaguesatthe exceptthatpaymentisdelayed.Incontrast,with FederalReserveBankofSt.Louisfortheircom- a401(k)plantheemployeecontributesoutof ments.PatriciaS.Pollard,researchofficerinthe currentsalaryandtheemployer’scontributionis ResearchDivision,providedspecialassistance. tiedtotheparticipationoftheemployee.Both However,Iretainfullresponsibilityforerrors. typesofplansareheavilyregulatedandtheir 2

TheRoleofSelf-RegulationandVoluntaryComplianceIncentivesintheDesignofPensionSystems characteristicsaresignificantlyaffectedby retirementthischildislikelytocollectbenefits income-taxlaws. for18yearsifmaleand21yearsiffemale. Thesecondkeydemographicfactisthatpeoplearehavingfewerchildren.Thebabyboom HISTORICAL SKETCH OF thatoccurredfollowingWorldWarIIresultedin asharpriseintheaveragenumberofchildren, DEFINED-BENEFIT PLANS peakingintheUnitedStatesat3.7.Thefertility Althoughthefocusofmyremarksisonprivate ratecurrentlyhoversclosetothereplacement pensionplans,Ibeginwiththesocialsecurity levelof2.1andisnotexpectedtorise. system,giventhatsocialsecurityremainsthe Thesetwodevelopmentsareresponsiblefor mainsourceofincomeformostU.S.retirees. adeclineinthenumberofcontributorstothe Ninetypercentofthose65andoverreceivesocial socialsecuritysystemrelativetothenumberof securitybenefits,andfor65percentofthese beneficiaries.In1955,therewerealmostnine individualssocialsecurityaccountsfor50perworkersforeachbeneficiary.Todaythereare centormoreoftheirincome.Yet,socialsecurity, slightlymorethanthreeworkersforeachbenefilikemostpublicpensionprograms,isunderstress. ciary.Expertsestimatethatby2030therewillbe Accordingtothe2003reportbytheSocial twocontributorsforeverybeneficiary. SecurityBoardofTrustees,beginningin2018— Thesedemographictrendsmakefinancingthe amere15yearsfromnow—taxreceiptswillbe publicpensionsystemmoredifficult.Thisdiffiinsufficienttocoverbenefitpayments.Atsome cultyiscompoundedbychangesthatincreased point,theUnitedStateswillmostlikelyhaveto thegenerosityofbenefits.Theearlypost-warera raisetaxesand/orreducebenefitstomaintainthe wasaperiodofrapideconomicgrowth.During viabilityofthesocialsecuritysystem. thistime,thegoalofmostpublicpensionsystems Twomainfactorsareresponsibleforthelong- shiftedfromkeepingretireesoutofpovertyto terminsolvencyofpublicpensionsystems— allowingthemtomaintaintheirpre-retirement demographicsandincreasesinthegenerosityof standardofliving.Congressincreasedbenefits thesystems.Twoongoingdemographictrends withoutcorrespondingincreasesintaxrates.As arekey.First,peoplearelivinglonger.In1940, aresult,bythelate1970ssocialsecurityreceipts lifeexpectancyintheUnitedStateswas61years wereinsufficienttocoverbenefitpaymentsand formenand66yearsforwomen.Thus,aboyborn asmalltrustfundthathadaccumulatedwasin in1940wasnotevenexpectedtobealivebythe dangerofbeingdepleted.Facedwiththerevenue timehewaseligibletocollectsocialsecurity. shortfallandwellawareofthechangingdemo- Thosemenwhoturned65in1940wereexpected graphics,theU.S.governmenttookstepsinthe tocollectSocialSecurityfor12years,andtheir 1980stoincreasesocialsecurityrevenuesandto femalecounterpartswereexpectedtoaverage13 graduallyraisetheretirementagefrom65to67. yearsofbenefitpayments. Afundamentalchangewasthedecisionto Thechangeinlifeexpectancybetween1940 increasepayrolltaxratessufficientlytoaccumuandtodayisstriking.Thetypical65yearoldin lateatrustfundtofundtheretirementofthe theUnitedStatestodayisexpectedtocollect babyboomgeneration.Althoughthistrustfund socialsecuritybenefitsfor16yearsifamanand willprovideacushiontothesystemoncerev- 19yearsifawoman.Thetrendtowardlongerlifes- enuesdropbelowbenefitpaymentsin2018,itis panislikelytocontinue.Achildborntodayin notalong-termsolution.GivencurrentcontributheUnitedStatesisexpectedtolivewellpast tionandbenefitlevelsandthebestestimatesof retirementage.Undercurrentsocialsecurity demographictrendsandlaborproductivity,the law,eventakingintoaccountthescheduled socialsecuritytrustfundwillbeexhausted increaseinthenormalretirementageto67,upon beforemid-century. 3

MISCELLANEOUS Privatedefined-benefitplansprecededthe existingretirees,fewassetsremained.Nearly socialsecuritysystem.TheAmericanExpress 4,000workersbetweentheagesof40and59 Companyestablishedthefirstprivatepension receivedonly15percentoftheaccumulated planintheUnitedStatesin1875.Itwastherail- valueoftheirpensions.Youngerworkersreceived roads,however,thatdevelopedthestandard nothingbecausetheywereyettobevested. modelforprivatepensionplans.In1900,the Oneofthelessonsofthisexperienceisthat PennsylvaniaRailroadcreatedanoncontributory, workersmaynothavetheknowledgeandinfordefined-benefitplanthatprovidedapensionto mationnecessarytodeterminewhethertheir allworkersuponreachingage70.Thepension company’spensionpromisesarelikelytobekept. wasbasedonlengthofserviceandaveragewage Inprinciple,fullyinformedworkersshould inthelast10yearsofservice.Ofcourse,onlya demandthatpensionplansbeproperlyfunded relativelysmallpercentageofworkersin1900 andmanagedsothatthepensionassetswillbe livedtoage70. secureevenifthecompanysuffersextremefinan- Untilrelativelyrecently,defined-benefit cialreversesleadingtobankruptcy.Acompany planswerethemainemployer-sponsoredretire- pension,afterall,isaformofdeferredcompenmentbenefitplan.Defined-benefitplansrequire sationthataworkerhasasmuchrighttoexpect noactiononthepartoftheemployee,andthe toreceiveashisorherpaycheckattheendof employerassumesalltheinvestmentrisk.The themonth.Inpractice,U.S.experiencesuggests pensionisaguaranteedamount,providingthe thatworkersoftendonotproperlymonitortheir employerremainssolvent. firms’financialmanagementtoensurethesafety Inpractice,however,theguaranteewas ofpensions. incomplete,asmanyemployeessosadlylearned TheterminationoftheStudebakerpension afteritwastoolateforthemtoprotecttheirretire- planledtocallsforlegislativereformandovermentincome.Beforeextensivereformsin1974, sightofprivatedefined-benefitplansintheUnited employerswerecompletelyfreetodetermine States.Thiseffortculminatedwiththe1974enactwhenaworker’srightstoapensionwerevested. mentoftheEmployeeRetirementIncomeSecurity By“vesting”wemeanthattheemployeegains Act,commonlyknownasERISA.ERISAand legalrightstopensionassetsandcanuponretire- subsequentamendmentstotheActsetminimum mentreceiveapensioninanappropriateamount standardsforprivatepensionplanswithrespect giventheemployee’ssalaryandyearsofservice. toparticipation,vesting,funding,reporting,and In1965,forinstance,40percentoftheworkers disclosureoffinancialinformation.ERISAlimits inpensionplanswereinplansthatawardedvest- afirm’sabilitytoexcludeworkersfrompension ingonlyatthenormalretirementage.Anolder coverageandestablishedmaximumworkrequireemployeewholosthisjobjustbeforenormal mentsforvestingrights.Undercurrentrules, retirementagewouldbeleftwithabsolutely fullvestingmustoccurwithin5to7yearsofan nothing.Suchapersonwasunlikelytobeable employee’sentranceintotheplan.Acompany toworklongenoughwithanotherfirmtoqualify cannotavoidpayingapensionsimplybyfiringa underthatfirm’spensionplan.Moreover,pension workershortlybeforeretirement. planswereofteninadequatelyfundedandcould beterminatedatthefirm’sdiscretionwithout requiringcompensationtothecoveredworkers. MAJOR ISSUES WITH PRIVATE Anotedexamplearosein1963.Studebaker DEFINED-BENEFIT PLANS Corporation,whichatthetimewastheoldest majorautomobileproducerintheUnitedStates, Manyprivatedefined-benefitplansareexpecloseditslastdomesticmanufacturingplantand riencingconsiderablestresstoday.Thesame terminateditspensionplan.Theplanwasheavily demographicfactsthathavecreateddeepprobunderfundedsothataftercoveringbenefitsfor lemsforthesocialsecuritysystemarestressing 4

TheRoleofSelf-RegulationandVoluntaryComplianceIncentivesintheDesignofPensionSystems manyprivatecompanies.Anumberofoldercom- priateinterestrate.Thechoiceoftheinterest panieshavedecliningemployment,bothbecause ratecanmakeahugedifference.Somecountries ofthechangingdemographicsoftheU.S.labor requireafixeddiscountratebeused,butthe forceandbecausetheyareinindustriesthatare UnitedStatesdoesnot.Congresshadmandated shrinkingforavarietyofreasons.Thesecompa- thatthe30-yearTreasurybondratebeused.The nieshave,orsoonwillhave,alargenumberof government’sdecisionin2001tonolongerissue retiredworkersrelativetothenumberofactive 30-yearbondseliminatedtheusefulnessofthis employees.Itisdifficultforthesefirmstoearn measure.Asatemporarysubstitute,firmshave largeenoughprofitstofinancetheirpension beenallowedtouseacorporatebondyield. obligations. Althoughtherehasbeenmuchcontroversy Apensionplanisconsideredadequately overthechoiceofinterestrateinrecentyears, fundedifitsassetsaresufficienttomeetthe thelargerproblemisthatmostpensionplans presentvalueofitsliabilities.Conditionsinfinan- havenotinvestedinassetsofsimilarcharacter cialmarketsinthepastfewyearshaveresulted totheliabilities.Thecomparisonwithpractice indeclinesintheassetsofmanypensionplans. bylifeinsurancecompaniesisinstructive.Life Atthesametime,declininginterestratesraised insurancecompanieshaveconcentratedtheir thepresentvalueofpensionliabilities.The investmentsinfixed-dollarassetsmaturingona investmentpoliciesofmanypensionfundswere similarscheduletotheexpectedfuturecashoutnotadequatetowithstandthelargestockmarket laysaspolicyholdersdie.Thispracticeofmatchdeclinethatstartedin2000. ingthedurationsofassetsandliabilitiesisa Thepresentvalueofaplan’sliabilities standardfeatureofbankportfoliomanagement dependsontheagestructureofparticipantsas aswellasoflifeinsurancecompanies.Pension wellasthenumberofyearsaparticipantis funds,ontheotherhand,havetraditionally expectedtocollectbenefits.Priorto1995,pension investedalargefractionoftheirassetsincommon planscouldmaketheirownassumptionsabout stock,eventhoughtheirpensionliabilitiesare mortalitytodeterminetheexpecteddurationof definedindollaramountsthatcanbedetermined benefits.Althoughmanyfirmsreliedonstandard quiteaccuratelyinactuarialterms. mortalitytables,otherfirmsassumedthatthe InthesamewaythatU.S.regulationoflife lifeexpectancyoftheirworkersandretireeswas insurancecompaniesdevelopedinthelate19th belowaverage.Suchanassumptionloweredthe century,regulationofinvestmentpracticesof calculatedpresentvalueoftheliabilitiesofthe pensionfundscouldevolvetoreducetherisk plan,whichcouldmakeitappeartobefully thatthefundswillfail.Inthemeantime,werely funded. heavilyonpensioninsurancethroughERISA, Allowingfirmstomaketheirownmortality whichestablishedmandatoryinsurancefor assumptionswasagiganticregulatoryloophole; defined-benefitplansrunbyprivatefirms.The Ifinditamazingthattheloopholewasnotclosed PensionBenefitGuarantyCorporation(PBGC),a until1995.Firmsarecurrentlyrequiredtouse mortalitytablesprescribedbytheSecretaryof U.S.governmentagency,operatesthisprogram. theTreasury.Thecalculationofexpectedfuture However,thepensioninsurancesystemhas pensionliabilitiesisaverysimilarproblemto anumberofdefectsthatrequirecorrection.With thatfacedbylifeinsurancecompanies,which anytypeofinsurancearrangement,thepossibility mustalsocalculatetheirexpectedfuturecash ofmoralhazardarises.Intheinsurancecontext, outflowsbasedonthelifeexpectancyofpolicy- moralhazardisreflectedinchangedbehavior, holdersandthetermsoflife-insurancecontracts. suchaswhenanownerofacarneglectstolockit Thefuturestreamofexpectedpensionout- knowingthattheinsurancecompanywillreplace layscanbeexpressedasasinglepresent-value thecarshoulditbestolen.Itappearsthatsome amountbydiscountingthestreambytheappro- U.S.companieshavepermittedtheirpensionfund 5

MISCELLANEOUS assetstofallbelowpensionliabilitiesknowing structure,withpremiumsunrelatedtorisk,prothatthepensionfundsareinsuredbythePBGC. videdlittleincentiveforfirmstoproperlyfund Althoughmoralhazardcannotbeentirely theirplans.Indeed,forthefirst14yearsofthe eliminated,therearestandardpracticesadopted PBGC’sexistence,afirmcouldvoluntarilyterbyinsurerstoreduceitsseverity.Twokeymeth- minateanunderfundedplan.Terminations,in odsarethroughtheuseofpartialinsuranceand combinationwiththelowpremium,ledtoa risk-relatedpremiums.ThePBGCincorporates seriesofdeficitsinthesystem.ThePBGChadno thefirstprinciplethroughstatutorylimitsonthe authoritytoraisepremiumsdespitethedeficits maximumpensionguarantee.Thisfeatureofthe buthadtorequestcongressionalapprovaltodo systemensuresaminimumpensionintheevent so.EvenwithCongresstwiceraisingthepremiaplanisterminated,butretireeswhosepensions ums,in1978and1986,thedeficitscontinued. exceedtheguaranteeandworkerswhoseexpected Theproblem,clearly,waslesswiththemanagepensionsexceedtheguaranteehaveanincentive mentofthePBGCthanwiththeunderlyinglaw tomonitorthefinancialconditionofthepension determinedbyCongress. plan. Finally,in1988,Congressinstitutedavari- Many,andperhapsmost,employeesdonot able-ratepremiumthatappliedtounderfunded understandhowpartialthefederalinsurance plans.Butstillthedeficitscontinued.Why?Part throughPBGCisand,accordingly,theirmonitor- oftheproblemwasthatthevariable-ratepremium ingisincomplete.Itmightbepossibletomake wascappedatalevelthatwastoolowtoprovide thisincentiveworkbetter,perhapsbyrequiring asignificantincentiveforfirmstostrengthenthe companiestosendannualstatementstotheir mostunderfundedplans.Thatis,itwassimply employeesreportingthefinancialstateoftheir cheaperforfirmstopaythesmallextrainsurance defined-benefitplansandthesizeoftheguaran- premiumthantoaddfundstotheunderfunded teedpensiontheemployeewouldreceiveinthe plans. eventthecompanyfails.Currently,onlyunder- AccordingtothePBGC,theplansthatpaid fundedplansmustprovidethistypeofinforma- themaximumpremiumaccountedfor80percent tiontoplanparticipants. oftheunderfundingyetprovidedonly25percent Workersandretirees,however,nomatterhow ofthetotalrevenuefrompremiums.Subsequent wellinformed,areatadisadvantageinenforcing legislation,in1994,phasedoutthecapon theirpensionrights.Usualcompetitiveforces premiums. permitworkerstomovetootherjobsiftheyare Currently,anyfirmofferingadefined-benefit dissatisfiedwithcurrentpayandworkingcondi- pensionplanpaysaninsurancepremiumof$19 tions,butthatconstraintisobviouslyineffective peryearforeachplanparticipant.Forfirmswhose foraworkerorretireewithvestedpensionrights. pensionassetsarelessthan90percentofthe Planparticipantscanseekredressthroughthe presentvalueofpensionliabilities,anadditional courtsystem,buttheymaynothavethefinancial premiumisassessed.Thispremiumisninecents resourcestobattlecompaniesinthecourts.This foreach$1,000(orfractionthereof)ofunderfundargumentsuggestsanimportantroleforgovern- ing.Becausetheextrapremiumiswellbelow mentinmonitoringpensionplansandenforcing therateofinterest,firmshavenoincentiveto pensionregulations. borrowfundstoaddtoweakplans;theincentive Thesecondmethodofcontrollingmoral affordedbytheextrapremiumisforallpractical hazardistheapplicationofrisk-basedinsurance purposesworthless. premiums.Unfortunately,initsearlyyearsthe Thepremiumpenaltyiscombinedwith PBGCdidnotemployrisk-basedpremiums.Every mandatorycontributionswhichinprinciple firmpaidthesamepremium,initiallyamere$1 couldtakecareoftheproblem.Firmswithplans perparticipantperyearforasingle-employerplan. thatarelessthan90percentfundedarerequired Thepremiumwastoolowandtheflatpremium tomakeminimumcontributionstotheplanto 6

TheRoleofSelf-RegulationandVoluntaryComplianceIncentivesintheDesignofPensionSystems reducethefundingdeficiencywithinthree-five neighborhoodof$150billion;theamountwas years.Thereare,however,manyexceptionsto muchhigherthanitwouldhavebeenhadaction thisrulethathavetheeffectofpermittingcontin- beentakensooner.Thatexpensivelessonledto uingunderfundingformanyfirms.Forexample, newlegislationandmoredisciplinedregulatory ifaplanisatleast80percentfundedthisyear practicesthatsubstantiallystrengthenedcapital andwasmorethan90percentfundedinthepast inbankinginstitutions. twoyears,themandatorycontributionsdonot Theunderfundingcoupledwiththeneedto apply. findareplacementfortheTreasurybondrate Legislativechangeshavealsomadeitno hasledtocallsforchangestothewayliabilities longerpossibleforafirmtovoluntarilyterminate arecalculated.Thereisamultitudeofproposals. anunderfundedplan.Nowaplancanonlybe Toensurethelong-runviabilityoftheprivate terminatedifthefirmmeetsthefinancialduress defined-benefitpensionsystem,weneedtofocus criteriaestablishedbythePBGC.Eventhough onmeasuresthatwillincreasetheleveloffundfinancialduresscriteriamakeitmoredifficultto ingfortheseplansratherthanpaperingoverthe terminateaplan,itisstilltruethatfirmsthat problemswiththehopethatmoneywillbethere meetthistestareabletoterminatetheirplans, whenyoungerworkersreachretirementage. leavingtheiremployeeswithgreatlyreduced Weneedtoprovideproperincentivesforfirms pensions. tofundtheirplans.Onepossibilityisthrough Thisrestrictiononterminationsandthenew proposalsthatwouldlimittheabilityofunderpremiumstructure,combinedwiththestrongU.S. fundedfirmstoincreasethegenerosityofthe economyinthe1990s,resultedinaseriesofsur- pensionplans.Suchaprovisionwouldbesimilar plusesforthePBGCforafewyearsafter1995. tothestandardprovisioninbondcontractsthat Nevertheless,thefundamentalsofthesystem prohibitsacompanyfrompayingdividendsto werenotsound.In2002,asaresultofseveral shareholdersifcapitalfallsbelowacertainlevel. largeplanterminations,thePBGCrecordedthe Somehavesuggestedthatthesolutiontothe largestdeficitinitshistory.Concernaboutthe PBGC’sdeficitistoraiseinsurancepremiums. healthofthePBGCisalsorelatedtotherecent Thebase-ratepremiumhasnotbeenincreased sharpriseinthenumberofunderfundedpension since1991.Pushinguppremiums,however, plansandtheextentoftheunderfunding.In increasesthecostofrunningadefined-benefit 2002,underfundingofsingle-employerpension planrelativetoadefined-contributionplan.Itis plansreached$300billion.ThispastJulythe essentialthatpremiumsberisk-based.Ifthebase U.S.GeneralAccountingOfficedesignatedthe premiumistoohigh,whatappearstobean PBGCasa“highrisk”programinneedofcareful insurancepremiumbecomes,ineffect,ataxon monitoring. financiallyhealthyfirmstosupportweakfirms. Theideabehindfinancial-duresscriteriaand Anexcessivepremiummayleadafirmtotermiotherexceptionsthatpermitunderfundingis nateawell-fundedplan,leavingahigherproporthatforcingacompanytofullyfunditspension tionofunderfundedplansandthusraisingrather planmightleadittodroptheplanorevenforce thanreducingtheriskoffuturedeficitstothe thecompanyintobankruptcy.Theideaisquite PBGC.Forthisreason,thelong-runviabilityof similarto“regulatoryforbearance”bybanking thepensioninsurancesystemrequiresthatinsurregulatorsinthe1980s.Thehopethenwasthat ancepremiumsreflectactualriskascloselyas weakbanksandsavingsinstitutionsmightbe possible. abletobuildcapitalovertimeandrecovertheir U.S.experiencewithbankregulationand strength.Inpractice,whathappenedisthatmany depositinsuranceisinstructive.Onelessonwe ofthesefinancialfirmstookunduerisksandeven- havelearnedfrombankingcrisesisthatfinantuallyfailedanyway.ThecosttotheU.S.taxpayer ciallyweakfirmshaveagreaterincentiveto ofresolvingfailedsavingsinstitutionswasinthe engageinriskybehaviorthanotherfirms,partic- 7

MISCELLANEOUS ularlyifthereisnoadditionalinsurancecostto AlthoughthePBGCisagovernmentagency, thefirm.Thisunderstandingledtochangesin itreceivesnotaxrevenues.Instead,itisselfthewaypremiumsareappliedfordepositinsur- financed,relyingonpremiumsandassetreturns ance.Currently,premiumsfordepositinsurance tooperate.However,itisprobablysafertosay arebasedontwofactors:thecapitaladequacyof thatthePBGChasnotyetreceivedtaxpayersupthebankandtheriskcharacteristicsofthebank. port.IfthePBGCcouldnotmeetitsobligations, Therearethreecategoriesofcapitaladequacy: atypicalassumptionisthattheU.S.taxpayer wouldprovidesupport,aswasthecasewiththe 1.wellcapitalized, failureoftheFederalSavingsandLoanInsurance 2.adequatelycapitalized,and Corporation.TheburdenofbailingoutthePBGC 3.under-capitalized. couldhitatthesametimeastaxpayersareasked tomeetshortfallsintheSocialSecuritysystem. Likewise,therearethreecategoriesofrisk: Asafinaliteminmydiscussionofproblems 1.financiallysound, withdefined-benefitplans,itisimportanttorecognizethatthereisacomplicatedinteraction 2.exhibitingweaknessthat—ifuncorrected— betweenplanfundingandthecorporatetaxlaw. wouldincreasetheprobabilityofalossto Forexample,permittingfirmstodeductexcessive thedepositinsurancefund,and plancontributionsbeforecalculatingcorporate 3.asubstantialprobabilityofalosstothe incomesubjecttotaxwouldpermitfirmsto fund. escapetax,whilepreventingadequatedeductions wouldleadtounderfundingofpensionplans. Banksthatarewellcapitalizedandfinancially Thisimportantsubjectofinteractionofpension soundpaynodeposit-insurancepremium.As regulationandthetaxsystemgoesbeyondthe capitalizationand/orriskrises,thedepositscopeofthislecture,butmustnotbeneglected. insurancepremiumrises. Suchasystemcouldbeappliedtopension insurance.Forfirmsthatfullyfundtheirpension HISTORICAL SKETCH AND plansandfollowconservativeinvestmentpolicies, matchingassetandliabilitydurations,thissystem MAJOR ISSUES WITH DEFINEDwouldproviderewardsintheformofloworno CONTRIBUTION PLANS premiums.Themoreunderfundedthepension MyconcernsdonotimplythatIwouldsupplan,thelessconservativetheinvestmentpoliportthephase-outofdefined-benefitplansin cies,andtheweakerthefinancialconditionof favorofdefined-contributionplans.Definedthefirmsponsoringthepensionplan,thehigher contributionplanshavebecomeincreasingly wouldbethepremiumsassessedbythePBGC. prevalent,butthereisanadvantagetoretaining Currentpracticetendstowardregulatoryforbearbothtypesofplansbecausetheirriskcharacteranceforfinanciallyweakfirms,whereasthe isticsaredifferent.Withdefined-benefitplans, appropriateapproachistochargehigherpremicompaniesbeartheinvestmentrisks.With umsforsuchfirms.Weakerfirmsaremorelikely defined-contributionplans,allinvestmentrisks toterminateaplanbecauseoffinancialdistress. liewithemployees.Amixofthetwotypesofplans Forexample,accordingtothePBGC,nearly90 spreadstheinvestmentrisksacrossallparties. percentofcompanieswhoseplanterminations In1978,84percentofworkerscoveredbyan resultedinlargeclaimsonthesystemhadjunk- employer-sponsoredpensionwereindefinedbondcreditratingsfor10yearspriortotheter- benefitplans.InthatsameyeartheRevenueAct mination.Inshort,thePBGCshouldusethe addedsection401(k)totheInternalRevenueCode. premiumstructuretoencouragecompaniesto Thischangeallowedworkerstocontributea followsoundpractices portionoftheirsalaries,tax-free,toanemployer 8

TheRoleofSelf-RegulationandVoluntaryComplianceIncentivesintheDesignofPensionSystems sponsoredretirementsavingsplan.These401(k) simplicityisanimportantgoal.Itissurelybetter planshavetransformedretirementsavingsinthe tohaveasinglewell-designedplanthantwo UnitedStates.By1998,only14percentofworkers poorlydesignedplans. withpensioncoveragewereindefined-benefit plansexclusively.Incontrast,56percentwerein defined-contributionplansexclusivelyand30 A REGULATORY FRAMEWORK percentparticipatedinbothtypesofplans. FOR GETTING THE INCENTIVES Therearevariousreasonsforthespreadof RIGHT defined-contributionplans.Forworkers,these plansgenerallyprovidegreatercontrolover Governmentswillbeinvolvedformany retirementsavings,includingarangeofinvest- years,andperhapsindefinitely,inregulating mentoptionsandaremoreportablethandefined- privatepensionplans.Taxpayersareultimately benefitplans.Itisrelativelysimpleforaworker responsibleforshortfallsinretirementsavings, toswitchemployerswithoutlosinganybenefits. eitherthroughsupportingguaranteesofpension Foremployers,defined-contributionplansprovide plansorthroughfinancingpublicassistanceprogreatercostpredictabilitythandefined-benefit videdtoretireeswholacksufficientresources. plansandarelesscostlytooperate. Regulationmustensurethatminimumfunding Nonetheless,defined-contributionplansare levelsaremetandthatprudentinvestmentrules notwithouttheirweaknessesrelativetodefined- arefollowed.Thatsaid,itisimportantforregulabenefitplans.Withdefined-contributionplans, tiontostrivetobeassimpleaspossible,bothto theindividualassumesalloftheinvestment reducethecostofcompliancetobusinessesand risk.Itispossibleforanindividualtodepletethe tomakeiteasyforworkersandretireestomonifundsinhisorheraccountpriortoretirement torthebehaviorofthefirms.And,ofcourse, throughwithdrawalsorloansagainsttheaccount governmentalsohasanobligationtotaxpayers. orgrossmismanagementofthefunds.Many Obligationstoretirees,futureretirees,andtaxworkersalsofailtoannuitizetheiraccountsupon payerscanbemetifthepensionsystemiseffiretirement,leavingthemopentotheriskofout- cientlydesigned.Incentivestoencourageprivate livingtheirresources.Ifthegovernmenttoo behaviorthatisinthepublicinterestareanessenreadilyprotectsindividualswhodepletetheir tialfeatureofefficientdesign. retirementfunds,thenknowledgeofthepolicy Thereareseveraldimensionstoasetofefficreatesmoralhazardthatprobablyincreasesthe cientincentives.Oneimportantconsideration, likelihoodofdepletion.Thecosttothetaxpayers certainly,isthatwewanttodiscouragerather ofsuchapolicycouldalsobeconsiderable. thanencourageriskybehavior.IntheUnited Someoftheseconcernscanbeovercome States,premiumsforpensioninsurancethat throughincreasingthefinancialeducationof inadequatelyreflectriskgivefirmswithunderworkers.Buteducationalonewillnotbesuc- fundedplansanincentivetoadoptriskierbehavcessfuliftheincentivesarewrong.Somewell- ior.Inaddition,theabilityoffirmstovoluntarily informedindividualswillsimplyexploitpoorly terminatetheirunderfundedplansalsoincreased designedfeaturesofwhateverplanisinplace. thisbehavior.Changeshavebeenmadetoaddress Overall,thereisnoonebestformofapension someoftheseproblemsbutitmaybetimeto plan.Acombinationofdefined-benefitplans restructurepremiumstobetterreflectcreditrisk. (whethertheybepublicorprivate)anddefined- Regulationshouldnot,however,besoriskcontributionplansshouldbeencouragedbecause focusedthatitpreventsfirmsandindividuals thedifferentriskcharacteristicsofthetwotypes fromundertakinganyrisk.Letmegiveanexamofplansmakethemnaturalcomplementsrather pleclarifyingthispoint.Thedeclineinthestock thansubstitutes.However,anissueIhavetime marketinthepastfewyearshasreducedthe tomentionbutnotdiscussisthatadministrative assetsofmanyindividualswith401(k)accounts. 9

MISCELLANEOUS Onewaytoeliminatethisinvestmentriskisto matchassetandliabilitydurationsandthatasset requireall401(k)assetstobeinvestedinU.S. characteristicsshouldbemorecloselyaligned governmentsecurities.Sucharegulationwould withthefixed-dollarnatureofpensionliabilities. reducetheinvestmentriskassociatedwiththese Overfundedplansshouldhavemoreinvestment accounts,butitwouldalsoreducetheirexpected freedom,astheydonotcreatearisktopension return.Furthermore,suchapolicywouldraise beneficiariesortaxpayers. warningsignsregardingthegovernment’sobjec- Thediversificationruledoesnotapplyto tives.Havingcaptiveholdersofgovernmentbonds 401(k)plans.Althoughmost401(k)plansallow makesiteasierforthegovernmenttoneglectits theparticipantsomeflexibilityindetermining ownfinancialhealthbyrunninglargebudget theallocationofhisorherinvestments,firms deficits. andemployeesarefreetoignoreprinciplesof U.S.bankingregulationprovidessomeguid- soundportfoliomanagement,suchasadequate ance.Regulatorsinsistthatbanksmonitorand diversification.Afirmmaydeterminetheallocacontrolriskratherthaneliminateit.Bankswith tionofbothitsowncontributionsandemployees’ highercapitalcantakemoreriskbecausethey contributionstoa401(k)plan.Onesuchfirmthat haveacushiontoshielddepositorsandthe followedthisapproachwasColorTile.Around depositinsurancefundagainstlosses. 80percentofthefundsinColorTile’s401(k)plan IntheUnitedStates,threelegalrulesgovern wereinvestedinitsownassets.In1996thefirm theactivitiesofpensionplanadministrators,who filedforbankruptcyandthevalueofitsstock havethelegalstatusoffiduciaries.Afiduciary plummetedresultinginlargelossestotheplan’s hastheresponsibilityofactingintheinterestof participants. beneficiaries,andnotitsowninterest.Thethree TheColorTilebankruptcypromptedthepasrulesaretheexclusivepurposerule,theprudent sageoflegislationtoapplya10percentlimiton manrule,andthediversificationrule.Thefirst companystockholdingsintheassetsof401(k) obligatesfiduciariestoactinthebestinterestsof plans.Thelimit,however,onlyappliestothe theplan’sparticipantsandbeneficiaries—not participant’scontributionstoplanswherethe thebestinterestsofthefirmsponsoringtheplan. firmdeterminestheportfoliocompositionofthe Thesecondrulerequiresthefiduciarytoactwith plan’sassets.Undercurrentlaw,employersmay thesamecare,skill,prudence,anddiligencethat controltheallocationofthefirm’scontributions aprudentpersonwouldtake.Thethirdrule to401(k)plansandmayrestrictaparticipant’s requiresthefiduciarytodiversifytheplan’s abilitytoreallocatethesecontributions.Thatis, investmentsbytype,geographicarea,maturity, afirmmaymakeitscontributiontoan andindustrialclassificationtominimizetherisk employee’s401(k)planinitsownstock. oflosses. Thestockmarketdeclineandparticularlythe Neithertheprudentmanrulenorthediver- collapseofthestockvaluesofafewnotablecomsificationrulesetquantitativelimitationson panieshaveledtosometocallforanapplication portfolioholdings.Indeed,theonlyquantitative ofthe10percentrestrictionontheemployer’s restrictionondefined-benefitplansintheUnited contributiontoa401(k)plan.Thereisnoeasy Statesisthattheycannotinvestmorethan10 answer.Thebenefitsofdiversificationarewell percentoftheplan’sassetsinthefirm’sownsecu- establishedand,assuch,supportrestrictionson ritiesandrealproperty.Thislimitationreduces mandatedholdingsofafirm’sstock.Indeeditmay theriskthatasharpdropintheplan’sassetswill makesenseforaworkertoholdaportfolioof occurifthefirmencountersfinancialdifficulties. assetswhoseriskcharacteristicsarenegatively Experienceinrecentyears,withthesharp correlatedwiththerisktoemployment.Thatis, dropinthestockmarket,suggeststhatthepru- anemployeewouldnotwanttolosehisincome dentmanrulemightneedtobeinterpretedto asaresultofthepoorperformanceofhisfirm requirethatunderfundedplansmoreclosely andhavethevalueofhisassetsfallatthesame 10

TheRoleofSelf-RegulationandVoluntaryComplianceIncentivesintheDesignofPensionSystems time.Ontheotherhand,requiringemployeesto planasaveraging$850perparticipantperyear holdcompanystockgivesthemalong-termstake forasmallfirmwith15participants,whereasthe inthecompanyandthustheincentivetomake costperparticipantdeclinesto$56foralargefirm surethecompanyisprofitable. with10,000participants.1Congresshasmade Thesearenotsimpleissues,butmyinstinct effortstocreatedefined-contributionplansthat isthatthelong-runconfidenceintheU.S.pension canbeeasilyset-upbysmallbusinesses,suchas systemwouldbeimprovedbyrestrictingtosome SimplifiedEmployeePensionPlans(SEPs),but degreethefractionofthefirm’scontributions nosuchefforthasbeenmadetoencourage thatcanbeinitsownstock.Therationaleforsuch defined-benefitplans. arestrictionisthattheinterestsofplanpartici- Anoften-overlookedareaistheneedfor pants—especiallyretirees—andthesponsoring financialeducation.Ifwearetoencourageworkfirmarenotthesame.Perhapsa50percentcap erstoassumemoreresponsibilityfortheirretireoncompanystockwouldstillretainasignificant mentsavings,weneedtomakesuretheyhave incentiveencouragingworkerproductivitywhile thepropertoolstomonitortheactivitiesoftheir providingsignificantdiversificationprotecting firm’sdefined-benefitplansormakedecisions pensionbenefits.Particularlyinthecontextofa regardingportfolioallocationsintheirdefinednewpensionsystem,itwouldprobablymake contributionplans.TheFederalReserveSystem sensetomaintainarelativelylowcaponcomhastakenaleadinthiseffort,creatingawebsite panystockuntilthesystembecomesestablished andmaterialsdevotedtopersonalfinancial andpeoplebecomeconfidentinitssoundness. education. Akeyaspectofregulationisestablishing AnotherareawheretheFederalReservehas soundaccountingstandards.Increasingthedisaroletoplayisinmaintainingoverallfinancial closureandtransparencyoffinancialinformation stability.Itshouldbeclearthatthereisalink regardingpensionplansisessentialifparticipants betweenthehealthofthefinancialsystemand aretomonitorthefinancialhealthoftheseplans. thehealthofthepensionsystem.Despiterecent Hereagainthereisroomforimprovementinthe problemsinequitymarkets,theU.S.financial U.S.system.Accordingtotheexecutivedirector systemremainshealthy.Thebankingsystemin ofthePBGC,participantsinterminatedplans particularisinstrongfinancialcondition.That areoftensurprisedtolearnthattheirplanwas strengthhasbeenimportantinlimitingtheextent underfunded. oftherecessionof2001andhelpingtosustain Itisalsoimportanttorecognizehowregulatheeconomyinthefaceofthelargedeclinein tionsmaygivepreferencestoonetypeofretiretheequitymarkets. mentsavingsplanoveranother.IntheUnited Aprivatepensionsystemwillclearlywork States,theshiftfromdefined-benefitplansto betterinaneconomywithwell-developedfinandefined-contributionplanswassupportedby regulatorychanges.Employeecontributionstoa cialmarkets.Agoodcapitalmarketisimportant 401(k)planaretax-free,butemployeecontribu- inprovidingarangeofassetstomeettheneeds tionstoadefined-benefitplanmustcomefrom ofthosesavingforretirementandthosedrawing after-taxincome.Moreimportantly,thecostsof uponthesesavings.Oneareawhereeveninthe operatingdefined-benefitplansarehigherthan UnitedStatesfinancialmarketsarelackingisin defined-contributionplans.Becauseofeconomies thereadyavailabilityofannuities.Withthe ofscaleintheoperationofdefined-benefitplans, increasingrelianceupondefined-contribution thecost-disadvantageofdefined-benefitplansis plans,theavailabilityoflow-costannuitiesand particularlymarkedforsmallemployers.One anunderstandingoftheirroleareincreasingly studyhasestimatedthecostofadefined-benefit important. 1 OliviaS.Mitchell,“InternationalModelsforPensionReform,”PensionResearchCouncilWorkingPaper98-5,1998. 11

MISCELLANEOUS Althoughitismucheasiertointroducea pensionplaninaneconomywithwell-developed capitalmarkets,itisalsotruethatthepension systemcanbeanimportantsourceofsavingfor agrowingeconomy.Theneedofpensionmanagerstofindgoodinvestmentswillstrengthen thecapitalmarket. CONCLUDING COMMENTS TheUnitedStates,asIhopeIhaveexplained, doesnothaveaperfectpensionsystem.Indeed, thesystemsufferstodayfromanumberofserious strainsandpoordesignfeatures.Nevertheless, therearewaystoaddressthesestrainsandto strengthenthesystemovertime.Withoutquestion, thecentralfeatureofaprogramtostrengthenthe systemistofocusonpolicychangesthatcreate betterincentivesfortheprivatesectortoactin thepublicinterest. Therearethreecoreprinciplesinthedesign ofbetterincentivesforthepensionsystem.One istofocusaboveallontheinterestsofplanparticipants,understandingthatpensionrights reflectcompensationfirmspaytoemployeeson adeferredbasis.Deferredcompensationbelongs toplanparticipantsandnottofirms.Second, financialincentivesshouldbealignedasclosely aspossibletoactualcostsandrisks,aswithriskbasedinsurancepremiums.Third,information onplansshouldbecompleteandreadilyavailable. Allplancharacteristicsandregulationsshould bereviewedregularlytobesurethatnounintendedconsequencesareunderminingthepensionsystem. Toreturntooneofmyopeningcomments, wearefortunatethattheengineerswhose bridgesfelldowndidnotgiveupbuildingrailroads.Developingsoundpracticesandinstitutionstakestime;progressrequiresawillingness tostudythesourcesofproblemsandtoaddress them.Thetaskisongoingandneverfinished. 12