speeches · September 24, 2003
Speech
William Poole · President
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- necessarytodistinguishstrongfromweakpen-
lished private pension plans well before social sionplans.
security. Thefundamentaladvantageofrelyingon
Myaimistoprovideabroadoverviewof incentivesisthatcompaniesaremotivatedby
self-regulationandcomplianceincentivesinthe profitsandriskoflosstomakesoundbusiness
contextofU.S.experience.Whatwemeanby decisions.Companymanagershave,orshould
self-regulationandcomplianceincentivesisthat have,theinformationnecessarytopursueeffi-
thegovernmentestablishesfinancialrewardsand cientstrategies,forwhichtheywillberewarded.
penalties,andrequiresreleaseofinformation, Regulatoryoversightshouldfocusoncompliance
thatencourageprivatefirmstoactinwaysthat withthetaxlaw,forexample,andnotsubstitute
servetheinterestsofpensionplanparticipants. theregulators’businessjudgmentforthejudgment
Servingtheirinterestssimultaneouslyservesthe offirmmanagers.Otherwise,twoparties—man-
publicinterestinasystemthatprovidessecure agerandregulator—arebothmakingthedecisions.
pensionsforallcitizens. Atbest,twopeoplearedoingtheworkofone;at
Asanexampleofanappropriateincentive, worst,thelackofclarityaboutwhoisincharge
thetaxlawmightprovideforreducedtaxeson andwhoisresponsibleforresultsdamagesthe
companyincomeifthecompanyprovidespen- qualityofthedecisionsmadeandthefirmissim-
sionbenefitsthatareavailableforallemployees. plylessproductivethanitotherwisewouldbe.
Thetaxbenefitswouldnotbeavailablefora Asanapplicationofthisprinciple,Federal
companythatprovidespensionsonlyforsenior Reservebankregulatorsdonottrytosubstitute
1
MISCELLANEOUS
theirjudgmentforbankmanagement’sjudgment, BASIC FEATURES OF DEFINED-
butinsteadfocusonthequalityofabank’sinter-
BENEFIT AND DEFINED-
nalinformationsystemsandrisk-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.Defined-
plans,isrelevanttodevelopinganunderstanding benefitplans—whetherpublic,likesocial
ofincentivesandcomplianceissuesinthepension security,orprivate—promisepensionbenefits
context.Ibelievethattheeconomicprinciples basedonapredeterminedformula.Benefitstypi-
involvedhavebroadapplicability;nevertheless, callyarebasedonlengthofserviceandsalaryin
exactlyhowtheyapplytoothercountrieswill thefinalyearsofservice.Mostprivatedefined-
dependonnumerousmattersofhistoricalexpe- 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
Itrytothinkaboutactualexperienceinthecon-
contribution.Theactualamountavailabletothe
textofeconomictheorytoprovideappropriate
workeruponretirementdependsupontheaccu-
analyticalstructure.Economistscanlearnfrom
mulatedcontributionsplustheinvestmentreturn.
experiencethewayengineersinthe19thcentury
Examplesofdefined-contributionplansinclude
learnedfromthecollapsesofrailroadbridges,
employeestockownershipplans,profit-sharing
whichwerealltoofrequent,ortheexplosionof
plans,and401(k)plans.Thelatterarethemost
boilersassteamshipsreplacedsailingships.
commonandmayincorporateaspectsoftheother
Engineersunderstandtheimportanceofdetermin-
twoplans.
ingthesourcesofaccidentsandroutinelystudy
Anothersurfacedistinctionbetweenprivate
suchevents.Similarly,carefulstudyofeconomic
defined-benefitanddefined-contributionplans
problemscanhelpmaketheeconomysaferand
isthatworkersgenerallydonotcontributeapor-
themarketsystemmoreefficient.
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.
Thesecondkeydemographicfactisthatpeo-
plearehavingfewerchildren.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
individualssocialsecurityaccountsfor50per-
workersforeachbeneficiary.Todaythereare
centormoreoftheirincome.Yet,socialsecurity,
slightlymorethanthreeworkersforeachbenefi-
likemostpublicpensionprograms,isunderstress.
ciary.Expertsestimatethatby2030therewillbe
Accordingtothe2003reportbytheSocial twocontributorsforeverybeneficiary.
SecurityBoardofTrustees,beginningin2018— Thesedemographictrendsmakefinancingthe
amere15yearsfromnow—taxreceiptswillbe publicpensionsystemmoredifficult.Thisdiffi-
insufficienttocoverbenefitpayments.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 increasepayrolltaxratessufficientlytoaccumu-
andtodayisstriking.Thetypical65yearoldin lateatrustfundtofundtheretirementofthe
theUnitedStatestodayisexpectedtocollect babyboomgeneration.Althoughthistrustfund
socialsecuritybenefitsfor16yearsifamanand willprovideacushiontothesystemoncerev-
19yearsifawoman.Thetrendtowardlongerlifes- enuesdropbelowbenefitpaymentsin2018,itis
panislikelytocontinue.Achildborntodayin notalong-termsolution.Givencurrentcontribu-
theUnitedStatesisexpectedtolivewellpast 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, workersmaynothavetheknowledgeandinfor-
defined-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,isaformofdeferredcompen-
mentbenefitplan.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- planledtocallsforlegislativereformandover-
mentincome.Beforeextensivereformsin1974, sightofprivatedefined-benefitplansintheUnited
employerswerecompletelyfreetodetermine States.Thiseffortculminatedwiththe1974enact-
whenaworker’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 coverageandestablishedmaximumworkrequire-
employeewholosthisjobjustbeforenormal 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-benefitplansareexpe-
closeditslastdomesticmanufacturingplantand riencingconsiderablestresstoday.Thesame
terminateditspensionplan.Theplanwasheavily demographicfactsthathavecreateddeepprob-
underfundedsothataftercoveringbenefitsfor 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
similarscheduletotheexpectedfuturecashout-
notadequatetowithstandthelargestockmarket
laysaspolicyholdersdie.Thispracticeofmatch-
declinethatstartedin2000.
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,pro-
thatthepensionfundsareinsuredbythePBGC. videdlittleincentiveforfirmstoproperlyfund
Althoughmoralhazardcannotbeentirely theirplans.Indeed,forthefirst14yearsofthe
eliminated,therearestandardpracticesadopted PBGC’sexistence,afirmcouldvoluntarilyter-
byinsurerstoreduceitsseverity.Twokeymeth- minateanunderfundedplan.Terminations,in
odsarethroughtheuseofpartialinsuranceand combinationwiththelowpremium,ledtoa
risk-relatedpremiums.ThePBGCincorporates seriesofdeficitsinthesystem.ThePBGChadno
thefirstprinciplethroughstatutorylimitsonthe authoritytoraisepremiumsdespitethedeficits
maximumpensionguarantee.Thisfeatureofthe buthadtorequestcongressionalapprovaltodo
systemensuresaminimumpensionintheevent so.EvenwithCongresstwiceraisingthepremi-
aplanisterminated,butretireeswhosepensions ums,in1978and1986,thedeficitscontinued.
exceedtheguaranteeandworkerswhoseexpected Theproblem,clearly,waslesswiththemanage-
pensionsexceedtheguaranteehaveanincentive 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)ofunderfund-
argumentsuggestsanimportantroleforgovern- 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 onmeasuresthatwillincreasetheleveloffund-
financialduresscriteriamakeitmoredifficultto ingfortheseplansratherthanpaperingoverthe
terminateaplan,itisstilltruethatfirmsthat problemswiththehopethatmoneywillbethere
meetthistestareabletoterminatetheirplans, whenyoungerworkersreachretirementage.
leavingtheiremployeeswithgreatlyreduced Weneedtoprovideproperincentivesforfirms
pensions. tofundtheirplans.Onepossibilityisthrough
Thisrestrictiononterminationsandthenew proposalsthatwouldlimittheabilityofunder-
premiumstructure,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 Anexcessivepremiummayleadafirmtotermi-
otherexceptionsthatpermitunderfundingis nateawell-fundedplan,leavingahigherpropor-
thatforcingacompanytofullyfunditspension tionofunderfundedplansandthusraisingrather
planmightleadittodroptheplanorevenforce thanreducingtheriskoffuturedeficitstothe
thecompanyintobankruptcy.Theideaisquite PBGC.Forthisreason,thelong-runviabilityof
similarto“regulatoryforbearance”bybanking thepensioninsurancesystemrequiresthatinsur-
regulatorsinthe1980s.Thehopethenwasthat ancepremiumsreflectactualriskascloselyas
weakbanksandsavingsinstitutionsmightbe possible.
abletobuildcapitalovertimeandrecovertheir U.S.experiencewithbankregulationand
strength.Inpractice,whathappenedisthatmany depositinsuranceisinstructive.Onelessonwe
ofthesefinancialfirmstookunduerisksandeven- havelearnedfrombankingcrisesisthatfinan-
tuallyfailedanyway.ThecosttotheU.S.taxpayer ciallyweakfirmshaveagreaterincentiveto
ofresolvingfailedsavingsinstitutionswasinthe engageinriskybehaviorthanotherfirms,partic-
7
MISCELLANEOUS
ularlyifthereisnoadditionalinsurancecostto AlthoughthePBGCisagovernmentagency,
thefirm.Thisunderstandingledtochangesin itreceivesnotaxrevenues.Instead,itisself-
thewaypremiumsareappliedfordepositinsur- financed,relyingonpremiumsandassetreturns
ance.Currently,premiumsfordepositinsurance tooperate.However,itisprobablysafertosay
arebasedontwofactors:thecapitaladequacyof thatthePBGChasnotyetreceivedtaxpayersup-
thebankandtheriskcharacteristicsofthebank. 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,itisimportanttorec-
ognizethatthereisacomplicatedinteraction
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,thedeposit-
scopeofthislecture,butmustnotbeneglected.
insurancepremiumrises.
Suchasystemcouldbeappliedtopension
insurance.Forfirmsthatfullyfundtheirpension
HISTORICAL SKETCH AND
plansandfollowconservativeinvestmentpolicies,
matchingassetandliabilitydurations,thissystem MAJOR ISSUES WITH DEFINED-
wouldproviderewardsintheformofloworno CONTRIBUTION PLANS
premiums.Themoreunderfundedthepension
MyconcernsdonotimplythatIwouldsup-
plan,thelessconservativetheinvestmentpoli-
portthephase-outofdefined-benefitplansin
cies,andtheweakerthefinancialconditionof
favorofdefined-contributionplans.Defined-
thefirmsponsoringthepensionplan,thehigher
contributionplanshavebecomeincreasingly
wouldbethepremiumsassessedbythePBGC.
prevalent,butthereisanadvantagetoretaining
Currentpracticetendstowardregulatoryforbear-
bothtypesofplansbecausetheirriskcharacter-
anceforfinanciallyweakfirms,whereasthe
isticsaredifferent.Withdefined-benefitplans,
appropriateapproachistochargehigherpremi-
companiesbeartheinvestmentrisks.With
umsforsuchfirms.Weakerfirmsaremorelikely
defined-contributionplans,allinvestmentrisks
toterminateaplanbecauseoffinancialdistress. liewithemployees.Amixofthetwotypesofplans
Forexample,accordingtothePBGC,nearly90 spreadstheinvestmentrisksacrossallparties.
percentofcompanieswhoseplanterminations In1978,84percentofworkerscoveredbyan
resultedinlargeclaimsonthesystemhadjunk- employer-sponsoredpensionwereindefined-
bondcreditratingsfor10yearspriortotheter- 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 plansorthroughfinancingpublicassistancepro-
greatercostpredictabilitythandefined-benefit videdtoretireeswholacksufficientresources.
plansandarelesscostlytooperate. Regulationmustensurethatminimumfunding
Nonetheless,defined-contributionplansare levelsaremetandthatprudentinvestmentrules
notwithouttheirweaknessesrelativetodefined- arefollowed.Thatsaid,itisimportantforregula-
benefitplans.Withdefined-contributionplans, tiontostrivetobeassimpleaspossible,bothto
theindividualassumesalloftheinvestment reducethecostofcompliancetobusinessesand
risk.Itispossibleforanindividualtodepletethe tomakeiteasyforworkersandretireestomoni-
fundsinhisorheraccountpriortoretirement torthebehaviorofthefirms.And,ofcourse,
throughwithdrawalsorloansagainsttheaccount governmentalsohasanobligationtotaxpayers.
orgrossmismanagementofthefunds.Many Obligationstoretirees,futureretirees,andtax-
workersalsofailtoannuitizetheiraccountsupon payerscanbemetifthepensionsystemiseffi-
retirement,leavingthemopentotheriskofout- cientlydesigned.Incentivestoencourageprivate
livingtheirresources.Ifthegovernmenttoo behaviorthatisinthepublicinterestareanessen-
readilyprotectsindividualswhodepletetheir tialfeatureofefficientdesign.
retirementfunds,thenknowledgeofthepolicy Thereareseveraldimensionstoasetofeffi-
createsmoralhazardthatprobablyincreasesthe cientincentives.Oneimportantconsideration,
likelihoodofdepletion.Thecosttothetaxpayers certainly,isthatwewanttodiscouragerather
ofsuchapolicycouldalsobeconsiderable. thanencourageriskybehavior.IntheUnited
Someoftheseconcernscanbeovercome States,premiumsforpensioninsurancethat
throughincreasingthefinancialeducationof inadequatelyreflectriskgivefirmswithunder-
workers.Buteducationalonewillnotbesuc- fundedplansanincentivetoadoptriskierbehav-
cessfuliftheincentivesarewrong.Somewell- ior.Inaddition,theabilityoffirmstovoluntarily
informedindividualswillsimplyexploitpoorly terminatetheirunderfundedplansalsoincreased
designedfeaturesofwhateverplanisinplace. thisbehavior.Changeshavebeenmadetoaddress
Overall,thereisnoonebestformofapension someoftheseproblemsbutitmaybetimeto
plan.Acombinationofdefined-benefitplans restructurepremiumstobetterreflectcreditrisk.
(whethertheybepublicorprivate)anddefined- Regulationshouldnot,however,besorisk-
contributionplansshouldbeencouragedbecause focusedthatitpreventsfirmsandindividuals
thedifferentriskcharacteristicsofthetwotypes fromundertakinganyrisk.Letmegiveanexam-
ofplansmakethemnaturalcomplementsrather 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.Afirmmaydeterminethealloca-
controlriskratherthaneliminateit.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 TheColorTilebankruptcypromptedthepas-
rulesaretheexclusivepurposerule,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- collapseofthestockvaluesofafewnotablecom-
sificationrulesetquantitativelimitationson 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.Ifwearetoencouragework-
firmarenotthesame.Perhapsa50percentcap erstoassumemoreresponsibilityfortheirretire-
oncompanystockwouldstillretainasignificant
mentsavings,weneedtomakesuretheyhave
incentiveencouragingworkerproductivitywhile
thepropertoolstomonitortheactivitiesoftheir
providingsignificantdiversificationprotecting
firm’sdefined-benefitplansormakedecisions
pensionbenefits.Particularlyinthecontextofa
regardingportfolioallocationsintheirdefined-
newpensionsystem,itwouldprobablymake
contributionplans.TheFederalReserveSystem
sensetomaintainarelativelylowcaponcom-
hastakenaleadinthiseffort,creatingawebsite
panystockuntilthesystembecomesestablished
andmaterialsdevotedtopersonalfinancial
andpeoplebecomeconfidentinitssoundness.
education.
Akeyaspectofregulationisestablishing
AnotherareawheretheFederalReservehas
soundaccountingstandards.Increasingthedis-
aroletoplayisinmaintainingoverallfinancial
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
Itisalsoimportanttorecognizehowregula-
theeconomyinthefaceofthelargedeclinein
tionsmaygivepreferencestoonetypeofretire-
theequitymarkets.
mentsavingsplanoveranother.IntheUnited
Aprivatepensionsystemwillclearlywork
States,theshiftfromdefined-benefitplansto
betterinaneconomywithwell-developedfinan-
defined-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.Theneedofpensionman-
agerstofindgoodinvestmentswillstrengthen
thecapitalmarket.
CONCLUDING COMMENTS
TheUnitedStates,asIhopeIhaveexplained,
doesnothaveaperfectpensionsystem.Indeed,
thesystemsufferstodayfromanumberofserious
strainsandpoordesignfeatures.Nevertheless,
therearewaystoaddressthesestrainsandto
strengthenthesystemovertime.Withoutquestion,
thecentralfeatureofaprogramtostrengthenthe
systemistofocusonpolicychangesthatcreate
betterincentivesfortheprivatesectortoactin
thepublicinterest.
Therearethreecoreprinciplesinthedesign
ofbetterincentivesforthepensionsystem.One
istofocusaboveallontheinterestsofplanpar-
ticipants,understandingthatpensionrights
reflectcompensationfirmspaytoemployeeson
adeferredbasis.Deferredcompensationbelongs
toplanparticipantsandnottofirms.Second,
financialincentivesshouldbealignedasclosely
aspossibletoactualcostsandrisks,aswithrisk-
basedinsurancepremiums.Third,information
onplansshouldbecompleteandreadilyavailable.
Allplancharacteristicsandregulationsshould
bereviewedregularlytobesurethatnounin-
tendedconsequencesareunderminingthepen-
sionsystem.
Toreturntooneofmyopeningcomments,
wearefortunatethattheengineerswhose
bridgesfelldowndidnotgiveupbuildingrail-
roads.Developingsoundpracticesandinstitu-
tionstakestime;progressrequiresawillingness
tostudythesourcesofproblemsandtoaddress
them.Thetaskisongoingandneverfinished.
12
Cite this document
APA
William Poole (2003, September 24). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_20030925_poole
BibTeX
@misc{wtfs_speech_20030925_poole,
author = {William Poole},
title = {Speech},
year = {2003},
month = {Sep},
howpublished = {Speeches, Federal Reserve},
url = {https://whenthefedspeaks.com/doc/speech_20030925_poole},
note = {Retrieved via When the Fed Speaks corpus}
}