Strategic Bankruptcy and Private Pension Default

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A rapidly growing literature focuses on potential problems for both private pension plans and the Social Security system. Almost all of the literature addressing private sector pensions assumes that the firm promising to pay the pension has the desire to fulfill this promise and provides suggestions as to how potential problems can be eliminated or minimized. Proposed solutions range from expanding the tax write-offs allowed for sponsoring firms to privatizing the insuring of pension promises. This paper argues that the basic assumption underlying this literature, when applied to private pensions, may be incorrect. It argues that sponsoring firms may not have a desire to fulfill their promise, and in fact, there may be a strong desire to default on these promises. It also describes the evolving interpretations of existing laws that may provide firms with a mechanism to default on their pension promises. This mechanism is called strategic bankruptcy.

The primary goal of all true pension plans is to provide a stable level of consumption during retirement. Regardless of how pension plans are structured, they share the common characteristic that they shift some amount of current production to those who are no longer involved in the process of production. Thus, pensions are an inherently social institution that link one generation of workers to another and, as a result, elevate the common welfare above the concept of individual gain. Private firm-sponsored pensions are a long-term social contract between workers and firms that belies the neoclassical notion of an impersonal labor market.

Recently, some economists have incorrectly described pension plans as nothing more than a contractual savings plan in which each person sets aside her or his own individual saving today to provide for individual retirement consumption in the future. These economists reduce what is in fact a social relationship to an isolated individual act [Hayden 1989]. However, current saving provides for retirement consumption only to the extent that it allows the real output of society to grow. The purchase of financial assets with currently saved income provides a particular social/legal mechanism for claiming a share of output at some point in the future and nothing more. It is a mechanism that defines a social relationship as a financial one [Lawson and Lawson 1990]. When a claim is made by a pensioner, it will be a claim on then current output.

If current financial saving is put into real productive investment, the total amount of output in future years will grow. Thus, the financial claims will effectively be claims on real output. However, if current saving is channeled into nonproductive speculative activities that do not increase real output, the financial claims will be "hollow," and the amount of real output transferred to retirees will be less than expected.

The role pension plans play in creating power for firms is also obscured in much of the literature on pensions. Richard Ippolito [1985] correctly suggests that pensions constitute a form of deferred compensation. Workers provide effort today with the understanding that they will receive a stable level of income, provided by the firm, in retirement. He goes on to argue that it is rational for firms to not pre-fund this pension promise. Unfunded pension promises act as "performance bonds" to ensure that workers do not organize to "overly exploit" the firm. If the workers exert too much of their power, the firm will fail, and the workers will lose their deferred compensation. This analysis ignores the concept of power, except for that of organized labor, and is part of the conventional denial of the power exercised by the corporate sector [Munkirs and Knoedler 1987]. However, as the discussion below indicates, the firm's control over this pool of deferred compensation provides the firm increased bargaining power over current wages and benefits and the power to affect the mobility decisions of workers.

This paper takes as its starting point the view that pensions are meant to serve the common good and that they constitute a long-term social contract. The paper provides background on defined benefit pension plans, including the market incentives they create and the nature of the funding and management of these funds. It then describes the incentives inherent in these funds to default on the pension contract, and it examines the evolution of techniques used by firms to default on or violate these contracts, along with the changing legal institutions developed to try to respond to these techniques. The paper then explores a newly evolving concept, strategic bankruptcy, that is likely to play an increasingly important role in pension defaults as the "baby-boom" generation ages into retirement unless preemptive legislation is put in place. Finally, policy changes for preventing widespread default are recommended.

A Brief History of Defined Benefit Pension Plans(1)

A defined benefit pension plan promises to provide workers with a stable flow of income, usually based on their final wage and years of service to the firm, for their entire life after retirement. The first employer-provided retirement plan in the United States was created by the American Express Company in 1875, but it only covered disabled elderly employees. A pension was not guaranteed to any employee; each individual pension had to be recommended by the firm's general manager and was subject to approval by the board of directors.

The first retirement plan that actually provided defined-benefit coverage was established in 1880 by the Baltimore and Ohio Railroad. Once the precedent was established at one railroad, pension coverage quickly spread to other rail companies. By 1916, more than half of all railroad employees were covered by pension plans, and by 1926 coverage had risen to 80 percent. At the turn of the century, pension plans were established in the banking industry in major urban areas and in public utilities. In the banking industry, these plans tended to cover only management personnel, while in public utilities coverage was somewhat broader. In many of these plans, retirement criteria that explicitly discriminated against female employees were established(2) [Seburn 1991].

Two unifying features describe this pattern of coverage: the existence of monopoly or oligopoly power for the firm and coverage extended primarily to skilled workers, who were often unionized. Near the end of the 1800s, no manufacturing firms provided retirement benefits. However, following the wave of horizontal mergers from 1896 to 1903, this changed quickly. By 1912, pension plans had been established at the United States Steel Corp., the International Harvester Co., and many other manufacturing firms. By 1929, most large firms in oligopolized manufacturing industries had established pension plans, and approximately 3.7 million employees were covered by these plans.

During the decade of the Great Depression, pension coverage increased only slightly, to 4 million employees. However the decade of the 1940s saw a very rapid expansion of pension coverage. By 1950, coverage had expanded to 10.3 million employees, or approximately 25 percent of the industrial labor force [ACLI 1987].

This expansion has been linked to three legal changes that affected incentives to firms. In 1942, the IRS extended a 1921 ruling that employer contributions to a qualified pension fund were deductible from corporate income for tax purposes. Thus, large contributions would allow many firms to avoid "excess profit" taxes of close to 100 percent that had been put in place to discourage war-time profiteering. In addition, earnings on these contributions accruing to the employer were also made tax-exempt until they were paid out in the form of pensions or removed by the firm for other purposes. Finally, due to the war-time wage freeze, many large firms offered expanded pension coverage as a form of deferred compensation as an incentive to attract workers [Ghilarducci 1992]. Each of these factors continues to play a central role in pension fund dynamics and will be addressed more fully below.

During the 1950s, pension coverage continued to expand rapidly both in terms of the number of firms offering plans and the number of employees covered. By 1960, 23 million workers, almost half of the industrial labor force, had pension coverage. Almost all of these pension plans were defined benefit plans. The rate of creation of new pension plans slowed during the 1960s, but the rate of coverage continued to expand rapidly. This apparently paradoxical result reflected increasing employment in firms that already had plans.

In 1974, Congress passed the Employee Retirement Income Security Act (ERISA), which is …