Academic journal article Journal of Risk and Insurance

A Termination Rule for Pension Guarantee Funds

Academic journal article Journal of Risk and Insurance

A Termination Rule for Pension Guarantee Funds

Article excerpt

INTRODUCTION

A defined benefit (DB) pension plan promises pension beneficiaries (employees) a specified amount of benefits on retirement, which is determined by a formula that usually takes into account the beneficiaries' years of service with the sponsor (the employer), their salary, and their age. Contributions from the sponsor and future investment returns constitute the plan's assets. When assets fall short of accrued pension liabilities, the plan is underfunded, which exposes beneficiaries to the risk of failure to receive the full promised pension benefits on their retirement. Underfunding of DB pension plans in the United States and in other countries has been documented in the empirical literature (see, e.g., Armstrong, 2004; Franzoni and Marin, 2006; Selody, 2007; Severinson, 2008). Moreover, underfunding has been shown to be an equilibrium outcome in an imperfect financial market (see, e.g., Ippolito,1985; Cooper and Ross, 2002). In an attempt to protect pension beneficiaries against loss of promised benefits, many developed countries have created a pension guarantee fund (PGF), also known as pension benefit guarantee insurance. (1) Examples are the Pension Benefit Guaranty Corporation (PBGC) in the United States (created in 1974), the Pension Benefits Guarantee Fund (PBGF) in Ontario, Canada (1980), as well as the guarantee funds in Sweden (1960), Finland (1962), Germany (1974), Chile (1981), Switzerland (1985), and Japan (1989).

The PGF charges the sponsor an annual premium, which is specified by law, for insuring pension benefits promised to beneficiaries. It can become active in two cases. In the first case, when the insured DB plan is underfunded while the sponsor is unable to salvage the plan without going out of business, the sponsor submits a distress termination application and waits for an approval by the PGF. In the second case, the PGF initiates a termination of the underfunded pension fund for protecting pension beneficiaries, which is known as an involuntary termination in practice. In each type of termination, the PGF takes over the underfunded DB plan, using its own assets to pay the benefits of current and future retirees, up to a limit called a maximum guarantee. The maximum guarantee is set by law and updated periodically, for example, annually in the United States). However, under different market scenarios, which include the decline of stock market prices in 2000, the decrease of interest rates, excessive risk taking by plan sponsors, and unfavorable demographic and employment trends, the PGFs have been experiencing difficulty in performing this function (see, e.g., Armstrong, 2004; Wilcox, 2006; Brown, 2008. Table 1 shows the financial status of the PBGC in the United States and the PBGF in Ontario, Canada during a recent decade. (2)

In view of the financial status of the PGF, a debate revolving around flaws in its design has sprung up. Thus far, most of the academic literature has focused on the lacking incentive compatibility of premium calculation, (3) proposing risk-based premiums instead (see, e.g., Lewis and Pennachi, 1994; Chen, 2011). However, Kalra and Jain (1997) argue that by law pension benefit guarantors (4) are prevented from controlling the riskiness of investments by pension plans and from adjusting their premiums accordingly. This leaves the involuntary termination of underfunded DB pension plans as their only possibility of intervention. (5) Rather than waiting for a DB plan to become severely underfunded, a PGF can terminate the contract, take over the plan, and cover the deficits.

From an economic point of view, two main arguments support this type of intervention. First, there is a moral hazard problem between the sponsor and the pension benefit guarantor. Cooper and Ross (2003) find that a PGF creates additional incentives for sponsors to underfund their DB pension plans and to incur excessive investment risk in their pension portfolios. …

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