Pensions: Financing and Regulation

In the industrial age, income to elderly persons often derives from past employment and the payment structure is formalized as a pension plan. The obligation becomes financial and contractual. For self-employed persons retirement income often comes from an individualized financial plan rather than from a family's loyalty or public charity. The income transferred to elderly persons is often paid from financial assets built up over the working lifetime or, as is common in social insurance systems, as an allocation of current income without an intervening fund. For example, in 1861 the federal government established the first major nondisability pension program in the United States, providing for the retirement of military officers after forty years of service. This pension program involved direct payments from the military budget. The first retirement programs of private employers also involved direct payments to retirees and the payments were considered a current business expense.

This type of pension funding or budgeting, in which the plan sponsor pays benefits each year from current general revenue and accounts for the payments as a current business expense, is called current-cost or pay-as-you-go funding. There are two basic objections to current-cost funding. The first is an accounting issue. One of the goals of accounting is to match the costs of production with the revenue generated by the goods and services produced. If costs and revenues are mismatched, the faulty information may result in bad business decisions. Current cost funding charges pension benefits against current revenues when in fact the services on which the pension is based may have been provided many years earlier. This could be a serious mismatching of costs and revenues. This objection to current-cost funding could be mitigated if the operating statement of the pension plan sponsor contained an expense item that is an estimate of the cost of future pensions associated with service in the current year. This is now required by financial accounting standards in the United States.

The second objection to current-cost funding of pension plans is the lack of security of employee pension expectations when benefit payments come directly from the plan sponsor. The payments depend on the continued economic viability of the sponsor. In a dynamic economy the survival and prosperity of a plan sponsor is not assured.

There are two methods for increasing the security of plan members. The first is some sort of insurance program to make the benefit payments if the sponsor cannot. The second is the creation of a pension fund, a pool of investments independent of the sponsor from which benefits will be paid and which will receive pension contributions. The separate pool of investments can also generate investment income that will lead to lower required contributions than those in a current-cost system with identical benefits. There is also a powerful macroeconomic reason for favoring a fund. The allocation of income to retirees comes from the body of goods and services created by the economy. If this body is bigger as a result of pension savings that result in investment in plant, tools, research, and education, the total system for maintaining the income of retirees may increase the economic well-being of all. In fact, in the United States savings made through pension plans have been the principal source of new capital since World War II.