Pensions: Financing and Regulation

The next steps in designing the financing of a pension plan are heavily influenced by government policy. The security of plan participants is enhanced if the pension fund is large. A plan with assets in excess of estimated liabilities can absorb market variations in the value of assets or the higher costs of possible low mortality without requiring additional contributions by the sponsor. On the other hand, pension funds are increased by the inflow of contributions and, in general, such contributions are recognized as a business expense of the sponsor in the determination of income tax. Thus a government must compromise between encouraging large pension fund contributions, which will increase the security of pension expectations but shrink the base of the income tax, and bounding such contributions to save the tax base. A lower bound on annual pension plan contributions would enhance the security of pension expectations but reduce the flexibility of sponsors in meeting pension obligations.

In the United States the regulation of pension plans before 1974 was in the hands of the Internal Revenue Service. The concern was to place a reasonable upper bound on pension contributions deductible for income tax purposes. The upper bound was stated as (normal cost) + (.10 × Initial accrued liability), where normal cost is an estimate of the cost of the plan attributable to the current year under the funding plan adopted, and initial accrued liability is the amount of liability under the funding plan adopted at the time the plan started. The objective was to prohibit a reduction in the income tax by rapid reduction in the accrued liability recognized when the plan started.

In 1974 the comprehensive Employee Retirement Income Security Act (ERISA) was passed, and upper and lower bounds on pension contributions were enacted. The upper bound was somewhat different from the pre-1974 rule mentioned above, but it incorporated the same basic ideas. What was new, with an acknowledgment that adequate funding was in the public interest, was a minimum funding requirement. The minimum contribution requirement was stated in terms of normal cost plus an amount of the initial accrued liability, depending on the type of plan, and an adjustment for deviations in actual experience from that assumed in earlier estimates of liabilities.

A related set of public policy issues arises about the management of the pension fund. One option is the use of book reserves, pension liability estimates that are included in the balance sheet of the sponsoring organization rather than on the balance sheet of a separate pension plan entity. Under this plan the estimated annual cost of the plan is an expense of the sponsoring organization and the contributions increase the size of the internally held book reserve. This plan is attractive in the absence of an active capital market and can be used to finance the expansion of a sponsoring organization. The disadvantages are that this nondiversified investment reduces the security of the income of beneficiaries. In addition, less of a nation's savings pass through open capital markets, where market forces will tend to allocate them to projects with the highest rate of return. With the absence of the discipline of open markets, macroeconomic growth could be compromised.

In the United States, ERISA held out income tax advantages only to those pension plans with external pension funds. Pension plans are prohibited from acquiring or holding more than 10 percent of plan assets in the securities or real property of the sponsor. Other nations have made more extensive use of book reserves. For example, Germany permits the use of book reserves to finance DB pension plans. Book reserves facilitated the internal financing of the rebuilding of the German industrial plant following World War II, when the German financial markets were chaotic. The sponsor's risk of insolvency in many nations permitting book reserves is managed by compelling participation in an insolvency insurance plan.

Financial accounting rules in the United States force sponsors providing post-retirement health benefits to account for their value using book reserves. These accounting rules are applicable to publicly held companies and are set by the Financial Accounting Standards Board (FASB). FASB is an independent, nongovernmental agency. In 1990 it issued Standard of Financial Accounting 106 which required employers sponsoring post-retirement health plans to report on their financial statements estimates of the liability of these plans. Post-retirement health benefits have not been the subject of detailed federal regulation.

Although ERISA discouraged the use of book reserves for pension plans, it also created the Pension Benefit Guarantee Corporation to ensure at least the partial payment of pension benefits under DB plans when the sponsor was unable to meet the funding requirements. The insurance system is funded by a premium related to unfunded accrued liability that is paid by all DB plans.