Lemon Socialism and the Federal Guaranty of Private Pension Obligations
Eric D. Chason
William & Mary Law School
For more than 30 years, the federally created Pension Benefit Guaranty Corporation ("PBGC") has guarantied private pension obligations. If a defined-benefit pension plan is terminated without enough assets to pay promised benefits, the PBGC steps in to cover most of the shortfall. Hammered in recent years by claims arising from bankrupt airlines and steel companies, the PBGC projected a deficit of $23.1 billion at the end of its 2005 fiscal year. These woes reflect the fact that the PBGC cannot charge a sufficient premium for its guaranty. The effect of the PBGC guaranty is to subsidize underfunded pension plans, possibly at taxpayer expense. Should the PBGC actually fail, most observers believe the federal government (i.e., taxpayers) would bail it out, rather than allowing it to default on pension payments to retirees. A taxpayer bailout would potentially be expensive, forcing Congress to choose between cutting other spending, raising taxes, and increasing government debt. For many, avoiding the fiscal impact is a sufficient imperative for putting the PBGC on stronger footing. The contribution of this Article is to identify another reason for reform beyond avoiding the fiscal impact. The PBGC-guaranty subsidy directly interferes with capital-market mechanisms. Pension plans are essentially corporate debt obligations that allow employers to finance their labor costs. Employers who finance these costs (or any other costs) through outside creditors must subject their business operations to the discipline of the capital markets. Outside creditors will attempt to minimize default risk by demanding restrictive covenants and security, and they will demand default premiums for any remaining risk of default. These demands are useful, as they ensure that scarce capital is allocated to the most worthy projects. In contrast, pension creditors (i.e., employees) are plagued by a moral-hazard problem. They have no incentive to make these demands, as the PBGC guaranties payment of their pensions. The moral hazard of employees suggests the true problem with the PBGC guaranty: it insulates employers from the discipline of capital markets when they borrow from their employees through pension plans. Since the tax code encourages financially strong employers to contribute to their pension plans and secure their pension obligations, financially strong firms do not benefit from the PBGC-guaranty subsidy. Financially weak firms are the primary beneficiaries. Because the PBGC-guaranty subsidy undermines capital-market discipline, it allows these weak firms to pursue risky, wasteful projects. Thus, the PBGC-guaranty subsidy can be seen as a form of "lemon socialism," whereby economically weaker firms are systematically aided by a federal loan guaranty at the expense of stronger firms and possibly the taxpayers.
Keywords: PBGC, pension, funding, pension insuranceworking papers series
Date posted: March 9, 2006
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