Unions, Default Risk, and Pension Underfunding
Journal of Economics and Business,Vol. 40, No. 3, pp. 239-242, August 1988
Posted: 28 Feb 2008 Last revised: 1 Jul 2011
Recent empirical findings by Allan and Clark (NBER WP1677, 1985) show that the pension wealth of union beneficiaries is dramatically greater than that of nonunion beneficiaries. Other findings by these and other authors show that union pension plans are more likely to be underfunded. Ippolito (JLE 1978) reports that the average funding ratio of union pension plans is substantially lower than that of nonunion plans. In parallel, he reports that the rate of pension-plan termination due to bankruptcy is significantly higher where the extent of firm unionization is greater. This paper shows that risk-averse shareholders choose to underfund a defined-benefits pension plan despite a substantial tax advantage of full funding. The two parameters entering the funding decision are the perceived probability of default and the risk-free rate of interest. For feasible values of these parameters, underfunding is shown to be the optimal policy where the extent of underfunding increases with the probability of default. The effect of unions on default risk is likely to further decrease the optimal funding ratio. This result explains the evidence that unionized firms tend to have larger pension plans, which are characterized by a lower funding ratio and a shorter life span.
Keywords: corporate pension plans, defined-benefits plans, unions, default risk
JEL Classification: J32, J33, J38
Suggested Citation: Suggested Citation