In at least one previous post, as well as in other research papers and articles, I have discussed the enormous problems facing the Pension Benefit Guarantee Corporation (PBGC), the government corporation that insures private defined benefit pension plans. This week, a very talented MBA student at Illinois – Gagan Bhatia – reminded me of a terrific idea that would go a very long way toward providing plan sponsors with economically appropriate incentives for funding their plans. Right now, plan sponsors lack appropriate and sufficient incentives to fully fund their plan or to choose a portfolio that immunizes the plan funding from market risk. Sure, the government imposes funding requirements, but they have proven woefully inadequate.
In fairness, while Gagan Bhatia came up with this idea on his own and independently, it is an idea that has been out there, including in some work by Doug Elliot of the Center on Federal Financial Institutions. Regardless of who gets credit, I think it is a terrific idea.
In a nutshell, the idea is to increase the seniority of pension claims in the event of a bankruptcy. When a company files for Chapter 11 bankruptcy, the company’s creditors and claimants fall into different pools as per their priority over the company’s assets. PBGC’s obligations fall into the Unsecured Creditors pool which are paid after the Secured Creditors.
Under this proposal, the PBGC would be moved up the line and be considered a senior, secured claim. In essence, it would allow the PBGC to get paid first (or at least earlier than under current law) from any assets that the plan sponsor has remaining.
Why does this help? Currently, creditors have insufficient incentive to consider the funding status of a firm’s pension plan when the firm is issuing debt. If creditors knew that the PBGC’s claim on the firm’s assets was senior to that of the creditors, then creditors and potential creditors would become powerful enforcers of economically appropriate funding behavior. Plan sponsors that failed to adequately fund their pension or plan sponsors who failed to engage in asset-liability matching would be considered – appropriately – to be a higher credit risk. Thus, the firm would have to pay more to borrow. Firms that funded their pensions and invested them in a manner that mitigated future funding risk would benefit from lower borrowing rates.
In essence, this approach would harness market forces to achieve a worthwhile public policy goal. Along the way, both pensioners and taxpayers would benefit.