Pensions: Theories of underfunding

Abstract

The widespread underfunding of private defined benefit pensions has generated concern over the viability of employers' promises of retirement benefits. Years ago, similar concerns led to the creation of pension benefit insurance plans by governments in the United States and a number of other countries. This paper studies the causes of underfunding in an environment without pension benefit insurance. We find that the optimal level of retirement benefits will be offered and fully funded if the employer has sufficient internal funds or is able to borrow all it needs. If loans are not enforceable, an employer with limited resources will generally underfund pensions. Further, if pension investments earn lower returns than other investments, pensions will be underfunded. Thus, the paper highlights the link between financial markets and the underfunding of pensions. © 2002 Elsevier Science B.V. All rights reserved.