The Labor Contract and True Economic Pension Liabilities

Abstract

Most pension-covered workers in the United States are covered solely or primarily by defined benefit plans.' In these plans, workers are typically promised a pension that is proportional to their years of service in the firm and their final wage. Depending upon how workers pay for it, the existence of a pension in the labor may play either an important role or no role at all in the worker-firm relationship. This paper addresses the issue, how workers pay for the cumulating pension benefit over their tenure cycle in the firm, and derives several economic implications for the worker-firm contract. While the theory itself has ambiguous implications, the data confirm the longstanding presumption that pensions offer strong incentives for the worker to complete the normal tenure cycle in the firm, not to quit early. But if this intuitive notion is accepted, it is shown that a perhaps less intuitive notion is also true: firms make workers longterm bondholders in the firm. The same flow of worker pension savings that tie workers to the firm are not accounted for in the pension trust fund: pension plans are significantly underfunded in a true economic sense. This is a peculiar characteristic of the labor which raises several unanswered questions. The paper also shows that the nature of the pension can play an important role in determining the wage-service profile and the capitalized value of the firm. Recent contributions to the literature pose an interesting and unconventional view of pensions, one which leads to the conclusion that pensions play a relatively minor role in the worker-firm contract. The argument has been implicitly made by Burt Barnow and Ronald Ehrenberg (1979) and William Sharpe (1976) but has recently been stated more directly by Jeremy Bulow (1982).2 In essence, their views rest on a interpretation of pension liabilities; namely, since the firm can legally terminate its pension plan anytime, the firm's pension liabilities cannot exceed the present value of the nominal pension promises it would owe workers if the firm terminated the plan immediately. If workers believe the firm will exercise its legal right, it is intuitively apparent and easy to show that workers will deposit only that amount of compensation into the pension plan that they expect to receive upon immediate termination. Using this interpretation of pension plan liabilities, pensions have no influence on whether the worker leaves or remains in the firm. Moreover, it will be shown that if the pension is written in nominal terms, reflecting the legal view, workers are not bondholders in the firm: pension plans are excessively overfunded. An alternative view is that the pension plan is an contract between the worker and the firm (see, for example, Jack Treynor, 1977). An implicit theory implies that workers anticipating careers with a firm will consider the package of wage and pension benefits they expect to collect over their life cycle. It is shown that these expectations lead quite directly to several implications: that the pension is written in real terms; that firms intend to meet their pension promises; and that the firm will re*U.S. Department of Labor, S-4521, Washington, D.C. 20210. The views expressed in this paper are my own and do not necessarily represent the views of the Department of Labor. The paper has substantially benefited from the comments of Pauline Ippolito and discussions with Jeremy Bulow. I am also indebted to Robert Clark, Gary Fields, Alan Gustman, Olivia Mitchell, James Pesando, John Turner, Michael Ward, and participants at the Labor Relations Workshop at Cornell University and the Law and Economics Workshop at the University of Chicago for comments. 'See my 1985a book. 2 The argument is also implicit in other related papers; see, for example, Martin Feldstein and Randall Morck (1982).

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