Protecting underfunded pensions: The role of guarantee funds*

Employer-related pensions are a common and extremely important component of the compensation paid to workers in both the public and private sectors of developed economies. Many private pensions are insufficiently funded, exposing workers to the risk of a loss should their employer cease operations and not be available to meet pension obligations. In this paper we study the role of guarantee funds as providers of insurance to workers against the failure of firms with underfunded defined benefit pension plans. Employing a model that predicts pension underfunding, we consider first how private guarantee funds might operate and then explore some potential advantages of public funds. Overall, we do find that both public and private funds provide insurance benefits. However, private guarantee funds requiring ex ante premia payments may be infeasible in the presence of capital market imperfections, and funds which rely upon ex post contributions may suffer from strategic uncertainty. A public fund can overcome this coordination problem. However, a public fund, such as that administered by the US Pension Benefit Guaranty Corporation, may lead to: (i) greater underfunding of pensions, (ii) distortions in the market participation decisions of firms and (iii) the inclusion of excessively risky assets in the pension portfolio. In some cases, a guarantee fund is not welfare improving.