Company Pension Plans, Stock Market Returns, and Labor Demand

Transcription

1 WP/03/222 Company Pension Plans, Sock Marke Reurns, and Labor Demand Enrica Deragiache

2 2003 Inernaional Moneary Fund WP/03/222 IMF Working Paper European Deparmen Company Pension Plans, Sock Marke Reurns, and Labor Demand Prepared by Enrica Deragiache 1 Auhorized for disribuion by Rober Ford November 2003 Absrac The views expressed in his Working Paper are hose of he auhor(s) and do no necessarily represen hose of he IMF or IMF policy. Working Papers describe research in progress by he auhor(s) and are published o elici commens and o furher debae. Wih asse values falling sharply in recen years, many companies around he world are under pressure o resore he solvency of heir defined-benefi pension plans. Will his lead o higher conribuions? Will higher conribuions increase labor coss and reduce employmen? Does his mechanism exacerbae economic downurns? Wha are he economic effecs of pension fund regulaion? This paper develops a heoreical model o address hese quesions. Alhough is scope is more general, he model capures he main insiuional feaures of he pension sysem in he Neherlands, a counry where he economic effecs of he pension shock are widely debaed. JEL Classificaion Numbers: J26, G28, G23 Keywords: Company pension plans, labor demand, pension regulaion, Neherlands Auhor s Address: ederagiache@imf.org 1 The paper has benefied from useful commens and suggesions from Marcello Esevão, Rober Ford, Marijn van der Ven, and Ed Weserhou.

3 - 2 - Conens Page I. Inroducion...3 II. The Pension Shock in he Neherlands...5 III. The Benchmark Model...8 IV. A Funded Company Pension Plan...9 V. A Small Company in a Funded Indusry Pension Plan...13 VI. Marke Imperfecions...16 VII. Conclusions...16 References...18 Figure 1. Asse Allocaion of Duch Pension Funds, End Tables 1. Pension Fund Asses as a Percenage of GDP in Seleced European Counries, Economic Effecs of he Pension Shock,

4 - 3 - I. INTRODUCTION Employers compensae heir workers hrough wages and a variey of nonwage benefis, including, imporanly, reiremen pensions. In some counries company pension plans (he so-called second-pillar pensions) are a subsanial fracion of reiremen income. From he poin of view of he company, pensions are a coningen liabiliy, which is usually financed upfron by conribuing o a pension fund. In defined benefi plans, he company guaranees a payou o he pensioner, regardless of he fuure value of capialized pension conribuions. 2 In a number of counries, company pension funds have accumulaed large amouns of asses over he years (see Table 1) and have become large players in inernaional capial markes. Wih populaions aging and less reliance on pay-as-you-go public pensions in many developed counries, he size of pension funds is expeced o increase even furher in he fuure. 3 Table 1. Pension Fund Asses as a Percen of GDP in Seleced European Counries, 2000 (In percen) France 5 Spain 5 Porugal 12 Belgium 14 Germany 15 Ialy 23 Norway 34 Finland 50 Ireland 54 Unied Kingdom 81 Sweden 96 Neherlands 110 Denmark 115 Swizerland 128 Source: UBS Asse Managemen. 2 An increasingly common alernaive is he defined conribuion plan, in which he pension paymen depends on conribuions and he acual rae of reurn earned on hem. For a heory of he coss and benefis of differen ypes of company pension plans, see Bodie (1990) and Gusman, Michell, and Seinmeier (1993). 3 Van Ewijk and ohers (2000) esimae ha pension fund asses will reach 195 percen of GDP in he Neherlands by 2040.

5 - 4 - In recen years, pension funds have increasingly invesed in risky asses, paricularly equiy, o ake advanage of higher long-run expeced reurns. While markes boomed in he 1990s, his sraegy yielded high reurns, he financial posiion of he funds improved, and funds were able o lower conribuions by giving discouns o heir members. Wih sharp declines in sock markes worldwide since 2000, hough, he siuaion reversed, and coverage raios eroded. 4 In defined conribuion plans, he employees and pensioners bear he losses, while in defined benefi plans he employer mus cover he shorfalls. This is forcing companies worldwide o raise conribuions or renegoiae pension plans. The former opion means addiional pressure on firms balance shees, which have already been hur by asse price declines and he recession. Problems are paricularly acue in he Neherlands, he Unied Saes, he Unied Kingdom, and Japan (IMF, 2003). Shorfalls in corporae pension plans have raised several policy issues, such as he ransparency of pension fund accouning, he proecion of paricipans agains he bankrupcy of he sponsoring company, he ineres rae used o discoun fuure pension liabiliies, and ohers. 5 A paricularly ineresing quesion, which has been widely debaed in he Neherlands, is he macroeconomic effec of pension fund shorfalls. Will he need o cover pension fund shorfalls lead o higher conribuions? Will his ranslae ino higher labor coss and pu furher pressures on employmen? Does his mechanism exacerbae he business cycle? Should regulaors exercise forbearance o reduce pro-cyclicaliy? The answers o hese quesions are no obvious. Increasing pension benefis, as wih any oher form of worker compensaion, undoubedly increases labor coss and lowers labor demand. The curren problems a pension funds, however, do no arise from increases in pensions benefis, bu from losses on he asses se aside o finance pension obligaions already incurred. These losses are sunk coss ha should no ener he calculaion of he marginal cos of labor affec labor demand. Similarly, i seems inuiively wrong o rea increases in pension fund conribuions o mee regulaory coverage raios as higher labor coss, unless promised pension benefis also become more generous. Ye, regulaions forcing firms o finance heir pension liabiliies in a paricular way mus have some economic cos. To shed some ligh on hese issues, his paper develops a heoreical model of a firm wih a pension plan. The model is used o sudy he effecs of pension fund solvency regulaions and negaive shocks o pension fund asses on he employmen and invesmen decisions of he firm. As i urns ou, in he case of large firms wih individual pension plans, losses on accrued liabiliies do no affec he marginal cos of labor. These losses are sunk 4 The coverage raio is he raio of he asses of he fund o he presen discouned value of is liabiliies. 5 Lynn Coronado and Sharpe (forhcoming) argue ha analyss do no see hrough he veil of accouning rules allowing U.S. companies o smooh heir pension earnings. As a resul, he significan decline in such earnings following he sock marke bus is being priced ino U.S. equiy values only gradually over ime.

6 - 5 - coss, unaffeced by he curren labor marke behavior of he firm. However, he regulaory requiremen ha fuure pension liabiliies be funded up fron does inroduce a disorion: he larger he difference beween he inernal rae of reurn of he firm and he expeced fuure reurn on pension fund asses, he lower is labor demand. In he case of a small firm belonging o an indusry-wide pension plan, on he oher hand, losses on pension fund asse holdings ha cause an increase in conribuions indeed raise labor coss and lower labor demand, because hese firms do no inernalize he budge consrain of he pension fund. These resuls sugges ha empirical models ha rea increases in pension fund conribuions, o cover losses on preexising obligaions, as increases in he marginal cos of labor oversae he impac of he pension shock on growh and employmen, and lead o excessive concerns abou he pro-cyclicaliy of defined-benefi pension schemes. This paper is organized as follows: afer a brief overview of he Duch pension sysem and he debae over he pension shock in he Neherlands in Secion II, a benchmark model wih no requiremen o prefund pension obligaions is presened in Secion III; he case of a company wih an individual funded pension plan is given in Secion IV; and he model of a small firm belonging o an indusry-wide pension fund is given in Secion V. A brief discussion of he case of imperfec capial and labor markes follows in Secion VI. Secion VII concludes. II. THE PENSION SHOCK IN THE NETHERLANDS In he Neherlands, alhough employers are no obliged o offer a pension benefi, over 90 percen of workers are covered by occupaional pension plans. 6 This is parly he resul of he adminisraive exension of branch-level collecive wage agreemens beween he unions and employers organizaions o all indusry members. Second-pillar pensions accoun for abou 40 percen of reiremen income. Firs-pillar, public pensions accoun for anoher 40 percen, while he remaining 20 percen consiss of privae individual pensions (Carey, 2002). Pension funds are legal eniies separae from he companies ha sponsor hem and are ofen organized on a secorwide basis. 7 Individual company funds represen around 40 percen of privae secor pension fund asses, wih secorwide funds accouning for he res. 8 Represenaives of employers, workers, and pensioners si on he board of direcors. 6 For a comprehensive overview of he Duch pension sysem, see Kremers (2002). 7 Thus, he accouns of company pension funds are compleely separae from hose of he sponsoring company. By conras, in he Unied Saes and he Unied Kingdom, pension funds are ypically par of he sponsoring company, and he accouns of he wo eniies are consolidaed. 8 Civil servans and healh care workers have heir own pension funds, accouning for abou 20 percen of second-pillar pension fund asses.

7 - 6 - While his srucure allows for risk-sharing wihin he secor, i virually eliminaes any poenial compeiion among funds (van Ewijk and van de Ven, 2003). Anoher imporan feaure of Duch second-pillar pensions is ha 97 percen of he plans are of he defined benefi ype. 9 For a majoriy of workers (54.5 percen), benefis are based on he wage in he final year of work, while for 31.8 percen hey are based on average pay. Pensions in paymen are usually indexed o wages or, less ofen, o prices, bu indexaion is ypically condiional on he financial healh of he fund. Over he years, however, Duch workers have come o expec full pension indexaion. Pension conribuions are, on average, 11 percen of gross wages, wih employers ypically paying wo-hirds of he oal. By he end of he 1990s, Duch pension fund had buil up a subsanial invesmen in equiies, o ake advanage of higher long-run reurns (see Figure 1 below). Afer years of double-digi gains, reurns urned negaive in 2000, and have no recovered since. As a resul, he average coverage raio declined from a peak of over 130 percen in 1999 o around 105 percen in 2002, and a number of individual funds now fall shor of 100 percen coverage (van Ewijk and van de Ven, 2003). Figure 1. Asse Allocaion of Duch Pension Funds, End-2000 Propery Cash Domesic Equiies Inernaional Bonds Inernaional Equiies Domesic Bonds Source: UBS Asse Managemen. 9 By way of comparison, in he Unied Saes more han wo-hirds of firms in he S&P 500 index have a defined benefi plan (Lynn Coronado and Sharpe, forhcoming). In he Unied Kingdom, abou 85 percen of pension plans are of a defined benefi ype (Associaion of Briish Insurers, 2000). In boh counries he rend has been o swich o defined conribuion plans.

8 - 7 - To address he problem, funds began o increase conribuions and considered limiing indexaion. Concerned ha his process was no sufficienly fas, he Duch insurance and pension supervisor (PVK) clarified and srenghened coverage requiremens in Sepember Under hese new rules, coverage mus remain a or above 105 percen and addiional buffers mus be held o ensure solvency in he case of a 40 percen decline in equiy values relaive o he peak in he previous 48 monhs, or a 10 percen decline from he lowes value in he las 12 monhs. A similar requiremen applies o declines in bond values. To avoid abrup increases in conribuions, he PVK has given funds eigh years o reach full compliance wih he addiional buffers. Noneheless, employers reaced negaively o he new measures, poining ou ha hey would have large adverse effecs on corporae balance shees and labor coss, resuling in a furher worsening of he compeiiveness of Duch producers. More generally, he macroeconomic and fiscal impac of pension fund shorfalls has feaured prominenly in recen discussions on he Duch economy. A serious concern is ha pension funding coss will aggravae he curren economic downurn and delay recovery. The Duch cenral bank recenly esimaed ha higher employer pension conribuions would increase uni labor coss in he privae secor by 0.8 percenage poins in boh 2003 and 2004, afer having increased hem by 0.7 percenage poins in 2002 (DNB, 2002). The bank also sressed ha higher employee conribuions would reduce disposable income, resuling in lower consumpion. The Neherlands Bureau of Economic Policy Analysis (CPB), a governmen economic research insiue, has also repeaedly poined ou ha higher pension conribuions will lower profis and disposable income and increase labor coss, resuling in lower economic growh. The Bureau esimaes ha o comply wih he PVK buffers a coverage raio of around 130 percen is needed. To reach such a coverage rae in he absence of pension reform, average conribuions would have o rise from he curren 11 percen of gross wages o 15 percen. This would resul in higher labor coss, lower employmen, and lower GDP (see Table 2). In addiion, since conribuions are ax exemp and, furhermore, he governmen needs o fund shorfalls in is own pension fund, ax revenues will be lower and oulays higher, resuling in a deerioraion of he fiscal balance Table 2. Economic Effecs of he Pension Shock, Cumulaive change in percenage poins Labor coss (privae secor) 1.3 Employmen (privae secor) -0.8 GDP -1.2 General governmen balance -1.3 Source: van Ewijk and van der Ven, The CPB has also raised he quesion of wheher i would be desirable o limi equiy invesmen by pension funds. Wih he curren asse srucure, conribuions rise in periods of falling asse prices, which ofen coincide wih economic downurns, hereby exacerbaing he cycle. This also makes he ax and conribuion wedge highly variable, conrary o principles of opimal axaion.

9 - 8 - The nex secion explores he connecion beween pension fund losses and labor demand in a basic model of a compeiive firm facing perfec capial and labor markes. III. THE BENCHMARK MODEL In he benchmark model he firm pays a porion of he worker s salary as deferred compensaion, i.e. afer he worker reires. The firm can precommi o pay he pension even if i laer goes bankrup. Hence, wih full informaion and raionaliy, here is no reason o impose regulaory consrains on funding. As in convenional models, he firm is assumed o be perfecly compeiive in produc and facor markes. Also, implici in his specificaion is ha he firm has full access o capial markes and here are no informaion imperfecions or oher disorions, so ha he producion decisions of he firm are separae from he financial decisions. 10 The producion echnology is represened by a sandard neoclassical producion funcion f(k, l ), where k is capial (assumed, for simpliciy, o depreciae fully afer one period) and l is labor. The firm maximizes he presen discouned value of fuure profis by choosing he capial and labor inpu. The renal rae on capial is r, and he rae a which he firms discoun fuure profis is β <1. Employees receive a wage w when hey work and a pension λ w when hey reire, so ha λ is he replacemen raio. For simpliciy, i is assumed ha each worker spends one year in employmen and one year in reiremen, so ha he enire labor force urns over each period. 11 The profi maximizaion problem is max β [ f ( k, l ) r k wl λ w 1l 1 ]. { k } = 1,{ l } = 1 = 1 Le V(l -1) be he maximum profi a period. Then, a any, his value funcion mus saisfy he following Bellman equaion V ( l 1) = max f ( k, l ) r k wl λ w 1l 1 + βv ( l ). k, l The necessary firs-order condiions are 10 The case of imperfec capial markes is discussed in Secion V. 11 This model can be easily adaped o he case of uncerain survival. If h is he probabiliy of surviving in he second period, hen he expeced pension is h λ w. Oher facors ha make he pension paymen uncerain in pracice such as he fac ha benefis depend on he wage in he las years before reiremen raher han he curren wage, ha benefis may be only parially indexed o inflaion, or may be indexed o wage developmens over he reiremen period would be more complex o inegrae ino he model.

10 - 9 - V ( l ) f / l = w + β = w (1 + βλ), l f k = r. / Thus, he marginal cos of labor is simply he curren wage plus he (discouned) deferred compensaion. Resul 1. Wih no regulaion requiring prefunding of pensions, labor demand depends on he wage rae and he discouned value of he benefis promised o workers. IV. A FUNDED COMPANY PENSION PLAN Suppose now ha he company canno precommi o pay ou pensions in case of bankrupcy. To proec pensioners, he regulaor mandaes ha pension liabiliies be funded up fron. 12 In paricular, he case of an auonomous fund financed by conribuions from he firm is considered. 13 The fund mus abide by a regulaory solvency requiremen saing ha he marke value of is asses A mus be a leas equal o x imes he presen discouned value of is liabiliies. The parameer x is he coverage raio, hus x=1 corresponds o a fully funded plan. The presen discouned value of liabiliies is compued using he acuarial discoun rae q <1. 14 Each period, he pension fund adminisraors se he level of conribuions c so ha he solvency requiremen is me. 15 The fund resources are invesed in a risky asse paying a gross reurn ρ every year. ρ is he realizaion of a firs-order, Markov, sochasic process, such ha ρ є Ρ and Pr(ρ ρ ρ -1 = ρ ) = G(ρ, ρ ). Under hese assumpions, he presen discouned value of he firm s profis is 12 The funding requiremen may be enforced by making i a necessary condiion for he pension plan o receive favorable ax reamen. 13 In pracice, workers may pay some of he conribuions, bu his is immaerial o he exen ha he firm is a price-aker in he labor marke. See Secion V below for a discussion of imperfec labor markes. 14 In he Neherlands, he regulaor mandaes ha he acuarial ineres rae mus no exceed 4 percen, hence q canno be less ha In he Unied Kingdom, newly inroduced accouning rules mandae he rae o be ha on AA-raed corporae bonds, while in he Unied Saes i is he rae on he 30-year U.S. reasury bond. 15 In pracice, Duch pension funds are prohibied by heir saues from raising conribuions by more han a given amoun in each year, so ha he reurn o he regulaory level of coverage may be gradual over ime. Also, as discussed in Secion II, he values of he funds ofen exceed he regulaory minimum, bu his possibiliy is ignored here for simpliciy.

11 o β = 0 E [ f ( k, l ) r k ( w + c ) l ]. ( 1 ) The dynamic of he pension fund asses is given by he following equaion: A + 1 = A ρ + cl λw 1l 1, ( 2 ) while he solvency consrain for he pension fund is A + 1 = xqλ wl ρ Ρand. Combining he las wo equaions, conribuions o he pension fund are cl = xqλwl + λw 1l 1(1 xqρ ). ( 3 ) The firs erm is he amoun needed o provision agains new pension liabiliies, while he second is he difference beween wha is paid o pensioners in he curren period and he funding already se aside o cover ha paymen. The firs erm is a funcion of he curren wage bill, while he second depends only on pas hiring decisions. Naurally, conribuions are decreasing in he realized reurn on he pension fund asses. Subsiuing (3) ino (1), he profi maximizaion problem of he firm becomes and he Bellman equaion is max E o β [ f ( k, l ) r k wl (1 + xqλ ) λ w 1l 1 ( 1 xq ρ )], { k } = 1,{ l } = 1 = 1 V ( l 1, ρ ) = max f ( k, l ) r k wl (1 + xqλ) λw 1l 1 (1 xqρ ) + βe max[0, V ( l, ρ+ 1)]. k, l This expression explicily recognizes he possibiliy ha he firm may choose o close down raher han coninue a ime. 16 Le ρ r (l -1 ) be he value of he financial shock for which he firm is exacly indifferen beween saying in business or shuing down. Then, Ρ r ={ ρ ρ ρ r (l -1 )} is he se of all realizaions of he shock for which he firm chooses o remain in 16 In he Neherlands, workers have no recourse agains he asses of he sponsoring firm in cases where he firm is bankrup and he plan is underfunded. This conrass wih he Unied Saes, where benefis are, in par, guaraneed by he Pension Benefi Guaranee Corporaion. The Unied Kingdom is considering inroducing pension insurance.

12 business. Denoing a E r expecaion aken over his se, he necessary firs-order condiions for profi maximizaion are 17 f r V ( l, ρ + 1) r / l = w + xq λ w β E = w (1 + βλ ) + xqλw (1 β E ( ρ + 1 )), l ( 4 ) f k = r. ( 5 ) / These equaions show ha pension fund regulaion and he financial performance of he fund do no affec he marginal cos of capial bu may affec he marginal cos of labor. This is refleced by he second erm in (4), which is he opporuniy cos o he firm of seing aside resources in he pension fund. If he firm s discoun rae was equal o he expeced reurn on pension fund asses (1/β= E r ρ +1 ), hen he marginal cos of labor is jus (1+βλ)w, as in he benchmark model in Secion III. 18 When 1/β> E r ρ +1, however, hiring more workers means seing aside more funds in he pension fund, an inferior invesmen opporuniy. This increases labor coss and reduces he demand for labor. This disorion, which could be called he regulaory wedge, is increasing in he regulaory coverage raio x, he acuarial discoun facor q, and he replacemen rae λ. On he oher hand, he higher he reurn on pension fund asses, he smaller is he wedge. Comparing (4) wih (3) also reveals ha he marginal cos of labor is generally no equal o he wage rae plus he conribuion o he pension fund (w + c ). This is he case because he level of conribuion reflecs no only he addiional pension liabiliy ha he firm incurs by hiring one addiional worker, bu also charges or discouns on liabiliies relaed o pension righs already maured. The laer are sunk coss, and do no ener he labor demand decision of he firm. Resul 2. Regulaion forcing firms o prefund pension obligaions increases he marginal cos of labor if he expeced reurns on he pension fund asses is smaller han he inernal rae of reurn for he firm. The marginal cos of labor is generally no he sum of he wage rae and he conribuion o he pension fund Labor demand and shocks o asse prices A key implicaion of equaion (4) is ha if he sochasic process for he asse reurn is independenly and idenically disribued (i.i.d.), hen he marginal cos of labor (and hence 17 The boundary of Ρ r +1 is a funcion of l, bu since V(l, ρ +1 )=0 for ρ +1 = ρ r (l ) his can be ignored in compuing V/ l. 18 On he inerpreaion of β in a general equilibrium framework, see, for insance, Blanchard and Fischer (1989), Chaper 6.

13 labor demand) is independen of ρ, he curren realizaion of he pension fund reurn. This is he case even hough a low asse reurn forces he firm o increase conribuions o mainain he fund s solvency, creaing he impression ha labor coss have increased. On he oher hand, if he shocks are no i.i.d., an adverse shock oday would induce he firm o revise (presumably down) how much i expecs o earn on he pension fund asses nex period. This increases he regulaory wedge, and hence he marginal cos of labor. If he news also induces he firm o revise down is inernal rae of reurn, however, he effec of a negaive shock on pension fund reurns may be small or nil. Resul 3. Losses on pension fund asse holdings do no affec labor demand. However, if low asse reurns cause he firm o lower is expecaion of fuure reurns, hen he opporuniy cos of pension fund regulaion increases, pushing up he marginal cos of labor. Even when hey do no change he marginal cos of labor and capial, financial losses or gains on pension fund asses do affec he level of profis. In erms of he model, he maximum level of profis V(l -1, ρ ) is indeed an increasing funcion of he curren realizaion of he shock ρ. Indeed, if ρ is low enough V(l -1, ρ ) may be negaive, and he firm may be beer off closing down. If he pension fund happens o be underfunded in ha period, pensioners will lose par of heir pension. 19 If hese firms are a nonnegligible segmen of he marke, hen aggregae labor demand may be negaively affeced by financial losses on pension fund invesmens (and so will he aggregae demand for capial), even if he regulaory wedge does no change. Resul 4. Financial losses on pension funds may reduce aggregae facor demand because hey may cause some firms o close down. The effecs of a higher coverage raio From (4), he effec of a higher regulaory coverage raio on he marginal cos of labor is dmcl dx r ( βe ( ρ )), = qλ w (6) which is posiive in he realisic case in which he inernal rae of reurn of he firm is higher r han he expeced reurn on pension fund asses (1> β E ( ρ+ 1) ). Accordingly, a higher coverage raio reduces labor demand. However, he effec is smaller han he increase in he conribuion rae necessary o comply wih he higher coverage raio. To see his, using equaions (3) and (4), he increase in conribuions is 19 This is why regulaors may require pension funds o be over funded (x>1). Of course, in pracice, shocks oher han pension fund reurns affec a firm s profiabiliy and, hence, is decision o say in business.

14 dc dx 1 dl qλ w w 1 1(1 ). 2 l xqρ (7) ( l ) dx = r In he realisic case in which 1> β E ( ρ+ 1), dl /dx is negaive, labor demand falls as he coverage raio increases, and dc dx dmcl dx = qλw (1/ l ) 2 w 1 1 qλw [1 βe l (1 xqρ )( dl r ρ + 1 ] / dx) 1 > 1 βe ρ r + 1 > 1. The difference beween he increase in conribuions and he marginal cos of labor can be quie subsanial. Consider a case in which he firm s inernal rae of reurn is 15 percen (so β=0.87) and he expeced reurn on he pension fund asses is 5 percen. Then, r 1- β E ( ρ+ 1) =0.09 and he increase in he marginal cos of labor is only 9 percen of he increase in conribuions. Resul 5. If pension fund regulaion is cosly o he firm, an increase in he regulaory coverage raio increases labor cos and reduces labor demand. The associaed increase in he marginal cos of labor, however, is much smaller han he increase in pension fund conribuions necessary o mee he higher coverage raio. V. A SMALL COMPANY IN A FUNDED INDUSTRY PENSION PLAN For small companies, seing up individual pension plans can be very expensive because of high, fixed, adminisraive coss or because he size of he workforce may be oo small o diversify survival and oher risks. Thus, small and medium-size firms may choose o paricipae in secorwide pension funds. To analyze his case, he exreme assumpion is made ha firms are aomisic. In addiion, he pension fund is assumed o be subjec o he same regulaory consrains as he individual company fund examined above, and o levy conribuions proporional o he curren wage bill of each member firm. Le he secor consis of a coninuum of idenical firms, indexed by i. µ(i): I [0, 1] is he measure of firms of ype i, and l (i) is labor demand of firm i, and similarly for capial. Finally, le oal employmen in he secor be defined as L l ( i) µ ( i) di. Then, he dynamic of pension fund asses is described by I A + 1 = A ρ + c L λ w 1L 1 = xqλw L ρ Ρand,. (8)

15 and he solvency consrain for he secor-wide pension fund is The conribuion rae mus saisfy A + 1 = xqλ w L ρ Ρand. c c ( L, L, ρ ) = xq λw + λ w 1 ( L 1 / L )(1 xqρ ), 1 ( 9 ) while he cos of funding pension for he individual firm is c l + l λw ( L 1 / L )(1 xqρ ). ( 10 ) = xqλwl 1 In conras wih he case of an individual company plan, cuing back on employmen no only reduces wha he firm has o conribue o he fund o cover new obligaions, bu i also reduces he ransfers ha he firm mus make o offse losses on pas obligaions. The Bellman equaion for he firm becomes V ( ρ ) max f ( k, l ) r k [ c( L 1, L, ρ ) + w ] l + βe max[0, V ( ρ + 1)]. = k, l The firs order condiions for profi maximizaion are f / l = w + c( L, L, ρ ) = w (1 + xqλ) + λw 1 ( L 1 f k = r. / L )(1 xqρ ) 1 / These equaions show ha he labor demand decision is affeced by he performance of he pension fund in a very differen manner han in he case of an individual company plan. Resul 6. For an aomisic firm belonging o a secorwide pension fund, he marginal cos of labor is he sum of he curren wage and he (exogenous) pension conribuion rae. The laer is decreasing in he reurn on pension fund asses. Wih a secorwide pension fund, he firm does no inernalize he link beween he deferred wages i owes o is workers and pension fund conribuions. Conribuions depend on he hiring decisions of all he fund members, as well as on asse reurns, and are herefore exogenous o he individual member. Thus, asse marke reurns direcly affec labor demand decisions via required conribuions o he pension plan. In addiion, he conribuion rae is influenced by he rae of growh of he oal labor force belonging o he fund. In paricular, if reurns on he asses are low (1> xqρ ), hen conribuions are higher in shrinking indusries and lower in growing indusries. This is because conribuions levied on curren workers mus make up for losses on mauring obligaions o old workers. By he same oken, in

16 periods in which fund asses are overperforming, declining indusries benefi, because he financial windfall per worker is higher. The conras beween he case of an indusry plan and a company plan is enirely due o he assumpion (consisen wih common pracice in he Neherlands) ha member companies are charged by he fund in proporion o heir curren wage bill. A wo-par pricing scheme could resore equivalence beween he wo cases. To see his, suppose he fund charges each paricipan he following conribuion: c = a ( w l ) + b ( w l ρ 1 1, ) = xqλw l + λ w l 1 1 w w l L 1 A. ρ The firs erm, a(w l ), is he amoun ha he firm needs o conribue o cover new pension liabiliies. 20 The second erm, b(w -1 l -1,ρ ), is he difference beween wha he fund pays ou o workers of he firm and he value of he firm s share in he fund a he beginning of he period (afer curren reurns are realized bu before new conribuions are added). The share is calculaed using he wage bill in he previous period. Using (6) o eliminae A yields c = xqλwl + λw 1l 1(1 xq ), which is he same as he conribuions in he case of he individual pension plan (see equaion (3)). Resul 7. The labor demand decision of a small firm in a secorwide pension fund would be he same as ha of a company wih an individual plan if conribuions consised of wo pars, one o cover new pension liabiliies and he oher o reflec he capial gains or losses on accrued liabiliies. This wo-par pricing scheme, alhough somewha more complex han he sandard one, would allow firms o beer inernalize he effecs of is labor marke decision on pension coss. In addiion, a new firm joining he fund would no have o pay conribuions reflecing capial gains or losses on pas obligaions (since l -1=0 for such a firm), bu would pay only wha is necessary o fund he pensions of is curren workers. In spie of hese advanages, however, i should be emphasized ha because labor demand in he case of a large firm wih an individual pension plan is no firs-bes, swiching o his pricing scheme does no necessarily reduce disorions. 20 This is someimes referred o as he cos-covering level of conribuions.

17 VI. MARKET IMPERFECTIONS Imperfec capial markes The models assume ha firms have unresriced access o capial markes. In pracice, hough, informaional asymmeries and oher conracing problems may creae a wedge beween he cos of inernal and exernal finance, so ha financing invesmen or working capial hrough reained earnings is cheaper han raising funds from he capial markes. This wedge, in urn, may become larger during downurns, when firms become more levered and face financial difficulies. In his case, losses on pension fund asses may increase he need o resor o cosly exernal financing, inducing he firm o cu back on curren producion. An exreme case of his problem is ha of a credi-consrained company. For such a company, he need o finance he pension shorfall would crowd ou invesmen or working capial one-for-one. Imperfec labor markes Anoher imporan assumpion is ha he firm is a price-aker in he labor marke, so ha he compensaion i promises workers (boh immediae and delayed) is no affeced by he profiabiliy of he firm. If he labor marke is no perfecly compeiive, perhaps because workers are unionized, he firm has monopsonisic powers, or here are hiring and firing coss, hen he firm no longer akes he wage as given. In paricular, a financial loss on pension fund asses, by reducing curren profiabiliy, may induce he firm o srike a beer bargain wih is workers. This could resul in an increase in employee conribuions o he pension fund, which is no offse by a higher wage rae. Alernaively, here may be a reducion in he pension replacemen raio λ, for insance by forgoing indexaion. Accordingly, wih imperfec labor markes he effec of losses on pension fund asses on profiabiliy and cashflow is likely more limied han in he perfecly compeiive model, because workers end up sharing some of he losses. On he oher hand, lower wages would reduce labor supply, which migh curail economic aciviy. If here is disequilibrium unemploymen in he shor run, however, a decline in labor supply may no have a sizable effec on growh. VII. CONCLUSIONS Wih asse values declining around he world for hree years in a row, large holders of securiies have realized subsanial losses. Prominen among hem, are occupaional pension funds in a number of indusrialized counries. Wih defined conribuion pensions, he losses are borne by employees, who face he prospec of lower reiremen income. Where pensions are mainly of he defined-benefi ype, as in he Neherlands, employers mus pay higher conribuions o resore he solvency of he plan. To gain insighs ino he possible macroeconomic repercussions of hese large financial losses, his paper has developed a heoreical framework o sudy how firm behavior in paricular labor demand changes when he firm sponsors a defined-benefi pension fund and he reurns on he fund asses are uncerain. The model also sheds ligh on he economic coss of solvency regulaion for pension funds.

18 In he case of large firms wih individual pension plans, he marginal cos of labor, which deermines labor demand, is equal o he sum of hree componens: he wage, he presen discouned value of he pension benefi, and a regulaory wedge, ha capures he opporuniy cos of ying up asses in he pension fund. This marginal cos generally differs from he sum of he wage and he pension fund conribuion. Thus, losses on accrued liabiliies do no direcly affec he marginal cos of labor, even if hey resul in higher conribuions. The inuiion is ha shorfalls in pension fund coverage depend on pas labor marke decisions, no on he curren ones, and are herefore a sunk cos. A low rae of reurn on pension fund asses, however, may make labor more expensive if i signals low reurns in he fuure, because his would increase he regulaory wedge. In he case of small firms belonging o indusry-wide pension plans, on he conrary, he marginal cos of labor is equal o he sum of he wage and he pension fund conribuion, because small firms ake conribuion raes as exogenous. Accordingly, as conribuions rise and fall, reflecing losses or gains on pension fund asses, so does he marginal cos of labor, and labor demand from hese firms ends o be more pro-cyclical. In he case of boh, large and small firms, losses on pension fund asses lower profis and cash-flows, which may make i more difficul for weak firms o access exernal capial markes, causing hem o reduce aciviy. Firms and pension funds may also seek o negoiae concessions from workers on he level of pension benefis, for insance by increasing he reiremen age or indexing he benefi o he average raher han o he las wage. Reducing he pension benefi, jus like a reducion in he curren wage, should increase labor demand by large firms, bu i may curail labor supply in he long run.

19 References Associaion of Briish Insurers, 2000, The Pension Sysem in he Unied Kingdom, Privae Pensions and Policy Issues, OECD Privae Pensions Series No. 1 (Paris: Organizaion for Economic Cooperaion and Developmen). Blanchard, Olivier, and Sanley Fischer, 1989, Lecures on Macroeconomics, (Cambridge, Mass.: MIT Press). Bodie, Zvi, 1990, Pensions as Reiremen Income Insurance, Journal of Economic Lieraure, Vol. 28, pp Carey, David, 2002, Coping wih Populaion Ageing in he Neherlands, OECD Economics Deparmen Working Papers No. 325 (Paris: Organizaion for Economic Cooperaion and Developmen). Gusman, Alan L., Olivia S. Michell, and Thomas L. Seinmeier, 1993, The Role of Pensions in he Labor Marke, NBER Working Paper No Inernaional Moneary Fund, 2003, Global Financial Sabiliy Repor, March, World Economic and Financial Surveys (Washingon, D.C.). Kremers, Jeroen J. M., 2002, Pension Reform: Issues in he Neherlands, in Social Securiy Pension Reform in Europe, ed. by Marin Feldsein and Hors Sieber (Chicago: Universiy of Chicago Press). Lynn Coronado, Julia, and Seven A. Sharpe (forhcoming), Did Pension Plan Accouning Conribue o he Sock Marke Bubble?, Brookings Papers on Economic Aciviy, (Washingon: Brookings Insiuion). Nederlandsche Bank (DNB), 2002, The Duch Economy in : A Forecas Using MORKMON, Quarerly Bullein (December), pp Ter Rele, Harry, Ed Weserhou, Marn van de Ven, Barhold Kuipers, and Casper van Ewijk, Ageing in he Neherlands: A Manageable Problem, CPB Repor 2000/3, Quarerly Review of CPB Neherlands Bureau for Economic Policy Analysis, (The Hague), pp UBS Asse Managemen, 2002, Inernaional Pension Fund Indicaors 2001 UBS Global Asse Managemen (London). van Ewijk, Casper, and Marijn van de Ven, 2003, Pension Funds a Risk, CPB Repor 2003/1, Quarerly Review of CPB Neherlands Bureau for Economic Policy Analysis (The Hague), pp van Ewijk, Casper, Barhold Kuipers, Harry er Rele, Marijn van de Ven, and Ed Weserhou, 2000, Ageing in he Neherlands, CPB Neherlands Bureau for Economic Policy Analysis.