Pension Funds

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Pension funds are collections of financial assets—government bonds, corporate bonds, corporate stock, etc.—held against the obligations for retirement payments incurred by pension plans. If the entity running a pension plan could look forward to perpetual life and continual growth or if it were armed with power to levy taxes or print money, it could, if it wished, conduct the pension plan purely as a transfer operation. Payments to beneficiaries would be wholly financed by contributions and earnings, and no fund would be necessary. Business firms, labor unions, and other private sponsors of pension plans do not, of course, meet these conditions. Hence, as a general rule, their pension schemes include a supporting fund, available to meet the plan’s promises, although in the normal course of events the fund would not be drawn down. Thus, the assets in the fund typically enter into the fiscal operations of pension plans, through the flow of interest and dividend income they generate.

As a rule, funds of the kind just described are also accumulated under plans run by governments for their own employees. However, there is great variation between countries in the funding practices of governmental social security programs. The latter, not of direct concern for this article, range from transfer operations that have no fund to programs in which social security and private pensions have been integrated and which accumulate a fund, like private plans. Characteristically, however, the funds of social security programs fall far short of the expected value of the program’s obligations.

A rapid growth of pension plans and their funds has occurred in many countries in the last quarter of a century. Among the factors responsible for this increased demand for pensions have been the growth in the number of the aged, the increase in their relative importance, and the sharp rise in the number of years a person over 65 will spend in retirement. The last is due in part to an increase in life expectancy but more importantly to a shorter working life. Also encouraging the growth of pension plans has been the favorable tax treatment generally accorded them. This in effect permits averaging of income over the taxpayer’s life, with a consequent diminution of tax liability—a privilege made more valuable by the sharp increase in tax rates that occurred in most countries in the late 1930s and has persisted since. Specifically, in the United States the number of plans increased rapidly when pensions came to be used to provide the equivalent of an increase in compensation in the face of wage stabilization during World War n and after the decision by the National Labor Relations Board in 1948 that pensions are an appropriate item for collective bargaining.

The dynamics of the “typical” pension fund are something like this: In the early stages there is rapid accumulation, as contributions (both on account of past and present service) attuned to the level of future benefit payments are made, while current benefit payments are low. As the fund accumulates, earnings grow and benefits close the gap on contributions. At some point benefits exceed contributions, but for a while earnings take up the slack, so pension fund assets still rise but by smaller amounts. Finally, with a population whose age, employment, benefits, and wage characteristics are fixed, the time comes when benefits just balance contributions plus earnings. The plan has matured; the fund no longer grows. By definition, of course, the plan of a growing firm will never mature. More workers will enter employment than will retire; wage scales will rise; and benefit formulas will be liberalized. Pension reserves

of the plan of a growing firm will increase each year, at a “rapid” rate when the plan is young and rather “slowly” as it ages.

Should pension plans be growing in number or, more to the point, should membership in all pension plans be growing, there would be an added reason for the private industrial pension plan structure to show rapid growth over a number of years. And since the plans composing this structure have come in serially over time, the period of rapid fund growth should be rather extended. For the United States, whose data are used in this article for specific illustration, the stage of rapid accumulation began about 1940 and will probably persist until at least 1980. The data of Table 1 illustrate past growth. Prognosis rests on estimates (Holland 1966) that put the value of private industrial pension and deferred profit-sharing funds at $125,000 million by the end of 1971 and $200,000 million by the end of 1981.

Supplementing the data of Table 1 and rounding out the picture on private pension funds in the United States are (1) the funds of plans for employees of state and local governments, whose reserves rose from $1,500 million to $32,000 million between 1939 and 1965 and whose annual accumulation increased from $200 million to $3,200 million over the same period, and (2) the funds of plans for federal civilian employees, which increased from $600 million in 1940 to about $15,600 million in 1965 and are growing each year by an amount in excess of $1,000 million.

Effect on saving . By almost any measure the annual asset accumulation of private pension plans is substantial. In the United States in 1964 it came to about $11,000 million a year, $7,000 million accounted for by private industrial and nonprofit-organization plans, the rest by plans for government employees. More striking, this annual addition to holdings appears to account for over one third of total personal saving (national income accounts definition) or net financial savings by individuals (Securities and Exchange Commission definition). But this by itself is just a numerical statement. Whether in fact pension fund “saving” has real economic significance depends on whether these annual asset accumulations result substantially in net new savings or are offset, in large part, by compensating adjustments in the savings that individuals would have made under other arrangements or in other forms.

Arguments have been put forth on both sides of this question. On the side of displacement are both theoretical arguments and the evidence of past experience. If the price of one particular commodity in a set of close substitutes is reduced (the favorable tax treatment accorded pension saving is like a cut in price), its sales will increase, as will the sales of the “industry.” But in general a large part of this increase will be in sales of the now cheaper commodity (pensions) at the expense of the rest of the commodities in the “industry” (other forms of saving). Pointing to the same conclusion is the Modigliani-Brumberg “life-cycle” hypothesis (1954). Thus, most of the rapid growth of pension funds might have been financed by reductions in other forms of savings. Consistent with this possibility is Goldsmith’s evidence (1955-1956) that savings (including consumer durables) ratios have remained stable over more than half a century and the Ando and Modigliani (1963) finding of a stable ratio of consumption to labor income and wealth from 1900 on. Rough constancy in the proportion of personal income saved and in the distribution of total saving among the personal, corporate, and government sectors in the face of strong institutional changes suggests that this pattern will persist into the future—with pension fund savings displacing other forms of saving. [SeeConsumption Function.]

To support the view that pension fund accumulation augments the total of saving, one can note, first, that many of those participating in pension plans did not save in other forms; for them there is nothing to offset pension saving against. Further, pension rights or expectations are at best imperfect substitutes for other forms of saving; and since benefits are highly contingent, it may be that potential beneficiaries heavily discount the benefits promised, and accordingly do not reduce other forms of savings on becoming members of a pension plan. Moreover, it is possible that the new alternatives made available to people—in this case a modest pension (from both a private plan and social security)—could induce a change in consumers’ tastes that would encourage potential pensioners to seek to add to income in old age by keeping up or even expanding their other savings.

It is clear that none of these arguments on either side seems very convincing a priori. More weighty is some evidence developed by Cagan (1965) which suggests very strongly that the annual accumulations of pension funds should be considered, in large part, to represent a net increase in personal saving. His findings are based on a large sample (11,000) of replies to a questionnaire which covered pension status, savings in various forms, income, etc. After standardizing for income and age, Cagan discovered that those covered by private pensions saved at least as much in all other forms as those not participating in such plans. It would appear that employer and employee contributions to pension plans are not, in general, substitutes for other kinds of personal saving. And because the government’s recoupment of the tax revenue deferred by the exemption of employer contributions and fund earnings is not likely to cut corporate or personal savings by much, Cagan concluded that on balance the increase in aggregate saving is almost as large as the annual growth of pension funds. The fact that his sample was drawn from the subscription list of a consumer magazine might seem to leave the general applicability of his findings open to question. But from another survey, based on representative samples of all American consumers, Katona (1965) reached substantially the same conclusion.

Currently, in the United States, private plans accumulate reserves and enhance the flow of saving, while the social security program, which has the effect of redistributing income from highincome to low-income recipients, tends to deter saving. But in all likelihood the composite structure of plans for income support in retirement is not neutral in its effect on total savings. The acceleration of saving by private pension plans appears to be considerably greater than the discouragement of saving because of the social security program (Cagan 1965; Carroll 1960, p. 149).

Effect on investment . The annual excess of contributions and earnings over benefits paid out by pension plans is invested. This process could be viewed in terms of its effect on the demand either for capital goods or for the financial assets which are their counterpart. The discussion that follows concentrates on the latter.

Pension funds are only one class of participants among many in the capital markets, and any analysis of their investment activity would ideally be undertaken in that broad context. However, without attempting formal completeness, it is possible to discuss some of the more pressing problems posed by the portfolio policies of pension funds, including the rapid rate of stock acquisition by noninsured funds. (By way of background, this set of funds held $47,000 million of assets as of the end of 1963, while reserves of insured plans were $23,000 million and those of federal and state-local government employee plans were about $41,000 million. But more important, of all pension funds only the noninsured funds purchase sizable quantities of stock. Indeed, the net purchases of stock by noninsured funds from 1960 to 1963 equaled over 70 per cent of net additions to total corporate stock outstanding; so, directly or indirectly, they provided most of the finance for new stock issues.)

For pension funds the particular merit of stock lies in its tendency to move with the general price level. Thus, if the general price level moves up, the capital gains experienced on stock could serve either to lower the employer’s cost of operating a stipulated pension plan or permit him to provide more generous benefits at no additional cost. But the prospect that pension funds will substantially increase their holdings of stocks year after year raises questions of corporate control and effects on stock prices—particularly since pension funds, together with other institutional investors, have tended to concentrate their purchases on a relatively small group of stocks of the highest quality.

Under the trenchant heading “A Drift Toward a Taraproprietal’ Society,” Harbrecht (1959) has examined the potential problem of control exercised by pension funds over corporations whose stock they own when the relationship between beneficial interests in the fund and control of the fund itself remains in some respects ill denned. Tilove (1959), recognizing a basis for concern, argued that ownership of stock by financial institutions is not a new problem; that in this connection pension funds do not constitute a “clear and present danger”; and, finally, that mechanisms to obviate the longer-run danger now exist and can be further developed. With industrial pension fund assets projected at about $200,000 million by 1981, a reasonable estimate of the assets of noninsured plans alone would be $140,000 million. Stocks are now 41 per cent of the assets of noninsured funds (on a book-value basis), and it hardly seems likely that the funds would choose to have more than 60 per cent of their assets invested in stock by 1981. Now, make the extreme assumption that the value of all stock outstanding in 1981 will be no greater than it is today— $650,000 million. (It is most likely, of course, that because of retained earnings the value of stocks outstanding in 1981 will be considerably higher.) Even under these assumptions, which tend to overstate their relative share, by 1981 noninsured pension funds would still own less than 15 per cent of all stock outstanding.

But directing attention to the aggregate amount of stock misses an important element of the problem, for it fails to cope with concentration in pension funds’ stock purchases, i.e., their penchant for choosing their holdings from a small number of “blue chips.” Here relevant data are hard to come by. However, it is known that, as of 1954, noninsured pension funds under trusteeship of New York banks (about half, by value, of all noninsured pension funds) held more than 3 per cent of stock outstanding in only 17 companies, and in only three of these instances did their ownership exceed 5 per cent. Also, of the ten stocks in which their total absolute holdings were greatest, they held, on the average, only 1 per cent of shares outstanding. Moreover, pension fund trustees could be expected to search for alternatives to these “favorites” should their yield relative to other securities be bid down (Lintner 1959, p. 199). And in addition, the companies whose stock is heavily in demand are likely to increase their supply, thus tending to reduce the proportionate importance of the pension funds’ holdings. This does not mean that danger of control of particular companies does not exist. But it does mean that extrapolating the growth of one entity—noninsured funds—and leaving everything else unchanged is likely to overstate the danger, for other things could very well change in a way that would moderate this trend.

The argument that the increased demand for stock represented by pension funds, plus the general tendency of the funds to buy and hold, should constitute a force pushing stock prices up is subject to the qualification that a trustee would search vigorously for alternatives rather than pay an “unreasonably” high price for an asset. On balance, however, the educated guess is that stock prices are somewhat higher because of pension fund demand than they otherwise would have been. For one thing, to a long-term investor the variability of stock prices is not as much of a deterrent and the yield on stock is more of an attraction than to the general investor; therefore, as Murray (quoted in Seligman & Wise 1964, p. 200) holds, “stock is worth more to pension funds than it is to most investors.” For another, the aggregate demand for stock has probably increased. If Cagan’s findings are correct, this gain in stock market funds has been at the expense of consumption. But even were the effect of pension funds’ accumulation to be a decline in other savings, Andrews (1964, p. 464) noted that, since the two most likely suppliers of the candidates for displacement—life insurance companies and savings banks—characteristically invest in corporate bonds and stocks, the mortgage market would lose funds and the stock market would gain them. Finally, this increased demand concentrated on “blue chips” could be expected to maintain or perhaps strengthen the “relatively more favorable access which large well-established firms have had to the equity capital markets” (Lintner 1959, pp. 196-197).

The economic effects of pension fund accumulation are significant and can be expected to grow stronger as the scope of private pension plan fiscal operations widens. But it is hard to say anything more precise than this. While pension schemes will continue to be liberalized—bigger benefits, lower retirement age, earlier vesting, etc.—with consequent changes in contributions, benefits, and net fund accumulation, the pace of liberalization could vary widely. In the United States (and a number of other countries) private pension plans are part of a larger structure of arrangements for income support in retirement, the other main component being social security. While designed to supplement or complement one another, the two strands of the composite structure are also substitutes, to some degree. If one is made more “adequate,” the other will not be relied on so heavily as it would have been failing this. To some extent, then, the role of private pension plans and funds will be determined by decisions made about social security.

Daniel M. Holland

[See alsoAgingand Wages, article onFringe Benefits.]

bibliography

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