What are the economic implications of underfunded pension plans?

Ask an Economist
Question: 

Using the worst case scenario (Illinois), what are the economic implications of underfunded pension plans?

Answer: 

The problem of underfunded pension plans is complex. Some possible economic effects are as follows.

1. Plan beneficiaries will suffer economically in retirement unless they are bailed out by taxpayers. Whether and how much to bail them out is primarily a political issue rather than an economic one.

2. Unfunded pension plans can retard economic growth. With a funded pension plan, workers’ savings are invested productively in order to pay them a benefit when they retire. Even if pension funds are invested in government securities, this frees up other funds to be invested in the private sector. However, if a pension fund is underfunded, workers’ contributions are lower than under a fully funded plan. If workers are unaware of the problem, they will not increase their private retirement savings (e.g., IRA’s) to compensate. Hence, less savings are made available for productive investment. This tends to reduce the growth rate.

3. Unfunded public pension plans can lead to poorer public services in the long run by discouraging talented workers from applying for jobs in the public sector.

Answered by:
Dr. David Frankel
Associate Professor