Why private pension plans?

Why are there private pensions?

It sounds like a simplistic question, but it's one asked by Alan S. Blinder, a sophisticated Princeton University economist, in a paper written recently for the National Bureau of Economic Research.

His answer: because there are tax advantages for the individuals covered and because they help employers reduce labor turnover.

In effect, the worker can defer paying taxes on a portion of his or her total compensation until the pension fund money is withdrawn at retirement. When the tax is finally paid, the worker won't have to pay any payroll tax (social security tax) and will likely be in a lower tax bracket than during his major earnings years.

Companies have strong incentives to discourage labor turnover, especially among experienced workers. That's because it is costly to hire replacements, it is difficult to judge the ability of such replacements, and the company may have invested a considerable sum in training an employee. So a firm provides a financial incentive for the employee to remain by structuring a pension plan so that the worker loses his pension rights if he leaves before a certain vesting time.

Why have pensions plans grown so much in recent decades?

Because, says Blinder, the tax advantages became highly significant after World War II with the rise in income tax levels. Before that war the income tax was negligible. In addition, the rise in nominal interest rates has added to the tax advantages.

When a person saves outside a tax-deferred pension plan, he pays tax on the interest earnings even though a portion of those earnings is due to higher inflation. Moreover, the greater stability of the postwar economy, with its milder recessions, has reduced the chance that a pension plan will go bankrupt because of the failure of the sponsoring company.

Why do private pension plans have the features that they do?

Many of their salient features can be explained if the plan is considered as a long-term labor contract in an uncertain world. The worker may be ''overpaid'' in his early years while he is being trained and ''underpaid'' during his most productive years. The worker is prompted to stay on while ''underpaid'' because his or her specific skills may not be of so much use at another company and because the company makes an implicit promise to ''overpay'' the person in his senior years prior to retirement, when his abilities may have slowed down somewhat.