Securing Pension Benefits in DB Private Schemes with Priority Rules: an Insight from Contracting Theory

This contribution aims at enriching the debate on the priority of unfunded pension rights in the case of a sponsoring firm's bankruptcy. Starting from the idea that pension promises in DB schemes are part of a financial contract between a sponsor and participants to a sponsored pension plan, we argue that plan participants are not ordinary creditors and should be given the same priority as other claimants in the event of underfunding and a sponsoring firm's bankruptcy. We build up a model consistent with this view, which gives room for more participants' involvement in pension fund management. We assume that the sponsoring firm chooses the optimal share of a pension fund deficit that it commits to cover in case of underfunding, while participants choose the contribution rates that maximize their expected utility. We show that two regimes govern the pattern of the relationship between the optimal level of funding chosen by the sponsor and the optimal contribution rates chosen by the plan participants. Allowing plan participants to determine their desired contribution rates gives the entrepreneur the proper incentive for funding the pension plan. In a certain way, our pension contract resembles a cash-balance contract and our model suggests that more security can be given to plan participants in their pension savings by offering them a cash-balance plan which states a priority of unfunded pension rights in case of a firm's bankruptcy.