Unintended consequences follow from do-gooding

By Michael Coote

Friday 9th July 2004

Moral hazard is an economic concept concerning the presence of incentives for individuals to act in ways that incur costs for which they do not have to pay.

Such risks can arise within the context of ostensibly worthy causes, particularly where the state gets involved with protecting citizens from themselves or others.

Governments have a habit of creating unintended consequences from their do-gooding.

In the UK an interesting case of moral hazard and unintended consequences has arisen over newly legislated protection for contributors to employment-based final salary pension schemes.

Such employer-subsidised schemes promise contributing employees a defined benefit pension that is related to final earnings at retirement.

Many UK final salary schemes hit the skids in a big way during the 2000-2003 equities bear market, because, unlike their US counterparts, the British schemes were heavily weighted to holding shares. When shares were belting along, employers were tempted to defer or reduce their scheme contributions, but when markets went into reverse, these same employers were caught out with huge accumulated liabilities and in some cases the prospect of insolvency.

The British government's response has been to set up the Pension Protection Fund (PPF), which will operate from April 2005 and act as insurer of last resort for final salary schemes of companies which have gone bust with too few assets left to fund pension liabilities.

Critics in the pensions industry have expressed concerns that failing companies could be tempted to skimp on their pension scheme contributions on the assumption that the PPF would pick up the tab.

The PPF could become a moral hazard incentive.

The PPF's chairman, Lawrence Churchill, was quick to deny on BBC Radio 4's Money Box show that his organisation would be a soft touch for sharp operators. "There is some evidence of unscrupulous employers out there.

"But there are measures in the Pensions Bill that allow us to set aside the liabilities of companies that are deliberately trying to put their problems on to the PPF and we will take full account of those powers when we look at individual cases."

The implication is that others owed liabilities might miss out if the PPF invokes its pass-the-parcel discretionary powers in favour of pension scheme beneficiaries. The PPF could have its own incentive to practise moral hazard.

Controversially, the PPS will be funded by a 2% annual levy on company pension funds.

Churchill denied that this levy would discourage companies from offering final salary schemes, although many major UK firms have now slammed the doors on new scheme entrants.

His argument was that a competitive job market would keep such schemes on offer to attract and retain staff. That remains to be seen.

But the simple fact is that by whacking off 2% annually from company pension schemes, the PPF represents a source of lost return to their investors.

Many such schemes are run pretty conservatively at lowish compounding rates of return. The only offsetting options are for employees to contribute more or for managers to run the schemes at higher risk/return settings.

Only a minority of employees can expect to be bailed out by the PPF, which means that the majority get no benefit, lose out on returns, and are confronted by the need to increase risk or saving.

There are no free lunches and the PPF represents a problem even as it is sold as a solution.

Similar moral hazard analysis could be done on the government's New Zealand Superannuation Fund, which with its projected gross-of-tax return is supposed to finance 30% of NZ Superannuation costs over a period of decades.

Arguably there could be moral hazard in that people do not save enough for retirement on the assumption that the taxpayer-funded NZSF will guarantee a pension.

Those who will need the NZSF-subsidised pension most are likely to be those who contributed least tax to it and did not save anything besides. And, like the PPF, the NZSF imposes a levy on workers in the form of its taxation-sourced $2.2 billion a year that is diverted away from pay packets of individual savers, hitting their potential returns.

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