Reversion Taxes, Contingent Benefits, and the Decline in Pension Funding

The evidence since the mid‐1980s contradicts the axiom that firms maximize the arbitrage value of their tax‐exempt pension funds. Instead, it suggests the emergence of a new minimum‐funding paradigm. A prominent candidate to explain the change is a sequence of escalating reversion taxes enacted between 1986 and 1990. A valuable option to a pension plan sponsor is its ability to cancel the contingent portion of its pension obligations (pension promises beyond those legally required). As a result of reversion taxes, this option value is preserved only if the firm maintains zero excess assets and falls in proportion to the amount of excess assets retained in the pension fund. The potential for this tax policy to profoundly affect the economics of pension funding seems apparent. By 1995, the cumulative effect of the new contribution behavior resulted in a 60 percent reduction in excess pension assets.