pension portability and labor market efficiency: a survey of the literature

Pension Portability and Labor Market Efficiency: A Survey of the LiteratureAuthor(s): Stuart DorseySource: Industrial and Labor Relations Review, Vol. 48, No. 2 (Jan., 1995), pp. 276-292Published by: Cornell University, School of Industrial & Labor RelationsStable URL: http://www.jstor.org/stable/2524487 .

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PENSION PORTABILITY AND LABOR MARKET EFFICIENCY: A SURVEY OF THE LITERATURE

STUART DORSEY*

This paper reviews the theoretical and empirical literature evaluating the labor market effects of policies to enhance pension portability. One perspective is that reducing the cost of job change will result in a more efficient allocation of workers. In contrast, long-term employment contract models suggest that incentives established by nonportable pensions may enhance efficiency by discouraging quits when there are job-specific productivity gains. No empirical studies have produced estimates conclusively showing that workers covered by pensions are more productive than other workers. Various indirect evidence, however-for example, on the relationship between pensions and wages, the pattern of pension coverage across workers and jobs, and the effect of pensions on layoffs-is consistent with pension-related productivity gains.

T his paper is a review of studies that have implications for the labor market

efficiency effects of policies to enhance pension portability. Federal policy toward portability has been an important issue since the 1960s. Approximately 40% of pension plans had no vesting provisions before the Employees' Retirement Income SecurityAct (ERISA) of 1974 established minimum vesting rules. The Tax Reform Act of 1986 further reduced the minimum vesting period, and enhanced portability may have been a goal of recent tax and regulatory

*The author, Professor of Economics at Baker University, thanks John Turner, Richard Ippolito, and Center for Pension and Retirement Research seminar participants for helpful comments. This study was supported by the Pension and Welfare Benefits Administration, U.S. Department of Labor.

changes favorable to defined contribution plans. However, benefits remain imper- fectly portable, even for fully vested workers, and current legislative proposals would further limit benefit losses resulting from job change.

Two worthy objectives of enhanced pension portability are increased retirement income and decreased uncertainty, but labor productivity implications of these policies should also be considered. A number of empirical studies have found that pension coverage is associated with less fre- quent quits and layoffs. There is disagree- ment and confusion, however, over whether reduced job mobility arising from nonportable pensions enhances or reduces the efficiency of labor markets. Ross (1958) voiced early concern that expanded pension coverage would create a "new indus-

Industrial and Labor Relations Review, Vol. 48, No. 2 (January 1995). ? by Cornell University. 0019-7939/95/4802 $01.00

276



PENSION PORTABILITY 277

trial feudalism," in which workers would be tied to jobs and unable to respond to new opportunities. The issue returned in the 1980s, as analysts searched for causes of declining productivity growth and reduced competitiveness of U.S. industries. Allen, Clark, and McDermed (1993) noted that Ross's concern is especially relevant in the face of putatively more rapid structural changes and shifts in labor demand. Choate and Linger (1986) argued that nonportable pensions contribute to an inflexible U.S. economy: "Weaknesses in pension avail- ability, benefits, and portability are now impeding the mobility that is so essential during this period of economic and technological turbulence, as an aging work force avoids job changes to protect pension rights" (p. 245).

Implicit in this concern is an auction model of the labor market, in which any shock to relative prices or technology re- quires quits or layoffs to reallocate workers into their highest-valued employment. In contrast, an implicit contract paradigm has dominated recent thinking by labor economists about wages, productivity and training, and employment and unemployment. The cornerstone of contract theories is productivity gains from long job tenure. Un- der this view, nonportable pensions can raise productivity by preserving productive job matches, stimulating investments in workers, or creating incentives for workers not to shirk.

The goal of this review is to assess the theoretical and empirical literature related to whether nonportable pensions are part of implicit contracts that enhance worker productivity, or are instead impediments to efficient job changes. The first section considers the role of nonportable pensions in labor market contract models. Although it has long been recognized that pension incentives can reduce turnover, the literature on implicit employment contract models has implications for conditions in which pension separation penalties are efficient. The remainder of the paper reviews empirical studies to determine whether there is evidence consistent with this productivity perspective.

Pensions and Productivity: Theoretical Issues

Pension Incentives and Labor Contract Models

In the auction labor market paradigm, nonportable pensions are a barrier to efficiency. Contemporaneous demand and supply conditions determine employee compensation, and the continuous equal- ity of the wage and value of marginal product (VMP) ensures the allocation of workers to their highest-valued use in each period. In the face of changes in tastes or technology, total labor productivity is maxi- mized when restrictions onjob mobility are minimized.

The auction market paradigm implies that workers are indifferent to where they work in any period, and employers can replace quitting workers with others of equal ability. However, several stylized facts about the U.S. labor market suggest that some gains are associated with durable employment relationships. These include the wide- spread phenomena of wage premiums for workers with long tenure, temporary layoffs with workers awaiting recall, and evidence of longjob duration. Such observed regularities have stimulated research based on implicit contract theories of the labor market. Unlike the auction market model, these theories emphasize long-term productivity gains from firm-specific training, efficient worker-job matches, or reduced shirking, and imply that pensions improve the allocation of workers by discouraging excessive turnover.

The remainder of this section explores the role of pensions in implicit labor contracts. The key to this function is the loss in wealth for workers who leave the firm prior to retirement. This separation penalty, referred to variously as the pension capital loss (Ippolito 1986), "backloading" (Gustman and Steinmeier 1993), or the "option value" (Lazear and Moore 1988), arises because defined benefit annuities generally are based on highest average earnings. When nominal wages are rising, job changers receive a benefit based on an



278 INDUSTRIAL AND LABOR RELATIONS REVIEW

earnings base lower than the one theywould have had if they had remained with the firm until retirement age. Since benefits accrue disproportionately as workers approach retirement, pensions are a form of deferred compensation.

Deferred compensation incentives are important in several implicit contract models. The theory of firm-specific human capital, pioneered by Walter Oi (1962) and Gary Becker (1964), provides a rationale for infrequent quits and layoffs: when the worker's marginal product is higher than in any alternative job, due to fixed hiring costs or training that is not perfectly trans- ferable, long job tenure is efficient and small or temporary shocks should not result in quits or layoffs. Alternatively, het- erogeneous skills andjob requirements can create rents from good matches (Bojanovic 1979).

For training to be feasible, both the worker and employer must have an incentive to preserve thejob relationship. Becker suggested that the optimal solution is a shared rent, with the wage set between the value of marginal product on the trained job and the alternative, that is, VMP > W > VMPal and the precise division of returns dependent upon the relative likelihood of a quit or layoff. Flanagan (1984) and Hall and Lazear (1984) argued that firm-specific capital calls for a predetermined wage, as bilateral monopoly and asymmetric information make period-by-period bargaining over the job rent too costly. However, the wage cannot simultaneously perform a contract function of dividing the job rent and provide for allocative efficiency. If a worker's alternative productivity rises above the fixed wage, a quit may result even though productivity is lower in the subsequentjob. Such socially inefficient quits can be dis- couraged by establishing a severance "tax."

Consider an employment contract grounded on firm-specific productivity, with

'Of course, the relevant criterion is that the discounted present value of all future productivity ex- ceeds that in all other possible career paths. Through- out this section I suppress the summation signs and discount factors.

a fixed wage, W, to minimize bargaining costs over thejob rent. Ex ante, both parties anticipate rents, that is, that VMP, > W> VMPa will be the normal state of affairs, represented by point 1 in Figure 1.2 How- ever, given W, an increase in the worker's alternative wage, say to VMPa, may induce a quit, even though the worker still is more productive in the current job. Inefficient quits will occur along the locus AB, given VMP1. A contract under which a quit is precipitated by any increase in the worker's alternative productivity above the fixed wage would not be feasible (Carmichael 1989). However, the contract can be made self- enforcing by spec~ifying a severance tax, T, equal to VMP1 - WU Given VMP1 and T, the worker has an incentive to quit only when a separation is efficient, that is, when VMPa > VMP1. Many economists have suggested that nonportable pensions establish such a severance tax to deter quits and insure employers against the loss of training investments. Becker surmised that "the effects on the incentive to invest in one's employees may have been a major stimulus to the development of pension plans with incomplete vesting" (1964:27).3

Nonportable pensions also may be important in the "shirking" model (Becker and Stigler 1974). Workers injobs in which monitoring is costly have an incentive to perform at low levels of effort, or even steal from the employer. The worker and firm recognize that incentives to eliminate such shirking would create a mutually beneficial productivity gain. One solution has the worker posting a bond, to be forfeited if he is detected shirking. Although actual cash bonds by new employees are very rare, an implicit bond can be created by underpay- ing the worker early in the career and over- paying later, that is, "tilting" the compensation profile relative to the path of VMP. A

2This diagram is borrowed from Lazear and Hall (1984).

3The history of the early development of private pensions in the United States suggests that a primary motivating factor was the desire to reduce turnover and encourage early retirement (Graebner 1980).




worker who is dismissed loses the value of the deferred compensation bonus.

If reduced shirking is important in labor markets, the pension separation penalty is a likely vehicle for deferring compensation. Backloaded defined benefit accruals mean that workers dismissed prior to retirement suffer a capital loss similar to that arising from deferred wages. Yet defined benefit pensions have several advantages over tilting the career wage profile. First, there are tax advantages.' Second, there is no need to enforce the end of the contract by mandatory retirement. Third, because pension benefits are partially insured, they may be more credible than promises of future wage gains. There is empirical evidence that the pension separation penalty has a greater impact onjob tenure than the steepness of the wage profile (Ippolito 1991).

Ippolito (1994) recently explored the role of pensions in preserving productive job matches in the Alchian and Demsetz (1972) model of team productivity. Expe- rienced worker teams yield rents that team members may try to capture by threatening to quit. Opportunistic wage bargaining is prevented by fixing the wage structure, with pensions used to discourage quits and preserve the team.

Defined benefit pensions also can encourage long-term employment relationships through early retirement incentives. Workers remaining on thejob too long are a problem in both the specific training and shirking models. If it is costly to renegoti- ate a lower wage, and mandatory retirement is not allowed, some older employees will continue working after their productivity declines below the value of alternative uses of time. A solution is severance pay, which Lazear (1983) suggested is conveyed by pension early retirement incentives. Most defined benefit plans have early retirement options, and in addition workers who delay

'Steepening an already positively sloped career wage profile will increase the lifetime tax burden under a progressive income tax. In addition, interest earned by deferred compensation in a pension fund accumulates tax-free.

VM--------------------E VMP=VMP'

VMP'9 ------- ---- MP-=T

-- -- -- ------ X ,P - \

2 / ' ' 1

V M V 1 --- -- t -- - - -4 -- - - -

VM / 2 / ' / i

/ ' @ __VMP W VMP. VMP,

Figure 1. Optimal Seveaiance Taxes.

retirement beyond age 65 generally suffer losses in the actuarial value of pension benefits.5

In summary, nonportable pensions can enhance efficiency in fixed-wage contracts when training, favorable matches, or reduced shirking createjob-specific rents. In these models the pension quit penalty may act as a severance tax, discouraging inefficient quits. Simultaneously, other provisions of defined benefit pensions may induce older workers to quit when their productivity falls below the value of opportunities.6

Pensions and Efficient Severance Taxes

Implicit contracts present a different perspective on mobility, in which ineffi- ciencies result from too many quits (Hall

5The ability of pensions to establish retirement incentives is not necessarily related to portability of benefits. Some policies to enhance portability, such as immediate vesting, would not reduce this capabil- ity. Other policies, however, would raise the cost of defined benefit plans, and defined contribution plans are much more neutral toward the age of retirement.

6Pension incentives also may play a role in implicit contracts based on worker risk-avei sion. In such contracts, less risk-averse firms provide a wage path




and Lazear 1984). Given the difficulty of enforcing payments from quitting workers to firms, pension backloading may be the only feasible way to deliver an incentive that preserves productive job matches in the face of modest demand and supply shocks. However, even if pensions pro- mote training or other benefits of durable jobs, nonportable pensions could become an impediment to efficient job mobility when economic conditions change perma- nently and the value of thejob match disap- pears. As Rosen has pointed out, implicit contracts sometimes require dissolution: Not all marriages are made in heaven. Firms go bankrupt, demand shifts to other locations, supply shifts to other countries, products become obsolete and relative demands for goods have been known to change over time. Contracts call for permanent dissolutions when quasi-rents on firm-specific human capital fall to zero. (1985:1170) An argument for enhanced pension portability is that workers will remain too long with firms in declining industries, and that growing firms will face increased costs of attracting labor due to pension-induced immobility. These concerns have attracted increasing attention because the pace of structural change seemed to accelerate in the 1980s (Mark 1987).

Simply stated, a pension separation penalty that initially is a barrier only to inefficient quits may discourage workers from leaving for better alternatives if productivity unexpectedly declines. Figure 1 illus- trates an implication of fixed-wage models: a first-best severance tax must be flexible, equal to the firm's share of the job rent. Suppose the worker's productivity declines to VMP2. If the severance tax is fixed, workers will quit only when VMPa > W+ T=

that is less variable than marginal product. However, wage insurance contracts will not be feasible without a method of making the contract self-enforcing, because without such a device workers will quit when alternative wages are high under favorable economic states (Carmichael 1989). Holmstrom (1983) showed that deferred compensation also can ensure against opportunistic quitting in these types of contracts.

VMP1. Quits along the locus ED are allocatively efficient, but the worker's productivity in a newjob is not high enough to offset the quit penalty. The efficient severance tax in this case falls to VMP2 - W= DC. If productivity falls below W, the pension quit penalty should disappear entirely, as the worker is more productive in any job that pays a higher wage (VMPa > W> VMP). An inflexible pension quit penalty thus impedes efficient quits when firm-specific productivity deteriorates.

However, if information were perfect and bargaining costless, nonportable pension benefits would never perpetuate an unproductive job match, because optimal quits can always be induced through side payments. The basic idea was laid out by Becker, Landes, and Michael (1977) in a paper on marital relationships. Whenever quasi-rents from ajob (or marital relationship) fall below zero, even though one party still may be receiving rents there is a buy- out that is mutually beneficial. In our example, the firm would be willing to end the employment relationship in exchange for compensation for the loss of its lower rent, VMP2 - W = DC. In this frictionless world it is not surprising that the private interests of each party are to establish the lower quit penalty, which gives workers an incentive to move to their highest-valued employment. A flexible quit penalty could be implemented either by conditioning the pension loss on within-firm productivity or, if the penalty is fixed, by giving the worker a severance payment. In this example a severance payment equal to ED establishes the efficient net penalty of DC.

However, implementing a flexible quit penalty will be difficult when information is not perfect. The problem of efficient separation incentives in implicit wage contracts recently has received much attention.7 Readers familiar with the literature will recall the difficulty of establishing information-feasible and incentive-compat- ible severance payments. In optimal fixed- wage contracts, layoffs require severance

7See, for example, Holmstrom (1983), Hall and Lazear (1984), Kahn (1985), Ito (1988), and Arnott




payments that vary inversely with the worker's outside wage opportunities. How- ever, if the latter are known only to the worker or if monitoring search effort is costly, a moral hazard arises. Workers who are separated have an incentive to under- state their alternatives and not to conduct costlyjob search in order to collect a higher severance. As a result, severance payments are incomplete.8

However, information about the worker's alternative productivity is not required for severance payments to perform the function of offsetting the pension quit penalty. The optimal severance payment in this case is solely a function of within-firm productivity. But a variable separation penalty will not be feasible if the decline in productivity is not verifiable by the wor~ker. If the firm is receiving a rent (VMP > W), its incentive is to overstate VMP to minimize the severance payment or maximize the net pension loss of the quitting worker. In addition, a moral hazard can arise because workers w~ho receive a wage offer greater than Whave an incentive to lower their productivity to minimize the severance tax.

If severance payments-or a variable pension penalty are not feasible, a second-best solution is to waive the loss for firm-initiated layoffs. Suppose that the value of the job match declines such that W > VMPa > VMP3, as at point 2 in Figure 1. A perma-

et al. (1988). Interestingly, the contract literature seems to have discounted the potential role of pensions in providing a severance tax, by focusing only on vesting provisions as a source of nonportability. Kahn (1985) suggested that unvested pensions may establish a negative severance payment, but that effect across the work force presumably would be small, since vesting generally is now required after only five years of service. Carmichael (1989) concluded that vested pensions are a puzzle, if the role of pensions is to penalize workers nearing retirement in a shirking model. As discussed above, however, even fully vested workers suffer significant losses in pension value upon separation prior to retirement.

81n these models it frequently is assumed that a quit penalty is not feasible, so severance payments are not needed to induce a quit when the worker's alternative wage rises above his current productivity. In- stead, severance payments are intended to induce quits when productivity declines, or to insure the worker against a layoff.

nent separation is warranted, but the worker is receiving rents and will not quit without a payment that compensates for lost wages plus the pension penalty. The implicit contract could allow the firm to initiate a layoff. But imposing a separation penalty on workers, when a first-best contract calls for severance payments, can only be an impediment to layoffs. If layoffs impose costs on workers that cannot be offset by severance payments, the optimal implicit contract will call for a lower rate of layoff, compared with the auction market. In addition, firms will be more reluctant to discharge workers when there is a pension loss, especially when they have better information about worker productivity, fearing that the layoff will be perceived as opportunistic (Cornwell et al. 1991). Thus, waiving the pension loss for firm-initiated separations will encourage efficient layoffs. One mechanism for doing so would be to index benefits to future wage growth for laid-off workers but allow inflation to erode the benefits of workers who quit.

Lazear (1983), however, suggests rea- sons why even this distinction may not be feasible. First, if the separation penalty is used to discourage shirking, the contract will have to distinguish between layoffs due to changes in market conditions and dis- charges for "cause." Workers dismissed with prejudice must suffer a loss, creating an incentive for the employer to opportu- nistically claim that the discharge is for cause. Second, a contingent pension loss creates perverse incentives. Workers for whom VMPa > W want to change jobs but have an incentive to lower their productivity to induce a layoff and avoid the penalty. Similarly, a firm wishing to lay off a worker would have an incentive to establish such disagreeable work conditions that the worker quits. A contract that created such incentives would be in neither party's interest.

Under some conditions, however, incentive problems would be minimal. In the case of a plant closing, there is no question of shirking, nor could the firm hope to induce the entire work force to quit. Thus, we should observe compensating payments




to offset worker pension losses in such a major layoff.

Summary

In an auction market any impediment to job mobility reduces labor market efficiency in the presence of changes in technology or demand. If job-specific productivity is important, the pension separation penalty may be the only feasible way to establish a severance tax and discourage unproductive quits when productivity rises outside the firm; but an inflexible pension penalty may deter some efficient quits and layoffs when productivity at the firm declines. An optimal severance tax declines with within-firm productivity, implying that pensions should be coupled with severance pay, or that the pension quit penalty should be waived and benefits become fully portable when the firm initiates a layoff. However, imperfect information and moral hazard make it ques- tionable whether the penalty can be made conditional on productivity. Thus the pension loss may prevent inefficient quits when workers' outside productivity rises, but be- comes a barrier to productive quits and layoffs when productivity within the firm falls.

I do not mean to imply that the labor productivity model is the only theory of defined benefit pensions. For example, Bodie (1990) reviewed how pensions provide insurance against several types of retirement risk, including inflation and out- living retirement savings. Severance payments to discharged workers also are consistent with a simple risk-shifting implicit contract. Another theory is that defined benefit pensions were pursued by unions to deliver higher benefits to more senior members (Freeman 1985). In the next section I evaluate whether empirical evidence is consistent with the productivity theory of pensions. My purpose is not to "test" whether this hypothesis is a more powerful explanation for pensions than other plausible theories of pensions. An assessment of the empirical basis for all pension theories is beyond the scope of this paper.

Pensions and Productivity: Empirical Evidence

In the remainder of this paper I consider evidence that pension incentives result in productivity gains. Three questions are considered. First, are tenure incentives established by defined benefit pensions consistent with severance taxes implied by contract models? Second, is there econometric evidence that workers or firms with pension coverage are more productive than those that are without it? Third, to what extent are pension separation penalties flexible? Even if pensions appear to be associated with job-specific productivity gains, a fixed penalty may yield too few quits and layoffs when job-specific productivity declines.

The Career Pattern of Pension Incentives

In both the firm-specific training model and the shirking model, the optimal severance tax should vary with tenure. The training model implies that the quit penalty should equal the value of the firm's investment in workers. A well-established result is that the optimal profile of the stock of human capital is concave (Ben-Porath 1967; Haly 1973). The stock of skills grows because a high proportion of earnings capacity is initially devoted to training. How- ever, training declines with tenure, and beyond some point depreciation causes the stock of skills to decline. Although this model describes the accumulation of general skills, the essential results also apply to the firm's share of investment in firm-specific skills.9

The typical pattern of the pension quit penalty also is concave. Workers who quit immediately after taking a job, or leave

90ne difference is that, compared with the stock of general human capital, the value of firm-specific training will grow more slowly initially and peak later. The employer calculates the payback period as the amount of time the worker is expected to remain with the firm, rather than the number of total working years left in the career. Because the firm has little




Table 1. Illustration of Pension Quit Cost as a Percentage of Annual Wage.

Years of i = 10%, i = 10%, i =5%, Age Service g=8% g=10% g=5%

35 0 0.00 0.00 0.00 40 5 0.39 0.68 0.52 45 10 0.79 1.27 0.95 50 15 1.15 1.74 1.18 55 20 1.35 1.89 1.17 60 25 1.11 1.47 0.82 65 30 0.00 0.00 0.00

Source: Ippolito (1991). The figures assume, in addition to the nominal

interest rates (i) and wage growth rates (g), that the worker retires at age 65 and lives until age 78.

upon reaching the plan's retirement age, suffer no loss. Table 1 reproduces Ippolito's calculations of separation penalties, at various years of service, as a percentage of annual earnings for a worker who joins a firm at age 35. For example, assuming a nominal interest rate and wage growth of 5%, leaving after ten years of service would result in a loss of real pension benefits equal to 95% of annual earnings. Table 2 presents estimates of actual losses relative to current earnings for manufacturing, professional, and administrative workers, as calculated by Allen, Clark, and McDermed (1988). Both tables indicate a hill-shaped function. This basic pattern persists with different assumptions about the interest rate, wage growth, retirement age, and pension plan parameters.'0 Thus, the path of pension losses is generally consistent with the concave severance tax implied by the

information about the quit propensity of new hires, it initially will make investment decisions based on a short projected tenure. As tenure grows, however, workers who remain are revealed to be non-quitters, and the ratio of training to earnings capacity initially will rise. Of course, it is likely that the firm will use pensions or other deferred compensation in an attempt to induce new hires to reveal lower quit pro- pensities.

I'XFor example, Lazear and Moore (1988) also reported concave pension loss profiles for different plan parameters.

Table 2. Earnings and Pension Loss: Manufacturing, Professional,

and Administrative Workers, 1983.

Age Earnings Pension Loss

25 $8,839 $0 35 11,866 8,921 40 13,744 13,727 45 15,912 18,029 50 18,398 20,833 55 21,231 20,416 60 24,428 13,661 64 31,448 0 65 32,809 0

Source: Allen, Clark, and McDermed (1988).

training model. However, this comparison only suggests that pensions have the potential to perform this function.'1 Empirical evidence linking pension losses with training is addressed below.

By itself, the pension loss-tenure path appears less well suited to the shirking model than to the training model. Akerlof and Katz (1989) questioned the logic of deferred compensation in general as a deterrent to shirking. They argued that the separation penalty is necessarily small for new hires, who are just beginning to establish an implicit bond by accepting wages below VMP or, in the case of pensions, initially trading off wages faster than portable pension benefits accrue. They show that it generally will be optimal for workers to shirk when the value of the implicit bond, or separation penalty, is low early in the career. Indeed, the pension separation penalty is low for new hires. The authors do not deny that deferred compensation may be a tool to discourage shirking, only that implicit performance bonds must be com- bined with an efficiency wage, or compensation above market-clearing, to establish a separation penalty for new hires.

"Other theories of pensions that imply basing benefits on highest earnings also will produce pension losses as long as nominal wages are expected to rise with tenure.




Direct Tests of Pensions and Productivity

There is virtually no direct evidence of the effect of pensions on productivity or firm performance. Gustman and Mitchell (1992), reaching a similar conclusion, cited a familiar culprit: inadequate data. Pro- ductivity studies long have been hampered by the lack of direct measures of employee output or firm productivity, and the endogenous nature of pension coverage results in even more stringent data requirements. Cross-section comparisons are apt to be misleading because the firm's decision to offer a pension may itself be a function of its work force's productivity. Even longitu- dinal data may not suffice, because changes in pension coverage may be endogenous.

Despite these difficulties, Allen and Clark (1987) made a first attempt at examining the pension-productivity relationship. The authors estimated a productivity equation across three-digit industries. The log of value added per worker was regressed against the capital-labor ratio, union membership, firm size, average age and school- ing, and the percentage of industryworkers covered by a pension. They found no evidence that industries with higher pension coverage were more productive on average. However, there were some interesting interaction effects. More extensive pension coverage was associated with higher productivity in industries with low union membership, younger age composition, and a lower hiring rate. A separate model of productivity growth was estimated for four- digit industries. The estimated coefficients were reasonable, revealing a positive effect of industry concentration and R & D inten- sity. However, differences in pension coverage were not significantly correlated with productivity growth. Finally, Allen and Clark found no significant differences in return on equity or profit margins in industries with high rates of pension coverage. They were aware that the estimates suffered from the shortcomings discussed above. Their productivity data are highly aggre- gated, and they did not attempt to model the endogeneity of pension coverage across

industries. Indeed, such a two-stage proce- dure probably would not be feasible with such limited data.

In a paper primarily focused on employment fluctuations and profit sharing, Kruse (1991) reported estimates on employment elasticities with respect to wages and pension costs. These estimates are a test of the productivity effect of pensions, because higher pension costs should also reflect greater incentives. In effect, this variable combines compensation costs with a shift parameter for labor quality. If pension- covered workers are more productive, the pension cost elasticity should be smaller (less negative) than the wage elasticity. Kruse estimated labor demand functions for a sample of firms taken from the Compustat file matched with Form 5500 pension plan reports. Coefficients on the pension variable were generally smaller than wage coefficients, but the hypothesis that the elasticities were equal could not be rejected.

Compensation Policies and Productivity

The absence of direct econometric evidence on pension incentives and worker productivity is understandable given the magnitude of the data needs. Perhaps more surprising, I find that the human resource literature also has had very little to say about the outcomes of pension incentives. It is tempting to conclude that personnel specialists dismiss as minor any potential productivity-augmenting effects of pensions. Until recently, however, there have been few systematic studies of the incentive effects of compensation policies in general. Our ignorance of the productivity effects of pensions extends to wage premiums, wage structures, bonuses, and other more direct incentives. Recently, labor economists and human resource analysts have begun to correct this deficiency. Un- fortunately, the wealth of new evidence does not extend to the effects of deferred compensation in general, or pensions in particular. Nevertheless, how workers respond to bonus systems, stock incentives,




or merit pay is relevant: if performance is not affected by these policies, it is unlikely to respond to the less direct incentives of pensions.

The literature on compensation policies, productivity, and firm performance through the mid-1980s was well summarized in a review by Ehrenberg and Milkovich (1987). Most of the studies they cited came from the finance literature, where the focus is on designing compensation policies that rec- oncile executive and stockholders' interests. They reported that a number of studies found a strong positive correlation between executive compensation and changes in firm performance. Other studies indi- cated that poor firm performance in a given year is associated with increased executive turnover in subsequent years, and there was a consensus that adoption of stock options and profit-based compensation schemes is associated with positive abnormal stock returns.'2

Ehrenberg and Milkovich's review turned up little evidence on alternative compensation systems for nonexecutive employees. Although a few studies had examined the relationship between wage levels and measures of performance such as absenteeism and turnover, none had studied the effects of seniority-based wage structures, which would be relevant to the shirking model. Also, the authors concluded that, due to methodological flaws in existing studies, very little could be said about the incentive effects of merit pay schemes. I draw similar conclusions from the primarily anecdotal literature on productivity-sharing and group performance. Ehrenberg and Milkovich (1987) concluded, "We do not know if a firm's pay position relative to its competi- tors, the number of pay grades it offers, pay differentials between these grades, or the profile of employees in a firm's pay hierar- chy have any effect on employee behavior or the firm's economic performance" (p. 112).

'2However, the literature is unclear as to whether these reactions are due to incentives, signaling new information about the firm's condition, or tax benefits.

Spurred by this paucity of evidence, a research effort was begun that would allow economists and human resource specialists to speak with more authority about the consequences of alternative compensation policies. Notable were several studies published in a special 1990 issue of Industrial and Labor Relations Review, "Do Compensa- tion Policies Matter?" edited by Ronald Ehrenberg. Jonathan Leonard (1990) and John Abowd (1990) each studied the effect of executive incentives on profitability. Leonard did not find evidence that firms with long-term incentive programs aver- aged higher return-on-equity. In contrast, Abowd found that bonuses and base salary increases in 225 companies over 1981-86 were strongly correlated with various measures of profitability. More significant, subsequent firm performance and excess shareholder returns were positively related to the sensitivity of compensation to performance.

Lawrence Kahn and Peter Sherer (1990) investigated the productivity effects of merit pay for middle- and upper-level managers. They estimated a positive and significant correlation between the sensitivity of pay to performance and subsequent performance ratings. Beth Asch (1990) presented evidence that production employees respond to incentives. She found that the output of navy recruiters, as defined by the quantity and quality of new recruits, varied over the tour of duty to maximize the likelihood of winning a prize. Recruiters nearing the end of their tour, with little chance of earn- ing a prize, sharply reduced their output.

John Abowd, George Milkovich, andJohn Hannon (1990) studied stock price reactions to announcements of changes in human resource policies. The authors examined 452 events in 1980 and 195 in 1987, including changes in compensation, layoffs, new hires, and pension policies. The reaction of the market was unpredictable: announcements of compensation increases and decreases both were greeted with negative abnormal returns, as were staffing re- ductions. Unfortunately, the reaction of financial markets to announcements is ambiguous, because the latter may provide




new information about the firm's situation in addition to improving efficiency. For example, an announcement of adoption of a gainsharing program may provide inves- tors with information that the firm's pros- pects are worse than previously believed.

A recent Brookings Institution project (Blinder 1990) also reviewed and presented evidence on compensation systems. Daniel J.B. Mitchell, David Lewin, and Edward Lawler (1990) presented estimates that workers under incentive pay systems earn significantly higher wages than other workers, suggesting that these incentives may induce higher productivity. Weitzman and Kruse (1990) reviewed the evidence on profit-sharing and productivity, conclud- ing that case studies and workplace surveys generally support a positive effect of profit- sharing on productivity. They also reviewed 16 econometric studies, estimated across 42 data sets. While noting that each of these studies had statistical and methodological weaknesses, they reported that 60% of all published regression coefficients were positive and statistically significant, and there were no significant negative productivity effects. Like the papers in the special ILR Review volume, no study explicitly considered deferred compensation or pensions.

In summary, econometric testing of how compensation policies affect performance is just beginning to accumulate. The evidence is strongest for executives, perhaps because a measure of their output, excess profits, is more easily obtained than is a similar measure for lower-level employees. For production workers the evidence is quite meager, primarily due to the difficulty of measuring output and the endogeneity of compensation policies. Evidence on the effects of deferred compensation is especially thin.

Indirect Evidence

Given data problems, testing for pension-productivity effects is likely to progress slowly. However, it is possible to make indirect tests of propositions of the type "If pensions increase worker productivity, we should observe X," or "If firms sponsor

pensions to raise productivity, an empirical implication is Y." Of course, such indirect tests are not conclusive, but a consistent pattern of results may be suggestive.

One piece of indirect evidence consistent with pension-induced productivity gains is the relationship between pension coverage and wages. If pensions are merely a vehicle for tax-preferred retirement sav- ing, with no implications for employee productivity, there should be a trade-off between cash wages and pension compensation. On the other hand, if covered workers receive more training, are more stable, or are less likely to shirk, some of this firm- specific productivity gain likely will result in higher wages.'3

The trade-off prediction is soundly rejected by the data. Even and Macpherson (1990) reported wage premiums of 15 % for men and 13% for women with pension coverage, controlling for other characteris- tics, based on the May 1983 CPS. Gustman and Steinmeier (1993) also found significantly higher wages for pension-covered workers in the Survey of Income and Pro- gram Participation data. Allen and Clark (1987) estimated that average hourly earnings would be 38% higher in industries with 100% coverage than in those with no pensions. Mitchell and Pozzebon (1987), using the 1983 Survey of Consumer Fi- nances, also generally found a positive association between pension coverage and wages. Finally, Dorsey (1989) reported pension wage premiums ranging from 12 % to 29% based on wage regressions from four widely used data sets. Montgomery, Shaw, and Benedict (1992) did find a negative pension coefficient; however, the coefficient was not always statistically significant and the estimated trade-off was less than dollar-for-dollar.14

13Note that some of this rent will be a compensating wage premium to offset the cost of reduced mobility and flexibility (Ippolito 1994).

14It should be noted that single-equation estimates may be biased upward. Pension coverage is a choice variable, and cannot be treated as exogenous in a wage regression. The potential for bias arises because an important factor in the pension decision is taxable income. It may be that the OLS pension coefficients




The strength and durability of the wage- pension relationship across different data sets and empirical procedures is consistent with the hypothesis that there are productivity gains for covered workers. A comple- mentary explanation is that the pension wage premium is itself designed to provide productive incentives. Gustman and Steinmeier (1993) argued that the pension premium represents an efficiency wage, and that the latter is more important than pension backloading in reducing turnover. In the Akerlof and Katz (1989) framework, the pension penalty is insufficient to deter shirking of workers with short tenure, so the pension is coupled with an efficiency wage. This model explains the wage premium for younger workers, but its further implication that the efficiency wage should evaporate as tenure grows and pension incentives become important has not yet been tested.

Pensions and training. Another indirect test is the relationship between pension coverage and employer-sponsored training. Pension plan parameters vary across firms, resulting in differences in the level and path of the separation penalty. Although the career pattern of pension losses generally is consistent with a role for pensions in deterring trained workers from quitting, there is no empirical evidence that varia- tions in pension incentives are related to differences in training acrossjobs. Data on detailed pension plan provisions and training policies are not available; however, a simple test of the relationship between pension coverage and training should be feasible, because such data sets as the Current Population Survey and the National Longi- tudinal Survey of Youth include measures of training and pension coverage. In a recent study based on the 1991 Current Population Survey training survey,

partly reflect a greater preference for pension tax incentives by high-wage workers. Although no published estimates have attempted to estimate the wage- pension trade-off with endogenous pension coverage, the results of one of my earlier investigations (Dorsey 1989) suggested that a strong positive correlation between pension coverage and wages remains after controlling for selectivity.

Macpherson (1994) found a strong positive association between pension coverage and firm-specific training.

Two studies report less direct empirical results consistent with a role for pensions in the specific-training model and the shirking model. An implication of the shirking model is that deferred compensation and pensions are more likely to be found injobs in which direct monitoring of employee effort is more costly. Hutchens (1987) tested this implication by assuming that jobs involving repetitive tasks are less costly to monitor. Estimates based onjob charac- teristics from the Dictionary of Occupa- tional Titles (DOT) implied that workers in jobs classified as repetitive had a nine percentage point lower probability of pension coverage. Although this result is consistent with the hypothesis that pensions deter shirking, it also has a specific training inter- pretation. Repetitive jobs likely require less training than non-repetitive jobs; indeed, Hutchens reports a negative correlation between repetitive jobs and a DOT measure of time required to obtain the skills necessary to perform the job. More directly, the estimated coefficient on this training measure in the pension coverage equation is positive and quite substantial.

Dorsey's (1987) estimates of the deter- minants of firms sponsoring primary defined benefit versus defined contribution coverage also were consistent with pensions as a complement to firm-specific training. An analysis of IRS-Form 5500 data showed that defined benefit coverage was significantly less likely in firms in construc- tion and wholesale and retail trade, industries generally thought to require less firm- specific training than manufacturing. Also, firms in industries with high concentra- tions of professionals, managers, and crafts- men were more likely to sponsor defined benefit pensions than were firms in other industries, and such coverage was associated with a lower rate of permanent layoff.

Defined benefit plans also were more likely in large firms than in smaller firms. This result is consistent with the idea that pensions complement firm-specific training, under Oi's (1983) hypothesis that large




firms' more rigid and formal production technologies necessitate greater investments in workers. Of course, large firms may have greater monitoring costs. Alter- natively, this result may reflect economies of scale in administering defined benefit plans (Mitchell and Andrews 1981), or the greater ability of large firms than of smaller firms to reliably promise future pension benefits. Workers would prefer fully funded defined contribution pensions from smaller firms, whose survival probability is lower.

Pensions and layoffs. Two studies have found that the pension separation penalty reduces employer-initiated separations, or layoffs. Allen, Clark, and McDermed (1993), using the Panel Survey of Income Dynamics, found that pension losses were a greater deterrent to layoffs than to quits. Similar results were reported by Cornwell et al. (1991) based on the National Longi- tudinal Survey-workers facing average pension losses were about 5% less likely to be discharged than were uncovered workers. This finding may reflect greater effort by workers to avoid discharge, as suggested by the shirking model, or the self-selection of employees who are less likely to be discharged. In addition, firms may be more reluctant to lay off pension-covered workers because they have received more training than uncovered workers. Finally, concern for their reputations may discourage firms from laying off workers who would suffer pension losses. If firms are indeed willing to accept constraints on their ability to initiate layoffs, however, then they must realize some offsetting benefits from providing pension coverage.

Are Pension Losses Flexible?

The firm-specific training model implies that a quit penalty should be flexible, so that workers whose within-firm productivity declines face a smaller quit penalty than do otherworkers. When thejob match rent falls below zero, benefits should be fully portable; in fact, the optimal contract calls for a net severance payment to the worker. Above ("Pensions and Productivity"), I discussed some informational and incentive

problems with conditional pension losses. Under certain circumstances, however, such as a major layoff or a plant closing, these problems could be overcome.

Doescher and Dorsey (1992) investigated to what extent separation penalties were smaller for workers who are laid off than for those who quit. The results, based on U.S. Department of Labor surveys of pension plan parameters, management surveys, case studies of plant closings, and Form 5500 data, can be summarized as follows. (1) Very few plans have different vesting or benefit accrual rules by reason for separation. (2) Early retirement benefits, both contractual (primarily in union contracts) and ad hoc, frequently offset portability losses of workers affected by a plant closing or large layoff. Losses of workers not eli- gible for early retirement, however, were not offset. (3) Regression estimates indi- cated that firms sponsoring defined benefit pensions were more likely than other firms to report a formal severance pay plan. (4) Although formal severance pay plans covered less than half the work force, case studies of plant closings and major layoffs revealed that ad hoc severance benefits were nearly universal. (5) There does not appear to be a mechanism to reduce the quit penalty when productivity does not decline enough to precipi- tate a layoff.

Thus, although plan rules generally establish the same penalty whether an employee quits or is discharged, older workers who are part of a large layoff generally can expect significant benefit adjustments and severance payments. Since mostjob losers are part of a large layoff, and since workers approaching retirement face the largest portability losses, these informal benefits may be important. It would be useful to be able to make a more precise judgment of the pension losses of job losers. Not only do retirement losses have implications for the efficiency of pension penalties, but they may also be a significant factor in the overall cost of job displacement. However, no study has calculated pension losses as part of the cost of displacement, and the U.S. Department of Labor's Displaced Workers




Surveys have not elicited information on either prior pension coverage or severance payments.

Conclusion

A concern motivating this literature review of the productivity effects of pensions is that nonportability may diminish the dy- namic efficiency of labor markets. If the labor market were similar to a continuously clearing auction, efficient allocation of workers across jobs would call for minimiz- ing costs of job change. Sometimes, however, barriers to worker quits prevent the dissolution of productivejob matches. It is ironic that concern over nonportable pensions has emerged at the same time that theoretical labor economics has become heavily influenced by implicit contract models. Just the title of Hall and Lazear's 1984 article-"The Excess Sensitivity of Lay- offs and Quits to Demand"-reveals this literature's different perspective on turnover. In these models, nonportable pensions can be viewed as creating productivity-enhancing incentives by preventing inefficient quits and encouraging firm-specific training or reduced shirking. But while nonportable benefits may discourage excessive quits when outside productivity rises, these same models also imply that quit penalties may become an impediment to efficient job mobility when productivity at the current job falls.

A number of recent policy proposals are aimed at moving closer toward full pension benefit portability (Turner 1993). Among the suggested means are shorter vesting periods, mandatory indexing of benefits to nominal wage growth after separation, and tax and regulatory policies that make defined contribution plans more attractive. A more ambitious policy proposal would make benefits fully portable by implementing a mandatory national pension fund (President's Commission on Pension Policy 1981).

What conclusion can be drawn about the probable impact of these proposed policies on productivity and labor market efficiency? My impression is that, on balance, the lit-

erature supports the view that incentives established by nonportable benefits do enhance productivity. First, the role of pensions in enhancing productivity is a plausible prediction of models that have proven useful in explaining other labor market outcomes. Second, a substantial amount of indirect evidence is consistent with positive productivity effects of pensions. Perhaps the strongest is repeated findings of large wage premiums for pension-covered workers across several data sets. Other studies indicate that employers are more reluctant to discharge pension-covered employees than uncovered employees, and that the pattern of coverage across workers and firms is consistent with predictions from the firm- specific training and shirking models. Thus, although the empirical evidence is far from conclusive, policy-makers need to consider the possibility that requiring greater portability would have adverse productivity effects.

A stronger conclusion is not warranted because I have uncovered no direct evidence that pension-covered workers are more productive than other workers. In fact, a primary finding of this review is the lack of empirical tests of the productivity effects of pensions, deferred wages, or compensation policies in general.

Another key finding is that pension quit penalties, to be fully efficient, must be flexible. A fixed pension loss can become obsolete and impede efficient mobility out of declining industries. Formal pension rules in the United States rarely provide for reduced pension losses when productivity declines or workers are laid off. Although some of the problem of excessive penalties is mitigated by ad hoc severance pay and special early retirement bonuses in plant closings or major layoffs, it is unlikely that pensions, or any other mechanism, could create a severance tax that always is efficient even in the face of changing economic conditions. But this is not, by itself, a compelling argument for eliminating the pension penalty. Although pension incentives clearly are imperfect, the appropriate question is whether the benefits of preserving ex ante productive job matches out-




weigh possible costs from insufficient quits should the value of the match fall. Given our lack of knowledge about the size of pension productivity gains, an answer to this question currently is not possible. However, the continued popularity of defined benefit pensions, despite recent gains by defined contribution plans, is an indica- tion that firms and workers believe that pension incentives, on balance, yield mu- tual benefits.

Of course, an overall assessment of portability policy involves more than just labor market incentives. I have not looked at studies investigating whether portability regulations can raise the level of benefits and reduce uncertainty. However, eliminating a mechanism that is likely the most feasible way to implement incentives for reduced quits may entail some efficiency costs that should be weighed against the benefits of enhanced benefit portability. At the very least, policy-makers should not automatically assume that efficiency gains from reduced barriers to job change will result from enhanced portability.

Better information is needed to assess the productivity effects of pensions. We are

as yet unable to estimate, for example, the size of the productivity gains associated with pensions. Explicit tests of pensions and productivity will require data sets that have direct measures of firm or worker output, with and without pensions, and allow the difficult issue of selectivity to be confronted. This recommendation essen- tially echoes that of Mitchell and Gustman (1992), who have called for the development of data files that can address these issues. More feasible with current data sets are tests of the relationship between pensions and private sector training. Such research not only would bear on the issue of pension portability, but also would improve our understanding of the economic functions of private pensions.

Finally, the purpose of this review has not been to discriminate between alternative theories of pensions, or even to argue that productivity enhancement is the primary reason for the popularity of defined benefit pensions. Other perspectives have proven valuable in understanding private pensions, and there is evidence consistent with multiple economic functions of pensions.

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pension portability and labor market efficiency: a survey of the literature

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