A broad range of plans that involve benefits to workers not in the form of cash currently exist,including a wide variety of plans that are for retirement purposes (and that employees cannot receiveuntil they leave the firm). These plans receive tax benefits in that contributions and earnings are nottaxed to individuals until received as pensions (or payments on separation). These plans fall into twobasic types: defined benefit plans (where workers are guaranteed a certain benefit related to earningsand years of service) and defined contribution plans, where employees receive benefits based on thesize of assets and accumulated earnings. For most types of plans, contributions to these plans aretypically made by employers, and thus do not permit employees to choose between them and cashwages. For a variety of reasons, defined benefit plans, which once dominated the pension landscape, have been in a decline over the past quarter of a century and defined contribution plans are on theincrease. This rise in defined contribution plans particularly reflects a popular form of definedcontribution plan: a 401(k) plan, where individual accounts are maintained, both employers andemployees contribute, and employee contributions are voluntary. Employees have some choice inthe allocation of their own contributions. Employer stock may be one of the choices; employercontributions may also be made in the form of employer stock. While all pension plans are subject to regulations of some type, the restrictions are greatest for defined benefit plans. Defined benefit plans are also covered by pension insurance, which insuresagainst total loss of assets. Some of the restrictions on plans, particularly defined benefit plans, weredesigned to insure sound investments and to make sure that the plans were not simply a tax shelterfor high ranking employees and managers. Only defined benefit plans have restrictions on theamount of employer stock that can be held (10%). For defined contribution plans, employees bearthe risk of loss of investment or low returns. Some types of plans with retirement features(Employee Stock Ownership Plans, or ESOPs) must hold assets primarily in the form of employerstock. Plans may be combined. Tax benefits are also provided for acquiring employer stock that is not restricted to retirement plans. These benefits include benefits for stock options and stock purchase plans: the former aregenerally directed to high ranking employees and managers, while the latter are generally availableto all employees. (1) Why should firms pay employee compensation in the form of pension or profit sharing plans(or other fringe benefits) rather than in cash? Does the existence of these plans hinge solely orlargely on tax benefits? In this section we briefly discuss several reasons that firms might desire topay compensation, or that individuals might like to receive it, in the form of pensions or stock. Thefirst three reasons are largely associated with defined benefit pension plans while the last two areassociated with profit-sharing or stock ownership plans. Defined contribution plans not in the formof stock may, indeed, have largely arisen from a desire to exploit tax benefits, as it is difficult todiscern another reason for using them. One reason for the popularity of these retirement plans might be that collective plans, such as pension plans, could be considered desirable because of administrative savings and risk reduction. Pension plans are also often constructed to provide insurance elements, such as disability andsurvivor payments and life annuities. Insurance of this nature is often not efficiently provided inprivate markets because of adverse selection. (Adverse selection occurs when individuals sortthemselves out due to private knowledge of risks. For example, a person with a terminal illnessmight desire to buy life insurance but would not purchase a life annuity.) While administrative savings could apply to any plan, risk-pooling and insurance elements would tend to apply most strongly to defined benefit pensions plans with diversified assets andwould not apply to stock ownership plans which tend to increase risk. Administrative and riskreduction benefits have probably declined over time with the current availability of large mutualfunds and the benefits are particularly less important for defined contribution plans that do not haveunique elements of insurance and risk reduction associated with defined-benefit plans. Investment in human capital is generally under-provided in a market economy, because individuals cannot engage in involuntary servitude or commit to a certain form of employment toinsure that future earnings are used to repay human capital investments. These problems apply bothto general education and to certain types of on-the-job training. Returns to on-the-job training thatteaches skills specific to the firm can only be exploited by remaining with the firm. However,returns to on-the-job training that teaches skills transferable to other jobs can be realized by eitherstaying with the firm or moving to another firm. It is in the interest of the firm to retain employeeswhen the firm has invested in their training and whose net product is low or even negative in theearly period of the career. Defined benefit pension plans that are not quickly vested, and whosebenefits become greatest when spending a long career with a company, can be used to allow firmsand employees to mutually exploit gains from these types of human capital investment. (Government pension regulations which require early vesting and portability as ways to protectworker retirement security and guard against tax sheltering may, however, have eroded this benefit.) Pension plans may also be a way of encouraging employees to retire as their marginal product falls, without undermining morale by firing older workers who have become less productive (or,these days, placing the employer in the position of potentially violating the law). Defined benefitpension plans are particularly effective because workers who have reached full retirement and remainat work forgo their pensions, and their net wage is reduced, creating a powerful substitution effectthat encourages retirement while also offsetting lost income. Defined contribution plans permitretirement but do not create as powerful an incentive to retire and thus do not perform this functionas well. Another problem that large firms with many stockholders and/or employees face is the problem of a misalignment of shareholder and worker interests. In the case of managers, this problem is oftenreferred to as the principal-agent or agency cost problem: managers who run the company as anagent for shareholders may make decisions that do not necessarily maximize stockholder profits. Moreover, large firms may find it difficult to monitor the performance of workers; in particular theycannot easily distinguish between the effects of work effort versus outside influences onproductivity. One way that firms may attempt to remedy this problem is through use of stock options(which provide employees an incentive to increase the firm's value) and stock ownership plans,which provide some alignment with the shareholders' objectives. Of course, in theory, this approachwould not be particularly beneficial for the rank and file employees of large firms, where additionalwork effort by any one employee would have a negligible effect on the value of that employee'sstock. Stock options and ownership could have an effect on top management, whose actions haveimportant consequences, and on closely held firms. Moreover, many managers believe that employerownership boosts employee loyalty and morale. (2) Employee stock ownership can also work against shareholder interests and economic efficiency. Firms where employees hold a large fraction of stock are more impervious to hostile takeovers, asemployees and managers may otherwise fear loss of pay and jobs in such a circumstance. However,threats of takeovers are also a market mechanism that may keep the principal-agent problem undercontrol and both takeover threats and actual takeovers may lead to a more efficient company. Reducing takeovers may be advantageous for managers and workers but may not be desirablesocially. Providing compensation in the form of stock is often considered cheaper because it does not reduce current cash-flow. Such an approach may be particularly attractive to new and fast growingfirms, where access to capital markets is difficult and initial profitability is low. This motive maylead to more economic efficiency if capital markets consistently overestimate expected risk. It maylead to less efficient markets if the dilution of stock makes information on the firm's profitabilitymore difficult to assess by investors. The previous section has suggested private motives even in the absence of tax benefits fordefined benefit pension plans and for stock ownership plans, but there does not appear to be a strongprivate rationale for defined contribution plans not held in the form of employer stock. Clearlyanother reason for pension and profit sharing plans that may play a crucial role in encouraging theseplans, particularly defined contribution plans not invested in employer stock, is the tax benefitsassociated with them. Amounts contributed to a pension plan and their earnings are not subject totax until received as pensions, usually many years into the future. The combination of deferral of taxon the initial contribution and deferral of tax on earnings is the equivalent of an exemption ofearnings from tax, and is thus a valuable tax benefit. Why should the government intervene with tax subsidies (and regulations) to shape the compensation package? And why should it intervene with mixed signals, including both benefitsfor and restrictions on ownership of employer stock in pension plans? The first set of rationales for supporting pension plans are also are among the reasons for establishing Social Security: adverse selection in annuity markets and failure of individualoptimization (failure to save a desirable amount). (3) Adverse selection in annuity markets occursbecause individuals expecting to have a shorter life span will avoid the annuities market, therebymaking the annuities unattractive for the average individual. This rationale would justify taxsubsidies to pension plans that provide retirement annuities, early vesting, and mandates for broadcoverage of employees. (The latter rule is probably necessary in any case to prevent the tax benefitsfrom becoming a tax shelter for highly compensated employees.) Of course, it is not clear thatindividuals do not save enough, and it is not clear why using resources (in the form of reduced taxes)to encourage a private pension system that covers about half of workers should be preferred todevoting those resources to an expansion of Social Security.