Pensions And Public Policy: The Golden Era

The pension industry is the result of complicated regulations, and discussions about pensions often devolve into arcane technical debates. In my view, this hiding behind technical arguments is a mistake; the economic analysis of pensions from the point of view of the public interest is straightforward. What the technical complexity hides is the complete lack of coherent views amongst policymakers as to what the public interest is. As a result, the problems with pension policy are moral, not technical.

Leo Kolivakis is an ex-colleague of mine, and he writes extensively about pension issues at his blog, Pension Pulse. The recent election of the Liberal Party of Canada to form the Federal government has opened up questions about Canada’s pension policy, as he discusses here . (He also has a recent article about the situation in the United States.) Despite the fact that I worked for an asset manager that managed funds for provincial public pensions, I would note that I am not a particular expert on pension policy. My interest is looking at pensions from a macroeconomic viewpoint. My analytical framework appears to be different than Leo’s, but I am unsure whether we would disagree about preferred policies.

The Golden Era Of Pensions

I will now give a stylised history of the post-war American (and Canadian) experience with pensions; the experience in other developed countries was probably similar, but I am less familiar with the details. Although experts may disagree with some of my assertions here, I believe that it would be safe to say that the post-war era (up until the 1960s) was the golden era for pensions and North American workers. (The inflation of the 1970s caused grief for pensioners, as it was not properly taken into account.)

We can summarise early post-war pension policy as follows.

• There was a national public pension provided to all workers (Social Security, Canada Pension Plan). The amounts provided were not huge, but they replaced most of the working income for the lower end of income distribution. The fact that it was mandatory meant that poverty amongst seniors was greatly reduced, when compared to pre-World War II standards. In order to make the programme politically palatable, it could not look like it was a welfare payment. Therefore, workers paid a special tax towards this pension, and there is a whole lot of fairy tale accounting put in place to pretend that it was not a pay-as-you-go scheme. (I discuss the pay-as-you go topic here.) Although I am not a fan of analytical fairy tales, this political strategy was extremely shrewd – Social Security was one of the few programmes that was not gutted during the conservative resurgence since the 1980s. Demographics and economic strength meant that the implicit returns on employee contributions were very high (that is, workers did well).
• Tax policy made it possible for corporations to offer defined benefit (DB) pensions. Large corporations, many of which employed tens of thousands of employees, could pool longevity risk and have a large hoard of financial assets that could be used to create competitive advantage (a superior compensation package than could be provided by smaller competitors). Accounting standards were lax, allowing management to effectively treat the asset pool as a slush fund.

These two pillars of the pension scheme helped buoy the standard of living of workers. If they were lucky enough to get a good defined benefit pension, they were set for life, even if they did not save very much out of their income. However, even if they did not have access to such a private pension, the minimal state pension at least kept body and soul together.

Although experts might quibble about the details of my summary, I doubt that anyone would question the basic premise that it was a highly successful system for at least a few decades. However, the current situation for pensions is much less rosy. Experts would probably argue that there are technical reasons for our current malaise; for example, the demographic situation is quite different. I would argue that current problems is largely political.* The early post-war system was successful because it fit with political objectives of the time.

1. There was a widespread belief that poverty needed to be alleviated. This was the result of humanitarian reasoning, or on the grounds that the Bolsheviks needed to be held back by demonstrating the economic superiority of the capitalist system. However, the right is no longer worried about labour unrest, and so the welfare state appears expendable on one wing of the political spectrum.
2. The defined benefit pension system was useful for the creation of “national champions” with large labour forces, protected behind trade barriers. However, “value maximisation” has replaced the desire to build corporate empires with AAA-rated balance sheets, and defined benefit pensions are no longer economically tenable. Although people refer wistfully to “job creators,” I see no sign of any policies being suggested anywhere that attempts to rebuild those national champions with bloated labour forces. For example, although the modern left complains about globalisation and the loss of jobs, there is no chance that they would adopt the loose environmental policies that would allow for the revival of competitive heavy industry in the developed countries.

Moreover, the underlying reason why these policies achieved their objective of income replacement for pension recipients was that they were baldly paternalistic. The pension providers imposed relatively high contribution rates while guaranteeing an adequate rate of return on those contributions. We have switched towards defined contribution pensions, where the amount contributed is under the control of workers, and returns are not guaranteed.

The paternalism of the pension system matched the political environment of the early post-war era. As Hyman Minsky described it, we had an uneasy coexistence between Big Business, Big Labour, and Big Government. However, paternalism is now unpopular across the political spectrum. The distaste of the “nanny state” by the libertarian right is well documented. Meanwhile, the modern left instinctively avoids any policies that could possibly damage the self-esteem of citizens. As a result, we ended up with voluntary systems for pension provision, with only the anti-poverty minimum income replacement obligatory. We have a perfectly adequate pension system if we assume that households can rationally plan their retirement income needs. However, it appears that many middle class households fall short of this ideal; the extent of the problem is entirely dependent upon the trajectory of house prices over the coming decades. (Under an optimistic scenario for Canadian house prices, retirees would generally be in decent shape.)

One could argue that this rise of behavioural economics is a way of reintroducing paternalism in a more politically palatable form. The state can “nudge” behaviour in a desired direction by the application of psychology by academic wonks, without the behaviour of the state becoming too overbearing. Unsurprisingly, I have a more pessimistic view. I believe that this adoption of “behavioural economics” by governments is just a way of hiding from awkward political decisions. If you do not know what you are trying to accomplish, and are unable to rally political support behind your objectives, your policies are unlikely to survive the test of time, no matter how many academic studies you can cite. In any event, "nudges" are at best able to lead to outcomes that improve the outlook for the young, but incremental changes are unlikely to be relevant for the over-extended older households.

Concluding Remarks

The success of the early post-war public and private pensions were the result of them being aligned with the political environment of the time. There is little political consensus on many important contemporary issues, and so pensions represent just another area of policy incoherence. This incoherence means that it is unclear what reforms would be seen as successful. I hope to discuss such reforms in later articles.

Footnote:

* I normally try to avoid discussing politics here. Partly, this is the result of the fact that I want to avoid political controversy, but it also reflects the reality that I have fossilised political views. By historical accident, I am a Western Canadian Prairie Populist. Although I would have had plenty of company a few decades ago, I see little sign that there are any other Prairie Populists still out there. I will not attempt to summarise Prairie Populism, other than to say that it does not fit into the accepted Left-Right divide of other political systems.

(c) Brian Romanchuk 2015