Defined Benefit Pensions: Superior When Feasible
A defined benefit pension has many advantages over a defined contribution pension. (The previous article linked above gives the definition of these terms.)
- Retirement income needs are based on actuarial averages, which means that those who die younger will receive less benefits, leaving more for the longer-lived pensioners. (In a defined contribution scheme without pooling, each worker should make plans based on an assumption of a long lifespan, which means that workers over-insure their longevity.) This reduces the amount of savings needed for retirement.*
- Investment allocations are made by investment professionals, whereas defined contribution plans typically leave workers to make the decisions. I think it is safer to leave the mismanagement of portfolios to professionals. You are usually going to end up with middling performance, whereas some individuals may make extremely unorthodox investment allocations, creating hard luck stories if and when they fail.
- The plan sponsor effectively backstops the plan, and has an incentive to maximise the returns of the portfolio. Managers of defined contribution plan asset portfolios are interested in maximising the fees generated by the portfolio; it is easier to increase those fees via marketing than it is via improving investment performance.
- Pension fund managers are supposed to take a long-term view of investment performance, and should behave in a way that stabilises the financial markets. Other asset managers have an incentive to jump on investment bandwagons (as they are easy to market), and act in a pro-cyclical fashion.
- Contribution amounts are set in a highly controlled fashion.** The fund performance is continuously monitored so that retirement income needs will be met. By contrast, it is wildly unclear what level of contributions are needed for defined contribution schemes.
Unfortunately, very few private firms are able to sustain pension plans (or are interested in doing so). This is partly the result of tightening up regulations; historically pension funds has a lax accounting treatment, which was a deliberate choice to encourage their development. This allowed pension funds to be a "cookie jar" for management. However, the trend has been towards more transparent accounting, and the pensions are now treated in more rigourous fashion. Furthermore, the tendency of firms to reduce workforces left many previously large employers with bloated pension funds, which overshadows the results of their operating businesses. Finally, many large employers are now in the retail and food services industries, and many of these employers are notorious for poor compensation of line employees.
These economic forces led to the near disappearance of defined benefit pensions within the private sector; existing plans are typically in run-off mode. It would take fairly radical changes to the incentives within the private sector to change this situation.
Defined Contribution: Feasible, But Have Drawbacks
I discussed defined contribution plans in an earlier article. The key problems from the point of view of policy are noted below.
- It is difficult to estimate the required contributions during workers' careers in order to meet a particular retirement income.
- The experience is that voluntary contribution levels were inadequate.
- Employees manage their own investment allocation.
- Firms have little incentive to steer employees into low cost portfolio management, since they no longer care about investment returns.
However, it should be noted that the private sector can manage the last stage of retirement income management -- offering an annuity to retirees. (An annuity is a stream of income payments paid during the lifetime of the purchaser; the ratio of the up-front cost to the monthly payment depends upon expected return.) Annuities pool individuals, so there is a hedging of longevity risk.
The path of least resistance for policymakers is to set policies to "nudge" or even force individuals to have higher contribution rates during their working careers, and then workers' portfolios can be turned into annuities at retirement. Some countries have followed that path; I have not really studied the results. In the countries I am familiar with, Canada and the United States, defined contribution levels are still voluntary.
Can Non-Employer Defined Benefit Pensions Exist?
One obvious question is: could a defined benefit be offered by a private entity that is not the employer? For example, a multi-employer scheme, or offered by a financial institution. (I will be discussing governmental options in a later article.) I seriously doubt that such schemes are possible.
The reason is that the sponsoring employer of a defined benefit pension plan also contributes to the plan. It is a component of total compensation costs, and so long as the plan is expected to continue, there is a fairly well defined stream of expected future payments into the plan. From a legal standpoint, the ownership of pension fund assets is a complicated situation. (There are three fairly distinct parties: workers, retirees, and the firm.) But so long as the plan is a going concern, the firm is the de facto owner: the better the plan does, the more the firm can reduce its future contributions while keeping its compensation levels unchanged.
A third party manager is not going to make contributions to the fund, so it has no economic incentive to do anything other than to gather as much assets as possible. That is not a formula for prudent long-term thinking. Furthermore, the contributors will be solely responsible for making up an shortfalls. There is little reason to believe that these can be dealt with in fair fashion, given the diverging interests of different age cohorts.
Can Governments Step In?
There is no doubt that the government can involve themselves further in universal pension provision, beyond the minimal universal state pension (in Canada, the Canada Pension Plan). (Most governments have defined benefit pensions for their employees. Governments of all levels are one of the few employers for which there are few difficulties to sustain a responsibly-managed defined benefit pension fund.)
Unfortunately, I view any serious extension of the existing universal pension plans being difficult in a country like Canada. This is not because I am some form of libertarian; rather I see some intractable political problems associated with greatly extending the universal state pension. I will outline my thinking in a follow up article.
Footnote:
* Many would argue that increasing personal savings is good for the health of the economy. This is typically based on parables about representative households or people bartering on desert islands, and not taking into account how a monetary capitalist system with corporations works. Corporate profits are a form of savings, and are the primary means of financing investment; personal savings is largely a drag on demand (which lowers capacity utilisation, hence the desire to invest). I discuss this in "Savings Equals Investment And All That."
** Defined benefit pension schemes are the result of tax advantages. The government tightly regulates these schemes so that they do not become opaque tax arbitrage machines. This is why assumed returns cannot be set "conservatively" at a very low level; if that were done, it would be easy to stuff large amounts of capital into the plan, which would grow tax free. The surplus could then harvested by the corporation in future years,
(c) Brian Romanchuk 2015
I am still trying to wrap my head around the economic notion of pensions. Here is my current thinking:
ReplyDeleteA pension acts like an ownership interest in a stream of income. It would be identical to a dividend with the obvious difference that a dividend can be refused at any decision point. If the income stream is not profitable, both pensions and dividends must be paid from borrowed funds (if payment is made).
Society often treats pensions like a "preferred dividend". The idea here is that pensions are treated like a fixed expense, coming before an "optional" payment like a dividend. [This attitude sets up a potential basic cost difference between old companies (with pension obligations) and young companies (without many pension obligations).]
If a pension is an ownership stake, then the risk of ownership is spread if actual ownership is taken in a wide variety of companies. No longer is pension risk tied to one company. But what if every company has a pension plan and every company is tied by pension-plan-ownership-diversification to every other company? It seems to me that this would take us to the condition of every company becoming owned by a pension fund. [Pension funds have a large ownership position in the U.S. economy.]
If a pension fund shifts (as just described) from a company obligation to an actual ownership obligation, the social treatment of pension priority (pay pensions before dividends) breaks down. A pension fund becomes a simple ownership interest, subject to the same treatment as any other owner might receive.
What might the role of government be here? Should government guarantee private pensions? If "yes", government would want to ensure that every company had the ability to pay dividends. [This seems to be a common goal in the developed economies.]
Competition is a powerful force undermining the ability of companies to make profits. Competition would be the antithesis of pension fund goals, which is to have more profitable companies. [This explains mergers and other anti-competitive measures.]
The framework outlined is nothing more than my current thinking. I am still trying to fill in more details such as including the position of the not-covered (with a pension) economic sector.
Yes, we reached a point where pensions are a major investor class. With the shift towards defined contribution plans, this ownership is just an outgrowth of the mutual fund industry.
DeleteAlthough government's intervene to save some pensions, since the benefits are not uniform, it cannot save all of them. If the plan has unrealistic return targets, the members are going to be disappointed. Otherwise, there is an incentive to crank up the expected benefits, and rely on a government bailout. (However, governments typically want to bail out workers who were hurt by management malfeasance.)
If there is pretty well any economic growth, diversified portfolios should rise in value. Therefore, there is a strong constituency in favour of (nominal) growth over time. This does not make pensions particularly special.