- A defined benefit pension plan promises a retirement income stream for participants (based on various criteria, such as working income and years of service), and contributions are levied during their working careers based on the actuarial assumptions of the plan sponsor. The contributions and benefits may be adjusted over time if there are developments that do not match embedded assumptions (particularly lifespan and investment returns).
- A defined contribution pension plan does not offer any promised retirement income stream, rather the worker contributes a defined amount into a personal fund, and this creates a portfolio of financial assets that are used to generate a retirement income. The contributor to the plan typically has to decide how to invest the assets, within a range of allowed options. Although this term is usually reserved for plans that are offered by firms to their employees, I would also lump in the various retirement savings tax shelters (for example, RRSP's in Canada) that are offered by governments.
A key difference between the two types is the personal ownership of the retirement assets. In a defined benefit plan (which is a going concern), workers will only receive an income until they die (although can be benefits for surviving spouses). After their death, they have no further claim on the pension assets. This means that the plan acts as a form of insurance scheme; those who pass away earlier will draw less benefits, allowing the longer-lived to have a higher income. By contrast, there is no pooling of assets in defined contribution schemes; any assets left in the pool revert to the estate of the deceased.
Advantages And Disadvantages Of Defined Contribution Plans
There have been a few major problems with defined contribution plans:
- the funds offered to employees had too high expenses leading to inadequate returns;
- employees have chosen very unsatisfactory portfolio weightings (particularly shares of their employer, which is disastrous if the firm fails);
- the worker has no clear idea how large a contribution is needed to meet a target retirement income.
The first two problems are not inherent problems of defined contribution plans, as low cost index funds are easily provided, and the framework set up in such a way so that portfolios are relatively sensible. (I realise that it may be hard to find agreement on what a "sensible" portfolio is; in some corners of the internet, the most sensible portfolio is seen to be guns, gold and canned goods.) However, the final problem is inherently difficult, given the uncertainty about the lifespan of an individual, working income over a career spanning decades, and investment returns.
That said, if a person has a high enough saving rate while having a steady income over their career, they would most likely end up with a retirement portfolio that can easily fund their retirement income needs, and leave a nest egg for their heirs. In other words, the insurance provided by pooling within a defined benefit pension is not needed if you over-insure yourself.
From the perspective of a policy maker, defined contribution plans look acceptable if the private sector is able to provide portfolio management at a reasonable price, systems are designed to steer people away from insane portfolio allocations, and contribution levels are adequate. If these conditions were met, the only real problem might be the tendency of the system to generate wealth inequality over time. (Since defined benefit pensions provide no benefit to heirs, wealth is not built up in a family over generations,)
Unfortunately, contribution levels have been generally too low, and so developed societies now have increasing numbers of people heading into retirement with inadequate retirement portfolios. This had been covered up by the rise in home values, but the housing crash in the United States laid bare the extent of the problem. (The Canadian housing market is still running on fumes.) Since contribution levels were a personal decision and is supposed to be based on rational expectations, I would view this as a market failure, which is an embedded characteristic of defined contribution plans.
One could debate whether this is in fact a policy problem that must be addressed; if one has a "devil take the hindmost" philosophy, it might be perfectly acceptable that people who did not make precautionary savings should have a crash in post-retirement income. Moreover, in a country like Canada, should we prioritise replacing the income of middle class households, when those incomes are significantly higher than those of the working poor? This is a rather awkward situation, which is why I am unconvinced that there is any particular clean solution in this field.
There are various schemes in place to prevent this low contribution situation; compulsory contribution levels (which I believe has been the situation in Australia), or the latest fad in policy making: "nudges." Although this may be able to reduce problems, I see two main issues.
- Forcing people to buy products from favoured suppliers creates plenty of potential conflicts of interest. Many fans of free market economics would be horrified at a scheme to force people to spend a fixed amount on fruit and vegetables from favoured suppliers, even though it might improve public health outcomes. However, many of the same people are perfectly happy to see the state force people to buy financial products from favoured firms.
- If the state sets a minimum contribution level, it has also created the expectation that this level of contributions will provide an adequate retirement income. But if the minimum level is too low, you will end up with a lot of angry elderly voters.
Defined Benefit Pensions As The Solution?The three problems outlined above can be eliminated by a well-run defined benefit pension scheme. The plan sponsor will ensure that expenses and the portfolio allocation are reasonable, and has to ensure that the contribution levels are adequate to meet promised benefits. This was seen during the golden era for pension schemes in the 1945-1980 interval. However, the private sector has moved away from defined benefit schemes, as they are extremely difficult to offer in the current environment. Meanwhile. the government cannot easily step in to offer them as a result of hidden political risks within such schemes. I expect to address these issues in later articles.
- My earlier article on the "golden era" of pensions.
- Leo Kolivakis writes extensively about pension issues at The Pension Pulse blog.
(c) Brian Romanchuk 2015
" compulsory contribution levels (which I believe has been the situation in Australia),"ReplyDelete
It's also the case in the UK now. The default pension scheme is NEST (http://www.nestpensions.org.uk)
Ultimately though the problem with pensions is structural. Private pension providers do nothing really other than take the savings of the current generation and pass it onto the retired generation - along with extracted income, largely from government bonds (aka corporate welfare payments). All while driving aggregate asset prices higher than they otherwise would be.
It is in effect a private tax collection system that employs an awful lot of people doing not a lot for business investment. In fact it cannot provide a stable private income without government funding (in the form of interest payments).
And it is the same as the normal tax take system. You can't really do an awful lot about the total take. All you are really doing is defining the distribution - which is a combination of contributions and portfolio decisions. If you go to index funds then really you're only driving asset prices up and causing a paradox of thrift effect with the savings that the central government )has to deal with.
So I'd go further than defined benefit schemes - which simply cannot work in a modern world where a corporation lasts about ten minutes before being taken over, merged or bankrupted. Think how many time 'pension liabilities' get in the way of deals or pension funds end up short.
For me the solution is a federally provided earnings related pension - non-contribution with generous 'in specie' swap in from existing funds that would take assets out of the market and annuities out of the private sector.
Nobody then has to save for a pension. It just happens at a known rate. No paradox of thrift effect. No feelings of insecurity that stop people spending. No build up of savings causing awkward deficits.
Unfortunately I don't think the pension industry would like it and more than taxi drivers like Uber.
I want to cover what you are writing about, but I felt I needed to lead off with just a piece on the defined contribution system. I hope to follow this up relatively soon.
To offer a spoiler of my thinking, the problem with a government-provided pension scheme (beyond the minimal one that is already in place) is that it gets extremely large; we have a situation where the state is a pension fund with a government attached to it. The second is that the state is in the position of entrenching the inequality of income -- it would be guaranteeing a pension to many middle class households which is a multiple of lower income households. My instincts tell me that such a situation is not politically sustainable.
Right Brian. Thats why only a universal BIG retirement payment is politically and economically sensible. The Govt pays to every citizen after some date some multiple of current poverty level each month. Currently the poverty level is $12K for a US individual, so maybe 3X poverty for everyone or $3000 per month. And you can save anything you want to add to that should you desire. No state and local govt pension problems, huge amount of local resources freed up to either cut taxes or increase local investment spending. Using poverty is better than just indexing to inflation (assuming your poverty metrics are reasonable of course :).Delete
I will be covering this in the later article. (Hopefully out this weekend; I have to write about the Fed circus in the next article.) My fear is that a "high" retirement payment would not be sustainable if it is much higher than what the working poor get during their careers. There would be a lot of people who would be legitimately angry about such an income distribution.Delete
"Thats why only a universal BIG retirement payment is politically and economically sensible."Delete
But the big difference between giving someone $15,000 per year (weekly/monthly), and giving them a $10/hr job 30 hours a week is when they get a $10.50/hr job (or the $9.50 one with excellent prospects) in the normal job sector, there is an automatic reduction in state spending. Which means that you don't have to put taxes up as much to recover, you don't disrupt the private sector pay structure, and the 'dead zone' between the guaranteed income and the income required for a 'normal job' is less.
People don't like paying taxes. They like other people to pay taxes. Time to realise that.
"we have a situation where the state is a pension fund with a government attached to it"Delete
No, you just pay the money like any other benefit. No fund at all. No saving. No contribution. Just a pension based upon your salary. (or your quintile, or whatever).
We have the crazy situation in the UK that due to 'funding' lobbying some of the local government pension schemes actually play the capital game - which just exacerbated the paradox of thrift and drives up asset prices.
The alternative is a private pension fund system with an economy attached to it, which as we've seen is working really well(!)
Pensions are always a current production issue. Some production is produced for people who don't have to contribute to making it. So just give them the money to buy that and tax it out at the other end.
You get rid of a load of middlemen who can then go and do something more rewarding.
People accept a difference level between the highest earners and the lowest earners that is considered 'equal'. I've no fundamental problem with either a flat living state pension or a graduated one. But both of them are infinitely more efficient than the current farce.
The currency issuer should just pay the pension. It is the one direct income payment that there is little political argument about.
"and the 'dead zone' between the guaranteed income and the income required for a 'normal job' is less."Delete
You're generally fine with guaranteed income for pensions and people that are 'retired' (including the disabled). They tend to be accepted.
The UK state pension is pretty reasonable at £155 per week, which is about twice the income support rate - but still less than the full time minimum wage rate.
My thinking about the "state being a giant pension fund" is not about any need to invest the proceeds. Even if it is a pure pay-as-you-go scheme, the income redistribution flows would still be pretty large. (I have not run the numbers, but it would be a big % of GDP as the population ages.) They would swamp the other cash flows of the government. Even if that can be sustained "financially", it would mean that it would have to be the centre of attention politically. Raising the benefit by 5% would have a massive effect on the economy.
By pushing retirement cash flows into the private sector, it reduces the size of the programme, making it less a centre of attention.
"My fear is that a "high" retirement payment would not be sustainable if it is much higher than what the working poor get during their careers. There would be a lot of people who would be legitimately angry about such an income distribution."Delete
It's called obsolescence.
There are far too many people who think they get higher wages because they are somehow magically brilliant or wonderfully skilled. Nope. It's simple supply and demand in a market alongside unionised activity to help keep that in trim.
Nobody should have any right to a higher payment than anybody else regardless of how wonderful they think they are.
Their 'higher wage' is only there because you have multiple bids in a market to drive the wage above the living wage. If that stops happening then your wage drops as well. That's what redundancy and economic shrinkage does in the actual job market that most people operate in (the secondary job market), where economic pullback and the effect on wages is a fact of everyday life. And we've recently seen it with the steelworkers in Redcar, etc.
"higher than what the working poor get during their careers. "Delete
Ah I see. I thought you meant upper middle class people disliking high pension for working poor. Never mind.
How to deal resentment is easy - Job Guarantee at Living Wage.
When someone who wants a sensible paid job also easily can get one it also makes people in general more tolerant against those who still won't or can't fit into that scheme mainly because it isn't seen as a big problem for society as a whole. When people have their life sorted the way they want it they are more likely to look kindly on others.
Imagine how much more generous they would be with a Job Guarantee in place – that allowed them to work in areas like theatre, singing or looking after their own children. A Job Guarantee that allowed them out of their ill-matched private sector job.
What is your views on JG? Some more advantages:
* Once you have a JG and the 'business confidence' bogeyman that Kalecki mentions is laid to rest then you can be far more aggressive pushing up the living wage. At the top end you give the Ministry of Competition real jack boots to stop oligopolies forming. Businesses actually hate competition but of course they are supposed to be supporters of it. So you exploit that Janus issue to the full.
* Workfare accusations are easily dealt with by simply pointing out that the the JG tailors the job to the person *which no punishment based workfare system ever does*. The JG is there to make sure that there is a job for you as an individual right up to the point where social care issues need to get involved (which then deals with people with chronic mental and physical issues).
* The Job Guarantee along with the Health Care and Pension systems provides *complete* social security. The only choice that is likely off the table is the one where you are fit and able to work, choose not to work *and* you still expect to receive a full living wage from the state.
"would mean that it would have to be the centre of attention politically."ReplyDelete
And why shouldn't it be the "centre of attention politically." It is time to admit the truth that pensions are paid from current output to current pensioners as a gift from current workers. If the current workers elect a government that wishes to cut the current pension, then cut it will be. There is no God given right to anything.
The problem is the boomers have started to believe their own BS. Sickness benefit was privatised in the 1980s. Unemployment benefit used to be linked to what you earned. Redundancy benefit has been capped for years.
It is another of those fantasies that people fall into many times.
And what of the other things not made "centre of the attention" (at least in the UK):
At some point the UK government went through a bit of arithmetic and found that to ‘fund’ retirements a substantial chunk of GDP had to shift from younger to older residents to pay the level of pensions that older voters would demand, and older voters are a huge voting block, and if ‘funded’ with taxes that huge shift would mostly be paid by higher income and wealth voters.
The UK government decided that they would not raise official taxes to do that, they would rig markets to the same effect, and the main way would be to raise house prices instead to create the same shift of GDP, or larger, as someone pointed out:
“guaranteed property price inflation was the best way to fund ones eventual retirement”
This rigging of the market to transfer a large chunk of income from younger residents to older voters (note the “residents” vs. “voters”) was accompanied by vastly increased immigration and offshoring to push or at least hold down wages, in particular in public services like the NHS, which are also costs to retirees and high income and wealth taxpayers.
Asset price bubbles and immigration and offshoring have many advantages apart from obscuring the government instigated redistribution of a lot of income from workers to retirees:
* Extremely popular with older and female South East voters who tend to vote more often and swing vote more often than younger or male or Northern who tend to be locked into Labour voting and thus electorally irrelevant.
* Asset price bubbles result largely in capital gains that are largely untaxed, establishing a principle.
* The capital gains can be realized by remortgaging, a vital tool, as it generates huge profits for the financial sector and holds up property prices.
* Ensures that that income redistribution is regressive with wealth, that is wealth is not only redistributed from those who have none to those who have some, but even more from those who have some to those who have lots.
* By providing massive property based income for many people it drives them to seek lower wage increases or retire, to not worry about pensions as in made it even easier for the ruling elites to *dismantle final salary pension schemes for everyone than them themselves*, and to make most voters be indifferent to or hate trade unions.
* The desire of heirs to get huge windfall capital gains from inheritance, which has made them lobby hard their ascendants not to sell, and to demand free care for those ascendants successfully leading to the “old ladies in mansions” story.
* Rent have gone up a lot too, and many middle aged or retired property speculators in the South East own several properties that generate enough income to live like a lady of the manor without having to downshift.
To get an idea of the size of the latter point, in a recent committee discussion with the BoE governor it came out that 40% (FORTY PERCENT) of all mortgages are interest-only.
As to the first point, remortgaging has given property owners a way to cash in (by borrowing) capital gains amounting to over 100% of GDP growth during both the Thatcher and Blair eras.
Asset price bubbles and income redistribution via the magic of rigged land markets has been “performative”, that is has shifted a large chunk voters to to the right to side with big property interests.
I think your previous comment Brain indicates this very well:ReplyDelete
"The minimum state pension (such as the Canada Pension Plan) only replaces the income for the working poor, and is only a small fraction of the pre-tax income of the "upper middle class". But if the government attempts to "replace" everyone's working income, it raises the obvious question why it provides an income for the upper middle class which is at least double the income it provides for the working poor. But if those middle class pensions are provided by private pension schemes, the government can pretend that it has nothing to do with income inequality (other than reducing it via a progressive income tax), rather income inequality is the result of "market forces". (That's the summary of a planned follow up article.)"
The question is - why not just have a state pension at the living wage? That would be fairest option.
The state pension in Canada (and most of the developed countries) is at a level that should be described as the "living wage". I will describe it further in a followup article, which should be out next week (I am wrapping up the next article, which is about private pension schemes more generally, to be published tomorrow). (The situation in Canada may be a bit better than the United States, particularly when you take into account the rather messed up state of medical provision in the United States. The Canadian medical model may not be perfect, but people generally do not go bankrupt as a result of medical expenses.)Delete
The problem is that "living wage" is well below the average income. If you were upper middle class when working, that living wage is well below what you were used to. But if you were a low income household when working (bottom 20% of the distribution, working from memory of the stats), that pension would actually replace your working income.
Therefore, the system appears "fair", but it may be a shock for those in the middle class who were not prepared for retirement. They will have enough to live on, but just not at the same style they were accustomed to. This is a very difficult thing for those people, as we define ourselves within society by our consumption patterns. It's a rather messy political situation.
"This is a very difficult thing for those people, as we define ourselves within society by our consumption patterns. It's a rather messy political situation."Delete
Agreed. I am just annoyed at them and resentful due to my own personal politics mostly. These people have made out like bandits in the UK and they are key Tory voters. The look for bigger better leverage arguably caused 2008 too. After this I will stop clogging up your blog I promise :)
My usual quote:
Most swing voters in marginal seats in the USA, UK, Australia, etc are so-called “aspirational” voters and their aspirations mean mainly two things:
* Ever higher asset prices with ever lower interest rates so the capital gains they enjoy can be cashed in tax-free with cheap remortgages.
* Ever lower wages and reduced rights for workers, because cheap hired help is hard to find today.
This is because neoliberal governments have made speculating on assets, in particular housing property, much more profitable than fighting for better wages and work conditions, and a lot of property owners don’t work or work part time (for example middle aged and older women who got their property via divorce or inheritance).
The numbers are startlingly clear:
"In 2001, the average price of a house was £121,769 and the average salary was £16,557, according to the National Housing Federation. A decade on, the typical price of a property is 94% higher at £236,518, while average wages are up 29% to £21,330"
The above involves a pretty modest two-up-two-down terraced house and middle income people like plumbers, nurses, bookeepers, etc.
That is £12,000 a year of extra tax free income via property capital gains on top of an after-tax income from working of perhaps around £14,000.
These people reckon that no trade union, no raise, no strike, no worker rights could have given them an extra £12,000 a year free case without raising a finger other than to vote smugly for neoliberal parties every several years.
They vote relentlessly for higher property prices for themselves and lower wages for everybody else, especially if they are non-working or retired, and there are plenty of retired people that vote, especially women, both because life expectancies have extended and women traditionally have been able to retire 5 years before men (why?) and live 5-10 years longer than men. These retired people (mostly women and some men) see their property as their main income producer, and the wages of younger workers as a cost.
It is not (just) a story of "evil elites screwing everybody else" - it is a story “F*ck YOU! I got mine” middle class or middle income people voting their wallets as if they were rapacious elites. It is the mass-rentier mindset.
There is a third option: Cash Balance PlansReplyDelete
While these are technically a Defined Benefit plan there are many key differences versus the traditional type you describe.
Thanks, I had not run across this before.Delete
Although I see that there are differences, those differences may matter more to participants in the plan than from the perspective of policy. However, that was my initial impression, and I have missed something.
This comment has been removed by a blog administrator.ReplyDelete