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Buttonwood's notebook
Economics and pensions
It's not just about costs
Mar 1st 2011, 9:44 by Buttonwood
ONE other point that leaps out from David Cay Johnston's post on pensions reporting is his comparison between DB and DC pensions. He writes that
Traditional or defined benefit pension plans, properly administered, increase economic efficiency, while the newer defined contribution plans have high costs whether done one at a time through Individual Retirement Accounts or in group plans like 401(k)s.
Efficiency means that more of the money workers contribute to their pensions - money that could have been taken as cash wages today - - ends up in the pockets of retirees, not securities dealers, trustees and others who administer and invest the money. Compared to defined benefit pension plans, 401(k) plans are vastly more expensive in investing, administration and other costs.
I am sure, when he reflects on the issue, that Mr Cay Johnston will want to adjust that passage. For clearly, economic efficiency is not just a matter of the costs of administering a pension scheme*. It is also a matter of whether the pension plan encourages labour mobility and encourages people to stay in the workforce for longer, which most experts agree is the best way of dealing with our demography problem.
In a final salary DB scheme, it is very expensive to hire older workers because the cost of funding the last few years is greater. That is not true in DC. Employers have also used their pension funds to offload older workers and cut short-term labour costs. And it is hardly more economically efficient to pay people not to work. According to Alicia Munnell and Steven Sass of the Centre for Retirement Planning in Boston, DC workers tend to work one or two years longer than those in DB plans. The switch from DB to DC in the US private sector is one reason why participation rates for 55-64 year olds has increased since 1990. DB plans also tend to penalise early leavers and more mobile employees since it can be costly and cumbersome to transfer benefits; again a more mobile workforce can increase economic efficiency.
There are other factors. Creating a DB plan in effect turns an employer into a kind of insurance company, having to monitor factors such as longevity and investment risk. Changes in accounting regulations also mean that the funding status of DB plans brings volatility to the corporate balance sheet, Dealing with these issues is, at the very least, a distraction from the business of running the componay and thus hardly conducive to economic efficiency.
Of course, there is a problem with DC in that contributions are not high enough and employees are saddled with the investment risk. But there are a number of possible adjustments, including career-average schemes, notional DC (where the employee gets a degree of certainty in terms of return but the pension is linked to annuity rates, so limiting the employers' longevity risk) and hybrid DB/DC schemes, where a minimum benefit is guaranteed to protect the lower-paid but additional benefits are linked to investment performance.
* This is not an insuperable problem in any case if a low-cost index manager is used. The British NEST scheme is aiming for costs of 50 basis points.
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Your comments mostly apply to final salary DB pensions, not the DB bit.
Tax.com columnist here:
You write "In a final salary DB scheme, it is very expensive to hire older workers because the cost of funding the last few years is greater."
The issue affects both DC and DB plans in terms of equal payouts.
DBs plan typically uses this formula: average of base pay last 5 years x years of employment x payment factor.
BTW, many US employers now have lower factors for new hires. Thus, a worker who is 30 and puts in 15 years (and then leaves for a different job) could cost more than a worker who is 50 and puts in 15 years.
That said, you again conflate.
In any system we can show that there are examples that run counter. For example, DC plans are sold on the basis of compound rates of return, minimizing investment risk in the marketing, and they are therefore not so great for older workers, either, since the compounding timeline is shorter.
So the same problem confronts a DB plan -- less time for compounding, which raises contribution costs for the employer.
Risk is shifted to the worker in a DC plan, who must both save more and then save a reserve, least he run out of money. That reduces current consumption more than a DB plan.
Of course there is an insurance aspect to a DB plan. That is where art of its efficiency comes in. You run the risk that you may die early and get less, but you also eliminate the risk that you will run out of money if you live a long time. These are factors that can be properly accounted for, as demonstrated by the sale every day of individual defined benefit pensions known as annuities.
Or does Buttonwood think that calculating future values is not science, but magic or, as critics of market economics contend, a sophisticated Ponzi scheme?
My essential point, per Adam Smith, is that specialization increases overall wealth. Expecting janitors and even school teachers and homicide detectives to have the skill to invest as well as professional investment managers is as foolish as thinking each of us to make our own pins and cars, computers and medical diagnosis.
And its Johnston; Cay is a middle name.
Couple of additional points - and Mr. Johnston, I regularly read your stuff and enjoy it:
1. There is a funding issue when you switch types of plans. This can be big $$. The private sector has been dealing with this for many years. It isn't a pain free, cost less transition.
2. My understanding is that Illinois, which has a real funding problem, some 24% is from early retirement offered by the state to prune the workforce. (About 54% is the legislature not putting in money.) This was a choice by the state. If they switch to a DC system and they want to offer incentives, that will still cost a lot of money, except that now that money will be more real, meaning actual cash rather than raiding the fund's future expectations.
I personally favor DC plans but mostly because DB plans don't cap pensions so we have a system where there is massive incentive for anyone covered - from politicians to managers to individual workers - to game the system to raise pension payouts (which then go on and on and on). In Boston, for example, the firefighters run a racket in which they fill in at a higher pay grade for a day and then retire, with their pension being based on that 1 day's pay grade. We have legislators who get pensions from the state and from some town where they worked for a hours a week. We have administrators who are able to roll all sorts of benefits into their salary calculation for pension determination.
For all of these and more, public unions play a small role. Most of the problem is the legislators are the beneficiaries of the same system so they feather their own nests and those of their fellows, families and friends. Actual fear of unions is small. In fact, the mayor of Boston has for years carried out a public feud against the firefighters union about their contract and he could be mayor for life if he chose despite their picketing and endorsement of other candidates.
Yes, there is an investment risk with DC plans, but there is an inflation risk with private sector DB plans. Of what use is it to a retiree to have a guaranteed $1000/month, if it will take $1000 to buy one loaf of bread in the future? No small consideration when food is up 25% in one year, and starving mobs are marching on the oil fields.