Get big or die trying
Finding a better way to deliver pensions
Nov 23rd 2013
PENSION funds have had a pretty good 2013: rising share prices and higher bond yields have reduced their funding deficits. Nevertheless, the combined strains of volatile markets and improved longevity are causing the industry to have a rethink, as a World Bank conference in Cape Town revealed this week.
Some funds in the Dutch system, long regarded as among the best in the world, have been forced to cut benefits to pensioners because of funding shortfalls. In Canada, the Ontario Teachers’ Pension Plan, often praised for its sophistication, has had to reduce inflation protection for workers who retired after 2009—a cut in pensioners’ real incomes.
These reductions reflect how seriously the Dutch and Canadian systems regard the issue of pension funding and the problem of inter-generational transfer. A pension scheme that is not fully funded implicitly depends on future workers and taxpayers to make up the shortfall.
Other systems have dealt with higher pension costs in different ways. Companies in America and Britain have shifted new employees away from defined-benefit schemes (in which retirement income is linked to final salaries) to defined-contribution ones (in which all the risk falls on the employee).
The American public sector has disguised the pension problem by optimistically assuming that nominal returns of 7.5-8% can be achieved in a world of low inflation and low interest rates. European public sectors have pay-as-you-go pension systems where the full costs are not made clear in the national accounts.
Although many pension experts accept that defined-benefit plans are too expensive, they worry that defined-contribution schemes are a lottery for employees. A worker who retired in 2000 when markets were buoyant would have ended up with a much bigger pension than one who retired in late 2008, after the collapse of Lehman Brothers.
So there has been talk in recent years of a middle way. The term of the moment is “defined ambition”, a phrase dreamed up by one of the doyens of the industry, Keith Ambachtsheer of the Rotman International Centre for Pension Management. (At 71, the sprightly Mr Ambachtsheer is a walking advertisement for the benefits of a prolonged career.) Steve Webb, Britain’s pensions minister, has just started a consultation on what a British defined-ambition pension might look like.
The underlying idea is that the best may have been the enemy of the good in pension reform. Early corporate pensions were little more than a vague promise, but over time governments tried to enhance workers’ rights, adding protections from inflation, benefits for spouses and safeguards for early leavers. These extras added significantly to the cost and so hastened the demise of final-salary schemes in the corporate sector.
Many workers might trade some of the extra benefits for a degree of certainty that they can keep the heating on in old age—an assurance not offered by defined-contribution schemes. The calculations are made more complex by the interaction between the state pension (usually available to all citizens) and occupational retirement plans. The more that fiscally constrained governments chip away at state schemes, the more workers will rely on their occupational benefits to reach a decent level of retirement income.
One version of defined ambition, which attempts to give workers some certainty, is a “notional” defined-contribution plan. Under such schemes (already in operation in Sweden and Latvia), each worker has an account and can see the likely level of future benefits; in some cases, a certain minimum level of benefits will be guaranteed, but additional payments will be subject to the financial health of the schemes, changes in longevity and so on.
Such schemes are easier to run on a large scale, and have so far been adopted solely by governments. The problem for any system that involves a guaranteed income is, first, that it is only as good as the guarantor and, second, that long-term guarantees are expensive. If occupational pensions are to be provided in future, they may have to be delivered by industry-wide schemes that can achieve the scale to control costs and manage risks. Indeed, that has been the trend in the Netherlands and Australia.
It is a historical oddity that pensions have been delivered by individual businesses, which are otherwise devoted to serving customers and making widgets. Pension provision needs to be left to the specialists.