Thinking About Pensions, Part 2

In part 1, I went through some of the history of defined benefit [DB] pensions using a Q&A format. I’m going to continue that in part 2.

Q: What are we supposed to do about pension policy in the US then?

A: Let me start with a quotation from an old article of mine, Replacing Defined Contributions.

Pension plan reform has to face three realities.  The first is people don’t know how much to put away for retirement.  I’ll give you a hint: for almost all people, it should be over 10% of your gross pay.  The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply.  The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.  This is usually an option only for defined benefit [DB] plans.

It would be nice if we could give everyone a DB plan, but as I pointed out last time, the costs would be too high.  DC [Defined Contribution] plans are inexpensive enough, but they have the above three flaws.

Q: How could we get people and firms to save more for retirement?

A: I’m not sure you can.  Present needs are large for many people, and they can’t imagine saving anything over 3%, much less 10%+ of pay.  Firms could do more, but it would raise costs, unless it is taken out of other benefits or wages.

Q: Why not “nudge” people to save more — create something that shows how far they are behind their most prudent peers?

A: Think about high school for a moment.  It’s a very peer conscious part of life for many people.  How well would an appeal go over asking the bulk of students to behave well, like the best-behaved students in the class?

Q: It might affect a few, but for the most part people are set in their ways.  They’ve already done their own implicit comparisons, and concluded that they are doing well enough relative to the peers they care about, given the circumstances.  They also might not like the comparison and say something like, “Fine for them, but I have different realities in my life.”

A: Right.  Effects should be small.

Q: Why not force people to save 10% of their pay then?

A: I think that treats adults like kids.  If they don’t want to save, let them be.  They might regret it later, or, they might say, “This is my lot in life.  I have to take care of what I think is important now, and when I am old, I’ll work if I have to.”  Also, people have an incredible ability to ignore reality if they need to.

Q: But isn’t there a public policy reason to encourage retirement plans and savings?

A: Most politicians think so, but retirement is a modern concept that with longer lifespans may not make sense in every situation.  The generation that fought WWII had a unique situation that allowed many of them to retire very comfortably that we don’t have now.  Productivity increases were larger, the demographics were right, global labor competition was a lot lower, and investment returns were a lot better.

You could look at my piece, Ancient and Modern: The Retirement Tripod for more on this.  As it is, it will be difficult to take care of the Baby Boomers to the same degree that their parents were taken care of — it doesn’t matter how you fund it — it is a humongous claim on GDP, and what will be left for those who are younger?

Q: So, you argue for freedom to choose in contributions, but you don’t argue for it in investing or distributions?

A: Uh, yes.  The main difference is that I think most people are capable of estimating their tradeoff of money now versus money in the future, and they are implicitly saying they don’t want to retire, regardless of what they say explicitly.

On investing, most people do not know what to do, and I would strip down most DC plans down to a small bunch of blended funds managed by professionals getting paid at low institutional rates.  There would be at most five funds, ranging from conservative to aggressive, with a default option that adjusts which fund a participant is in based on age.

On distributions, no one, not even professionals, are good at managing a lump sum of money to provide a stream of income.  Dig the ten reasons for that in this article.  People are capable of budgeting, so give them a fixed or slowly rising income to live off of, while investing their slack assets to cover future increases in costs.

Q: It seems inconsistent to me.

A: I’m just trying to be realistic about what people are capable of doing, and what their needs are.

Q: Why not have the government do the investing, or invest all pension monies in government debt?

I don’t think it is wise to entrust so much of the investing in the economy to a single entity.  Backdoor socialism is a real risk here.  Nor is it wise to fund the government via pensions.  Note how well the government did with Social Security.  It would be one thing if the government had used the money to improve infrastructure, but the money was generally spent on current consumption.

Q: The CFA Institute has put out their own plans for an Ideal Retirement System.  Wouldn’t that be a good idea?

A: When I was a kid, one of my friends would say to me, “If wishes were fishes, we’d all have a big fry.”  Like giving everyone a strong DB plan — it fails the cost test.  You could start doing this for a new group of retirees that would retire in the 2060s and beyond, but it is unrealistic for the present cohorts looking to retire sooner that have not saved enough individually or corporately.

Q: This is pretty dour.  Don’t you have anything encouraging to say here?

A: I would note that elderly people tend to be happier than younger people.  Some of it is coming to terms with life, grasping that many of the things that we aimed for when we were younger weren’t worth it, and taking some satisfaction in what good you have in the present.  It’s not all money based, but certainly money helps.  Some will look back at the past and say they did what was best for all their responsibilities.  Others may regret missed opportunities.

There may be some good that comes out of the American tendency toward voluntarism.  Who knows what elderly Baby Boomers might do when they put their mind to it?  Hopefully it won’t be voting more money for themselves from the public purse.

Q: Any final advice?

A: You are you own best guardian of your own retirement.  I encourage you to:

  • Save what you can.  This is one factor you can control.
  • Invest prudently, keeping fees low.  Don’t let yourself give into greed or fear.
  • Use immediate annuities to provide a minimum amount of income, and other assets for growth.
  • Make sure that you have younger friends to watch out for you.  Every older person needs advocates that can watch out for their best interests.