Pensions

Should defined benefit schemes exist at all?

Pension legislation exists to encourage people to save for their retirement. Although they are considered the "gold standard" pension, defined contribution or Final Salary schemes have some serious drawbacks. They are a risk to company stability, now the unfunded pension liabilities appear on the balance sheet. As they represent an obligation for someone else to meet, for decades, they could cost wages and jobs to existing employees, potentially putting businesses under, if actuarial calculations are wrong. This is why there are few remaining in the private sector which are open to new employees. They also create perverse incentives to the employed. Defined benefit schemes are the reason we've got mandatory retirement ages and other outrages against individual liberty. People stay in professions - the military and the Civil Service are particularly prone, in order to accumulate pension entitlement. This is rent seeking rather than adding value, preventing people's redeployment to other, more productive areas.

Defined benefit Pension funds are forced to buy fixed income assets especially at times of high volatility in order to match assets to liability. This forces pension funds to eschew their best investment weapon: their long time horizon. As many trustees use a capital asset pricing model, which equates volatility with risk, they are forced to sell equities in favour of fixed income at times when the former may offer best value. There is one major problem with the volatility-based measure of risk. It's bollocks. Thus when shares look most risky (i.e. now), the spreads on bonds goes up, and the yield available on them goes down. The pension fund is forced to reduce the return on its investment, by selling equities and buying bonds. In addition individuals and institutions which are genuinely risk averse are denied proper returns because of the inverted yield curve caused by unnatural, legislation-mandated demand for long-dated gilts. The fact this enables the government to borrow cheaply at the expense of investors and pensioners of course, has nothing to do with it....

Financial products based on the direct ownership of assets, which have the virtue of simplicity are typically the ones which survive financial crises. Any product which involves gearing, capital protection or financial engineering, there's usually some risk you've not considered. Defined benefit schemes are no different.

The Defined benefit pension is a big risk to the Pensioner, who is betting on the company he worked for and the competence of the trustees they appoint. If you've worked for a company for decades and rely on its pension when you retire, what happens to your income if the company goes bust, or the pension fund is badly managed: You become poor, unless the fund is fully funded and the actuaries have made no mistake. What about positive investment returns? You've no upside! The pensioner endures total risk and excess returns are spent by the company who enjoy "payment holidays". In money purchase schemes, so long as you don't make funding commitments based on investment returns (eg stop funding if your fund is doing well or panic when the market falls and stop funding) you are very unlikely to be left destitute. This is especially true if there were no legally enforceable retirement ages. If your income will be insufficient when you retire, you should be able to work for another year, reducing the cost of an annuity and increasing the funding available. Of course the legislation allows firms to fire at will over 65 so at present this simple solution is unavailable to most.

On a grand scheme, the entire country faces a huge unfunded public sector pension liability which is to be met by future tax-payers. Gee thanks, baby boomers! First we need to allow those who wish to work longer to do so, then we need to scrap the civil service superannuation scheme. But before we do that, we need to strip MPs of their gold plated pension, so they face the same shit as everyone else. This is a boil which needs to be lanced, now.