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The false promise of private pensions

J Bradford DeLong is Professor of Economics at the University of California at Berkeley and a former Assistant US Treasury Secretary. His first article on Webdiary was Semi-rational exuberance. This article from the Project Syndicate's Anatomy of the Global Economy series, whilst focussing on th US pension programs, makes some broad claims about 'rich countries', and I am hoping can be a springboard for an important debate about the issues of pensions  for the growing number of retiring workers in our own country. Hamish Alcorn.

by J Bradford DeLong

One of the strangest claims made in the debates about social insurance now roiling the world’s richest countries is the that government-funded defined-benefit pension programs (such as America’s Social Security system) are outmoded. These programs were fine, the argument goes, for the industrial economy of the Great Depression and the post-World War II generation, but they have become obsolete in today’s high-tech, networked, post-industrial economy.

Advocates of this argument propose a different model. Just as corporations today are much happier supporting workers’ pensions by contributing to employees’ private accounts, so governments today should offer (or require) contributions to privately owned accounts. The value of these accounts would fluctuate with the market rather than resting on a defined-benefit scheme that guarantees a fixed real sum of resources available upon retirement.

This argument is strange because it gets the economics of the situation backward. When there are lots of companies offering workers long-term defined-benefit retirement pensions, there are fewer advantages to the government in setting up a parallel defined-benefit scheme and requiring workers to participate in it. After all, in such a world, workers who set great value on a defined-benefit pension can go to work for firms that offer such pensions.

The major benefits that arise from the government’s requiring that workers also participate in a national Social Security system accrue to those workers who really ought to value a defined-benefit pension highly but have not been able to figure out what their true preferences are. They also accrue to relatively poor workers who lack the bargaining power to induce bosses to offer the pensions they really want – and need.

But there aren’t a lot of companies today that are willing to offer long-term defined-benefit pension schemes. One reason is that companies nowadays are much more aware of their own long-run fragility than they were in the post-World War II decades. Not even America’s IBM – which prides itself on stability – wants to take the risk of offering defined-benefit schemes.

The risk from defined-benefit pensions used to be offset by two benefits for companies that offered them. First, the fact that leaving the company usually meant cashing in one’s pension at a discount increased worker loyalty. Second, complaisant accountants’ optimistic assumptions about returns on pension reserves, together with large firms’ greater risk-bearing capacity, brightened the financial picture that companies could report to investors.

Today, the risks are seen to be much greater, and the benefits are seen to be less. As a result, an ever-smaller slice of employers are offering anything like defined-benefit pensions.

This fall-off in private defined-benefit pensions all across the rich core of the world economy is a bad thing, because the configuration of asset prices suggests that young and middle-aged workers value defined-benefit pensions extremely highly. Historically, the gap between expected returns on low-risk assets like government or investment-grade bonds and high-risk assets like stocks and real estate has been very high. To some degree, as economists like Harvard’s Robert Barro and mathematicians like Benoit Mandelbrot argue, this may be because high-risk investments are in reality much more risky than the theories and math of standard finance techniques suggest.

In my opinion, at least, this is partly because the memory of years like 1930 and 2000, when stocks performed very badly, occupies too large a place in investors’ minds. Workers and other asset holders place a very high value on safety, security, and predictability, so a defined-benefit pension plan is extremely valuable.

But in today’s world, only national governments are large enough to be able to do so with any assurance that the pension assets will actually be there when workers retire. I am enough of a social democrat to believe that if there is an economic service or benefit that citizens value extremely highly and that only the government can provide, then the government should provide it.

We economists know that there are many drawbacks to expanding government beyond its basic role of providing true public goods like defense, public safety, and justice, as well as providing citizens with incentives to counterbalance the effects of true market failures. If the private market has the flexibility of two hands, government bureaucracy has at best two thumbs.

But the collection of payroll taxes from tens of millions of workers and the writing of tens of millions of pension checks is the kind of routine, semi-automatic task that government can do well. With private companies backing away from defined-benefit programs, it is even more important and valuable that government do it in our post-industrial network-age society than it was in the past.

Copyright: Project Syndicate, 2006.


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Trite but true

The financial (self-promoting) guru Robert Kyosaki, Rich Dad, Poor Dad, has many interesting things to say about the switch from defined benefit pension schemes to the self-funded 401k (superannuation to us Aussies) that relies on stockmarket performance.

 In the US, 12,000 mutual fund companies (read, superannuation managers) are underpinning the value of the current stock market. That is more managers than there are stocks. So what is really driving up stock prices, the real value of performing companies or the relentless search by fund managers to find a place to park their (nominal) billions?

By 2013, all the baby-boomers will be in retirement. Millions of them will want their pensions cashed in. In the US it is mandatory to do so otherwise there is a significant tax penalty. What will underpin our crazy, never-ending stockmarket boom when all these people exit the stockmarket?

The operative word, I believe, is BOOM, like "blow up in your face".

Private vs Govt. Savings

Hamish, it is unfortunate that Prof. Delong has not gone to the trouble of mentioning the size of accrued under-funding of the current social security system in the US.

Combined with their massive current account and budget deficits and an on balance sheet debt of USD8 Trillion I would not want to trust their or any govt. for my future from a state run system.

One only has to look at the increasing price of commodities and an increasing wariness of overseas creditors to hold US t bills to realise that inflation will be the only way that they will be able to pay their liabilities.

What this means for people on fixed pensions will be a steady decline in their standard of living.

It would be interesting to know where Prof. Delong holds his investments - in real or govt. assets such as T bills.

And another thing, through history fiat currencies have always reverted to their inherent value.

vanishing pension

There are some things that government should be able to do better than private enterprise and pensions are one of them.

Last week I visited an old friend in the country who has retired from the largest suburban newspaper chain in Sydney. Her husband still works there but is due for retirement in 2 years. He and fewer than 10 other employees are the last that company will have who will receive funds to live on from the company's past well-funded retirement scheme. All new workers have now been hired on AWA's for a maximum of 2 years with few benefits but no superannuation. This change has been happening long before Howard's IR changes and this newspaper chain is the most profitable sector of the owner's world wide empire.

We discussed how  the youngest workers don't really see a problem with these short term contracts as they perceive it frees them to change to other employment areas. Yet while the media may be expanding and gaining more power, its opportunities for jobs are rapidly shrinking. Sadly the young, as is so often the case, do not think of the far future when they may be too old to work. Pensions are a far distant thought and that's why government has a responsibility to provide a scheme that will protect all citizens and if necessary co-opt private business to share that responsibility.

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