Wednesday Night #1199 – Peter Ratzer & Pension Funds

23 February 2005

The end of an era?
John Peel is turning over in his grave. Hounds may no longer kill the foxes that they have frightened out of their lair in the morning. They may, however, be shot by the hounds’ faithful human companions. This craftily constructed legislation is in the finest British tradition in that it satisfies everyone (with the exception of some hunters), including the anti-cruelty advocates and they Royal family. Aside from the brilliance of this accomplishment, the legislation begs several questions. While admitting that although foxes are, themselves, predators who do not necessarily regret the cruelty imposed by nature on their prey, one must ask whether killing rats or fishing should be considered illegal. Certainly, the use of cats as mousers is analogous to the use of fox-killing dogs, with its implicit human acceptance of protracted killing.

Pension Funds and Social Security Reform
In order to understand more clearly, the complexity of the current world pension fund crisis and predict the outcome of measures taken or proposed to remedy it, a clear definition of the problem, although it may do little or nothing to address possible solutions, may clarify its magnitude.
Pensionable age is not synonymous with retirement age, but is the age at which full benefits are provided. While retirement age may vary with the type of work done (heavy labourers perhaps require an earlier retirement than clerical workers), pension funds must work on the principle of a pre-defined pensionable age.
There are three criteria for any pension plan:
– Coverage
– Adequacy of benefits
– Sustainability of the system

The biggest problem is sustainability, which is difficult to calculate almost a half century in advance, considering the increasing longevity of the human population which was certainly unpredictable, the changing nature and size of the workforce and the unevenness of investment yields. This has led to the recent trend from defined benefit plans to defined contribution plans, which, while providing greater security for the survival of the plan, increases the insecurity of the employee, for whom the burden of ensuring his security has shifted from the pension fund administrator to the accuracy of the crystal ball and the survivability of the employer.
In Canada, if a company goes bankrupt, pension funds are very low in the list of preferred creditors. It would seem reasonable have them satisfied ahead of many other creditors, a move that would be resisted by the banks who are at the head of the list, but would ultimately be accepted by them. In post 9/11 United States, airlines, which have been struggling to survive, have been sloughing off pension liabilities onto the government. As of April, in Great Britain, instead of the government accepting this responsibility, it will raise an annual levy on all pension funds to bridge the gap. This plan has the disadvantage of enabling the bad actors to slough off pension liability to the responsible firms and penalize successful fund administrators.
As human lifespan continues to increase and as the productivity of the workforce rises, the ratio of pension plan contributors to pensioners decreases, as well adding to the sustainability problem. Exacerbated by the current defined contribution philosophy, future pensioners face the uncertainty of an even greater risk of poverty in their old age.
Guaranteed annual income is one suggestion to overcome this problem, but this is a solution that, though acceptable to many countries, has been implemented by few, if any. Other recommendations include selective use of guaranteed income supplement for those whose income falls below a certain level, thus favouring more people who have contributed much during their working life, being guaranteed income, at or not much above the poverty line.
George W. Bush has made Social Security Reform a pillar of his second-term programme, but is encountering some opposition even within his own party. The campaign is already becoming acrimonious with recent attacks on the AARP (American Association of Retired Persons).
The U.S. proposed solution to the Social Security “problem” (there is much debate about the seriousness of the problem, or whether there is indeed one) is to share responsibility for investment in the scheme with citizens who will, presumably, invest a portion of their social contribution privately through the stock market, mutual funds or in other ways. Artisans on both sides of the question invoke models in Sweden, Poland, Singapore (one of the most successful).
Margaret Thatcher had implemented a similar scheme in the United Kingdom, which resulted in a scandalous failure. It is precisely the people who find it difficult to make choices between a multiplicity of options offered, or who will choose immediate reward over future income, or, as in the recent instance of the American Armed Forces, where annuities had had an internal rate of return of between 17.5% and 19.8% when government bonds were yielding 7%, 52% of officers and 92% of enlisted personnel opted for the lump sum.
In the U.K., the Pensions Commission has studied the situation and published its findings before Christmas, 2004. The commission made a very deep analysis of the problem in the U.K., with recommendations to be published next October, coincidentally (perhaps) following elections.
Peter Ratzer noted that the Pensions Commission Report has an interesting section on the insights from behavioural economics into how people make financial decisions on pensions savings. People may recognise that saving is in their best interest, but there is extensive evidence of procrastination, i.e. the decision is always to start saving next year, but when next year arrives the preference is to start the year thereafter.
Another key finding is the power of inertia. People often accept the situation as it is or choose the course of action that requires least decision-making. As an example the commission cites the difference in participation rates in a 401(k) pension saving scheme for two different cohorts of employees in an American firm. When the scheme enrolled people automatically unless they registered a deliberate opt-out, the participation rate was 30% higher, even after 48 months, than when enrolment required an employee to opt-in.
Moreover, people’s decisions on asset allocation are influenced by the options available. The relative number of equity and bond funds that are offered has been shown to influence the decision on the proportions invested in equities and bonds. People also shy away from complexity. More choice can produce more procrastination and research has shown that participation in 401(k) schemes can vary with the number of funds that employees can choose. When only 2 funds were offered the participation rate was 75%, falling to 60% if over 50 alternatives were available. Another finding is that people chase the market and follow fashion.
Perhaps the optimum solution, but one certain to be rejected by a large segment of he population, might be a more generous state pension, given according to need. Means tests usually do not make for a contented electorate. It is evident, however that pensioners will become poorer relative to the rest of society unless taxes and National Insurance contributions devoted to pensions (or savings) increase, or average retirement age rises.
Although the situation is serious, it must be kept in mind that most Canadian pension funds are municipal, provincial or federal. These are funds that do not go bankrupt to the detriment of the pensioners, even when inadequately funded.

The Budget
In Ottawa, the Liberal government has once again acted true to form in the presenting their current budget. Clearly it was a budget designed to ensure the survival of the government while maximizing the probability of re-election, as the benefits kick in largely after the mandate of the current government expires. One element that was greeted with enthusiasm was the immediate elimination of the 30 per cent foreign content rule on RRSPs and pension plans, a move that Wednesday Nighters have been urging for many years. Commentators have all underlined that this is an election budget and as such, it departs from traditional spending commitments for two years and makes commitments for five years, allowing the Finance Minister to make promises to just about everyone.