In Search of the Perfect Pension

Naked Capitalism guest-blogger Leo Kovilakis continues to blog up a storm on the problems of state pensions.  He aptly points out all the risks of a defined-contribution plan.  But in my opinion, he doesn't go nearly far enough.

Kovilakis says:

Someone wrote me that defined-contributions are the future and that "people must assume responsibility for their financial health as well as their physical health. We cannot expect the government to take on such responsibilities because that is not the way evolution (real world) works."

But as I have written before, the shift to define-contribution (DC) plans is not the solution. Most people cannot deal with the stress of investing their own money or selecting between funds that are offered to them. It is important that people start doing their own due diligence and build up some knowledge on investments, but the reality is that most individuals cannot handle these responsibilities.

This is why I recommend we scrap private pensions altogether and create several large public defined-benefit plans that are capped at a certain size. These funds would follow the highest standards of governance and they would be managed by professional money managers whose interests are aligned with their stakeholders and pension beneficiaries.

In my opinion, this ignores the 800 pound gorilla in the room:  pensions never work very well.  Not for individuals, not for companies, not for the government.  Predictions are hard, especially about the future--and predicting what you'll need forty years off is a fairly unhealthy activity.  Who knew my English degree would actually turn out to be an investment good rather than a consumption good?

Everyone is very good at picking out the flaws in the pension systems they don't like.  Basically, there are three entities who can save for your future:

1. You
2. Some company
3. The government

Liberals are very good at pointing out why you are not very good at saving for your future:  you are not an actuarial universe.  If you make the mistake, as my mother did, of retiring into the teeth of a financial crisis, you will find your life savings sadly depleted.  Also, since you probably have some skill other than being a professional financial planner, you may make stupid decisions, and/or get bullyragged into one by a dishonest broker.

Liberals tend to prefer "your company" to "you", but many recognize that companies are also problematic, because if something goes wrong with the pension fund, employees can be left with . . . well, if not "nothing", certainly "a lot less than they expected".  Sound financial planning dictates that your retirement and your paycheck should not both be dependent on a single company--which is why everyone tells you not to put your 401 (k) into your company's stock. 

That's why we need the government to save for us!  Conservatives have this taped:  the government is also terrible at saving.

The idea that the government can handle pensions for those who lost money in a financial crisis has a major problem:  in financial crises, all correlations go to one.  GM's pension fund isn't in trouble because the managers were venal or stupid; their management seems (at least from the thin information available) to have been a model of sensible financial theory.  The problem is, the price of virtually every financial asset except US Treasury debt has plummeted.

Would a government fund be any better?  Er . . . look at the state of state pension funds.  They're often worse, because the private pension funds (now) have the government to sit on them and make sure their assets bear at least a theoretical relationship to their eventual liabilities.  The government is rather too inclined to cut itself slack on that necessity.

Of course, maybe we should just have people pay out of current tax dollars.  That avoids the asset problem, but introduces another one.  Remember, in a financial crisis, all correlations go to one.  That means tax revenues, too.  Any potential source of funding for retirement will be severely undercut by a financial crisis.

And a PAYGO system (which is what we call this sort of tax-payer financed quasi-transparent Ponzi scheme) just ups the government's incentive to promise now and figure out how to deliver later.  When you are supposed to be accumulating assets to cover your liabilities, you are at least forced to assess the cost of new liabilities against the political benefits of new promises.  With PAYGO . . . well, anything paygoes, as it were.  That's why all the changes to Social Security and Medicare go in one direction:  increasing them.

PAYGO also provides the illusion of saving without the actual saving.  Private saving (in which category I include government pension funds) gets invested.  PAYGO receipts are lent to the government and fund current consumption.  Some of those sums are at least arguably spent on things that make the economy more productive, and thus make us better able to pay benefits in the future . . . but when you look at most of what government revenues are spent on, it is not possible to argue that this is true in aggregate.  Benefits for retirees and aircraft carriers may be morally wonderful, but they do not much boost our productivity.

That means that, as we're now seeing with state pension funds, there's a risk that someday, some peoples' benefits will have to be cut--which means that we will have encouraged people to save less than they ideally would, if they hadn't been expecting better health care or pension benefits.

There is no entity that is capable of ensuring that everyone can consume a serene twenty or thirty years of leisure at the end of their lives.  And we may be making people worse off by pretending that there is.    Perhaps instead of looking for a magic system, we could seek a more flexible and ad-hoc approach--abolishing state pensions, say, and rolling them into a more generous disability benefit.

That's not politically possible, of course.  What is politically possible is grinding along this path until the problem becomes too big to fix.