Pension Funds: a never ending saga

This is Joseph.

It is worth noting that pension plans are always going to be a regulated industry.  There is a huge amount of trust in giving somebody money now and expecting it back (with interest and earnings) in 30 years.  If you do a truly private firm, then there is a concern about outright theft.  If you do a government overseen hybrid model, it appears that things can also go wrong:

Why is this becoming a big issue now? Because for its first 35 years, when it was being hailed as a free-market miracle, not many people were actually retiring. Now they are, and it turns out their pensions are pretty paltry. If net returns had been closer to the 8 percent retirees deserved, their pensions would be three times higher. Fees like this are basically legalized theft.

I think Kevin Drum is a bit bombastic in his conclusions here. but it is easy to see how there can be a lot of wealth extraction.  After all, a 401(k) plan has a management fee and then invests in instruments (like mutual funds) that also have management fees.  It's easy to see how these layers can add up, even before one considers the possibility of investing in a hedge fund with both management and performance fees.

That is why I am interested in options like social security.  Governments have political risk (they can cut benefits or be destroyed by war) but they have the longevity to make these types of commitments.  Governments do best in the face of issues like collective action problems and social insurance, and saving for retirement has features of both of these problems. 

California Pension Reform

I have always had a fascination with California politics and we've talked a lot about personal finance. So I read this reform proposed by Jerry Brown with interest:

To deal with what have been widely seen as abuses of the retirement system, Mr. Brown said the pensions of all new employees should be based solely on their regular salaries, not taking into account any overtime or bonuses. For existing employees, he said the retirement benefits should be based on an average of the last three years’ salary.

I was always surprised that it was any other way. After all, employee base salary is a reasonably predictable variable for actuaries. Furthermore, base salary is likely to be more representative of the income that actually needs to be replaced in retirement and inflating that number can lead to very high liabilities. Finally, it creates the potential for unfairness as the ability to get overtime in one's final three years may depend on the discretion of the supervisor.

I am completely against the current assault on pensions but that doesn't mean that we shouldn't look for places where intelligent reforms can happen.

All in all, it seems like a much saner approach. We'll see if it manages to gain any traction!

Alternatives to Social Security

Matthew Ygelesias tackles the difficult question of what is the alternative to a government run universal pension plan. After all, if we want to replace the current system of government run pensions then it makes sense to have an alternative.

The results are pretty dismal.

So where else does the money come from? Well:

— Defined benefit pensions.
— Labor income.
— Private savings.

These three alternatives are all deeply problematic. The problems with defined benefit pensions in the public sector (chronic underfunding, etc.) are well-known, and in the private sector those problems are even more severe. Labor income is not a realistic option for people over a certain age. And private savings are, frankly, a disaster. As a country, we’ve tried to deal with the decline of defined benefit pensions by encouraging the mass middle class to engage in private retirement savings with 401(k) plans, IRAs, etc. And it doesn’t work. On the one hand, people don’t save enough. On the second hand, the tax policy is deeply regressive. On the third hand, virtually 100 percent of the management fees extracted from customers through these vehicles are value-destroying rents. On the fourth hand, it’s extraordinarily difficult for a middle class person to properly diversify his portfolio. And on the fifth hand, widespread ownership of index funds and mutual funds undermines corporate governance.

I think the drawbacks to the first two approaches are well known. But the concerns about the government savings vehicles are very thought provoking. Instead of a single (fatal objection), like the first two options, he lists a series of smaller problems that add up to a big issue. That being said, the issue of people not saving enough is always a concern.

I'd say that there is one more issue, though, that we should consider. Older adults are more easily subject to fraud on the part of either third parties or their money managers. It's not always clear that they have strong advocates. So even if people saved enough, the third option has the sixth downside of being vulnerable to theft in a way that pensions and labor income are not.