In Defence of DB Pensions
It is unfortunate that the extensive collection of articles on pensions, published in December’s FW, repeated only too many of the canards, errors and incomplete analyses that have plagued the subject. The reality is that pensions broadly as formerly envisaged are sustainable and affordable.
A pension is a claim on future production. The increasing longevity and ageing of our society has been associated with increasing production, and greater affordability of pensions, from the industrial revolution onwards. In particular, this holds true for the baby-boom generation. Since 1981, UK GDP has doubled while life expectation has increased by just 6% – living standards at all ages have increased.
Simple dependency ratios are misleading; they fail to consider the quality, the human capital, of the labour force and the increasing capital intensity of smaller working cohorts.
We are spending far longer in retirement; since 1981 the expected time in retirement, a basic measure of pension costs, has increased by 53%, less than half the increase in GDP. There is no affordability problem. The issue is one of distribution between the retired and working generations.
There are two ways in which redistribution of production may be unquestionably achieved – state intervention and ownership of the capital productively employed by the working generation.
Recall that there are only two forms of claim on future production which are in positive net supply – private sector equity and government debt. The state and private sector firms can make direct commitments on their future production. This is actually the principal rationale for employment-based pension provision, rather than the more usually cited behavioural aspect that we tend to save from what’s-left-over, leading to inadequate savings given our preference for jam today.
Saving, of course, is self-provision for future redistribution; investment in equity and government debt. The declines in household savings rates are lamentable, but it should be noted that, in the developed world, these declines have been largely offset by increased corporate saving. The hope for increased household savings faces headwinds of ageing in the developed world and increased consumption in the emerging economies.
The declines in real rates of investment return since the early 1970s have been driven by lower global investment demand, which has fallen by twice as much as aggregate savings. With far higher demand for investment from the emerging economies, in productive capacity, infrastructure andeven residential housing, real returns should rise markedly over the coming decades, further ameliorating the pension position.
It is often said that DC arrangements are more appropriate than DB for an increasingly mobile labour force. On closer examination this appears suspect, since over the period when this mobility trend has been evident the share of capital in production has been increasing in most of the developed world; in other words labour’s negotiating position has weakened and periods of unemployment widely experienced.
An open collective DB scheme is designed to reduce dependence upon financial markets; the contributions of current employees and investment income pay much or even all of the pensions of retired members. It is a highly efficient risk-sharing and pooling mechanism, benefiting both employee and employer. It greatly simplifies the game. DC, by contrast, leaves all risk with the individual. The game is complex, partly against nature but overwhelmingly against others. This is grossly inefficient; to produce the same retirement income as DB, a DC arrangement requires contributions at least 50% higher.
The widely-held belief that pensions are unsustainable and unaffordable has some very questionable foundations. If DB schemes are now unaffordable, and the rate of closure of these schemes would suggest that the corporate sector widely believes this, then the source of the problem is not the economics of ageing, consumption or investment, but the deadweight costs of regulation, including the accounting. The alternate, DC, is appallingly inefficient, so much so that there is actually a case for the subsidy of DB provision, which contrasts starkly with the demonising, penalising regulation of recent times. To date the analysis of pensions has been woefully inadequate and grossly misleading in result.
Con Keating Head of Research BrightonRock Group