Con Keating; vi har råd med förmånsbestämda pensioner

The idea that occupational defined benefit pensions are unaffordable has gained currency in the past decade, but is a misconception. Unfortunately, based on this belief, employees are now offered poor simulacra which are grossly inadequate and unsustainable – simply not fit for purpose. Inchoate concepts such as “Defined Ambition” and defined contribution savings arrangements, including the much promoted NEST, are symptoms, not resolutions of the problem. We risk creating a substantial and influential new voting class of grey discontents, and with that, irresistible pressures on public finances.

We are enjoying longer, healthier retirement, but these increases in lifespan, and related pension cost, have been far lower than increases in our productive output, in all but the most recent years. The longevity cost increase is simply far too small to explain the explosion of costs faced by employers. Over the past twenty years, the real cost of DB pension provision has risen approximately 75%, while employer real contribution costs have risen by more than 300%. The explanation for this lies in the unique convergence of accounting, regulation and financial management for pension schemes and their associated pension cost.

With the near-total melt-down of popular trust and confidence in financial institutions, it is hardly surprising that the fund management industry has recently come under widespread and vociferous criticism over its costs and their transparency. This appears incidentally to have acquired some political currency. However, there is a much more fundamental problem.

This is not the criticism that the behaviour of financial intermediaries, insiders, has been rent-seeking at the expense of the savers and users of capital, though there is ample evidence of that reprehensible behaviour. It is the criticism that they are managing for the short-term. The Kay review is required reading in this context.

There is a longstanding conundrum in empirical economics. Portfolio performance is dominated by asset allocation, to which more than 80% of returns and their volatility may be attributed. This is the short-term view; it is transactional rather than relational in nature. In this framework, portfolio investment returns are empirically unrelated to economic performance. Price action is all-important and the asset management game reduces to the beauty parade of Keynes, in which managers are trying to outguess all others’ actions rather than looking to any economic or financial fundamentals. Risk in this world is principally endogenous, a game against others; it is risk of our own creation.

 In this short-term view the “hedging” of price risks is a key management action, though often requires perverse behaviour such as the purchase of assets as their price rises.  To reduce this to its pathological extreme, we need only to note that the only perfect hedge of a financial asset is its sale, which of course, converts the asset held to cash, and prompts the question: how is that compatible with investment in any sense?

In the long-term, investment performance is dominated by income and its growth, and price is almost entirely incidental, accounting for less than 5% of the total returns achieved. The absolute insignificance of the price element merits emphasis; over the past hundred or more years it is a return of just 0.1% p.a. Yet this is where fund management attention is overwhelmingly focussed. In the long term risks are predominantly exogenous; the problem a game against nature, not others.

This distinction between the long and the short-term might not matter if the sequence of optimal short-term results yielded the optimal long-term, but it doesn’t. The aspect of particular concern is that under a short-term approach, many viable and productive long-term projects will not get financed. Perversely, pursuit of the short term optimal will lead to lower total investment, less specialisation in production, fewer gains from trade and lower output; the total returns from a short-term market will be lower than from the long-term. Those pursuing passive indexation, in avoidance of the imposts of financial intermediaries, are nonetheless accepting an abject second best.

Regrettably, it is unlikely, for a number of reasons, that fund managers will adjust their business model for pension funds in the near future. Setting aside their short-term interests, the accounting and regulation for pensions are both firmly rooted in this short-term, speculative worldview. They are all conditioned by the ‘freshwater’ economics of efficient financial markets. Perhaps the only positive of the recent crisis is that this theory is now totally discredited. Pension accounting and regulation inappropriately impose and emphasise the very same short-term, but it is unlikely that the standards-setters, supervisors and regulators will rapidly, or graciously, recognise and correct their mistakes – in large part because they were its architects. There may though be hope: The Netherlands, Finland, Denmark, Sweden and the United States have all abandoned ‘freshwater’ fundamentalism in recent times.

Pensions are incomes in retirement, cash-flows over time. The savings to finance them are accumulated over time. They should be managed as such; they should certainly not be managed through the distorting lens of point-in-time, imprecise, estimated present values and current market-prices.

Economically a pension is a claim on future production; it is appropriate and efficient that employers, as producers, should compensate their employees, in part, with pensions based upon their service. However, when we introduce regulations and funding requirements which raise the cost of provision well beyond the benefits to employees, it is rational for companies to cease provision. There are now many disincentives to employer provision of occupational pensions, and absolutely no incentives.

While the problems of legacy funded occupational schemes appear intractable in the absence of change, there is a simple solution for the future. This is the book-reserve occupational DB scheme. In common usage, it is unfunded. It avoids entirely the costs of financial intermediation. It avoids all dependence upon financial markets. It offers incentives to the corporate sponsor for provision, since it lowers working capital requirements. It may become a material and highly predictable source of capital for companies, reducing their dependence upon banking relations. It provides the employee with both the comfort and reality of a pension. It introduces a degree of mutuality to the workplace relationship, with employees, management and shareholders having an interest in the long-term health and success of the firm.

Such book-reserve schemes are well-known elsewhere in Europe. In Germany many attribute the growth of the Mittelstand and the post-war ‘Wirtschaftwunder’ to this source of capital funding.

The problem of sponsor insolvency which prompted the regulation which has smothered funded defined benefit schemes can be resolved by pension indemnity assurance. This is simply insurance of the pension scheme against the consequence of sponsor insolvency, payment of the pensions when due after the event of sponsor insolvency. This is not another government sponsored mutual compensation scheme with many sunk costs and extremely marginal benefits which mindlessly apes the risk management practices of the investment banking community. It is commercial private sector insurance, which prices and provides for the long-term risks it faces.  It may even be described as corporate life assurance. The costs of such insurance are far less than the costs of fund management, as has been proved the case in Sweden.

This requires no tax incentives. Book-reserve pensions are taxable when paid to the individual and deductible as expenses to the employer company at that time. In fact, all that this form of pension requires of government is inaction.


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