Falling Short

More and more people are speculating on their retirement income, even though they may not know it. According to Watson Wyatt, an actuarial consultancy, the amount of money that is saved in defined-contribution (or money-purchase) schemes worldwide will overtake the amount of money in defined-benefit (or final-salary) schemes by 2014.

For a lot of people, this is going to be a problem. In a defined-contribution (DC) scheme, the eventual pension depends on the investment performance of the fund that the employee has paid into—and he takes the risk of poor investment performance. By contrast, defined-benefit (DB) schemes promise employees a retirement income based on their pay and length of service. The employer takes the risk.

But an even bigger problem is that the level of contributions from both employers and employees into DC schemes is lower than it is into DB schemes. Whatever the arguments about the merits of the new wave of schemes, if you put less money in, you will get less money out. To make the shortfall worse, the costs of running DC schemes are, on average, higher. And finally, DC pensions call for a degree of decision-making that their members are often ill-equipped to undertake. As a recent paper* published by Britain's Pensions Institute points out: for "financial products extending over long periods of time, many consumers are clearly not well-informed or well-educated. The retirement-savings decision needs accurate forecasts of lifetime earnings, asset returns, interest rates, tax rates, inflation and longevity; yet very few people have the skills to produce such forecasts."

The result may be that many employees face retirement with an income well short of their expectations. An employee who pays into a DC scheme for 40 years may get only half the retirement income he could have expected under a final-salary system. When pension experts were polled by Watson Wyatt their biggest concern was that DC schemes will yield inadequate pensions for DC members. As the Pensions Institute paper says: "When the plan member eventually discovers how low his pension really is, it is by then too late to do anything about it."

If pension incomes are too small, employers will face the problem that their older, and usually more expensive, workers are unwilling or unable to retire; firing them may not be an option in places such as Britain, that have laws against age discrimination. Even when employees do retire with a decent pot of money, many countries, including America, Germany and Australia, do not require the pensioner to convert those savings into an annuity. That creates the risk that the pensioner will outlive his savings, prompting him to fall back on the mercy of the state. Indeed, the evidence suggests that employees are not good at estimating how long they are likely to live.

Whatever the flaws of DC schemes, the world—or at least the private sector—is not about to return to DB plans. Companies introduced DB plans after the second world war as a benefit for employees—sometimes as a way of heading off demands for higher wages.

Initially, the costs of this promise were manageable, largely because companies could decide whether to raise the pension of someone in retirement. Steadily, however, the promise of a DB pension became more expensive. For example, British schemes were forced to protect employees against the ravages of inflation. Longer lives also added to the burden.

The bull market of 1982-2000 disguised this, as investment returns outpaced the rise in pension liabilities for a long while. But the cost eventually came to seem intolerable, because of a combination of the bear market of 2000-03, falling interest rates, and a change to accounting standards, which asked firms to report the annual change in their pensions burden.

DC schemes have been around for 30 years or so, and were at first widely used by the self-employed and small businesses. Such schemes promise nothing. Although employers usually contribute to them, they do not have to top up the fund if its returns are disappointing.

DB or not DB

Enthusiasts for DC pensions argued that the investment risk was at least partly offset, since a DC member avoided the "credit risk"—that the company would go bust before fully funding its pension plan. However, in Britain and America credit risk is less of a factor these days, since insurance schemes now protect employees from the bankruptcy of the sponsoring company. And changes to DB rules have reduced the penalties on early leavers (albeit at the price of making the schemes more costly to run, and thus more likely to be closed).

Nevertheless, there is a strong argument that companies should not be offering DB schemes. Since the schemes require companies to take bets on the financial markets, it turns firms into quasi-hedge funds and distracts them from their core business. The DC approach allows businesses to stick to their knitting.

In addition, DC pensions arguably suit a modern economy better. Final-salary pensions tended to penalise early leavers and reward "time servers" who spend all their careers at a single firm. Instead, workers should be encouraged to be mobile, taking their pension rights with them every time they move. A study by Richard Hinz of America's Department of Labour found that, because of employment patterns, DB plans were actually more risky for employees than DC ones are.

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