The social benefit of pension funds

By Felix Salmon
December 29, 2011
Matt Yglesias is, I think, very wrong about this:

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Matt Yglesias is, I think, very wrong about this:

The idea that a mass market of retail investors ineptly attempting to maintain a balanced diverse portfolio serves a useful role in steering capital to productive uses doesn’t pass the laugh test.

Not only does it pass the laugh test: it’s the driving idea behind capital markets. You take a large mass of inept investors — call them noise traders, or dumb money, or whatever you like — and watch as they do silly things, often lose money, and nearly always underperform some simple buy-and-hold strategy. Then sprinkle in some smart investors and arbitrageurs and the like, who make markets vaguely efficient and help with price discovery. The effect is a market where people feel safe stashing millions of dollars, and where companies can raise billions in equity and debt.

The point here is that you don’t need the noise traders to be smart or efficient in order to make markets work; their role is basically to provide the fuel for the fire. It’s the companies and entrepreneurs who light the match, add value, and create economic growth.

And the more efficient a market is, the dumber investors can be while still making near-optimal returns.

Yglesias has an alternative, of course. Basically, retail investors pay more in social-security taxes, leaving less money left over for savings; that money gets put into some form of federally-insured savings account where it can be used on a rainy day or maybe Christmas. The government takes on the job of insuring all those savings at 100 cents on the dollar, and of guaranteeing a comfortable retirement from Social Security.

Now I’m a great believer in the government offering defined-benefit pensions to its own employees. But there’s a difference between Social Security and defined-benefit pensions: pension funds can and do invest in anything they like, while the Social Security trust fund invests only in Treasury Securities, nearly all of which currently trade at a negative real yield.

The point here is that pension plans can do something that Social Security can’t: they can invest in the future growth of the economy, rather than just paying out pensions to the elderly and maybe buying a few Treasury bonds, at the margin, so long as the plan is still cashflow positive.

There’s another reason, too, why individual pensions are a great idea: they don’t suffer from the kind of maturity mismatch that’s endemic to most of the rest of the financial world. I can invest my pension-plan money with a 20-year time horizon, because I’m not going to be retired for another 20 years. (And even once I’m retired, I’m not just going to liquidate everything and go to cash.) By contrast, the people putting money in a savings account until Christmas literally measure their time horizon in months. Banks take that money and lend it out for much more than a few months, of course — it’s called maturity transformation, and it’s basically a good thing. But it’s also dangerous, and needs careful hedging and insurance and risk management.

And banks do much more than simple maturity transformation: they’re involved in what Steve Waldman calls a mutually-beneficial con. (Go read his post, by the way, it’s fabulous. Chris Hayes says it “may be the most thought-provoking post I’ve read all year”.) Banks create all manner of opacity and complexity just so that everybody thinks that he’s not bearing any risk; as a result, they can end up putting on risk trades that none of us would really have any appetite for on our own.

Except, that is, perhaps, in our ultra-long-term retirement accounts.

Pension plans are the one part of the financial world where risk appetite is real, and doesn’t have to be covered up with financial opacity and complexity. Let’s build them up, rather than try to marginalize them by constructing an ever-growing welfare state. “No firm is nearly as big or durable as the entire United States of America”, says Yglesias, quite rightly. But if there’s one thing we’ve all learned this year, it’s that even the United States of America isn’t risk-free. And the bigger its entitlement programs get, the bigger the amount of sovereign risk there is in the US.

By radically expanding Social Security, you would be making it riskier, at exactly a point in time at which it’s generating negative real returns. And that can’t be sensible. Right now, thankfully, there’s an enormous amount of demand for Treasury securities coming from all over the world. Let’s embrace that demand, and use it to fund our present expenditures. But let’s not kid ourselves that Treasury bonds are a smart investment over a retirement-style time horizon.


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The thing is nobody, even the best academics, has a good idea of the ultra-long term risks (Pastor & Stambaugh “Are stocks less volatile in the long run?”), simply because we only have that kind of data on one market (the US) and a very specific history (the XXth cenetury). Balanced portfolios are all well and good, but when it gets down to actually compute what mix they should be balanced on for the long run, it’s much more tricky for pros, never mind for individuals.

Posted by Th.M | Report as abusive


Spot on.

Moreover, government pension schemes and social security systems have their own legislative risks.

Many countries across Europe currently have generous social security pension systems. Most are funded on a pay as you go basis. The implicit liabilities of these schemes are not accounted for in most measures of national debt. So it is very difficult for voters to know whether a politicians pension and social security policies are sustainable or affordable.

If circumstances change, if life expectancy increases, or expected future growth falls, politicians rarely have sufficient support to make changes to ensure these social security systems are sustainable. E.g. in Italy it took an unelected economist to deindex pensions.

Does Yglesias believe that US politicians are that much more responsible and able to make difficult decisions than Italian or Spanish politicians?

Private pension plans provide a much stronger signal to investors if expected future growth falls, 401ks plummet, investors have to save more for retirement.

Under a government guaranteed scheme this signal is muted at best, so workers continue to consume too much of their current income and save too little, and politicians are loath to raise taxes, especially if there has been a negative shock to growth. This continues until bond market analysts start to raise concerns about the solvency of the state. At which point it’s too late.

Posted by Asdasdasd.. | Report as abusive

Yes, yes and yes. But. I followed through on the suggested links (and then some), and it strikes me the various discussions assume a ‘closed end’ model, where all investors wish to exit simultaneously? Sensible banks take a portfolio approach to fundraising, and also assume some churn in their investor base (notwithstanding occasional runs), but there is a wider bribe paid (through return or structure or both), to ensure some stability in the investor base. Just as you rightly mention that all retirees don’t convert to cash, you forget there is a constant supply of ‘entry investors’, whose horizon is 20years + 1 day and so on. N’est pas?

Posted by Troyboy | Report as abusive

Agree with the general point re: SS vs. pension funds.
Disagree w/ the interfluidity article tho’. I submit that there is a different equilibrium available too – the one that goes something like “in a world of honest people, the lone criminal will make a killing”. The point being that the very opacity that is provided by banks is easily subverted into a different type of opacity, viz, where it is used to deliberately defraud people.
In essence, it doesnt matter how well intentioned Finance may be, somewhere there is going to be an Evil Bastard who reasons that
a) There is a ton of money available here
b) Nobody amongst the sheep really knows whats going on
b) I can bend our internal rules (if there are any!) and make a killing
Once he (or she) has made a killing, others will look at this outcome, and realize that they are underperforming. In essence, there is an all new equilibrium that develops around extending the opacity into a globally non-optimal equilibrium, i.e, one where Finance is operating for the Greater Good And Glory of Finance, and not of the economy. (Sound familiar? It should…)

Posted by dieswaytoofast | Report as abusive

Great idea, the u.s. can start a sovereign wealth fund to fund future solyndras or which ever industry is favored by political insiders in Washington. And since we’ve learned that congressman outperform the rest of us in their stock selections this initiative can’t help but succeed(tongue in cheek)

Posted by Sechel | Report as abusive

Exactly right, Felix. The “dumb money” serves as fodder for the “smart money”. Thus having plenty of dumb money around creates very attractive opportunities for the smart money to exploit.

The stock market these days is like sloshing water around a bathtub, and only the “dumb money” pretends that it is impossible to tell at which point in the slosh the wave spills over the edge.

I agree that in an efficient market, the dumb money would achieve near-optimal returns. But it is blatantly obvious that the stock market has not been efficient over the past five years. Movements are highly volatile and highly correlated — as I said, water sloshing in a bathtub. Wait until that settles down before you preach market efficiency.

Posted by TFF | Report as abusive

nice post, felix, especially this:

“And the more efficient a market is, the dumber investors can be while still making near-optimal returns.”

Posted by KidDynamite | Report as abusive

Arguments for pension funds:
* Leaves the investment decisions to the professionals.
* Access to alternative investments for diversification.
* Actuarial amortization allows lifetime benefits with a much narrower safety margin.
* They could potentially hold whatever investments promise the greatest long-term return, paying benefits from a combination of inflows and dividends. No need to hold large amounts of low-yielding cash in retirement.

Arguments against pension funds:
* As typically constructed, they lock you into a specific job for a specific number of years. It is easy for a non-teacher to blather about “cushy teacher pensions” that reach 80% after just 30-35 years, but most people wouldn’t last one year in a classroom let alone surviving into their 60s.
* The “professionals” in charge of managing pension funds are typically better at charging fees than at managing your money. They index the majority of the fund assets at fixed percentages (you and I could do the same more cheaply), and farm out the remainder to other highly-compensated professionals.
* You cannot design a defined-benefit pension system without a guaranteeing agency. Moreover, unless you begin from reasonable assumptions, that guarantee might end up being ridiculously expensive (i.e. a wealth transfer from the guarantors to the pension beneficiaries). Last I checked, the Massachusetts pension fund was calculated based on an 8.25% annual return (after fees). I figure the stock market is good for 7% annual returns, the bond market for 4% annual returns. So how the heck does that average out to 8.25%?!?
* Cronyism and corruption. Put together massive amounts of money, controlled by politicians, and you are simply inviting plunder of the public purse.

Posted by TFF | Report as abusive

I think you’re mistaken about the relative societal advantages of Social Security and pension plans. A key consideration you’ve neglected is that the Treasury investments of SS displace private sector funding of the same US gov’t financing. Also, the payout design of SS effectively ties the “investors” in SS (US employees) to the overall performance of the US economy, since the payments are indexed to average wages. So as the economy becomes more productive, SS payouts rise. Over the very long run this is going to be roughly equivalent to payouts tied to investments that perform in line with economic growth per capita.

Meanwhile, pensions have agency problems (because the corporate pension funders and managers want to minimize the cost), and have to be kept in line by regulations of limited reach and effectiveness. Witness the current straits of the PBGC, most recently dented by the AMR bankruptcy.

Posted by FosterBoondog | Report as abusive

I’m not sure that there really is appetite for risk in long-term retirement plans. There is appetite for return, and, I believe, people accept the concurrent risk in large part because they’ve been assured that, in the long term, markets always go up.

There is appetite for risk in retirement plans as long as the markets go up. When markets go down, that appetite for risk will quickly disappear, and the clamor for government-guaranteed pensions will be deafening.

I would point out the converse of your statement: Social Security can do something that pension plans can’t, namely guarantee, really guarantee, a benefit that is not subject to market risk and is backstopped by the US government’s power to tax.

That’s not to say that I agree with Yglesias that typical people shouldn’t have to invest. Pension plans can do what Social Security can’t. Social Security can do what pension plans can’t. Why not stay with our current, hybrid retirement system? A guaranteed minimum benefit funded by tax dollars, with a wide array of market-based investment options for those who (wisely) want more than their Social Security income in retirement?

Posted by arthropod | Report as abusive

The problem with this explanation is that a greater supply of “dumb money” actually makes the market less efficient, leaving greater opportunities for the smart money to exploit. This works against the average person achieving “optimal returns” and often means a direct transfer of wealth from mom and pop retirement savers to clever prop traders, hedge funders, etc., not to mention all of the people skimming fees off the top. I suppose all this “fuels the fire” of economic growth inasmuch as inflated IPO prices provide companies with more capital, but if you really believe in any kind of efficient market theory than you should consider that capital to be poorly allocated.

Posted by Jboy609 | Report as abusive

I vote with Yglesias on this one. Robert Shiller has made the point that as a society, we can’t all do better, as whole, outside of Social Security, which is directly tied to GDP growth. I read Felix’s rant here as a disguised variant of the ‘replace SS with private accounts to promote growth and make us all rich’ school of thought. The economics of that position have been debunked by Shiller and others.

Posted by maynardGkeynes | Report as abusive

I thought that the point of Yglesias is that everyone should pay higher social security taxes, but the government wouldn’t save it, or try to invest it. The government would pay it out in higher benefits to current retirees.

Posted by C-Ealy | Report as abusive

Much agreed with C-Ealy and maynardGkeyes. The performance mismatch between defined benefit pensions only emerges when Social Security receipts are re-invested in treasuries, rather than paid out as benefits.

I realize this puts me in an odd position, since this is, of course, currently exactly what happens. But it probably shouldn’t be! Social Security is a transfer program, and it should be implemented and judged on those merits. That means good things for its finances and performance, since the upper limit of a transfer program is the growth of the underlying economy. But it’s generally bad politics, because people see it as another form of welfare. Which, really, it is.

To put it more simply: Social Security will always lag pension performance if money is literally stowed in long-dated US treasuries. It will generally hold its own when current tax receipts are paid out in current benefits.

Posted by strawman | Report as abusive

Pension funds work well in a society where lifetime emplyment can be expected. We had a short golden age of that post WW II until the 1980s.

Ultimately, a government funded “bond” like Social Security combined with personal tax-deferred defined contribution savings with some reasonable percentage of portable employer contributions as well as employee contributions is probably optimum. That allows for megration of jobs and careers over time which is necessary to allow for “creative destruction” to keep the economy efficient.

The biggest single issue with a program like this is that “fiduciary duties” include allowing high-fee investments to be required in the plans. Long-term good glide path target date funds or reasonably well balanced funds (like Vanguard LifeStrategy Moderate Growth) have provided good long-term returns in a variety of markets. These can be passive (Vanguard) or active (T.Rowe Price) as long as they are relatively low cost (typically less than 0.75%/yr). these types of investing vehicles provide for a cariety of bonds and equities, including US-based and international to provide additional diversification.

During crises, all correlations seem to go to 1.0 but these are very short duration and don’t necessarily impact a low rate of withdrawlas over a period of several decades. Ultimately, there is always some percentage of probability of total societal collapse (Russia 1917, Zimbabwe 2000s etc.) but the only defence against that is hoarded food, gold and jewelry, and weaponry. any financial instruments that are paper or electronic may come out of that with no value.

Posted by ErnieD | Report as abusive

Social Security does invest in the economy in that it takes in a share of all wages up to a certain level. When the economy is doing well, it takes in more money, just as a shareholder might, if he or she is very lucky, might get a bigger dividend if a company does well. By eliminating worries about one’s old age, Social Security encourages entrepreneurial efforts that might interfere with pension vesting or even a regular income stream while the business gets going. In fact, even higher Social Security taxes combined with higher benefits might result in a business formation boom which would be supported by the higher incomes of the retired. It sounds win-win to me, though not enough billionaires will get a piece of the action, so it will never happen.

Posted by spiffy76 | Report as abusive

I agree with Yglesias and Fosterboondog. SS is not just investing in Treasuries–it’s mainly a system by which younger citizens’ taxes pay for older citizens’ benefits. And for most Americans, SS is pretty much all they have. By all means, let’s expand it!

Posted by colburn | Report as abusive

Two bad fallacies don’t make a whole, Felix. First, there is no benefit to society of having a large number of 401(k) investors fleeced by the smart money. That encourages bad behavior – think Cramer-style manipulation, and further concentrates wealth by making the thousands of smart money people richer and impoverishing millions of honest hardworking people. Efficient markets come from sophisticated investors will good information making reasonable bets.

Second, beefing up pensions would be great – and only the government can do it, and only the government can do it for private employees, because the private sector in the US has proven that it will not do it. So government-sponsored private pension schemes a la Chile make sense – as a supplement to Social Security.

Posted by Dollared | Report as abusive

“So government-sponsored private pension schemes a la Chile make sense – as a supplement to Social Security.”

Nice idea, Dollared. Could you explain how Chile’s system is structured? And who bears the cost if investment returns fall short?

Posted by TFF | Report as abusive

Hi TFF, the Chilean privatised, self-drected old age pension system was designed by the Chicago Boys to perform in Chile the equivalent function of US’ social security sytem. It hasn’t worked well in that role, as it has been expensive and returns have not been great. Surprise, surprise, the Magical Free Market fails again. With those attributes, it has failed in its role as a replacement for the basic income floor role played by Social Security.

But as a model for a second tier of old age pensions (call it the lifestyle preservation layer of old age pensions), a system of semi-private pensions with carefully regulated administrative expenses and limited self-directed investment options might make some sense.

Posted by Dollared | Report as abusive

Dollared, my own research turned up the same comments of “expensive” and “not that great returns”, which is why I was a bit puzzled by your suggestion.

As for your “lifestyle preservation layer”, how would that be different from the present 401k system? Tighter regulation of expenses? More strictly limited options? An automatic annuitization of the balance?

One possibility would be to force everybody to choose from a handful of “target date” funds, essentially the model emphasized in the 529 plans that I’ve seen. I’m not personally thrilled with that model — it is possible to do much better. But it is also possible to do much worse, so I can understand why this might be sensible public policy.

Perhaps centralize the 401k plans, taking the administration aspect away from the employers? Introduce some competition to help keep costs down?

Posted by TFF | Report as abusive

A révkomáromi tanár október végén jelentette be, hogy a szlovák mellé felvette a magyar állampolgárságot is. Miután nem tett eleget annak a felszólításnak, hogy önként mondjon le szlovák állampolgárságáról, a városi hivatal lakosság-nyilvántartó osztálya telefonon közölte vele: utasítást kaptak rá, hogy töröljék a nyilvántartásból.

Az állampolgárságától megfosztott 99 éves asszony mellett tüntettek Rimaszombatban
Magyar állampolgársága miatt veszítette el a szlovákot egy révkomáromi férfi
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Újabb szlovákiai magyar közölte, hogy a magyar állampolgárság felvétele miatt a hivatalok személyi iratai leadására szólították fel. A Hí szlovákiai magyar hírportál információi szerint Fehér István révkomáromi tanár október végén Nyitrán jelentette be, hogy felvette a magyar állampolgárságot. Később az illetékes hivatal levélben közölte vele, hogy elveszíti szlovák állampolgárságát, és arra kérték, hogy töltse ki a mellékelt nyomtatványt, melyben lemond szlovák állampolgárságáról.
Ezek a magyarok őshonos magyarok. Ez a terület Magyarországhoz tartozott és elvették tőlük igazságtalanul. Jogvédők ez diszkrimináció!

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