Occupy defined-benefit pension funds!

By Felix Salmon
April 19, 2012
The Occupy Handbook, your excellent one-stop shop for analysis of the financial crisis and everything about it.

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I’m working my way through The Occupy Handbook, your excellent one-stop shop for analysis of the financial crisis and everything about it. A lot of really big names have pieces here: among the authors you’ll find Michael Lewis, Paul Krugman, Gillian Tett, John Cassidy, Raghuram Rajan, Bethany McLean, Daron Acemoglu, Carmen Reinhart, David Graeber, Nouriel Roubini, Pankaj Mishra, Ariel Dorfman, Barbara Ehrenreich, Peter Diamond, Brad DeLong, Martin Wolf, Scott Turow, Robert Reich, David Cay Johnston, Eliot Spitzer, Lawrence Weschler, Tyler Cowen, Jeff Madrick, Dan Gross, Jeff Sachs, and even Paul Volcker. (Full disclosure: I’m in there too.)

One author who might not be familiar to a financial audience is Arjun Appadurai, who has an excellent short chapter entitled “A Nation of Business Junkies”.
“Business news was a specialized affair in the late 1960s,” he writes. “Now it is hard to find anything but business as the topic of news in all media.”

He explains:

Look at the serious talk shows, and chances are that you will find a CEO describing what’s good about his company, what’s bad about the government, and how to read his company’s stock prices…

Turn to the newspapers and things get worse. Any reader of the New York Times will find it hard to get away from the business machine. Start with the lead section, and stories about Obama’s economic plans, mad Republican proposals about taxes, the euro crisis, and the latest bank scandal will assault you… Turn to the sports section: it is littered with talk of franchises, salaries, trades, owner antics, stadium projects, and more. I need hardly say anything about the Business section itself, which has now become virtually redundant…

Go through the magazines when you take a flight to Detroit or Mumbai, and there is again a feast of news geared to the “business traveler”. This is when I catch up on how to negotiate the best deal, why this is the time to buy gold, and what software and hardware to use when I make my next presentation to General Electric.

I thought of Appadurai’s chapter earlier today when I was talking to a fund manager at a conference in DC. He was talking about the move from defined-benefit to defined-contribution pension plans, and was bemoaning the fact that people who invest in defined-contribution plans have seen returns not only below the returns in the stock market or the bond market, but even below the level of inflation. The solution, he said, was more education: we had to teach people about the power of diversification, the intelligence of passive investing, and so on and so forth.

My feeling was that such attempts would never work. The investment returns of people with defined-contribution pensions are woefully low — much lower than the returns seen by the managers of defined-benefit schemes. And the difference, to a first approximation, is rents being extracted by the financial-services industry. That’s the industry which does all of the educating: so it’s unrealistic to assume that it’s going to educate people and thereby reduce its own income.

Besides, as Appadurai says, the US population has never been more educated about matters financial than it is now. We can try to improve the level of education even further. But a little financial education can be a dangerous thing, if it instils overconfidence. And what’s more, there’s zero empirical evidence that educated investors have higher realized returns. Besides, you can’t hope to effectively educate everybody.

Much better, I think, to allow people to invest alongside the defined-benefit scheme of their employer, and accept the returns of that scheme. Most employers still have some kind of legacy defined-benefit scheme, and those schemes, as a rule, tend to be invested pretty sensibly. Those pension funds should accept defined-contribution money alongside their defined-benefit money: it would beef up their AUM and thereby their negotiating power, while at the same time delivering higher returns to the company’s employees.

Some employees, of course, will think that they are very clever and will be able to get large returns for themselves. But most of us aren’t that hubristic, and consider asset-allocation decisions and the like to be something of a chore. Give us the opportunity to outsource those decisions to somebody acting on our behalf, and we’ll jump at it. We might not get the same implied returns as the lucky people on defined-benefit plans. But at least we’ll have our money professionally managed, at little or no cost.

21 comments

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Mr Market not a winning move there. Here in Australia we have some quite large (and growing) defined contribution schemes. The key to keeping returns up – they are member owned and non-profit entities (industry funds).

From today, more about governance issues.
“According to industry data, industry funds returned 1.8 per cent in the year to the end of February, just below a return of 2.2 per cent for retail master trusts. Over three years, the retail trusts returned 10.5 per cent and industry funds returned 9 per cent.

However, longer-term statistics still favour the not-for-profit funds (that’s industry funds and government funds, basically). They turned their heavier ownership of unlisted assets including property and infrastructure into an average return of 6.2 per cent a year over the past eight years, comfortably above an average return of 4.6 per cent for the retail funds management sect

Read more: http://www.brisbanetimes.com.au/business  /shorten-push-leaves-industry-super-fun ds-between-rock-and-hard-place-20120418- 1x7jz.html#ixzz1sSZxsAzs

Posted by tqft | Report as abusive

Do they have the article from David Graeber where he mangles how the Fed works? Or maybe his story about how Apple was founded by ex-IBMers working on laptops? Or maybe his story about how the work for debt comes from some other root than obligation in the languages of other major religions[they don't]? Or maybe his incorrect history of bimetallism?

Has it got Paul Krugman’s brilliant idea to use cash as collateral for loans?

As for pension funds they are consistently amongst the worst investors on the planet, usually the last to leap on the bandwagon. Exactly who do you think was driving the demand for higher-yielding highly rated paper during the bubble? The only advantage that they have over retail is that they can hide their losses over time due to the duration of their liabilities.

Posted by Danny_Black | Report as abusive

Danny_Black, the advantage that pension funds have over individual investors is that a significant number of individual investors bail out of markets at the worst possible time. Not clear to me how Felix’ plan would change this?

Also, I think he confuses business *reporting* with business *education*. We would be better off with less of the former, and a system for the latter that doesn’t depend on the brokerages that profit off ignorance.

Posted by TFF | Report as abusive

TFF, I would also argue that people are not any more financially educated than before. There is more business news but far far lower quality. I would estimate that over 90% is worthless. One of the great things about Mr Salmon is he posts the original documents.

Pension funds also bail out and dive in. The actual fund managers are usually selected for a year up to three and so are required to show short term “performance” vs the long term they have to recognise any cash losses so are perfect targets for accounting scams.

Posted by Danny_Black | Report as abusive

That why I come here, Danny_Black! Original material and comments from smart people to help me understand them.

I’m not sold on the “intelligence of passive investing”. Passive investors are effectively allocating their funds alongside the active investors who control the price levels — but much of the money in the market is out looking for a quick buck. Do I really want my investments sharing in that?

My stock picks aren’t perfect, and they might or might not beat the market in the long run, but they WILL avoid bubbles. Quite easily done if you aren’t passive.

Posted by TFF | Report as abusive

“Most employers still have some kind of legacy defined-benefit scheme.”

Really? Weird. I’ve never worked at such an employer in the private sector (though I’ve worked for governments which pretty much all do). Per BLS only 10% of private establishments offer defined benefit plans (http://www.bls.gov/ncs/ebs/benefits/201 1/ownership/private/table01a.pdf) though of course that doesn’t address the legacy question; I don’t know where to find that stat.

More generally hoping to piggyback on the performance of something that won’t exist in 20 years just strikes me as problematic. Even if most employers really do have legacy defined benefit plans now, eventually they won’t, and then what?

Posted by msl46 | Report as abusive

“The investment returns of people with defined-contribution pensions are woefully low — much lower than the returns seen by the managers of defined-benefit schemes. And the difference, to a first approximation, is rents being extracted by the financial-services industry.”

I’m under the impression that the returns to DC plans are low mainly because with most 401Ks the default option is (still) a money market plan, and a plurality of DC participants never get beyond the default. So the problem is not rents extracted by the industry, but rather risk aversion (or ignorance) by participants. That’s also an argument for DB plans, but a different one – DB plans function more like insurance, as risk sharing mechanisms. (As well as effectively a forced savings mechanism.)

Posted by FosterBoondog | Report as abusive

I think that the biggest issue with this is that a lot of legacy defined benefit plans, especially ones that are frozen (no benefit accruals), are moving towards a derisking strategy where the target is to be fully invested in bonds that match the bond duration to the duration of the plan’s liabilities. For plans that are not completely frozen but are closed to new entrants, this may make sense, but most plans are completely frozen or moving in that direction.

Posted by jaronherad | Report as abusive

One of the enduring myths about the US stock market is that returns were great until the 00′s, when we had the lost decade.

I’ve done a lot of historical research involving prices in the 60′s and 70′s, and there have always been periods when the stock market would perform badly for a number of years. Bear markets can endure much longer than many think. The bull market of the 80′s and 90′s was mainly due to lower interest rates pushing up P/E’s.

Over a very long time period, such as 10 years, stocks almost always do outperform bonds. The equity premium adds up to a substantial number *if* the investor spreads out their buy and sell orders over a long time span.

The only thing defined-benefit funds have over defined-contribution funds is that investment managers are graded on relative performance. Both DB funds and hedge funds lose money in transaction costs vs. unmanaged funds. But unlike many DC investors who buy and sell at the absolute wrong times, they stay totally invested in the stock market at all times.

Posted by mwwaters | Report as abusive

I really despair of the average person being able make good investment decisions. I consider myself barely literate in this respect even though I’ve been reading the WSJ (and now Financial Times) and following business news for several decades. That didn’t stop me from doing some very foolish things with my own money during the tech bubble. For the most part, I’m now invested in idex funds.

How does the average person even begin to know how to invest for their retirement in a defined-contribution fund? What percentage of the population really understand what a bond is, and how price and yield are connected? Who do they turn to for advice, how much will the advisers charge? I looked over a friend’s 401(k) investments and thought that he was being overcharged for bad investments while paying his “financial advisor” a very hefty percentage. Although a professional who was college educated, he stayed with his plan because he knew nothing about investing.

At the extreme, San Diego is looking to move from defined-benefit to defined-contribution for new hires. Yet the city withdrew from the Social Security program long ago. In retirement, all the pensioners will have to live on will be what they have put away in their defined-contribution plans. One hopes the new employees will have monster investing skills.

Posted by Parabolica | Report as abusive

Parabolica, I believe that if San Diego eliminates their defined-benefit plan then they will be required to rejoin Social Security.

Otherwise, you make some excellent points!

Posted by TFF | Report as abusive

Probably fair to say that most Fortune 500-sized employers still have at least a legacy defined benefit scheme, though, agreeing with msl46, that number approaches 0 for smaller businesses and large businesses founded in the past few decades. I’m sure someone will correct me if I’m wrong, but I’d be really surprised to find defined benefit plans at Dell, Cisco, or Google. We therefore could set this up for some workers, but far from all.

I think that employers using clout to negotiate lower fees on defined contribution plans is likely a better path to success than this defined benefit plan idea, which has a variety of structural and practical complications.

If I participate, am I allowed to withdraw my funds at any time? If so, as other commenters have noted, we’re then back to the problem of individuals hurting their returns by selling low and buying high. Also, many DB plans invest in part in illiquid assets – real estate, private equity, timber, etc. – so large withdrawals during a downturn would dramatically change asset allocation percentages. A large part of how DB plans operate is based on the fact that the payments they’ll be making are fairly predictable, at least over the near to medium term.

Also, as an individual I probably don’t want to keep the same asset allocation over my lifespan, which is implicitly what I’m doing if I put my money alongside a DB plan. When I’m young, I want an equities heavy allocation, and I then should transition gradually to a fixed income heavy allocation as I age.

Posted by realist50 | Report as abusive

http://alephblog.com/2012/03/27/replacin g-defined-contributions/

Felix, I agree — replace DC plans with DB plans, but then get the actuarial profession to create better funding standards that pre-fund plans, and then get the IRS to call off the dogs when it reduces tax revenue.

Posted by DavidMerkel | Report as abusive

A nice alternative, DavidMerkel.

Much of my animosity to DB plans stems from my years in the public schools. It was funded primarily by an 11% employee contribution, and benefits were calculated on years, age, and final salary. Seems like a reasonable deal, no?

Except in my case, I started late (too many years of education) and knew that I wanted to take some years off to raise my family. Had I remained in the system, I would not have received credit for the investment returns from that decade. Nor could I have received Social Security benefits (paid on self-employment and outside income throughout the years).

Moreover, I would have been trapped in the job well into my 60s. Was that a commitment that I wanted to make at the age of 35? Instead I left the system, received my contributions back (with just a paltry 2% interest added), and invested them on my own.

Traditional pension plans are a trap for all involved. Your alternative sounds much more fair, much more flexible.

Posted by TFF | Report as abusive

It is not a choice. Employers do not want to be in the pension business, though they are happy to exploit the idea of pension plans to achieve various ends.

Please feel free to correct me, as I recall it;

20 or so years ago the great evil afflicting employers was the defined-contribution pension. It seemed that because that pensions were being well managed, they were accumulating stunning amounts of money. Seemingly, they were more profitable than the companies that were contributing to them.

The great crime then, was that if allowed to continue, defined-contribution pensions could end up paying beneficiaries far in excess of the pathetic amounts originally envisioned, when that money could be used for something much better right now.

See, those pathetic fixed payments were really all that employers morally owed, and the defined contributions were resulting in over funded pension plans, and that was just terrible. Well, that situation was remedied.

That was how we got to the criminally generous defined benefit pension of today.

Posted by somecomputerguy | Report as abusive

Expanding on Danny_Black’s point, I’ll also state, without having read any of this collection, that removing Spitzer’s contribution from it would be addition by subtraction. (Correction – unless it involves lessons learned on how to avoid law enforcement when hiring escorts. I’m willing to acknowledge that Spitzer should be an authority on that topic.)

Regarding Appadurai’s point, there may be more business news, but most of it is written by reporters who are woefully uneducated in business, economics, and accounting. WSJ, the Economist, and the FT are almost always high quality. There are other pockets of educated media – some NYT business coverage, especially Dealbook and certain feature writers such as Bethany McLean. I often don’t agree with Felix’s conclusions, but I’ll admit that he’s generally knowledgeable about business, finance, and economics topics. Most business journalists, never mind general or political journalists, aren’t very knowledgeable on business or economics topics, though. I’m amazed by the number of times that I see reporters write “balance sheet” when they mean “income statement”.

Posted by realist50 | Report as abusive

realist50, there also seems to be a difference between what some people write in books and what they write in their day jobs as newspaper journalists. McLean is a case in point, she co-wrote one of the best books, IMO, on the financial crisis and also on Enron but her newspaper articles are usually awful. I think it is a different competitive landscape and different approach to fact checking.

Posted by Danny_Black | Report as abusive

Expand social security ?

Posted by -To- | Report as abusive

It’s “free lunch” time again, at OWS and right here.

Everybody loves DB plans and the guarantee of future investment returns implicit in them. That “tail risk” has been the ruin of more companies than one can count – think AMR, Delta, GM, the entire steel industry to name just a few. That’s why we need the PBGC – to clean up the wreckage when these plans fall to pieces. At the end of the day, it’s taxpayers who have to underwite too much of the promised benefits.

DC plans aren’t any better in concept, but at least they don’t imply promises they can’t keep.

Posted by MrRFox | Report as abusive

Perhaps the GM pension fund should spin itself off and offer closed-end fund shares, both for purchase (in some fashion) by GM employees and for investors on the stock market in general.

Posted by dWj | Report as abusive

dWj, if they were to do so, would you trust them with your money?

Posted by TFF | Report as abusive