Politics plays an important role in pension reform, and always has ever since Otto Von Bismarck introduced the first old age pension in 1889. Apparently a major motivation for Bismarck’s conservative government to introduce this pension was to reduce the attractiveness of socialism. Maybe the current initiatives are Bismarck phase II.
But it isn’t just the pension reform process that is political. The essential design features of pension plans themselves reveal underlying political philosophies.
Left wing
On the left wing of the spectrum, we have the classic DB plan, a communal arrangement with a pooling of risk and rewards to beneficiaries that are not always commensurate with their contributions. Supporters of DB plans point to the value of a guaranteed pension for life. This is what a retirement arrangement is supposed to provide.
But as with any socialist program, in DB plans there are winners and losers and transfers of wealth. As author George Orwell pointed out in Animal Farm, “Some pigs are more equal than others.” Those who leave the plan subsidize those who stay and the younger members often subsidize the older ones. Many taxpayers working in the private sector are paying higher taxes to fund public sector pensions that are more generous than anything the private-sector taxpayer can ever hope to have.
One of the great dangers of an expanded DB-style Canada Pension Plan (CPP) is the potential for large-scale intergenerational transfers of wealth. It is so much easier to shift our financial burdens onto the next generation than to deal with them responsibly ourselves, and the larger the plan, the more leveraged the transfer of wealth. This is the major problem with DB plans: a disconnect between those who receive the benefit and those who pay the price.
The DB pension is a wonderful concept, but it may never have really been affordable.
A lot of corporations have figured out that the pension plan that once looked affordable when it was small with lots of new entrants and cash flows coming in greatly exceeded cash flows out going out, is now less sustainable now that the fund is large relative to the sponsoring organization, the active membership is declining and the cash flows have a much less significant impact on funding than interest rates and investment returns. So, corporations are shifting to the right end of the spectrum and shifting the responsibility onto individual employees. And even the deep pockets of governments are not boundless; many countries’ aging populations are already resulting in a need to scale back the government-provided pensions.
Right wing
One the right side of the spectrum, we have the rugged individualism of DC plans. What you contribute, and what you can earn on those contributions, is what determines your retirement income. This has the virtue of simplicity. Unlike the CPP and other DB arrangements, employees can understand a DC balance, if not how large the DC balance needs to be to achieve an adequate retirement.
But as with any free market system, there appears to be a need to protect us from the market. The first acknowledged shortcoming of DC plans is a lack of financial literacy. Despite educational sessions and sophisticated planning tools on the website, employees often still need help. Just telling them to “consult your financial planner” does not address the problem. This is like the shepherd telling the sheep to consult a wolf.
The other major shortcoming of DC plans is costs. The agency fees are far too high and high costs mean less money available for benefits. Recent announcements of pooled registered pension plans and voluntary registered savings plans have claimed that these would be lower-cost retirement vehicles. But since the regulatory machinery associated with them would seem to be greater than what is required for a group RRSP, it is unclear why they would be expected to lower the fees being paid by the members.
The group retirement industry is competitive, so transparency is probably the most effective approach to lowering costs, but we really need disclosure in a prescribed form before those members who do not have advanced degrees in financial engineering are able to make an informed comparison between competing products.
All about compromise
In general, a shift to the right of the plan design spectrum may result in a larger disparity between pension haves and have-nots. According to Statistics Canada, in 2005 the median balance in an RRSP was only around $30,000. This won’t fund much retirement.
Pension design—and politics—is the art of compromise. Plan sponsors that attempt to avoid the excesses of being too far left or right on the spectrum, will have still have limitations. But understanding the philosophies implicit in the designs, and the necessary trade-offs entailed in each, is a good first step.