The fact of the global pension crisis is not news: across the globe, there has been ample media attention to the impact of demographics, a prolonged low interest rate environment, disappointing investment returns, and political shenanigans that have conspired to leave many ill prepared for the financial obligations of their latter years. At the heart of the issue is how much responsibility individuals should assume for providing for their financial well-being, and how (or whether) governments can backstop personal investing.
Acknowledging the problems and fixing them are two entirely different propositions, and definitive solutions still are elusive. But JP Morgan Asset Management’s Paul Sweeting, CFA, contributes to a better understanding of the issues and potential solutions with his recent paper The Future of Pensions: A Plan For Defined Contribution. Sweeting reviews the basics of demographic pressures, including a look at old-age dependency ratios (the proportion of the population aged 65 or over to the proportion aged 16–64, a good proxy for a society’s ability to “pay as you go” to support retirees). Beyond the usual dimensions of fertility rates and expected longevity, Sweeting considers the impact of long-term immigration on improvements in the old-age dependency ratio — food for thought in the United States as the immigration reform debate continues.
The paper’s review of a variety of European approaches to pension plan design is very useful in advancing ideas that may form the basis of a sustainable future system. Annuitization figures prominently in the current and potential future landscape, allowing pensioners to convert assets to a predictable stream of income that they can’t outlive and limiting their ability to outspend their retirement assets in the early years of retirement. But annuities can suffer from expensive structures and capital charges that erode their power, and also contradict the common impulse to try to provide for heirs with a so-called “bequest motive” of individuals.
Drawing in particular on the example of the Danish system, Sweeting imagines a future basic system that combines a mandatory contribution within a specified band of compensation to buy fixed, collective deferred annuities as well as fund a “growth” component that would invest more aggressively to fund increases in annuity payments if possible (reflecting inflation adjustments or longevity increases, for example). Annuities structured with provisions for cash flows for spouses and children (as in Switzerland) could help overcome objections borne in bequest motives. Sweeting also proposes a supplementary level of benefits, funded with optional payments drawn from income beyond the specified band for the basic mandatory contribution. This would fund a decumulation fund designed to pay benefits from 20 years from the time of retirement and purchase advanced deferred annuities to provide payments after 20 years from retirement. The cost of such advanced deferred annuities is much more reasonable, and a small allocation to a more aggressive investment program could help enhance the deferred annuity benefit.
Much of Sweeting’s proposal depends on collectivizing both contributions and decumulations, and as he notes, the merits of such an approach may run counter to cultural and societal values in nations that would make such a design difficult at best. For a problem of this size and importance, however, the need is for actuarial and investment experts, employers, and politicians not to talk past each other. It is necessary for all concerned to consider the best of a variety of experiences, as well as to acknowledge explicitly the difficult choices to be made. Sweeting’s article does a good job of pointing us in that direction.
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