Pension Nonsense

Roger Lowenstein wrote a book on the failure of Log Term Capital Management and a series of other books on economics related topics. A number of years ago he wrote a pretty good book on Warren Buffett. But in the NYT today he wrote an article that lacks a lot, called the End of Pensions, he argues (correctly) the the pension system is broken. He goes into great detail about the development of pension systems and their underlying assumptions. There are promises made but not promises kept. But there his comments veer off a bit. He describes the multiple moral hazards of a system that offers a guarantee in payout that is backed by insurance -

"In such situations, individuals are tempted to take more risk than is healthy for the group; economists, in a glum appraisal of human nature, call it "moral hazard." In effect, America's pension system has been a laboratory demonstration of moral hazard in which the insurance may end up bankrupting the system it was intended to save. Given that pension promises do not come due for years, it is hardly surprising that corporate executives and state legislators have found it easier to pay off unions with benefits tomorrow rather than with wages today. Since the benefits were insured, union leaders did not much care if the obligations proved excessive. During the previous decade especially, when it seemed that every pension promise could be fulfilled by a rising stock market, employers either recklessly overpromised or recklessly underprovided - or both - for the commitments they made."

He does a great description of the problems facing both corporate and government pensions - both rely on the hazards that he describes so well. But where I disagree with his analysis is in his assumptions about causes and solutions. Corporate and political leaders tended to use the Cole Porter theory of financing/politics - accentuate the positive and decentuate the negative. Thus, in both places where the guarantee was offered they promised more than they could deliver and relied on the future to correct their mistakes. But implicit in his discussion is an assumption that if you take away the guarantee that individuals will not be able to recognize their future risks. That is the explicit assumption of defined contribution plans - set reasonable limits for savings, allow the savings to accumulate tax free, and (*in the best plans) give the savers lots of information about alternatives so they can plan best for their future. The assumption that Lowenstein makes is that "people are imperfect savers" (although he also makes an implicit assumption about the errors/hazards in government and corporate defined benefit plans.

Ultimately, it should be possible to improve individual performance in savings. Defined benefit plans were made under the assumptions that the payout for a pensioner would be Hobbesian (mostly short but the rest of Hobbes seems to have been true - cruel and brutish) - if that assumption were ever true with all the extensions in life - the assumption is no longer true. What is the better policy - to try to fix the numerous hazards in defined benefit plans or to move as quickly as possible to defined contribution plans with some serious attempts to encourage the informational improvements that will increase the possibility of making individuals less imperfect savers? We shouldn't try to reform a system fraught with hazards - the better alternative would be to use the best alternative for today's times.