Gareth Sutcliffe: Defined Benefit Pensions are a bad idea

Gareth Sutcliffe, a Conservative Party supporter from North West London and a Fellow of the Institute of Actuaries, argues that Defined Benefit (DB) pension schemes are bad for the economy

DB pension schemes receive the broad support of the Conservative Party and indeed all the main political parties. They have their advantages - DB schemes remove risk from individual workers. They also provide a useful tool to employers for retaining employees. 

But they are a bad idea. Anyone who is lucky enough to be a member of such a scheme would be loath to give one up. But the collective effect of DB schemes is to damage the efficient functioning of the economy through corrosive effects on microeconomic decision making.

This topic may seem arcane but it impinges on us all. As longevity continues to increase and the valuation methods for UK pension funds become more and more onerous the number of organisations that can afford a DB scheme will fall over time to only encompass the government. All of our retirements will be affected – and it is important to decide whether a rearguard action in defence of the DB scheme should be fought. I think not and I will explain why.

A defined benefit pension is, in essence, a simple beast. An employer pays an income for life to a former employee starting from the normal retirement age, whatever that might be. There are possible complications to this – lump sums, life and disability insurance are all available. But these are just frills. The income for life is the most important part.

My line of thinking on why I dislike DB schemes really runs along three strands:

• The divergent objectives of the sponsoring firm and the DB scheme
• The ‘put option’ that a sponsoring firm freely gives to the DB scheme
• Efficiency of action

Taking each of these in turn...

DB schemes and the firms to which they are tethered have differing objectives

1. Defined Benefit schemes are tethered to firms that will have a shorter time horizon than the DB scheme itself. A pension fund may contain workers that will not die for 80 years. By contrast, the average life of a large company is 40 years and many will last for periods of time that are less than this. Further, the management of a sponsoring firm will not look anything like 40 years ahead.  Even if the firm lasts for a long period, its income in 80 years time may be small relative to the weight of its pension fund (the Post Office is a good example). A firm cannot, then, be the best vehicle for securing the retirement incomes of many workers who will retire long after the firm ceases to exist.
2. DB schemes are subject to a lot of risk. Your pensioners may not die on time or your assets may not perform. Because asset prices will tend to be more volatile over time than liabilities, the pension fund surplus (assets less liabilities) will be very volatile. Because this surplus is disclosed on the balance sheets of companies this causes a volatility of a company’s apparent financial strength.
3. The investors in, say, a manufacturing firm, are probably not looking to take on geared investment risk, as is generated in a pension fund. The attachment of a pension fund to a firm therefore distorts investment decisions of investors in a firm.
4. The presence of a pension fund may also affect investment decisions by management. For instance, a pension fund deficit may convince management to direct surplus cashflow toward the pension fund, rather than into a higher return capital investment project within the company. This is (i) detrimental to the shareholder; (ii) detrimental to the DB scheme if over time this sort of behaviour reduces the financial strength of the firm; and (iii) if replicated across many firms it will damage the economy as a whole.
5. The presence of a pension fund may affect the performance of a company directly. On average, $1,500 of the cost of a General Motors car on sale in the US goes to cover the cost of pension and health benefits. This makes it difficult to compete with, say, Toyota, which is not subject to such onerous pension fund contributions.

The sponsor’s contribution to a DB scheme can be viewed as a put option on the sponsor’s cashflows

1. Sponsoring firms have little incentive to run a surplus in a DB scheme. Once the surplus arises, it cannot be used again by the sponsor, as money in a pension scheme can only be used for the members. Through this arrangement the sponsoring firm has essentially sold a put option on the firm’s cashflow to the DB scheme. If the cashflow rises above the level needed for DB scheme to break even, the DB scheme wins. If not, the firm is obligated to increase its cashflow into the DB scheme until a surplus is reached. The DB scheme still wins. This arrangement is used because…
2. ...a sponsoring firm can run a deficit on its pension scheme for a period. This is not the case for a financial firm, like an insurance company, which would hold a capital buffer to increase the security of depositors’ / policyholders’ capital. If a DB scheme held a capital buffer against deficits they would be more secure, but the sponsoring firm’s capital would be tied up in a scheme that has different objectives from the firm, which is unfair. It is also expensive and so would bring closer the end of the DB scheme.

Pension funds reduce the efficiency of markets

1. The existence of a pension fund may act as a ‘poison pill’ preventing takeovers of badly run companies. The market for corporate control is one of the main mechanisms in a stock market dominated economy of ensuring that corporations are run efficiently. Therefore DB schemes reduce the efficiency of a market economy.
2. DB schemes are frequently run by trustees with little investment / actuarial knowledge. While Trustees have a duty of care toward their pension funds, this cannot make up for a lack of knowledge and having ‘skin in the game’ i.e. being at risk of loss if the pension fund does not perform.