Larry, your analysis, as always, is rock solid. The source of the problem goes beyond these calculations. When the employer makes a new promise to employees of a defined benefit in the future, it immediately sets up an intergenerational problem, as it will not fund that promise immediately but only over time. The extreme case, as when DB pension plans first began, involved no requirement for funding but a windfall for the older workers in the firm.
I also struggle with how to let current employees benefit from the higher returns in the stock market. The risk to traditional bonds held for long periods of time, largely due to inflation, is greater than the risk to stocks. DB plans, particularly for a permanent employer like a state government, do offer the possibility of allowing an intergenerational sharing of risk both because of the implicit requirement to hold onto the stocks for long periods but also because the plans can avoid some of the wins and losses that derive from the timing of the deposit and the withdrawal.
Hi Gene -- Thanks very much for the thoughtful comment and the kind words.
Astute observation that the origin story of most DB plans usually included some sort of past service credit which meant a liability off-the-bat that was funded over future years. And that this violated intergenerational equity because the people who benefited from the services that gave rise to the past service benefit did not pay for them. The solution from an intergenerational equity standpoint would have been to reflect only future service in the pension benefit.
I think most of that is water under the bridge, though, and at various points in their history (when interest rates were higher), there were many plans that were genuinely overfunded, and the opportunity to keep them that way was often blown through contribution holidays, risky investments, raising benefits, etc., all abetted by liability mismeasurement. On the last of these, to be fair, actuaries didn't become conscious of proper liability measurement except in the last 20 years or so. But it's also fair to disapprove of the continuing (to this day) hostile reaction of many actuaries to the resulting question of whether things should be done differently.
Another level of intergenerational equity violation occurs when employers don't fund the "actuarially determined contribution" (ADC). Actuaries often use that as cover for their liability mismeasurements by arguing along the lines of "it's not our fault that plans are underfunded, it's the fault of sponsors who don't contribute what we tell them to." That's often fair to an extent, but incomplete.
The level of intergenerational equity violation I'm talking about in this essay is the next level, where the ADC itself is insufficient and reflects an implicit violation of intergenerational equity because of the mismeasurement of liabilities.
Public DB plan participants are currently benefiting from equity risk premia. They receive a high level of benefits based on presumed (though unearned) future investment risk premia. They benefit from the presumption and bear none of the corresponding risk.
I don't object to any particular level of benefits, but I think whatever is chosen should be valued correctly.
I would take issue with the notions that (A) public DB plans are useful for allowing intergenerational sharing of investment risk, as well as (B) the notion that investment risk (in dollar terms) decreases over long periods.
A translates to arguing for intergenerational cross-subsidization, which I'm not in favor of. If there's a loss borne by a younger generation for the benefit of a later generation, then from that point forward, the younger generation is not being fairly compensated for the cost and risk it bears.
Regarding B (sometimes called "time diversification"), equity risk premia are not a free lunch, even over long periods; they are not certain. Risk increases over time. Zvi Bodie has written extensively about this.
There's nothing about a DB plan that changes that financial reality. DB plans are (or can be) efficient for longevity pooling, but offer no particular efficiency in terms of market risks, in my understanding.
If the desire is to let participants benefit from equity risk premia while bearing the corresponding risk, that can be accomplished with DC plans (with a tontine payout or annuity purchase during retirement if longevity pooling is desired) or a variable DB plan where benefits change 1-for-1 with investment experience.
I believe that people should, on an individual basis, probably take some risk in their lives, including investment risk. I just don't think public pension plans should take risk on behalf of unknowing future taxpayers for the benefit of current taxpayers. That amounts to appropriation of the former by the latter.
Larry, your analysis, as always, is rock solid. The source of the problem goes beyond these calculations. When the employer makes a new promise to employees of a defined benefit in the future, it immediately sets up an intergenerational problem, as it will not fund that promise immediately but only over time. The extreme case, as when DB pension plans first began, involved no requirement for funding but a windfall for the older workers in the firm.
I also struggle with how to let current employees benefit from the higher returns in the stock market. The risk to traditional bonds held for long periods of time, largely due to inflation, is greater than the risk to stocks. DB plans, particularly for a permanent employer like a state government, do offer the possibility of allowing an intergenerational sharing of risk both because of the implicit requirement to hold onto the stocks for long periods but also because the plans can avoid some of the wins and losses that derive from the timing of the deposit and the withdrawal.
Hi Gene -- Thanks very much for the thoughtful comment and the kind words.
Astute observation that the origin story of most DB plans usually included some sort of past service credit which meant a liability off-the-bat that was funded over future years. And that this violated intergenerational equity because the people who benefited from the services that gave rise to the past service benefit did not pay for them. The solution from an intergenerational equity standpoint would have been to reflect only future service in the pension benefit.
I think most of that is water under the bridge, though, and at various points in their history (when interest rates were higher), there were many plans that were genuinely overfunded, and the opportunity to keep them that way was often blown through contribution holidays, risky investments, raising benefits, etc., all abetted by liability mismeasurement. On the last of these, to be fair, actuaries didn't become conscious of proper liability measurement except in the last 20 years or so. But it's also fair to disapprove of the continuing (to this day) hostile reaction of many actuaries to the resulting question of whether things should be done differently.
Another level of intergenerational equity violation occurs when employers don't fund the "actuarially determined contribution" (ADC). Actuaries often use that as cover for their liability mismeasurements by arguing along the lines of "it's not our fault that plans are underfunded, it's the fault of sponsors who don't contribute what we tell them to." That's often fair to an extent, but incomplete.
The level of intergenerational equity violation I'm talking about in this essay is the next level, where the ADC itself is insufficient and reflects an implicit violation of intergenerational equity because of the mismeasurement of liabilities.
Public DB plan participants are currently benefiting from equity risk premia. They receive a high level of benefits based on presumed (though unearned) future investment risk premia. They benefit from the presumption and bear none of the corresponding risk.
I don't object to any particular level of benefits, but I think whatever is chosen should be valued correctly.
I would take issue with the notions that (A) public DB plans are useful for allowing intergenerational sharing of investment risk, as well as (B) the notion that investment risk (in dollar terms) decreases over long periods.
A translates to arguing for intergenerational cross-subsidization, which I'm not in favor of. If there's a loss borne by a younger generation for the benefit of a later generation, then from that point forward, the younger generation is not being fairly compensated for the cost and risk it bears.
Regarding B (sometimes called "time diversification"), equity risk premia are not a free lunch, even over long periods; they are not certain. Risk increases over time. Zvi Bodie has written extensively about this.
There's nothing about a DB plan that changes that financial reality. DB plans are (or can be) efficient for longevity pooling, but offer no particular efficiency in terms of market risks, in my understanding.
If the desire is to let participants benefit from equity risk premia while bearing the corresponding risk, that can be accomplished with DC plans (with a tontine payout or annuity purchase during retirement if longevity pooling is desired) or a variable DB plan where benefits change 1-for-1 with investment experience.
I believe that people should, on an individual basis, probably take some risk in their lives, including investment risk. I just don't think public pension plans should take risk on behalf of unknowing future taxpayers for the benefit of current taxpayers. That amounts to appropriation of the former by the latter.
Thanks again