For fashionistas Zadig & Voltaire is a chic French brand. For those of a more literary bent Voltaire’s Zadig ou la Destinée (1747) is the forerunner of the detective novel. It tells of the fate of Babylonian philosopher Zadig, who ends up being accused of sorcery because he can describe a missing dog and horse without ever having seen them, drawing his conclusions from minute observations.
It is often said that statistics are a dark art, used to obfuscate rather than illuminate. However, every once in a while a scrap of data comes along that the likes of Zadig, Poirot or Inspector Morse would seize on to build a case around. In that spirit the Towers Watson global pension asset study makes fascinating reading.
The report examines the world’s 13 largest pensions markets and $23.2 trillion in total assets. There is enough detail to satisfy any data junkie. But one profoundly counter-intuitive statistic leaps off the page. In 2009 global defined benefit assets grew by 4% and defined contribution assets fell.
Reluctant guinea pigs
This is completely at odds with every headline declaring the death of defined benefit pension schemes as well as the experience of millions of employees who have become reluctant guinea pigs in the great defined contribution pensions experiment. At first blush it does not even tally with other figures in the Towers Watson study, such as that DC assets account for 42% of total pension assets compared with 32% in 1999.
With defined benefit pension schemes closing at a dizzying rate what can explain this apparent anomaly? Scratch the surface and these figures are as much of a concern as they are contrary to received wisdom. The only explanation that stacks up is that defined benefit schemes are better run than their defined contribution peers. Indeed, other research from Towers Watson backs this up. The rates of return for defined benefit plans outpaced those for defined contribution plans in 2007 and 2008. Over the past 13 years, during bull and bear markets, DB plans outpaced DC by an average of 23 basis points.
It is hardly surprising. Big DB pension funds have access to alternatives, and can use tactical asset allocation, including overlays, derivatives and optimization. None of these tools of modern finance are available to the typical DC plan participant. They are fighting the investment battle with one hand tied behind their backs. But there are four bigger problems still.
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None of these tools of modern finance are available to the typical DC plan participant |
First, financially unsophisticated individuals are almost bound to make worse decisions regarding investments than professionals, even if the right options are available to them. A study by the Employee Benefit Research Institute in the US found that nearly a quarter of 401(k) plan participants aged 56 to 65 had more than 90% of their account balances in equities at the end of 2007. If they were unfortunate enough to retire in 2008, half of their retirement income could have gone up in smoke.
Secondly, who really devotes time to thinking about their pension? Writing this, I cannot tell you how my DC pension fund is invested, though I do check it annually. By contrast I can tell you every single stock I hold in my ISA and provide a rationale for each investment even though it is a far less significant part of my overall savings. Pensions are boring. Buying stocks is exciting.
Thirdly, any system that relies on employee contributions and management largesse is inherently flawed. Employees will be minded to under-invest and spend the money on holidays and smart cars. Employers will tend to cut contributions in hard times and suffer from amnesia when the cycle turns, preferring instead to reward pampered shareholders with buy-backs.
Finally, transferring risk from the employer to the employee does not really work. Ultimately the risk of impoverished pensioners is borne by society as a whole. The danger is that those few who did save to fund their retirements will end up getting taxed to pay for the majority who did not. This presents a further disincentive for savers.
No comeback
Unfortunately, DB pension schemes are not going to make a comeback. They too were flawed. With DB schemes struggling with deficits it is now patently obvious that projected rates of return were overly optimistic. If you discount a liability at too great a rate it is axiomatic that costs are also understated. For employees, buying £1.50 worth of benefits for £1.00 was an attractive proposition but one that employers would inevitably cut.
If we stick with DC there have to be incentives for people to save in the form of tax breaks or compulsion. Australia’s superannuation funds offer one way forward. Mandatory state-run systems that are a hybrid of DC and DB, such as the Central Provident Fund in Singapore, are another attractive model. The issue of adequate retirement saving is not a simple case to solve, but you do not need a detective’s magnifying glass to see that DC is failing.
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues. The views expressed are the author’s own
