Why We Need a Pension Revolution

Abstract

A broad consensus exists that workplace pension arrangements around the world are sick and in need of strong medicine. Rather than resurrect the traditional defined-benefit (DB) plan or broaden defined-contribution (DC) plan coverage, this article argues that we move from an “either/or” to an “and/and” mindset to improve global workplace pension coverage, adequacy, and certainty. Pension arrangements can combine the best of DB and DC plans and minimize the impact of their less-attractive features. However, we must also redesign the institutions through which workplace pensions are delivered. The ideal pension-delivery institution is expert, has scale, and acts solely in the best interests of plan participants.

A broad consensus acknowledges that workplace pension arrangements around the world are sick and in need of strong medicine. Pension coverage and adequacy are low, and pension uncertainty is high. The prescription of some pension experts is to resurrect the traditional defined-benefit (DB) plan. Others say broad defined-contribution (DC) plan coverage is the cure. This article argues that we have to move from an “either/or” to an “and/and” mindset if we want to seriously improve global workplace pension coverage, adequacy, and certainty. Integrative thinking about these issues leads to pension arrangements that combine the best of traditional DB and DC plans and minimize the impact of their less-attractive features.

The kernel of “the optimal pension system” (TOPS) lies all the way back in Robert Merton’s seminal 1971 article that laid out the optimal consumption and portfolio rules in a continuous-time model. The basic idea is that informed, rational people strive for smooth and adequate lifetime consumption. Unfortunately, we have learned that the “informed, rational” part of the assumption is inoperative in the real world. So, we need to design a series of “autopilot” mechanisms for enrollment, target pension, implied contribution rate, age-based investment policy, and capital-to-annuity conversion processes. Although these redesign ideas might have sounded radical just a few years ago, they are now being widely discussed as the way to move forward.

However, redesigning the pension formula is only half the cure. We must also redesign the institutional arrangements through which workplace pensions are delivered. The ideal pension-delivery institution is expert, has scale, and acts solely in the best interests of plan participants. Far too few pension funds in the world today can pass this triple test. Consider each in turn: Expert means that the pension institution would have enough internal expertise in pension finance, investments, and administration to be managed expertly “from the inside out” rather than by outside agents. That does not necessarily mean that all functions would be carried out 100 percent internally. It does mean that outsourcing decisions would be based on expert judgment that outsourcing is the cost-effective alternative. A related issue is that organization oversight (or governance) would be carried out by a board with sufficient expertise and experience to expertly perform this critical task.

This kind of expertise cannot be assembled and retained without scale. Pension-delivery institutions must be large enough to operate at low unit costs. So, ideally, the institutions would manage assets in at least the tens of billions of dollars and would serve hundreds of thousands of plan memberships.

At the same time, the institutions would have to pass the governance test: in the best interests of plan participants. This test requires that the ideal pension-delivery institution has an arms-length, co-op legal structure. Peter Drucker observed 30 years ago that such institutions—acting as motivated, expert owners—are ideally equipped to own capitalism’s means of production. Although a few such institutions already exist, many more are needed. Indeed, we need a literal pension revolution.

Editor’s Note: This article is adapted from the introductory chapter to the author’s book Pension Revolution (John Wiley & Sons), which is scheduled for release in January 2007.

Reprinted from Financial Analysts Journal, vol. 63, no. 1 (January/February 2007): 21–25. Author affiliation is accurate as of the original publication date.