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A misunderstood shift

The system-level implications of shifting from defined benefit (DB) to defined contribution (DC) pensions systems could be dangerously misunderstood. The body of knowledge on DC pensions is growing and with it grows our understanding of how the design of DC systems influences individual retirement outcomes.

But the question of how shifting from DB to DC plays out at a systemic level seems to receive much less attention. Shifting pension risk from firms to individuals may be the only viable option in a low-interest-rate environment. But once the risk is borne by individuals, the danger that poor individual choices will create systemic imbalances could be far greater. People who are poor in retirement are a huge burden that society at large has to bear in some way. 

This is not to say that the shift towards DC pensions should be stopped. But there is a need for better understanding of how individual choices on retirement savings could affect the economy. In particular, what are the broad consequences of falling short of DC outcomes? Other questions on the impact of DC pensions involve the role of employers and asset managers, the outcomes of pension legislation, as well as issues such as financial literacy and labour mobility. 

The example of Chile, an early adopter of a fully DC-based system, is striking. Employees there fear that the mandatory private DC plans will not deliver an adequate retirement. This has led to calls for a return to the public DB pension system. Chile is a particular example, in that employers do not contribute to DC pension pots. There are examples of much more efficient DC-based systems in other parts of the world. But in many countries the transition from DB to DC could last decades, and the consequences need to be explored more deeply. 

Evidence from Chile shows that 60% of retired workers choose annuities instead of phased withdrawals. This means the pressure on insurers to find sources of liability-matching returns has increased. In Chile, interestingly, the Organisation for Economic Co-operation and Development (OECD) says it does not matter whether the system is private, public, DB or DC. The question is whether Chilean workers save enough.

Elsewhere, the International Monetary Fund (IMF), in the latest edition of its twice-yearly Global Financial Stability Report, suggests the growth of DC-based pension savings could boost passive investment products to a point where price discovery in the markets becomes difficult.  

Of course none of this would be a problem if the ailing Western economies returned to growth. But until that happens, we need to make sure we are not simply forgetting to answer some fundamental systemic questions about DC pensions.

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