Brighton Rock's Con Keating responds to a 'litany' of misunderstandings and errors on DB penions.
This blog discusses a response to a short article I wrote published in Financial World in February 2011. The article prompted a spirited letter in reply from Pauline Armitage, whom I don't know, but which I reproduce in full below:
"Con Keating may be right in saying defined benefit pension schemes are affordable. Most things are if you have enough money. The question is, who should pay for them? (Sic)
Should a pension be a claim on future production, as he maintains? If pensions are not fully funded during a working lifetime, there are similarities between a pension scheme and a Ponzi scheme. Both depend on new contributors to maintain payouts. We need to consider how much we can expect the next generation of workers, either in an individual company or nationally, to subsidise the previous one.
Employers are closing pension schemes not just because of cost, but also due to the open-ended nature of the liability they face. Future costs cannot be predicted accurately. It is debatable whether any employer would have set up a defined benefit pension scheme if the true costs had been known from the outset. The public sector keeps final salary schemes open because the next generation of taxpayers will pay the shortfall. Analysis by the Public Sector Pensions Commission shows that a typical public sector final salary scheme is worth 40% of salary. Employees and employers are paying about half of this.
But we should take nothing for granted. After our children have ousted an older worker, paid off their student debt, secured a mortgage, paid the higher taxes necessary to meet the increasing NHS and welfare bill and funded their own money purchase pension pots … they may rebel."
This letter contains such a litany of misunderstandings and errors I shall respond to it line by line:
Con Keating may be right in saying defined benefit pension schemes are affordable. Most things are if you have enough money.
This introduces the first fallacy. The relevant role for money is one for government - that there should be enough money and credit available for the economy to maximise the utilisation of its capacity for productive output. Too much money results in inflation and too little in unemployment and an output gap.
The question is, who should pay for them?
The subject of the article was occupational pension schemes. The payment is clear, as it is part of the labour market contract between employer and employee. The employer in the traditional balance of cost defined benefit scheme bears all of the cost in partial return for the services and labour of the employee.
Should a pension be a claim on future production, as he maintains?
This demonstrates a fundamental miscomprehension. A pension is a claim on future production and cannot be anything else. We consume what we produce - at the time scales of pensions, productive output cannot be stored, and much cannot be stored at any time scale. How would Armitage propose storing haircuts or manicures? Pensioners wish to continue to consume in their retirement, if not only to stay alive, to be buried.
If pensions are not fully funded during a working lifetime, there are similarities between a pension scheme and a Ponzi scheme.
This introduces yet more error. We may purchase claims on future production in financial markets - these are government securities and private sector equity. They are no other claims in net positive supply. We do this in financial markets, and we suffer the costs of the vagaries of these markets. Far more efficient is for the employer, who is, of course, a producer to issue this claim or make this promise directly - there is no funding in this book entry arrangement. The claims are credible precisely because the employers are producers, and it is precisely this aspect that makes their other issued and market-traded claims credible. Pauline wishes to introduce a dependency upon financial markets into a labour market contract - this is time inconsistent and grossly inefficient.
In fact, the only individuals who must rely upon financial market claims on future production are the self-employed, who, by definition, will not be producing anything in their retirement. This brings us directly to the question of self-sufficiency, and another fallacy becomes evident. A company or government may borrow at the time pensions are payable; an individual usually cannot, precisely because they have no productive output from which to repay this debt. It also raises the flaw at the heart of generational accounting. A generational balance is actually no more than a market clearing condition on the value of a non-convertible or fiat currency on the foreign exchanges. This may be relevant if you are hoping to spend your retirement in the south of France, but it is irrelevant for the affordability or sustainability of pensions.
Both depend on new contributors to maintain payouts.
Ponzi schemes are, indeed, characterised by the requirement for ongoing new contributors to pay, through the organiser of the scheme, some of the earlier participants. Unfunded pension schemes do not share this property. A government may pay pensions or any of its obligations without having previously funded this expenditure through taxes or borrowing. Only in monetary unions do governments forego this sovereign capacity. In fact, taxes only function to regulate the economy.
The property that current contributions meet the current payments of pensions is a substantial positive property of corporate defined benefit schemes, since it reduces the dependence of the scheme upon purchase and sales of assets in financial markets, with their well-known frictions and costs.
We need to consider how much we can expect the next generation of workers, either in an individual company or nationally, to subsidise the previous one.
The miscomprehensions continue apace. The fact is that future generations get to consume what they produce, regardless of whether or not there is any debt overhang. This is true of all generations. There is no question of subsidy across generations, which would actually require succeeding generations to move production backwards in time - and if there were any way of doing that, the potential for paradox would require us to rewrite rather more than the laws of economics.
Employers are closing pension schemes, not just because of cost but due to the open-ended nature of the liability they face.
I don't know about all employers, but I do know some, and they are closing schemes because they no longer represent value for money to them - that the costs of employing individuals and paying them in part in this way is now far less efficient than simply paying them cash wages. And this cost is driven principally by regulation and faulty accounting standards. Open-ended liabilities actually occur extremely widely in business - it comes with the economic activity. These pension liabilities happen to have a now-unacceptable benefit to risk relation for the employer, and that is the result of a long tradition of inept and politically motivated regulation.
Future costs cannot be predicted accurately.
This is one of only two sentences in the entire letter with which I unconditionally agree. But it does lead to the paradox that Armitage refers in the very next sentence to the "true costs", as if these were knowable ex-ante.
It is debatable whether any employer would have set up a defined benefit pension scheme if the true costs had been known from the outset.
The most obvious response to this is that the costs of providing these pensions were nowhere near as high as they are today due again to changing regulation. We should not forget that, prior to Robert Maxwell, government was only too happy to place ever more true cost burden upon employers with such developments as limited price inflation linking and deferred member rights.
The more relevant, however, is that the current estimates of these pension costs are hopelessly high over-estimates due to flawed accounting and actuarial standards. It also doesn't help that language has been reinterpreted by the regulators such that the concept of 'prudent' now means estimates are biased and conservative rather than simply rational and well informed.
The public sector keeps final salary schemes open because the next generation of taxpayers will pay the shortfall.
This re-introduces the fallacy that taxes are necessary preconditions for the state to make payments or incur expenditures. They aren't.
Analysis by the Public Sector Pensions Commission shows a typical public sector final salary scheme is worth 40% of salary.
As any actuary can tell you, we can achieve almost any value by 'judicious' choice of assumptions. Of course, if they are worth as much as this, the investment they represent in the economy through taxes not levied upon the population today, which permits higher consumption and investment by that population today, is enormous. But rather more important, it would mean the dominant economic party in these schemes is not the state but members of these schemes. The cap and share arrangements limit the cost to government of these schemes to just 14.4% of salaries, and the balance is borne by members. These schemes are, in fact, member mutuals rather than employer supported balance of cost schemes.
Employees and employers are paying about half of this.
This is the second sentence with which I agree. Perhaps this is telling us how hopelessly wrong an estimate of 40% really is, or is the proposition that private sector employers are collectively wrong, which would make for a very interesting variant to the wisdom of crowds.
But we should take nothing for granted.
This is the philosophy of scepticism, and it should be realised that self-verification of everything would be costly to the point of extinction of the species.
After our children have ousted an older worker, paid off their student debt, secured a mortgage, paid the higher taxes necessary to meet the increasing NHS and welfare bill and funded their own money purchase pension pots ... they may rebel.
There's a lump of labour fallacy here with respect to children ousting their elders from employment. They, of course, have repaid their student loan to the elder generation. They have secured a mortgage by borrowing some of the savings of that elder generation. Again, I will remind Armitage that higher deficits today do not mean higher taxes tomorrow, that, by some magical process, our children's real standards of living will be necessarily lower as a result of this debt.
Will they rebel - I doubt it very much. Such a rebellion would be an assault on property rights, including their own.
Con Keating is head of research at Brighton Rock Group