Don’t blame the pension scheme

Pension schemes have been much maligned lately. With austerity coming into fashion, the pension scheme bashing has got even worse. In particular, any firm or employee on a defined benefit pension scheme has been held up as demonstrating the very worst sort of greed, an example of company excess. Anyone would think that they were bankers or something.

This is bizarre because economics says that defined benefit schemes should actually be more efficient.

Defined benefit schemes are schemes where a firm guarantees a particular level of pension during retirement. The firm invests contributions, and if the investment turns out better than expected, they get to keep the spoils. If not, the firm has to make up the difference.

Defined contribution schemes are schemes where the firm offers no guarantees over the level of the pension during retirement. Contributions are invested, and employees get whatever the markets deign to offer as an investment return – it could be higher or lower than expected.

In effect, the difference between the two types is who bears the risks and rewards. With defined benefit schemes, the ones that everyone seems to think are somehow morally wrong, it’s the firm. With defined contribution schemes, it’s the employees.

Defined benefit schemes ought to be a better deal for the firm. Why? It comes down to attitudes to risk. If someone is risk averse, they will prefer a low, guaranteed amount of money, to an uncertain amount of money – and if you want them to choose the uncertain amount instead, you’ll have to pay them more.

It is uncontroversial to suggest that individuals are likely to be much more risk averse than a large corporation, or indeed most firms apart from perhaps the very smallest. But this means that it costs a firm more to force employees to bear the risk of the pension scheme investments – they will have to pay employees more than firms offering defined benefit schemes.

So why are firms and the public sector switching their pension schemes from defined benefit to defined contribution? One reason could be that they are fairly risk averse themselves – but I very much doubt that individuals are better able to bear risk than governments or large corporations.

An alternative reason is that individuals don’t pay much attention to their pensions, and saving for the future in general.  Sunstein & Thaler’s book Nudge devotes a large section to why people don’t bother to look into their pension contributions and make simple decisions that would make a huge impact on their future well-being.

This could be one reason behind what is making defined contribution schemes perversely more popular. If employees have no idea what contribution they are making, or what pension that might result in, then suddenly offering a poor pension scheme to your employees makes financial sense, from the firm’s point of view.

Still, in these austere times, who cares about short-changing future pensioners?

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One Response to Don’t blame the pension scheme

  1. Richard says:

    Many of the criticisms of the defined benefit pension schemes seem to be concerned about the fact that the pensions that result are simply too high and that the companies providing them lose out. This suggests to me that firms themselves are bad at judging the levels they set the pensions at. If this is the case, a shift to defined contribution would seem a sensible move for those organisations who believe that they too have/will mess up a defined benefit scheme.

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