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Who will bear the risk of DB pension plans and DC annuities? By Estelle James.

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Presentation on theme: "Who will bear the risk of DB pension plans and DC annuities? By Estelle James."— Presentation transcript:

1 Who will bear the risk of DB pension plans and DC annuities? By Estelle James

2 2 Sources of risks in pension plans In all pension plans and annuities: –Interest rate falls so liabilities and cost of attaining target pension increase –Stock market falls so assets lose value –Medical breakthroughs, pensioners live longer Extra risk in employer-sponsored DB plans –Worker turnover may decline –Workers may retire earlier than expected –Wage growth may be faster than expected –These risks are greater when plan is mature, many pensioners, so benefit obligation is set, only costs vary (so real labor costs aren’t known until many years later)

3 3 “Full funding” is supposed to maintain reserves to cover these risks, but FF requires assumptions For all pension funds and annuities –Interest rates –Equity prices –Longevity Additionally, for employer-sponsored DB plans: –Worker turnover –Retirement age –Wage growth –Longevity of specific labor force –Very long-lived assumptions—70 years from age of young worker to death of retiree Virtually impossible to get assumptions right

4 4 Given wide range of possible outcomes, “full funding” is a continuum of values, with different probabilities of shortfalls, Conservative assumptions & investments=> small probability of shortfall even if “bad” events are realized, but high current costs Optimistic assumptions & risky investments =>high probability of shortfall unless good events are realized, but low current costs Younger workers and managers want optimistic assumptions, older workers and pensioners (& taxpayers?) want conservative assumptions But some risk of higher costs and shortfall always remains (the unexpected can always happen)

5 5 Who will bear these risks and costs when outcomes differ from assumptions? Employers who sponsor DB pension plans? Consumers who buy their products? Insurance companies who provide annuities in DC plans? Workers who will get future pensions? Retirees who are now depending on their pensions? Taxpayers—the broadest group?

6 6 Three kinds of risks Volatility: ups and downs around the assumed mean—manageable by provider Gradual change in one direction—still manageable although more difficult; changes past labor costs as well as present and future Extreme risk due to bad outcomes that continue for prolonged periods or are severe in magnitude and correlated across firms (depressed economy or dying industries)—small probability but potentially high cost, difficult to manage

7 7 Main theme In globally competitive economy employers or insurance companies can bear year-to-year volatility and very gradual change but difficult to bear extreme outcomes or pass this on to consumers or current workers. So pensioners and taxpayers are likely to end up bearing extreme risk, if realized—but they are probably not aware Current crisis in DB plans was almost inevitable given many long-run assumptions, incentives to make optimistic assumptions, & fixed obligations in mature system with many pensioners

8 8 Employer-sponsored DB plans Initially—few retirees, long vesting periods, few funding requirements, market less competitive 1970’s-1990’s— –Regulations re vesting and funding increased –Pensioners live longer than expected but retire earlier –Lower worker/retiree ratio (<1 in US auto industry) –Therefore higher costs than expected when young workers were initially given DB promise –But booming stock market covered costs for most —very low interest rates, stock markets declined dramatically, tightened regulations re shortfalls.

9 9 Underfunding Currently most plans in US and UK underfunded, need large contributions (Davis, Scheiber). –In US unfunded obligations 50% (dying industries) –Therefore in most cases firm (shareholders) can cover pension liabilities. This can be accomplished by transfer of operating revenues or by selling bonds to get cash to transfer (decreasing debt to pension fund by increasing debt to others; allows gradual pay-off--GM) But caveats: –Total NW & credit rating of firm may fall because debt becomes transparent, future prospects fall –If firms are efficient in current production not optimal to go out of business because past liabilities revalued, but bad incentives if they can avoid these obligations –Definition of “full funding” remains probabilistic, “extreme risk” still not covered

10 10 Will company’s workers or consumers cover these costs? Consumers will buy from new firms with younger workers, few retirees (perhaps in other countries) Workers are willing to accept lower wages to get secure pension, but may not be willing to forego enough wages to cover extreme risks Hard to get finance from workers or consumers for pensioners who aren’t working or producing (except depressed areas & coll. barg.-US autos) Exceptions—public sector or its contractors; public utilities (inelastic demand, lack of competition, tax compulsion—but as costs escalate, do local governments face tax limits?)

11 11 How can DB plan sponsors reduce or manage risk? 1) investing in bonds only? Tempting because of recent fall in stock market and possibility of declining equity premium But raises expected costs in long run because lower expected returns if equity premium>0. Firms that invest mainly in bonds have higher expected labor costs in long run than those investing in equities (but lr advantage if no equity premium). Bonds not completely safe—credit risk and reinvestment risk. Marking to market increases short run risk even if value at maturity is constant.

12 12 2) Diversify investments Diversify out of stocks and bonds—into real estate, private equities, emerging markets (GM) –If not correlated with domestic stocks and bonds reduces risk over-all –But introduces new risks –Managerial expertise and private information important; some will lose Use of derivatives to avoid extreme outcomes –Not well understood; hedging vs. speculation –Problem if outcomes are correlated across pension funds and many try to exercise options at same time— seller not credible

13 13 3) Other ways to manage DB risk Cyclical overfunding—especially useful to handle volatility risk, but expensive and discouraged by regulations and tax treatment in US and UK (more common in Netherlands and Switzerland) Up-date assumptions and check against reality—to handle risk of gradual change Insure DB—but insurance companies price on basis of conservative portfolios so costly; and risk of insurance company failure if extreme outcomes

14 14 Bottom line for DB plans Many future projections needed. Probability of shortfall depends on how conservative are assumptions, but risk never goes to 0. With right assumptions, firms can cover gradual change, small fluctuations, but not extreme risks— especially in global competitive markets. Owner-equity covers some risks, but covering all may not be possible or optimal. Workers and consumers will seek other employers and suppliers, won’t take lower W and P. Ex post financing of past labor costs especially difficult. So risk of extreme outcomes is pushed back to pensioners and taxpayers, who can’t escape.

15 15 Does shift to DC solve these problems? New pension plans are DC, many old DB plans shut down to new entrants Solves risk problem for employers but not for workers, pensioners or government Annuitization or gradual withdrawal of DC accounts often required. If gradual withdrawal, worker bears investment and longevity risk, but government bears cost of safety net in case retirement income falls below poverty or other socially acceptable level

16 16 Risk under annuitization Individual risk pooled but cohort risk hard to pool Worker bears risk that interest rate will be low at time of conversion, if fixed rate annuity Insurance company bears reinvesment and longevity risk after annuitization Investment risk shared if variable annuity Insurance companies will have an increasing role to play in handling retirement income risks in the future

17 17 How do insurance companies manage risk? Invest in conservative portfolios—bonds, mortgages, etc. Good asset-liability matching but expected returns lower than in employer DB plans. Risk reduced through –diversification across insurance products with non- correlated risks (e.g. life insurance v. annuities), –international diversification with different outcomes (if countries aren’t correlated), –reinsurance Avoid industry–specific risks faced by DB plans Annuity promise made at much later age than DB obligation, therefore less uncertainty

18 18 Risk vs. costs in annuity market My work on money’s worth ratios of annuities shows that insurance companies pay annuitants risk-free term structure. Cover their costs by investing in riskier portfolio—but less risky than DB plans. Low risk, low returns. More conservative assumptions and investments mean that insurance companies face smaller danger of extreme shortfall than DB plans but require higher contribution to reach pension target But contributions to DC schemes are lower— annuities may be smaller than workers expect. Problem exacerbated by current low interest rates And sometimes insurance companies fail or miscalculate (Equitable example).

19 19 In both cases, ultimate risk of extreme outcomes is borne by beneficiaries and taxpayers Dilemma: Low capacity of pensioners but moral hazard if taxpayers Should individuals be left to purchase their own guarantees in the market? What form for government risk-sharing? –Insurance—explicit or implicit –Regulations—to reduce risk and moral hazard –Safety net—to set floor at or above poverty line

20 20 Public insurance for private pension and annuities? May be explicit, charge premiums to cover cost –For cases of insolvency and fraud –Shares risk while limiting public liability –But may involve non-transparent liability that is covered by taxpayers when premiums insufficient— subsidy of covered workers by taxpayers not covered –May penalize prudent firms & subsidize imprudent— moral hazard, encourage risky DB plans & annuities –Examples--steel and airline industries dumped large liabilities on PBGC in US in recent years –Partial insurance & regulations to limit moral hazard Implicit insurance (bail-outs)—no premiums or legal obligation, less moral hazard, but political power may bring about government aid-uneven

21 21 Regulations over DB plans and annuities to limit moral hazard & risk Funding to cover liabilities-but what assumptions? Which interest rate should be used for discounting liabilities? Current controversy in US: –Government bond rate? Corporate bond rate? AA or investment grade? Term structure (age)? Equities? –Recent rates or lagged over last few years? What will return on assets be? –How long will interest rates remain low? –Is equity premium falling? –Will stock prices fall & r rise as baby boomers retire? –Who sets assumptions on turnover, retirement age? Regulations over investments—tighter for insurance companies than DB plans. Why?

22 22 Regulations to manage risk (Cont’d) Mortality tables –What rate mortality improvement is assumed? –Differentiate rates by occupation and SES? (US autos) –What other allowable categories for risk differentiation? (gender, DNA, family background?) Regulations re disclosure of plan deficit and time period for making up deficits— issue in UK, where FRS17 requires pension deficits declared on balance sheet of firm in 2005 (will affect credit rating) and must top up assets to match liabilities rapidly

23 23 What is right mix of risk and costs? Tighter regulations and funding requirements, more conservative investments, will reduce probability of shortfall. But each reduction raises costs, reduces average pension. Expensive to avoid extreme outcomes. What is right mix of risk and costs? Who should bear risk of extreme outcomes and cost of avoiding it?How to insure but avoid moral hazard?

24 24 Conclusion Adequate pensions and annuities are costly, as people live longer. Expected costs can be reduced by incurring risk, but that raises possibility that actual costs will be higher or benefits lower. Regardless of strategy, some risk is inevitable, but trade-off between risk and expected costs. Beware of long term promises—not credible In global competitive market, employers can’t pass extreme risk costs to workers or consumers but have ltd capacity to bear that risk themselves. Risk-pooling of annuities through insurance companies may be safer (diversification) but costs greater because of investment policies and regs

25 25 Conclusions (Cont’d) Whether DB or DC annuities, pensioners bear much of risk that some plans will fail. Public back-up needed, especially if part of mandatory system –Insurance + regulations to avoid moral hazard and subsidy; –safety net that particularly protects bottom end.


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