Defined Benefit Pensions Are a Foolish Dream

Benefit v Risks

Pensions are good. Pensions are worth preserving until something better comes along. But pensions that make impossible promises and cultivate lies are not the pensions we should hope for.

If you are fortunate enough to have a pension these days (and you’re probably not), it is one of two types. Defined contribution plans are pensions where you put in a fixed amount of money each month, which is invested and perhaps supplemented by your employer, and after you retire, you get a payout based on how much money is there. The final pool of money that you have at the time of your retirement depends upon how much was put in and how much it grew as it was invested.

Defined benefit plans are pensions with one key difference: when you retire, you are guaranteed a payout of a certain amount. In other words, it is the responsibility of the pension plan to ensure that by the time you reach retirement age, they have invested the money well enough to make it grow enough to be able to make the payments they have promised to you.

Defined benefit plans are considered the gold standard of pensions, and are perceived as the most desirable by workers. They are also a mirage. We should end them.

Why? Because as any honest investment consultant can tell you, it is impossible to guarantee a specific investment return over the course of many years. And it is certainly not possible to guarantee a large annual investment return over the course of many years. But that is exactly what defined benefit pensions incentivize their administrators to do: to promise a hefty (absurd, unrealistic, unwise) annual investment return in order to make the math work. After all, the higher the annual return on investment, the less money you have to contribute from your paycheck and the less money your employer has to contribute on the front end. Everyone loves to imagine that they can put in as little as possible and the pile of money will grow enormously through the magic of investment! Yet pension crisis after pension crisis after pension crisis has proven that it is not so. The incentives to lowball how much money has to be put in on the front end and to overestimate the amount of money that will come out on the back end is just too large. And when you are dealing with public pensions, where politicians are involved, the incentive towards magical thinking is even greater. Free pensions for everyone! No money down! And in the meantime, we can borrow the money for other things!

It does not work.

In decades past, it was easy for pensions to invest in relatively safe assets like bonds and still pick up, oh, 8% a year, and everyone was happy. Returns were strong, and risk was low. Those days are over. Economic growth is much harder to come by—permanently, many believe. As the Wall Street Journal notes, pension plans today are forced to pursue riskier and more expensive investments in a desperate bid to achieve investment returns that once seemed just average. This is why public pension plans, which manage the retirement money of nurses and firefighters, end up funneling billions of dollars in feesinto the pockets of high priced Wall Street private equity and hedge fund managers. They are chasing the foolish promise of investment returns that they cannot achieve through safer means. Instead of saying “our investment returns will be whatever our safe, low-cost investments give us,” they continue to lust for unrealistically high numbers to fulfill promises that are either outdated or completely dishonest. So hedge funders and other expensive money managers get rich—their fees are set in stone, after all—and the retirees are still left with pension plans that are desperately short on the funds needed to pay what they owe, because they made promises that they could not keep.

Already, U.S. pensions are in such a hole—approaching $2 trillion in total—that many of today’s pensioners will inevitably be shorted on their payments. The money simply isn’t there. This is not the fault of the workers, and the political cowardice involved in letting the pension crisis get this bad is immense, but it has gone too far to be set right at this point. Moving forward, there are only two real options. Defined benefit pensions can drastically lower their projected investment returns (down to, say, 3%), put their money in safe, low-cost investments, and raise the amount of money that workers and employers need to put in to realize the promised payments at retirement. Or, we can just do away with defined benefit pensions altogether. They were always an idea that would fall apart as soon as easy investment returns dried up. For people who do have pension plans, make them defined contribution: you put your money in, it is invested as well as possible, and at the end you get what you get. In either case, any politician or pension fund manager who fucks with people’s pension money irresponsibly should be put in jail.

Ideally, we would have a national Social Security system so robust that everyone could rest easy knowing that they would be provided for in retirement. Until then, some people will still have pensions. Those pensions should pay them money, not promises that cannot ever be kept.