The pensions crisis for dummies

Online pension forums and advice websites often tend to be very specific. Pensions are quite a complicated subject and though I’ve repeatedly come across discussions of the current pensions crisis I haven’t been able to pinpoint exactly the sources of the problem. The following is an analysis of the pensions emergency from a beginner’s point of view.

Pension plans can generally be classified as either defined benefit or defined contribution schemes according to how benefits are determined, though hybrids of the two do exist. Defined benefit plans place most of the fiduciary responsibility on an employer. The employer guarantees that the employee will receive a certain payout at retirement according to a fixed formula, usually dependant on the individual’s salary and their number of years' of membership in the plan. So this type of pension might see a company guarantee a post-retirement annual payout of for example 60% of an employee’s salary averaged along their working life.

Defined contribution plans remove the responsibility from the employer and place it on the employee. This type of scheme provides a payout at retirement that is dependent upon the amount that the individual themselves has contributed into their pension fund over their working life and also on the performance of the investment choices that they have made. Contributions usually consist of employee salary deferrals. In most cases an employer will agree to match at least some percentage of these contributions, so the employer does still play at least some part in the accumulation of a pension (besides the obvious).

In the 50s, 60s and well into the 70s, benefit schemes were the most dominant form of pension fund. Employees could expect them as standard. Most of my friends’ parents, regardless of whether they worked in the private or public sector, are now drawing down this type of pension. Generally they provide a very adequate standard of living for the retired recipient.

Today these schemes are far less common. The majority of firms in the private sector have abandoned benefit plans in favour of contribution plans. There are a multitude of reasons for this shift, led both by employer and employee, including a desire for increased control over one’s pension investments and support for a less paternalistic type of company structure. However the most obvious reason for this change is that contribution schemes pose less cost to employers. The employer has less fiduciary responsibility and in some cases can avoid making any contribution to the employee’s pension fund altogether.

The problem is that left to its own devices, the average individual’s contribution pension fund is very vulnerable. Many of us (and unhappily I include myself at this point in my life) do not possess the financial savvy to choose the correct investment vehicles, or do not have the discipline to voluntarily contribute money to retirement accounts. An individual needs to save two hundred grand over the course of their working life and have their contributions matched every step of the way by their employer to ensure a meagre annual pension of just over €23,000. That means putting aside €8,000 every year for 25 years – very difficult if you are on the average industrial wage of €36,000 (that’s pre-tax). Granted, pension contributions are often tax-deductible, but we are still dealing with a big number that will be deducted from one’s discretionary income.

Both types of pensions took a massive hit as a result of the recent downturn but this hit was borne in crucially different ways. Employees covered by defined benefit plans suffered less, since regardless of investment fluctuations their retirement benefits were guaranteed. Their employer always bears the brunt of any falling investment values. On the downside, one unfortunate shortcoming of this type of scheme is that weighty pensions obligations can sometimes cripple struggling corporations. Aer Lingus, a company know to have trouble with cash flow, currently holds a worrying debt in pension responsibilities. But short of a company going bankrupt, workers with this type of pension are safe.

Contribution pension funds tell a different story. This type of pension was decimated by the recession. In the United States the nation's 100 largest corporate pension plans fell by $303bn in 2008, going from a $86bn surplus at the end of 2007 to a $217bn deficit at the end of 2008. The average Joe, who possesses neither financial training nor the time to devote to monitoring his investments, saw the value of his pension massively decline. Pensions fell even as some companies made big gains and expanded; employers were not responsible for the health of their employees’ pension.

Civil servants are by and large the only remaining recipients of defined benefit pensions. This has created even more discourse between workers in the public and private sectors. It is hardly fair that public sector pensions are safe while private sector pensions have taken such a hit. 

We now know how difficult it is to build up a contributions-based pension, and how those who have managed it have still seen their savings diminish. The end result of these factors is that the state will be forced to bear the burden of financing the old age of this generation. Our struggling public purse will have to fund the retirement of those who in many cases worked for employers who could have easily afforded to pay for their pensions. The state can not afford this. Life-spans are increasingly getting longer. This will cause particular problems in countries like the US that have adopted an anti-immigration stance, since flows of immigrants are not available to counteract an ageing population (thought the US’ high birth rate will stave this off in the medium-term). Countries with low birth rates, including most of Europe, will really struggle.

To conclude I must say that having grasped the roots of this problem, I can’t quite see a solution. As always comments are welcome from sources with a better grasp of this subject than I.