The financial crises of 2002, 2008 and 2011 have important implications for retirement provision all over the world. In many countries unfunded pension rights have been cut because of budgetary problems for the government. Likewise pension wealth in funded defined contribution (DC) accounts has often dropped significantly and defined benefit (DB) plans are often severely underfunded. Growing old contains four chapters that reflect on the implications of the crisis in 2008 and is primarily based on a conference in October 2010. The title somewhat optimistically refers to the 2008 crisis only, but of course many of the lessons from the book are equally relevant for the implications of the subsequent Euro crisis as well as for preparation for the future.
The book addresses three main topics: valuation of pension rights in and sustainability of DB systems, the pros and cons of public versus private pension systems and the determinants of adequate risk taking for retirement provision. Robert Novy-Marx and Josh Rauh convincingly argue that the financial crisis has further worsened the underfunding of many DB pension systems. For US municipal pension obligations they show that the market consistent value of the claim offered to participants hugely exceeds the available assets. More and more assets and liabilities in the financial sector are to be valued on a market consistent basis and the European regulator (EIOPA) even argues in favor of a market consistent ‘holistic balance sheet approach’ to achieve more consistency in pension accounting within Europe. Nevertheless US legislation still allows discounting of future cash flows at rates as high as 8%. Much more transparency about the current underfunding and how it might affect future pension payments seems required to protect the sustainability of the system. The plea in other chapters to help participants to select adequate investment risks and to communicate clearly on the risks that are present supports the need for market consistent valuation. In the Netherlands, drastic steps have recently been taken in this direction. Benefit cuts have been announced and the entitlements have been made explicitly dependent on return on financial markets. Pension rights are valued at a market consistent basis and strict supervisory rules force funds to reduce benefits if not adjusting them would hurt the sustainability of the fund and the interest of future participants.
In another very interesting chapter Akito Nomura identifies a global shift from public to private pensions, to increased levels of prefunding and from DB to DC plans and argues that notwithstanding the recent crises this is the right direction to go. Specifically Nomura compares the pension systems of Japan, Korea and China and how they developed over the years. Among other issues he discusses the growing importance of DC plans in these countries, in particular in China. The financial crises have shown that investment risks can have drastic implications for pension provision. This opens the issue as to how decisions on asset allocation in funded pension systems are to be taken and who takes them. In China this is done by trustees, in other countries participants take major investment decisions themselves. The choice between these two models is also discussed in the contribution by Olivia Mitchell on managing risks in DC plans. She advocates a role for plan sponsors in helping employees combat financial illiteracy and inertia. Adequate defaults such as automatically enrolling participants in target maturity date funds and adequate annuity structures can give employees some control on their risk taking and support the legitimacy of the system while avoiding all the financial mistakes that individual decision-makers easily make in such complex problems. Mitchell also rightly argues that many other risk factors than just market risks are important and refers, e.g. to longevity risk, to labor market risk and to the risk of significant changes in the costs of living for the elderly (health care costs in particular). Also the risk of system failures is important because promises that have been made (e.g. even by pension guarantee funds) cannot be met due to inconsistency between the nature of the promises and the valuation standards and supervisory rules (compare Novy-Marx and Rauh).
In the final chapter Bob Pozen, Betsy Palmer and Natalie Shapiro examine the asset allocation of institutional investors in the wake of financial crisis. They document a changing allocation from equities to bonds and alternative investments. Unfortunately the authors did not or could not analyze the question to what extent these changes in asset allocations are driven by (return) guarantees that have been provided to participants. Surprisingly the authors argue in favor of additional risk taking after a drop in asset value because ‘pension funds need high returns to fill their funding deficits’. To me it seems that the needs and preferences of the participants should be leading here and I assume that the risk appetite of most of them has reduced rather than increased because of the financial crisis. Cutting benefits that cannot be met seems preferable to additional risk taking.
A common theme in all chapters and an important take away from the book in my view therefore is the need for consistency between the preferences of participants, the risk profile selected for or by them and the valuation of all existing promises. The financial crises have forced us to consider lots of hard questions. This book contains important ingredients to finding adequate answers to these questions.
