This book studies the impact of the global financial crisis on defined benefit and defined contribution pensions and retirement. It is based on papers presented by leading experts in the retirement savings field at a 2011 symposium held by the Pension Research Council at The Wharton School.
From October 2007 to March 2009, the S&P 500 stock market index declined by almost 58 percent in real terms, a seemingly unprecedented and devastating blow to retirement financial security. But over the following four years, the market recovered, and is now hitting record highs.
With the benefit of hindsight, however, the pattern of stock market panic, collapse, and eventual recovery follows a pattern that has occurred several times in the lifetimes of current retirees. I calculate that between January 1973 and December 1974, the S&P 500 declined by 56 percent in real terms, and between March 2000 and October 2002, it declined by 52 percent in real terms.
As far as I am aware, the Pension Research Council did not publish similar books in response to the prior crises. So what was different about the stock market collapse of 2008?
The first important difference is that during the intervening period, 401(k) and similar plans have largely displaced defined benefit plans in the private sector, transferring investment risk from employers to employees. Employees may have a lesser capacity and willingness than plan sponsors to bear risk. Retired workers need to be able to convert financial assets into cash, even when prices are low and anticipated returns correspondingly high. In contrast, plan sponsors, who may only anticipate being net sellers in the distant future, can afford to take a longer-term perspective. An additional concern is that workers may panic and sell their holdings or suspend their contributions during market downturns. The second important difference between the recent and previous crises is that state and local pension plans were both in worse shape going into the crisis, which made them more vulnerable to market downturns.
The third important difference has been the dramatic decline in nominal interest rates during the recent crisis, which dramatically reduced the returns to balanced portfolios. Between March 2000 and October 2002, the Baa corporate bond yield declined from 8.37 to 7.73 percent. In October 2007, at the start of the crisis, corporate bonds yielded just 6.48 percent. After a brief spike, yields declined to an historic low of 4.51 percent in November 2012.
The good news, reported in the papers by Jingling Chai, Raimond Maurer, Olivia S. Mitchell, and Ralph Rogalla and by David Wray, is that participants generally behaved very sensibly and largely did not engage in panic selling. But there is not necessarily good news in another finding, by Barbara Butrica, Richard Johnson, and Karen Smith, written before the recovery in stock prices had become apparent. They found that the crisis will have only a modest effect on the retirement incomes of today's workers, but this reflects the fact that workers approaching retirement didn't have much to lose in the first place. One conclusion I draw from their paper is that, just as in previous crises, the primary mechanism by which the current crisis affected workers was the increase in the unemployment rate.
The chapter by Michael Hurd and Susann Rohwedder reports the impact of the crisis on consumption and on plans for retirement. Using data from the Health and Retirement Study and the Consumption and Activities Mail Survey, they find that households consumed less and plan to delay retirement. But economic theory predicts that these choices will depend not only on current stock and house prices but also on anticipated returns. Hurd and Rohwedder report that households in 2009 had strikingly pessimistic assumptions about prospective stock returns, with only 41 percent anticipating an increase, compared with 51 percent in 2009. Even without the benefit of hindsight, the beliefs held in 2009 were clearly irrational. Similarly, only 31 percent anticipated that their house would be worth more in a year's time. One wonders how much of the changes in households behavior reflects a rational response to changing circumstances, and how much was the result of a shift from irrational exuberance to irrational pessimism. The only redeeming feature of this irrational pessimism is that, even though households anticipated further stock declines, they did not, in general, act on their beliefs.
The book devotes five chapters to defined benefit pension plans. This emphasis is at first glance surprising, because private-sector coverage rates are declining rapidly. But the chapters reveal that such plans were hard hit by the crisis. Their funding levels had not fully recovered from the declines of 2000-2002 when the 2008 crisis ensued. In contrast to previous crises during which corporate bond interest rates remained broadly stable, corporate bond rates increased at first, reflecting an increase in anticipated defaults, and then plunged, driving up pension liabilities.
Retirement researchers in the United States sometimes look enviously at The Netherlands, where ‘social partners’ supposedly manage things better. The chapter by Lans Bovenberg and Theo Nijman contains a very clear description of the Dutch system, focusing in particular on the risk mitigation and risk pooling mechanisms used. Although the Dutch system has many admirable features, including mandatory annuitization, the chapter will disappoint some of those who admire it from a distance. The Dutch have not discovered a way to abolish investment and longevity risk. But while the old system sometimes brushed such risks under the carpet, the reformed system is to be commended for being more explicit in specifying how such risks will be shared.
The final chapter, by Andrew Biggs, examines how public-sector plans have responded to the crisis. It shows that they have increased their already high target allocations to risky assets. We can only hope that the bets pay off.
I wholeheartedly recommend this book to readers of the Journal of Pension Economics and Finance. The individual contributions are of a high standard, and the editors have done an excellent job of pulling them together into a coherent whole.
