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In this uncertain era, middle class Americans may be asking themselves what happened to the dependable pensions they were hoping to live on. In Brazil, pensions are perceived as hollow promises for the many, while the few retire in luxury at 50 years of age or younger. Chile’s famous pension system is proving to be a crushing disappointment to the cohorts who began saving 35 years ago.

In the United States and Europe, the topic is especially controversial. The World War II generation fared well, compared to the bleak prospects for the people born after the Baby Boom. Every year, the proportion of non-government employees entitled to pension benefits declines, and other trends have also worsened the prospects for the middle classes.

In the 1950s and 1960s, pensions were an expected part of the employment contract for a broad and growing range of skilled or unionized workers. Unions advocated for pensions for their members, and union membership rose until the mid-1950s. Wall Street liked pension funds because the funds bought stocks and bonds, and generated fees and commissions.

Each year the proportion of America’s marketable securities owned by pension funds increased, fueling the great stock market rallies of the 1950s and 1960s. In a period of exceptional economic growth, pensions performed well. Benefits came as promised or better, particularly when the actuarial assumptions were set with Depression-era conservatism. That post-WWII long boom set the expectations high for future generations.

What undermined that happy confluence of forces?

Young companies (technology firms, for example) wanted the best and the brightest, and those individuals demanded either cash or the right to manage their own savings for the big profits that were so easy to achieve in the stock market. Think the self-managed individual retirement account (IRA) or 401(k). Technological change and higher risk preferences increased job mobility. Meanwhile, old smokestack oligopolies, with traditional defined benefit pension plans, declined, and some plans went into default.

As a reaction to major pension defaults, Congress passed the Employee Retirement Income Security Act (ERISA). This law attempted to prevent future disasters by imposing reporting requirements on pension funds. It also allowed retirees to sue the pension fund administrators for poor performance. In consequence, new and growing companies chose to provide pre-tax income to employee-directed IRAs and 401(k) funds.

Company-sponsored pension plans went into a steep decline, and self-directed, tax-deferred savings took their place. Now, decades later, the beneficiaries of these self-directed pension plans are chagrined about how inadequate the results of the privatized systems have been. Millions of American workers over age 65 have had to postpone retirement because they have not accumulated enough to retire.

What derailed the financial express train?

First, young people tend not to start saving immediately. And when they do start, they do not save as steadily as their parents did. Nowadays, pensions are individual and portable. That sounds like a virtue but has a cost that is hardly ever mentioned: the sum of all self-directed pension accounts cannot perform as well as the sum of pensions, because the portable, self-directed scheme lacks the tontine effect. That is, beneficiaries who die early do not subsidize beneficiaries who live longer than the actuarial assumption.

A key part of the pension arithmetic is that while all contribute, not all live long enough to collect. By dying early, they subsidize the ones who live longer. This is the tontine effect, named after a Victorian-era investment contract or annuity organized on the same theory. In contrast, the contributor to a portable, self-directed plan who dies early leaves the account balance to his heirs.

Therefore, workers in the aggregate must contribute more to portable, self-directed pension plans, in order to assure themselves of the same monthly pension check for as long as they live. And the beneficiary of a portable, self-directed account may save more that his pension-receiving comrade, but he doesn’t know how much to pay himself, because he doesn’t know how long he’s going to live.

What can we do about it?

After decades of experience, it appears that portable, self-directed, tax-deferred accounts can be good supplements to a basic Social Security pension that pays for basic needs. But a private, voluntary self-directed scheme does not protect the entire age cohort that is retiring now, and might work even worse for future cohorts.

To arrive at a practical set of remedies, we must first accept the declining role of large companies, and relinquish the dream of lifetime secure employment. Small companies are the greatest job creators, and job hopping is here to stay. To gain the tontine effect again, “group” pension accounts will help. These pension funds already exist for teachers and university administrators. This design can easily be extended to other professional groups. Workers leery of volatile stock markets and anemic returns on 401(k)s might embrace the group plan approach.

John C. Edmunds is a professor of finance at Babson College. He has taught at Harvard University, the Fletcher School of Law and Diplomacy at Tufts University, the Arthur D. Little School of Management, Boston University, Hult International Business School, and Northeastern University. Mark F. Lapham, CFA, is a consultant to Massachusetts-based companies. He holds degrees from Harvard University and Babson College.


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