Retirement Income Guarantees Are Expensive

Traditional defined-benefit pension plans depend on funding by employers to preserve the security of their income guarantees. The U.S. Social Security system depends on demographic stability. In both cases, security has proven to be elusive. In neither case does one find contingency reserves created in good times to help sustain security in bad times. Instead, society turns to defined-contribution arrangements, thereby throwing the risk onto individuals. Individuals have their own problems to cope with, however, involving uncertainty of both longevity and investment returns. The unsurprising lesson overall is: Eliminating risk is expensive. It is all too easy, and all too tempting, to forget in good times that retirement income guarantees are expensive. Employee benefit plans, the U.S. Social Security system, and individual retirement arrangements—all confirm this lesson.When the U.S. Congress passed the Employee Retirement Income Security Act in 1974, it strengthened the funding requirements for corporate defined-benefit (DB) pension plans. Congress failed to recognize, however, that uncertain investment returns create risk, which in turn requires funding flexibility so that contingency reserves can be built up in good times and drawn down in bad times. Instead, Congress imposed further restrictions in the 1980s, restrictions that ensured an underfunding bias in DB plans.In addition, actuaries, ignoring equity risk in their valuations, have assumed simply that the risk premium will be realized. In consequence, actuarial funding targets make benefits insecure. Moreover, the confusion between a funding target (which ignores risk) and the value of the benefit (which is based on a risk-free return) leads to defined benefits being underpriced.Sponsors need flexibility to underwrite defined benefits for employees. And employees need to recognize that the cost of the defined benefits is higher than commonly thought.In the Social Security system, the mechanism for security is a demographic balance between retirees and contributors. This balance has become unsustainable in the United States, as in many countries. But no contingency reserve was built while Baby Boomers were contributing to the system, so Social Security benefits are now subject to political risk.Both in traditional employer plans and in Social Security, income guarantees are under attack. This development is a pity because defined benefits are healthy for society. They enable individual risks to be shared by groups, thereby making retirement incomes secure.In the corporate world, defined-benefit plans are rapidly being replaced by defined-contribution plans. Defined-contribution arrangements, however, leave individuals facing two forms of uncertainty in generating retirement income—longevity and investment returns. Experts understand investment uncertainty and speak of distributions and standard deviations of returns. Lifespan uncertainty needs to be understood, and explained, in a similar way. What is the standard deviation of life expectancy? Planners should be as familiar with this concept as they are with the standard deviation of equity returns.Coping with both kinds of uncertainty is difficult and costly, particularly when interest rates are low and the present value (cost) of a fixed retirement income increases. To guarantee their retirement income, many individuals have to take on investment risk or reduce their hoped-for standard of living—or both.Risk is not nice. But retirement income guarantees are expensive.