Misunderstanding public pensions

The battle lines have now been fairly clearly drawn between the position of the Ontario Liberal Party and the Federal Conservative Government on public pensions. The Liberals would like to expand the government pension program, and since the feds are not willing to expand CPP, they are proposing the creation of an Ontario Pension Plan. The Harper Government is opposed to this, as is the provincial Conservative party. Their view is that people should just save for their own retirements.

This is a line of argument that one hears fairly often, but which upsets my inner economist. (You hear it all the time in the United States – whenever people talk about privatizing Social Security, they propose individual savings accounts as the alternative.) The problem is that it involves comparing apples and oranges. Wynne is saying “we are going to provide oranges,” and Harper is saying “why should people get oranges from the government, when they can just go out and buy apples?” — to which the natural response, it seems to me, is to say “because they want oranges.”

Okay, that’s a bit obscure so let me try to explain. Put simply, pensions are not the same thing as savings. Pensions – of the sort that Wynne is proposing – are an insurance product. Savings are just savings.

To see the difference, consider the central problem with savings. How much should you save for your retirement? That depends on how long you expect to live. Average life expectancy in Canada at age 65 is about 87, so you need to save for just over 20 years of retirement. But what if you live to be 100? Or 110? If all you have is savings, you face a significant risk of running out of money.

This is where the insurance industry comes in, with a niftly but obscure product called a life annuity. It helps people to protect themselves against the risk of outliving their savings. You make a large upfront payment, and in return the annuity pays out a fixed monthly sum, starting when you retire and continuing until you die. That way you are guaranteed not to run out of money.

(The insurance dimension comes from the fact that the company sells a lot of these annuities, to people from different walks of life. It makes money on those who die young, and loses money on those who live a long time, so that on average it comes out even. This is the same principle as any insurance pool – with automobile insurance, for instance, the insurer makes money on those who don’t have accidents, to cover the losses it incurs from those who do.)

The problem with life annuities is that they are very hard to buy, as an individual, and they are very expensive. In other words, they are subject to market failure. (For example, if I go to RBC right now and try to buy an annuity, they won’t sell me one. Why? Because I’m too young. This a textbook market failure.) The central problem is adverse selection – the insurer has great difficulty separating the good risks from the bad risks, and so at any given price point it attracts a surfeit of bad risks, forcing them to raise prices, which makes the product unattractive to the good risks.)

One response to this is to purchase life annuities collectively. This is essentially what a defined benefit pension scheme is. You pay a certain amount upfront, in return for a fixed monthly payment upon retirement, until death. People who allowed their employer to convert their defined benefit pension to a defined contribution pension essentially got suckered, because a defined contribution pension is nothing but a fancy name for a savings account, and a savings account is basically self-insurance.

Just to be clear, self-insurance is always an option. Instead of buying car insurance, in principle you could just “save up,” so that if you have an accident you can buy a new car, or if you hit someone you can replace their lost income. Or instead of having home insurance, you could just “save up,” so that if your house burns down you could buy yourself a new one. I think we can all see the problem with these alternative arrangements.

If someone came up to you and said “I’m taking away your home insurance, but it’s no problem, you can just save up, and buy yourself a new house if you need one,” you would rightly protest. But if someone comes along and says “I’m taking away your life annuity, but it’s no problem, you can just save up for your retirement,” you should react in exactly the same way. You don’t just want a house, you also want home insurance. And similarly, you don’t just want retirement income, you want retirement income insurance.

But because of the inefficiencies in the private life annuity market, and the increasing scarcity of defined benefit pension plans, the only place that the average person can go to, in order to get an annuity, is the government. Public pensions, such as the CPP, or the proposed OPP, are essentially a bundle of collectively purchased life annuities. Furthermore, government delivers them far more efficiently than the private sector does (one need only look at the overhead costs – premiums taken in minus payments made out), to see that public pensions are a good deal. But one can only see what a good deal they are if one makes the relevant comparison, oranges to oranges – public pensions versus privately purchased life annuities, not public pensions versus private savings.

One parenthetical remark: All women should be in favour of both defined benefit pension schemes and public pensions, for reasons of pure self-interest. Because women live, on average, longer than men, women have to pay more for life annuities when purchased on private markets. For various reasons (having to do with confusion about the economics of pensions and insurance) employers and the state are prohibited from imposing higher pension contributions on women than on men. The result is significant cross-subsidization between men and women in the insurance pool.

Finally, just to emphasize that the decline of the defined benefit pension schemes is a serious problem, consider this nice article in the Financial Post:

In the past decade, life expectancy at age 65 has increased by two years, a rate of growth that is about twice what it was in previous decades.

“That means that reasonably healthy people will have to find two more years of pension income from somewhere,” said Ian Markham, Canadian retirement innovation leader at pension consultancy Towers Watson.

There are “profound societal implications” when life expectancies increase so dramatically, including an expected “material” drop in many people’s standard of living later in retirement, he said.

The lucky ones will be those with defined-benefit pensions, Mr. Markham said, because many such plans promise set benefits for a worker’s entire retirement.

Those without a defined-benefit plan will “need to seriously manage their available budget during their retirements years, spend carefully, and make sure they have a great relationship with their loved ones who may feel compassionate enough to help out financially later on,” he said.

That last sentence is worth rereading, because it reveals exactly what’s wrong with the Harper government’s proposal: people will need to “make sure they have a great relationship with their loved ones who may feel compassionate enough to help out financially later on.” I’m not sure if that’s what I would call “security” — the fact that your children “may feel compassionate enough” to support you!

The “lucky ones” are those with defined benefit pension schemes. The fact that you have to be “lucky” to have this insurance product is, again, a symptom of pervasive market failure. That is exactly why the state should be expanding public pensions. The article fails to mention that the Canada Pension Plan (or the Quebec Pension Plan) is also a defined benefit plan – and no one needs to be “lucky” in order to participate. Which is the way it should be — you should not need to get “lucky” in order to have a secure retirement.


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