The simple, popular, and naive way to address the looming pension crisis

Future of Finance
Future of Finance

Stock markets are volatile, interest rates are low, and people are living longer than ever. This is an ugly combination for pensions, which are struggling to fund increasingly long retirements with increasingly meager returns.

But there’s a solution: just guarantee a certain level of investment returns. This could be a minimum return, a range of returns, or a certain amount each year. Remove the uncertainty of how savings grow over time, and you avoid the risk of running out of money in retirement. Forget all that stuff about you hear about how “past performance does not guarantee future results.”

There are serious policy proposals suggesting such things, like this one (pdf) by Teresa Ghilarducci of the New School (an economic adviser to US presidential hopeful Hillary Clinton) and Tony James of Blackstone, a big asset management firm.

In their proposal, all American workers would contribute to a special savings account, choosing from a set of investment managers on an exchange administered by the government. Savers would have a choice of several diversified, low-cost funds. But, crucially, if markets tanked before a person retired, or they just had bad luck investing their savings over time, the account would be credited as if it earned 2% each year.

Both California and Connecticut—neither state particularly flush with cash—seriously considered offering a minimum return on new pension accounts for people without employer-provided retirement benefits. The state of Nebraska offers a plan to state employees that sets a minimum annual return of 5% when the time comes to pay out benefits.

Private pension accounts in which savers shoulder all of the risk, like the 401(k) in the US, are here to stay, so we need creative ideas to address the risks associated with savings. A 2% guarantee is a fairly modest proposition. Even so, it’s not clear who will pay for it, though Ghilarducci and James suggest that savers could pay “a small insurance premium like depositors pay on savings accounts.”

Even small guarantees can be expensive. Insurance companies charge dearly for them. Brookings also recently detailed the cost of government-backed guarantees, and they are not cheap (pdf). What’s more, since putting a floor on returns creates an incentive to invest in riskier assets, it makes the guarantee more expensive because it must insure against more risk. Even for a 2% guarantee, which ensures that assets more or less keep up with inflation, the cost is estimated to be 5-6% of every dollar put into the account.

Setting aside the question of affordability, even with a return guarantee savers face lots of hidden risks. The guarantee only ensures a certain amount when a worker retires. But it doesn’t help with the riskiest aspect of pension investing: judging how much to spend and save after retirement.

Ghilarducci and James address this problem by requiring account holders to buy an annuity with their savings. This probably won’t be popular with anyone but economists. Annuities are very expensive right now, and not just because of fees. Annuity prices are based on current interest rates—the lower the prevailing rate, the harder it is for a provider to generate returns to fund long-term payouts, and thus the higher the annuity price.

That means even if a worker is promised a certain amount of retirement wealth, their actual income in retirement (from the annuity) can be totally unpredictable. A person with $1 million in savings who retired in September 2004 could buy an annuity of $60,000 for 30 years. Today, the same amount would fetch only $44,000.

No problem: One way to deal with this risk is to guarantee the annuity price, too. But this heaps extra costs and risks on pension plans. Nebraska offers an annuity to the state’s public employees that’s based on an interest rate of 7.75%, an enormous premium to the 2.5% yield on 30-year US treasury bonds.

Nebraska’s plan director Phyllis Chambers tells Quartz the plan, despite the generous guarantees, is in great financial shape—so great that it has made extra bonus payments. That may be because, shockingly, only 10% of plan participants take up the extremely generous annuity option. (For their part, Ghilarducci and James say their plan would initially offer a 2% annuity rate, and then vary according to the average of interest rates over the five years before retirement.)

Guaranteeing pension returns—either before or after retirement, or both—is clearly a popular policy for both savers and sponsors. But the details are daunting, and the risks only grow as the scope of guarantees expands and more people take up the plans, testing the generosity of sponsors—and the taxpayers who back them.

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