Retirement risk - you can't remove it

Megan McArdle always wrote interesting (if occasionally economic-nerd-appealing) articles when she was at The Atlantic, and I'm glad to see that her move to the Daily Beast hasn't quenched the fire. Her latest piece on risk transfer in the USA retirement system should be required reading for anyone with a vested interest in retirement - and if you're planning to live to 65, this means you:

There is no system that gets rid of retirement risk. It just shifts who bears the risk. And don't think that there's some easy political fix, because the same political incentives that have stymied sound regulation of whatever system you want to fix, will also shape whatever new system you want to create.

McArdle is looking at the US retirement system, but the same situations and incentives apply almost equally in the UK. Indeed, she points out that the US state retirement solution (Social Security) is generally lauded for its relative lack of perverse incentives compared to other countries - yes, George Osborne (and Gordon Brown), we're looking at you.

For UK readers of McArdle's article, a 401K is pretty much the same as a personal (defined contribution) pension with tax relief on the contribution; Roth and IRAs (Individual Retirement Accounts) are similar though have different tax relief components. The problems faced both sides of the Atlantic appear to be distressingly similar:

That is, private pensions no longer rely on the premise that retirement can be made cheaper through investment in assets that grow faster than GDP. But such a free lunch was what made the plans attractive for employers in the first place, and as employers have faced the plans' real costs, they have increasingly eliminated them.

For anyone on the receiving end of a shutdown of a defined benefit private pension, McArdle's explanation will doubtless be cold comfort, but the truth is usually uncomfortable. She also identifies the risks associated with retirement:

• investment risk: the money you put into the stock market gives lower returns than you were promised;
• savings risk: you've saved too little for your retirement;
• sovereign debt risk: government has borrowed too much and run out of the money promised to public sector workers and social security retirees.
• company risk: the company pension fund either has too little money to pay retirees the full whack, or is nailed by a company bankruptcy.
• tail vs idiosyncratic risk: attempts to provide a more "reliable" retirement funding concentrate risk so that previous common-but-small-impact failures (like companies going bankrupt) are replaced with unlikely-but-catastrophic failures (government running out of money, affecting pretty much everyone).

She points out that the move away from defined benefit pensions in the private sector removes company risk but replaces it with investment and savings risk. The attempts to get government to backstop all pensions are removing idiosyncratic risk but trading it for tail risk - if you think a government running out of money is unlikely, just look at Greece. And look at Spain, and Portugal, and in 10-20 years maybe France as well. She doesn't cover actuarial risk, but it's a factor too - if people live longer, annuity rates will fall and governments will need to pay out state benefits for longer.

Luckily public sector workers are rolling in the clover - aren't they? Well, being in the public sector they've traded idiosyncratic risk for tail risk:

Idiosyncratic failures are less likely to be catastrophic. It's very bad if your pension fund collapses. But you may have a sibling whose pension fund has not collapsed, or a spouse. Your children have a spare bedroom. You have social security benefits. And unless you live in a company town, you can probably pick up a part-time job--and if you do, you can move to one. But if everyone loses half of their social security benefits, your social network is probably suffering just as badly as you are.

For this reason, any country with an increasing fraction of employees employed by the public sector should be terrified. The cost of public sector pension payments can be met by increased public sector contributions, but governments find it much easier to raise contributions by employing more people - thereby deferring the problem, but ensuring that it's going to be that much worse when it hits.

The one solution I really like is Denmark's:

Denmark's quasi-mandatory system forces almost everyone to put 9-15% of their income into a defined contribution plan. Average assets in these plans total almost $200,000 per person.

Let's be clear; there's still investment risk here, but at least Denmark has eliminated savings risk. I doubt, however, that such a system can be extended to the UK (let alone the USA) without a massive depressive effect on the economy, and no politician is going to go for that. After all, the benefits won't be felt for 10-20 years, and he'll be up for election in 4.