8. Smoothing investment returns
long-term and a short-term component. This is perhaps best illustrated in the context of mortality risk, which is also transferred from DB scheme sponsors to DC members. It applies to the costs of the death benefits payable to members’
dependants, and to the risks of longevity. The relatively short-term risks of fluc- tuations in experience can be absorbed by insurance contracts and life annuities.
These can be purchased from life insurance companies or self-insured by the fund. Longer-term fluctuations require changes to premium rates. The distinc- tion between the long- and short-term risks effectively depends on the financial capability of sponsors and insurance companies to provide guarantees. They can do so for short-term risks, but not for the long term.
The issue of financial capability is also relevant to long- and short-term investment risks. The risks are, however, much larger. Estimates of the long- term net real rate of return vary from about 1 per cent to 5 per cent annually.
The lower return is that available from indexed-linked stocks – after inflation, taxes and expenses. The upper end of the range arises from the estimates of Dimson et al. (2004) of the likely equity premium. The equity premium arises from a number of sources: the inherent risk and the costs of investing are prob- ably the most important. Dimson’s estimate of 3.5 per cent for the equity premium is lower than that reported by Welch (2000) in a survey of econo- mists, but probably more realistic. With typical contributions and expenses, the difference between 1 and 5 per cent would translate into a DC pension of between 35 and 130 per cent of average income when spread over a 60-year span. This compares with a variability of perhaps 10 per cent each way in the value of a life annuity as a result of unexpected changes to mortality over the life of a typical pensioner.
If long-term investment returns are lower than expected, members of DC funds will have to contribute more during their working lives, accept lower pensions or work for longer. The last strategy can be very effective: each year of additional contributions will increase a pension by some 10 per cent. The major role for investment smoothing is to provide members with more time to adjust their plans for retirement in line with variations in long-term investment returns.
Cross-subsidies and Inequities in DB Funds
The DB design does not provide a model for such smoothing, not least because it is impossible to guarantee investment returns forever. In a DB fund, the long-term variability in investment returns will produce differences to contri- bution rates of the same order as differences in DC benefit levels. Lower investment returns will lead to higher contributions by sponsors (either the employer or the state) over a period that is likely to extend beyond the work- ing life of the members.
In employer-sponsored schemes, there would be no inequity if the salary packages of new employees reflected the ex ante fair value of the promised benefits, and the employer absorbed the profits and losses arising from devia- tions in investment returns from those expected. Neither condition is usually met. The first condition would require salary packages to be adjusted for the value of the pension benefits accruing. It is, however, practically impossible to distinguish between groups of members, such as different generations of recruits. This creates cross-subsidies between the groups, the value of which is seldom, if ever, determined.
The failure to calculate the value of the cross-subsidies between different groups of employees also means that the second condition cannot be met.
Little attempt is usually made to determine whether the employer is bearing a fair share of costs. This opaqueness and imprecision in the allocation of costs open the way for strong opportunistic parties to benefit at the expense of others, either by manipulating changes to benefit levels, or by frustrating equi- table changes. The beneficiaries are likely to be shareholders, but could also be senior management or union officials. This insurable moral hazard is explored in more detail in Asher (2000).
These issues are writ large in a state-sponsored scheme. Even if the rela- tionship between contributions and benefits is determined initially in such a way as to be fair, economic and demographic changes will soon create unin- tended, and frequently implicit, cross-subsidies between different groups of contributors. Making changes is politically fraught, as the acrimony of current debate on the issue bears witness.
If the rules of DB funds were never changed, they would give rolling guar- antees that extended for the lifetime of every cohort of new members: an infinite guarantee. This is clearly unreasonable, but there is no simple way of setting the rules to ensure that no interested group will wrest an unfair advantage for itself.
Modern finance and accounting, with their increased focus on market values, have begun to identify the cross-subsidies that arise in DB funds, and the unacceptable risk that they can bring to the finances of the sponsor. It is perhaps not surprising that growing numbers are being converted into DC funds, which have four clear advantages over DB designs:
• Members’ entitlements are clearly set out and not subject to manage- ment discretion or political manoeuvring.
• The relationship between contributions and benefits is clearly fair, and free of significant but implicit cross-subsidies.
• The risks to the sponsor are not inherent in the benefit design, and any guarantees can be explicitly managed.
• Members are free to participate in the equity premium, so possibly reducing contributions or increasing benefits.
Smoothing investment returns 147
Managing Risks in Retirement
In the long run, the equity premium means that investments in equities produce lower pension costs. The price is significant short-term volatility: falls of 30 per cent and more within a year have been commonly experienced.
Once they have retired, it is likely to be difficult for fund members to re- enter the employment market to make up for investment losses. Members therefore need protection against such significant falls in income after retire- ment. This protection should probably begin before the retirement date, as plans for retirement presumably take some time to implement. Superannuation funds therefore need investment instruments that offer protection against investment fluctuations over this relatively long, but finite, period.
The strategy employed by most DC funds and their members is to use a combination of investments in order to give an optimum mix of security, infla- tion protection and participation in the equity premium. To the extent that the equity premium arises from the correlation of share prices with the universe of consumption, it may be possible to develop other assets that share this risk without the short-term volatility. One possibility would be to develop invest- ments that provide a cash flow that could match pensions, and was linked to a wage index. This is the approach taken by the new Swedish notional DC national scheme. Asher (1994) suggests a method for utilizing housing finance.
In the absence of these instruments, the next section describes how volatile investment returns can be smoothed to produce a more acceptable income flow, and provides a family of algorithms to do this fairly and efficiently.