I initially posted this blog as a forum here, but as that has only been read twice (and I am one of that count) I decided to cross-post it as a blog.
On the risk and fairness of a uniform contribution rate and award regardless of member age
A uniform rate of pension award, say 1/40th CARE, regardless of age is a form of risk-sharing among members. It serves as glue binding members together in a common enterprise. However, it has been widely characterised and criticised as being simply a transfer of value from the young to the old. The argument here being that a young member’s contribution is invested for far longer than an older member. As we shall demonstrate this argument is flawed.
The idea that a 64-year-old should receive the same award as a 25-year-old runs counter to basic intuitions of the time value of money. The contributions of a young member are invested for far longer than those of an older active member and should accrue much higher investment returns. There are some strong views on this. For example, from one reviewer we received the following comment: “If the self-employed person is choosing where to put his retirement savings for a year, he is not going to buy CDC pension units where the price for a 30-year-old is the same as the price for a 60-year old.”
The traditional response was to accept this proposition but proceed to offer the counterargument that the young member could in time and turn expect to benefit in that same way as today’s 64-year-old. This has fallen from favour with the often-cited view that labour mobility has increased, that few of today’s 25-year-olds will be employed by the same sponsor firm or members of the same scheme in their fifties and sixties. Of course, if membership of the scheme is unaffiliated with an employer, as is the case in Australia, this counterargument once again has merit. Here, membership of a scheme would be a matter of individual choice as, for example, with the choice of bank account that one’s income from employment is paid into.
An illustrative example
Let us consider this proposition for two members of a scheme, one 24 years old and one 64 years old. The first point to note is that the younger member will expect to receive a much larger pension in absolute terms than the older member, because of wage and price inflation and increasing their longevity in the intervening 40 years. In the numerical illustration which follows, the total undiscounted pension which will be received by the younger member over their time in retirement is 2.27 times that of the older member.
Table 1 below considers a range of contribution rates for this particular set of projected pension benefits and their associated scheme contractual accrual rates (CAR). The CAR here may simply be thought of as the rate of return needed for the total contributions to the scheme to compound to the pensions projected. It also shows the contribution rate necessary to achieve payment on time and in full for each of the 24-year-old and the 64-year-old.
We can see immediately that there are transfers from the young to the old at contribution rates up to 25% of salary. However, at higher contribution rates and lower CARs, there are transfers from the old to the young. In other words, the uniform rate of award serves as insurance for the younger member against falling rates of investment return. For these particular benefits projections, the point of no transfer between the old and the young is a CAR or investment return of 2.79% or equivalently a contribution rate of 28.6% of salary.
As we move to higher rates of wage and price inflation then this breakeven point of no transfer rises; if we move from the 2% of the earlier projections to 4%, then the breakeven rises to around 5%. In other words, for the younger member, the uniform rate of award also serves as an inflation hedge.
The breakeven point
It is also worth noting that the breakeven is the special case of contributions being the same proportion of salary for all members. This is often presented as a different approach, when in fact it is a subset of the wider approach. If we adopt this approach of using the same contribution rate as the scheme average for all members (which makes member pots at retirement age-related) we are abandoning the collective insurance offered.
It is also clear that the use of inflation adjustments as a risk control mechanism will tend to disadvantage the young relative to the old actives versus pensioners by altering this breakeven or insurance trigger point.
For completeness, we should state that if pensions are identical for all members in monetary amounts, that there are no increases in longevity or wage or price inflation, the breakeven rate and insurance aspect do not exist.
What about fairness?
This brings us to the question as to whether the cost of this insurance is fair to all members. For CDC schemes? This a matter of estimating how likely it is that investment returns will fall below the breakeven CAR and the magnitude of the transfers resulting.
Fairness among members of the terms of initial award and then the maintenance of fairness among members within the scheme are key to ensuring intergenerational sustainability. If a scheme is fair among members, then it is fair also to new members and with that, is intergenerationally fair.
The younger member faces far greater uncertainty and risk than the older member. This is uncertainty is its broadest sense and risk is simply the quantifiable subset of that (and a very small part of it at that). It is present in all of the variables that contribute to the projections and ultimate pension amounts and their duration once awarded. In CDC schemes, this risk is assumed by the pension scheme as a question of intent though not guarantee.
If we consider just the investment risk faced by the younger member arising from this mismatch of term, it is 1.7 times that of the older member. If we now consider the 15% contribution case above with its 5.67% mean CAR and introduce an asset portfolio having a volatility of 15%, this investment risk alone has a value of 2.13% pa to the younger member. The CAR of the younger member is 3.98%, which means that the member is forgoing 1.69% relative to the mean, but that is significantly below the investment cost they would face from volatility if standing alone. The younger member’s position is much improved relative to individual DC. We are accustomed in collective arrangements to cross-sectional risk pooling and its benefits; this award arrangement extends this to the time dimension.
Of course, there are some younger individuals who will prefer to see their contributions and the resultant benefits related to the time invested. They are simply saying that they prefer the traditional DC arrangement where they will stand alone at retirement faced with what has been described as the ‘hardest problem in finance’, uncertain beforehand as to the value of their pot at retirement and if or how to convert that to income in retirement. Given the uncertainties we have described, there is little that they can do to resolve these difficulties in advance.
The fact is that all outcomes are highly uncertain and particularly so for younger members. However, this arrangement constructed amidst all this uncertainty, clearly conforms with the Rawlsian concept of fairness[i] as arrangements which are constructed and accepted behind a “Veil of Ignorance”. As such, a willingness to be part of the scheme is due to the likelihood of a better outcome for a member. While perhaps not costless, in the sense that they may have to give something up, it is much more secure than going it alone, as what is forgone is uncertain anyway. Member motivation is therefore simply that they want to do well for themselves and are prepared to conform to reasonable terms of cooperation, provided others do as well.
[i] John Rawls (1999) A Theory of Justice: Revised Edition, Cambridge, MA: Harvard University Press