THE FUTURE ROLE OF PRIVATE SUPERANNUATION

Brian Ferguson Department of Economics

Australian National University

Introduction Discussions of the problems of providing for a large

aged population like that with which a number of developed countries will be faced in the next few decades generally concentrate on the role of national superannuation systems. The national superannuation system proposed by the Australian National Superan- nuation Inquiry is probably typical of the sort of answers proposed, with its recommendation of a pension of thirty per cent of average weekly wages, indexed to a combination of average earnings and the consumer price index, to be paid to all Australians over the age of sixty five and to be financed on a pay as you go basis supplemented by funds from general revenues.

This sort of social security system has the disad- vantage that as the number of the aged rises relative to the number in the working population the tax that each worker has to pay must rise. In some countries, notably the United States, social security taxes are forecast to rise very sharply over the coming years, and the burden that this places on the working age group has become a major political issue, even though the steepest increases are still in the future. In Australia the National Superannuation Inquiry an- ticipated that workers would treat superannuation taxes as deferred wages and so not object to paying them. While social security may once have been regarded as a sort of social wage, this attitude has broken down in most countries, in part because people are increasingly doubtful about the capacity of un- funded national superannuation schemes to meet their obligations.

One way to ease the tax burden of a n ageing popula- tion is to ensure that as many workers as possible have as much access as possible to private savings in- struments, so that social security can aim more at assisting those whose income during their working years did not allow them to save for retirement a t a level society would regard as adequate. This sort of suggestion is often said to go against the social aim of universality in social security programs, but this should not really be a n objection since much of the im- petus to universality can probably be traced to the almost universal inadequacy of private mechanisms for retirement saving in the past.

Private Superannuation The potential of private pension plans in supporting

a large aged population appears to be significant. It also appears that very little of that potential has yet been realized. In Australia in the mid 1970’s only thir- ty per cent of the total workforce was covered by

superannuation, and this figure is misleading because while sixty per cent of public employees were covered only twenty per cent of the private sector work force had coverage.’. In the United States over half of the total workforce was covered, including forty four per cent of the private sector workforce, while in Canada between forty and fifty per cent of the total workforce was c o ~ e r e d ~ . ~ . In both Australia and Canada fifty five per cent of those covered were in the private sector, but there were considerable differences in coverage by industry as well as the large difference in total private sector coverage. Most notably, in Australia twenty nine per cent of workers in manufacturing and seven- teen per cent in construction were covered, while in Canada roughly forty five per cent of paid workers in each of these industries had pension coverage. By 1978 half of the paid workers in the Canadian manufactur- ing industry were covered.

There are problems with the management of private pension plans, as they stand, that may delay their growth in Australia. Many plans have stringent vesting and portability conditions so that a worker who changes jobs loses his claim on a pension from his previous job. Employers can take advantage of this to discourage quits by older, more experienced workers and use the pension fund contributions forfeited by younger workers who change jobs to cover part of the cost of the pensions of the workers who stay past vesting4. This means that fewer than the twenty per cent of private sector workers nominally covered in Australia may actually collect pensions. I t also means that the pension collected may be small, since it will depend on the number of years of contribution to the plan that actually vests. A survey conducted by the Australian Association of Superannuation Funds in 1979 found that the average lump sum benefit paid to workers earning $lO,OOO a t retirement was equal to only eighteen months salarys.

There is an additional disincentive to the develop- ment of private pension funds in the fact that in the past many funds appear t o have been poorly managed. Management quality is difficult to judge, especially in periods of economic upheaval like the 1970’s. when the best management can find it difficult to earn a satisfactory rate of return. For Australia the National Superannuation Inquiry reports that the average an- nual nominal rate of return earned by a sample of pen- sion funds over a four year period t o mid 1976 was 1.7%. This is very low for a period in which the infla- tion rate ranged from six to sixteen per cent and government bonds were paying six t o eight per cent, but it includes the period 1973-4 when the rate of return o n equities became negative in nominal terms. Over that period according to the inquiry three

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quarters of funds surveyed had a nominal annual growth rate of 3.2% or less. Canadian funds perform- ed similarly badly over the mid 1970’s. again because of poor stock market returns. Private pension plans earned average nominal returns of 4.88% a year while provincial government bonds were paying 6.92%. Even so in cases where longer term data are available pension funds typically have earned low rates of return. In the United States over the period 1966-77 bank managed funds earned an average nominal return of 4.4% annually, well below the average infla- tion rate over the period, and some of the larger American companies have taken their funds away from outside managers because those managers have consistently failed to earn reasonable returns on the funds6. Canadian pension plans have been subject to regulation of funding for some time. In the United States a major factor behind the introduction of strict regulations in the 1974 Pension Act was serious mismanagement of a great many funds.

In particular in the United States many plans were seriously underfunded. By 1976 Lockheed Aircraft’s pension fund had unfunded vested liabilities equal to 166% of the company’s net worth’. This adds another element of uncertainty to the employee’s pension since even a fully vested pension will be paid only i f the company has sufficient resources to make up the dif- ference between the funds accumulated by the plan and the firm’s pension obligation. When a firm with an underfunded pension plan goes bankrupt even workers whose rights have vested lose their pensions. The same applies to a fund that invests heavily in the company that sponsors it. In Australia it has been common for company pension funds to invest the re- quired thirty per cent of their assets in government bonds and invest the remaining seventy per cent in the company. This kind of profit sharing pension fund can pay pensions only so long as the company makes a profit. This is obviously undesirable if the firm is one the capital markets would regard as risky and would charge a high interest rate, since the firm will generally not pay a risk premium to the pension fund. The risky firm which uses its employees pension fund as a source of investment pays less than it should for the funds and forces its employees to bear the risk of losing both their incomes and their pensions should the firm fail.

Even a well managed firm is risky from the workers point of view if his pension depends mainly on the firm’s survival. Over the forty years of a worker’s working life even the best managed firm can fail if consumer tastes shift away from its product, and very few firms actually survive forty years. N o matter how solid the firm looks, an undiversified pension fund is a risky one.

Retirement Mutual Funds These management problems are not insurmoun-

table. The 1974 Pension Act in the United States was designed to deal with many of them. One suggestion that has been made to overcome a number of the pro-

blems now faced by private superannuation is that pension funds be managed by independent financial institutions, that is. mutual funds that would invest in a wide range of assets and be independent of the short run interests of the sponsoring firm or union. Anyone, regardless of what union he belonged to or what firm he worked for would be able to have his pension con- tribution paid into an account with such a fund. To re- tain the characteristics of a pension fund rather than becoming simply a savings bank contributions to the fund might be locked in, or a t least subject to favourable tax treatment only so long as they stay with the fund or are transferred from one fund to another. Allowing members to move their accounts from one fund to another would encourage competition among funds and should ensure that they earn better rates of return than existing funds have managed. There is evidence in Australia that more active competition has improved the returns earned by at least some funds la tely8.

In many ways these funds would be similar to the Registered Retirement Savings Plans that Canadians have been able to join since 1957. Total premiums, in current dollars, paid into RRSP’s rose tenfold between 1960 and 1970 and tenfold again between 1970 and 1976. and the number of contributors rose from 250,000 in 1970 to 1.3 million in 1976. In 1976 ag- gregate premiums paid into RRSP’s exceeded total employee contributions to employer sponsored pen- sion plansg. On this evidence the prospects for some sort of retirement mutual funds look very good.

The main argument for setting up such independent funds is that they would be operated in the long term interests of their members. This is long term interest defined in the narrow sense of maximizing the retire- ment income a member can expect. We must recognize that as the population ages many of the institutions that have traditionally acted in the interests of large groups of the population will face intergenerational conflicts of interest.

The union movement is likely to be particularly troubled by these conflicts of interest. Up until now rapid growth of both population and union member- ship have meant that the majority of union members were relatively young. Now, as both growth rates slow, unions will come to have increasing proportions of older members, whose interests will not necessarily coincide with those of the younger members.

There is an increasing tendency in the United States for union managed pension funds to be regarded as devices to be used to achieve general union goalsi0. Often this takes the form of refusing t o invest in firms that are regarded as anti-union, but it is increasingly coming to mean that a t least part of the pension fund should be invested in projects the union regards as socially beneficial. While some of the best managed pension funds have been investing in such socially beneficial operations for years with’out serious damage to their returns, this will not necessarily be true in general. Particularly so since what is regarded as socially beneficial tends to change fairly rapidly.

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When a union removes its investments from a firm which, though paying a good return on the funds, is regarded as anti-union, or when it directs part of its funds into projects like child care centres, i t is taking a step that is likely to benefit the younger union members, who have the whole of their working lives ahead of them. The risk associated with the decision is being placed on the older union members whose retire- ment income depends on the returns the pension fund will earn in the near future. This may have been feasi- ble in the past when there were many more young members than old, so that i f the pension fund was damaged the younger members could make increased contributions out of their gains from the use the fund had been put to. When a large part of the union membership is aged. however, this sort of compensa- tion runs into the same problem as does unfunded na- tional superannuation. The tax that has to be levied on each younger member becomes more than they are willing to pay. Rather than face the internal problems that can arise from this situation it will probably be in the long term interest of unions as institutions to remove the temptation to tax their older members for the benefit of the younger.

The major problem associated with the idea of retirement mutual funds is how to ensure that they d o invest in the long term interest of their members. Cer- tainly competition among them should help, but the institutional structure established would be important. In the United States pension fund managers have been tending more and more to concentrate their in- vestments in a few stocks. As a result, when the pen- sion funds buy or sell in the share market they can cause significant movements in share prices. This is some indication of the size of the funds but in this case it is also an indication of poor management since an undiversified fund is a risky one. Part of the reason for this increased concentration was that fund managers were often paid commission rates that depended not on the return earned but on the size of the trade. The basic fee was that paid for a 100 share purchase or sale, and a purchase or sale of 10.000 shares earned one hundred times the basic fee". The result was a concentration of investments that was in the interest of the agent, not of the principal. Similar problems would arise i f the fund were rewarded on the basis of short term returns. Clearly the incentives paid to managers of such funds would have to be given careful consideration.

Benefits to the Economy of Private Pension Plans

The benefits to rhe members of well managed pen- sion funds are clear, but there are also general economic benefits to be considered. One obvious benefit is that people with satisfactory private pen- sions are less likely to demand social welfare benefits. In the Australian case whenever a private pension plan fails and its members fall back on national superan- nuation the burden falls chiefly on the seventy per cent

of Australians who had no private pension of their own. This does not seem a particularly equitable distribution of the burden.

Another benefit to the economy as a whole is the fact that private superannuation can be a major source of funds for a long term capital investment. By 1974 in the United States, for example, pension funds had reserves of close to two hundred billion dollars12. Canadian funds, which had been subject to stricter funding regulation than had American plans and so tended not to be seriously underfunded, had assets somewhere in the vicinity of f i f ty billion Canadian dollars'3. While this Canadian figure includes assets of public sector funds, which tend to place most of their reserves directly into government securities, i t still represents a major source of funds for the private in- vestment sector. Australian private fund assets come to about five billion Australian dollars, so there is still room for growth.

There is some disagreement over how much growth these large pools of capital generate. Drucker has sug- gested that over the ten or fifteen years prior to the mid 1970's they were one of the two major sources of American economic growth, and elsewherei4 that retirement saving was a major factor in Japanese economic growth. The National Superannuation In- quiry expressed some doubt about how much growth actually results from increased capital stock. We must consider the effects not only of increasing stocks of ex- isting types of capital but also the effects of technological improvement. The sort of innovation that many people oppose now in the fear that increas- ing the level of output a single worker can produce will generate unemployment, will be very welcome at a time when the productive labour force is small relative to the retired population. For that type of capital to be in place when it is needed will require fairly extensive research and investment programs over the next years.

The advantage of pension funds is not that they in- crease national savings greatly. It is reasonably well established now that people respond to increases in both national superannuation and private superannua- tion by reducing their saving in other forms. The essential difference between the two types of superan- nuation is that funded pension plans replace the lost savings while unfunded national superannuation does not. The result is that aggregate saving is increased slightly by increased private pension coverage and reduced by national superannuation.

The most significant factor in the effect of private pension funds is that they tend to invest much more heavily in long term assets than d o individual saversiJ. The probable result of shifting a large part of person saving into pension funds would be a reduction in the long term interest rateI6 and an increase in investment. Private funds would probably be much more effective at this than would public employee superannuation funds since only thirty per cent (the 30120 rule) of private fund assets are in public sector securities while fifty per cent of public sector funds a re in public sector securi t iesl'.

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Problems of Private Funds The major obstacle to taking advantage of the

economic benefits associated with a well developed system of funded pension plans is that people do not particularly want funded pensions in the current state of the economy. The rate at which a funded pension accumulates real purchasing power for retirement depends on the real interest rate. I f the real interest rate is negative, as it was for several years in Australia in the mid-1970’s a pension fund typically loses rather than gains real value, unless it makes significant capital gain.

Fully funded pensions, which are necessary i f the worker is to be certain that funds will be available to pay him a retirement pension, are typically defined contribution plans. This means that the member makes a fixed contribution to the plan each year and the pension he receives on retirement depends on the value that has accumulated in his fund over his work- ing life. In periods of high current and expected infla- tion people prefer not to lock their savings into in- struments that are going to lose value.

I n general in times of uncertainty about inflation people tend to shift their savings into short term in- struments. even though these instruments pay lower nominal (and therefore lower real) rates of return than do long term instruments. Short term instruments have the advantage of greater liquidity, allowing sav- ings to be moved into whatever form seems to be the best inflation hedgeI8. In particular this may make i t easier to move into real assets, which may appear more likely to hold value. Despite the higher interest rates paid on long term assets it is frequently not possible to move out of a particular asset without incurring a significant penalty.

In terms of pension funds the response has been a move away from defined contribution plans in favour of defined benefit plans. These are plans which tie the pension a worker receives not to contributions he makes but to the salary he earns over some period of employment. It has been common, for example, for the pension to be some fraction of the average income he earned over his last three or five years before retire- ment. Increasingly common are plans that base the pension on the average income the worker receives over his best three years, the three years of highest in- come from work. In periods of rapid inflation the highest income years are also likely to be the final years of employment. Another response to rapid infla- tion is for the period over which the average is calculated to be reduced - from five t o three years, for example.

I t is frequently suggested that by agreeing to a defin- ed benefit plan the worker is simply transferring the risk associated with inflation to the employer. This oversimplifies the case, since what the worker is ac- tually doing is exchanging the risk of inflation for the risk that the firm will be unable to meet its pension obligations in the future. The reason is that a defined benefit plan is virtually impossible to fund in any

serious sense. A fund could be accumulated, but for i t to accumulate sufficient resources to pay a pension whose level is independent of the level of the fund would require accurate forecasts of incomes, inflation and interest rates over periods as long as forty years. I f the fund has not accumulated sufficient reserves to meet its pension obligations the difference must be made up from the firm’s current resources. This is precisely the situation of many American pension plans before t h e 1974 Pension Act. and the high rate of failure of these funds was one of the reasons the act was introduced.

For the employee near retirement age who works for a firm that can reasonably be expected to survive for the period he expects to live in retirement the introduc- tion of a defined benefit plan is a good thing. I t would probably pay him a higher pension than he would get from a defined contribution plan, especially i f there has been a recent period of inflation driving his nominal income up. For younger workers i t is equivalent to buying a lottery ticket that will not pay off for forty years. The probability of any given firm surviving forty years is very low. so the pension plan becomes a very risky asset. Of course new firms come into existence as old ones die and some workers will be able to protect their pensions by moving from an old firm to a young one with a defined benefit plan, but even in this case the level of the pension benefit may depend on the number of years service with the firm. Other workers will be unable to move and will lose all or part of their pensions.

Switching to a defined benefit plan essentially puts the private superannuation plan in the same situation as an unfunded national superannuation plan, with one vital difference. While national superannuation can be funded out of taxes imposed on the whole economy an underfunded defined benefit plan must be paid for by the active employees of a single firm. The tax burden that becomes a political problem for the economy as a whole can drive a single firm into bankruptcy, ensuring that employed workers lose their source of income and retired workers their pensions.

The beneficiaries of the defined benefit plans being introduced now are workers who will retire in the near future. The potential losers are workers who will not retire for many years and whose pensions are made more risky assets than they would be if they were fund- ed. The second level of losers consists of the future taxpayers who will have to pay social security benefits to workers whose pensions have failed because of deliberate underfunding.

An ageing population need not put serious strain on an economy with a well funded private pension system, but an inflationary economy is one in which a well funded pension system is unlikely to develop. I f there is a burden associated with the coming ageing of the population it will probably be because the ageing happens to coincide with a period of continuing high inflation.

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Footnotes

I would like to thank J . D. Pitchford and 1. G. Mann- ing for discussion on this Paper.

1 .National Superannuation Committee of Inquiry, Final Report, Part Two, Occupafional Superan- nuation in Australia Canberra, March 1977.

2.Peter F. Drucker. The Unseen Revolution, Lon- don, Heinemann 1976.

3 Statistics Canada, Pension Plans in Canada 1974 and Pension Plans in Canada 1978, Ottawa, 1975 and 1979.

4.Schiller. B. R. and Weiss, R. D., “The Impact of Private Pensions on Firm Attachment,” Review of Economics and Statistics, August, 1979.

5.Australian Financial Review, July, 1979. 6.Canadian figures from Economic Council of

Canada, One in Three, Ottawa 1979. American figures from The Economist, September 1 5 . 1974. On firms see Business Week, May 15. 1978.

7.Fortune Magazine, November 1977. 8.The Bulletin, October 2. 1979. 9.Statistics Canada, Pension Plans in Canada 1978.

Part of the popularity of RRSP’s is clearly due to the favourable tax treatment they receive.

I0.Fortune Magazine, December 3 1, 1979. l1.Martin Mayer, The Bankers, paperback edition

Ballantine 1976. 12.A. H. Munnell. The Future of Social Securiry,

Brookings Institution, Washington 1977. 13.Economic Council of Canada, Onein Three. 14.Peter F. Drucker, “Japan: the Problems of Suc-

cess” Foreign Affairs April 178. Drucker also sug- gests that Japan has benefited in the past from the fact that few people lived long enough to collect their pensions, so the saving did not have to be con- verted into comsumption.

15.Committee of inquiry into the Australian Financial System, Interim Report, 1980.

16.For an American Study of this effect see Friedman. B. M.. “The Effect of Shifting Wealth Ownership on the Term Structure of Interest Rates: The Case of Pensions” Quarterly Journal of Economics. May 1980.

17.Committee of Inquiry into the Australian Financial System.

18.Committee of Inquiry into the Australian Financial System.

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