The pension system is a broken system that is quietly driving us over the cliff to another financial disaster, and worse, a potential human tragedy. Yes, I’m talking about social security, the system that helps Grannies and Grandads enjoy their golden years. Most people may not have much of an opinion on social security; those that do may have qualms but still accept the system in a more abstract sense. I want to overhaul the system from top to bottom. It sucks.
“Why do you hate the pension system so much, Ross?” Well, I’m glad you asked. Here are a list of the things that get me angry about the way the pension systems in the UK and US are structured:
- The ability for the government to meet its pension obligations is predicated on the fact that it can tax a large employee base to provide pensions to a much smaller group of pensioners. Today, the dependency ratio of workers to pensioners is roughly 4.5 in the US and 3.6 in the UK; by 2035, those numbers will have plummeted to 2.6 and 2.4 as the baby-boomers retire. Can the government pay all these new pensioners without raising taxes? The unproductive retired class possesses more wealth in aggregate than any other age group, so how can the government justify redistributing wealth from the Millenials, the very age-group it desperately needs to be productive?
- On the other side of the equation, while the government is struggling to raise funds to meet its obligations, the income received by pensioners themselves is barely enough to maintain an adequate quality of life by itself. What’s the point in providing any income if that received is inadequate? 36% of boomers plan to rely on Social Security as their primary source of income post-retirement, but the average retirement benefit is a meager $1291 per month in the US, and a miserly £116 per week in the UK.
- The whole system is so frickin’ arbitrary!!! There is no variation to the payment a pensioner receives, whether they live in the heart of San Francisco or rural Iowa, whether they are Warren Buffet or your average Joe. Anyone who has paid taxes for 10 years is eligible once they hit 65. Why is 65 the magic number? It is a threshold that is the way it is because that’s the way it always has been. Given how arbitrary the system is, we might as well reward everyone with a “pension”, also known as a universal basic income, but that’s a whole different story.
- The system in its current form is on a path to its own destruction, an implosion the likes of which could produce widespread poverty amongst the elderly at Great Depression-era levels, a potential tragedy worsened by the fact that it could have been prevented with effective policy making.
The Canary in the Coal Mine
The Airline industry is the canary in the coal mine in regards to pension crises. United, American and Delta have all had to file for bankruptcy over the past 15 years in order to escape the pension obligations they owed to their employees under their “defined-benefit” pension plans. These plans mimic the national social security system, paying a fixed amount of income to their employees once they retire just as the governments in the US and UK pay their citizens a fixed income once they reach retirement age. Under these plans, the burden of responsibility falls on the entity providing the income (the Airline company or the government).
To cut a long story short, the airlines were crushed under the weight of this responsibility in the face of competition and a changing macroeconomic environment (especially in regards to the super-cyclical decline in interest rates). Post-bankruptcy, employees were left at the mercy of the Pension Benefit Guaranty Corporation, whose job it is to pick up the slack of companies who have abandoned their pension commitments. Today, the airlines utilize the “defined contribution” model in which the burden of responsibility falls upon the employee to save for their retirement, incentivized by employee matching schemes.
Millenials will be the victims when the current system implodes
Fortunately, a government is not a company, and there is no way (though never say never) developed nations with deep capital markets such as the UK or US would ever enter any kind of strategic default in order to escape their obligations. But they do share many of the characteristics of the airline companies pre-bankruptcy: it is too easy for governments and companies to inadequately fund their pension plan assets due to the long-term investment horizon. Fund managers mask the problem by using unrealistic assumptions as a hurdle rate for expected growth, which in today’s low-for-long rate environment would be laughable if it didn’t have such massive implications for so many people’s financial health.
The long and short of it is that the baby boomers will probably be fine: the government can afford to borrow at historically low interest rates and the pension plans will bleed for a long time before killing the patient; the real victims will be today’s workforce, who pay social security and national insurance taxes but are unlikely to ever see anything in return. So how do we fix this?
A model solution in Singapore
Singapore is a tiny country, but its methods of running a government are admired around the world, and one of the ways they stand out is in their welfare distribution model, and especially their social security system. In Singapore, the government operates a social security system called the Central Provident Fund (CPF) which operates similarly to the “defined contribution” plan utilized by companies throughout the world. This is from the CPFs own info packet:
“Singapore’s social security framework is founded on the principles of self-provision and self-reliance. The responsibility to provide for one’s own retirement needs lies primarily with the individual, and with his family. This reduces reliance on the state and ensures fiscal sustainability for the long-term. For vulnerable individuals unable to provide for themselves despite best efforts and who have no other sources of income support, the Government administers financial assistance as well as other non-financial help measures.”
How does it work? Citizens under the age of 50 are mandated to contribute 20% of monthly wages (pre-tax) to their individual CPF account, and their employers contribute 15.5%. 90% of what Singaporeans ultimately get is tied to what they put into the system, so hard work is rewarded; there is a safety net, however, for the very sick and poor who cannot contribute. The result is a system that may be result in higher pay outs for those who have contributed most, but it still manages to cover everyone in Singapore and, crucially, is financially sustainable in good times and bad, without relying on indefensible assumptions and politician approvals (read more about how the CPF works here).
The other benefit of this system is that it removes the “agent” problem, whereby the government has the requirement to continue funding its pension funds adequately, but has the perverse incentive to fund it only at the bare minimum (because funding a pension fund doesn’t win votes). The CPF is entirely divorced from the government’s budget, and everyone is able to maintain their own account and keep track of their retirement savings.
We have a messed up social security system that was designed and conceived in a bygone era. In order to stave off bankruptcy we need a more flexible and adaptable system that empowers and incentivizes individuals to take ownership of their retirement planning.
My frustration stems from the lack of dialogue around the problem as it exists today, coupled with the fact that a potential solution has been implemented so successfully in a developed country on the other side of the world.
I’m not trying to argue that Singapore has all the answers; Sweden, for example, has a model which allows citizens to choose a private pension or a public pension scheme, and has automatic triggers that allow the state to reduce pensions if the government can’t afford them.
There are a thousand ways to improve the system as we have it today. Lets start talking about them, before its too late.