Growing Old: Paying for Retirement and Institutional Money Management after the Financial Crisis

Introduction

1 Introduction 1 The recent financial crisis and subsequent recession resulted from a series of major failings: excessive incentives for lenders to originate subprime mortgages and for others to securitize them; poor risk management by financial institutions; serious failures of oversight by state and federal financial regulators; and far too much leverage in too many financial institutions and households. While the immediate dangers from the crisis have abated—the financial system has returned to profitability and the economy is growing, albeit slowly—the damage to the economy will linger for years. Among the many impacts of the crisis is the growing interest in early retirement, perhaps because so many of the older unemployed are unlikely to find another job. That, in turn, has highlighted a problem that may be most acute in the United States: how government and private companies will honor their obligations under “defined benefit” (DB) pension plans—those that promise a post-retirement stream of payments based on some combination of workers’ seniority, their average or highest level of pay, and perhaps other factors. The yawning gap between the costs to support pension obligations and the funds available to cover the costs is, without overstatement, highly disturbing if not alarming. In part the problem is one of demographics: the number of workers relative to the number of retirees has been shrinking and will continue to do so. But that challenge has long been yasuyuki fuchita richard j. herring robert e. litan The authors wish to thank Matthew Garza for his extraordinary assistance in preparing this chapter. known and therefore cannot fully explain the shortfalls. Why, then, are so many pension schemes so hard pressed? One widely publicized answer lies in the generosity of many plans. The anecdotes are many. In California, for example, more than 9,000 state and local managers have retirement incomes of over $100,000 a year. Public schemes often calculate benefits based on final salary rather than average salary and allow employees to cash out unused sick days without limit. Private companies have been shying away from such commitments for some time now, but the original plans still exist and the residual commitments are significant. Although most pension plans in the United States today are “defined contribution” (DC) plans— which are based on a worker’s own contributions, typically with some employer match—as of 2006, DB plans could still be found in two-thirds of the companies in the S&P 500. A second answer lies in the tangle of accounting standards and actuarial conventions that allow DB plan sponsors, especially those in the public sector, to obscure the extent of their obligations and to scrimp on funding. To be sure, calculating those obligations is complicated, but current rules often permit generous return estimates of 8 percent while eschewing best practice techniques such as risk adjusting expected returns. That is especially pertinent because regardless of financial performance, pension fund obligations will need to be paid. With market returns on risk-free or low-risk assets having been driven to record low levels by the Fed and other monetary authorities, how will or can these obligations be met? That question vexes not only pension funds, but insurance companies, university and charitable endowments, and other institutional investors. Questions regarding the future of pension plans and institutional investment following the financial crisis were the centerpiece of the 2010 conference on financial policy issues jointly organized by the Nomura Institute of Capital Markets Research, the Brookings Institution, and the Wharton Financial Institutions Center and held at Brookings in October 2010. This volume contains revised versions of four papers presented at the conference. This introductory chapter provides a summary of the chapters that follow. The broad theme that runs throughout the chapters is that DB pension systems are in direct need of reform and that there exists no better time than the present to reckon with the challenges involved. Akiko Nomura, of the Nomura Institute of Capital Markets Research, contextualizes the global nature of pension reform in chapter 2 by examining what has been happening in Japan, Korea, and China. The discussion in this chapter provides a useful introduction to many issues that relate to the United States and Western Europe as well, which are addressed in the remaining chapters. 2 yasuyuki fuchita, richard j. herring, and robert e. litan Nomura identifies three global trends in pension reform: a shift from public to private pensions...