Climbing the Pension Mountain: A Review of Michael Otsuka’s 2020 Uehiro Centre Lecture Series

Written by Professor Larry Locke (University of Mary Hardin-Baylor and LCC International University)

On three successive Tuesdays last November, Michael Otsuka of the London School of Economics delivered the annual Uehiro Centre Lecture Series.  The Series, entitled “How to Pool Risk Across Generations”, focused on the ethics of pension reform.  Otsuka attacked the real-world problem of low bond yields producing a crisis of pension funding with three alternative models.  Echoing Derek Parfit’s magisterial work, On What Matters, Otsuka presented his proposals as three alternative means for scaling the dangerous summit of pension obligations.

Otsuka’s proposals are important.  Ethics issues rarely come with this much money at stake.  In 2018, the Office of National Statistics published a study showing that UK pension schemes were underfunded by over £5 trillion .  That is an attention-grabbing number but not extraordinary in the context.  The Trustees of the US Social Security system recently published their 2020 report indicating this scheme alone anticipates a shortfall of US$16.8 trillion over the next 75 years.  Like scientists employing standard form when the numbers they use become too large to comprehend, the US Social Security Administration now refers to its shortfall in terms of percentages of total payroll taxes.

The proposals Otsuka has set forth are not amoral financial models.  Each involves shifting risk and responsibility among parties, and sometimes across generations, with diverse arguments as to the fairness of these shifts.  Any resulting pension system’s impact on lifestyles and liberty for workers, employers, and governments may strain the social contract between these groups and set them up for a potential fall.

Proposal 1: Funded Defined Benefit [LINK to presentation recording]

Otsuka’s first proposal is for a funded pension scheme with a defined benefit.  The current trend in both the UK and US is to migrate pensions away from defined benefit schemes (in which employers provide pensioners fixed retirement payments for life) towards defined contribution schemes (in which workers invest a portion of their earnings and draw upon those investments in retirement).  There are several reasons for this migration.  One of the more prominent is that the bull market in fixed income securities over the last 25 years has resulted in interest rates approaching (and sometimes beneath) 0%.  With rates at these levels, an investment portfolio of low risk securities sufficient to fund employers’ pension obligations could require employers and employees to double their contribution from what it was 25 years ago.  The impact on worker take-home incomes would be dramatic, not to mention the impact to employer profitability, and the broader economic impacts resulting from both.

Otsuka’s proposal is to encourage employers to invest in higher return investments such as equities.  This could allow employers and workers to keep contributions closer to historical levels.  Otsuka proposes to reduce the additional risk accompanying equity investments by pooling employers in the same industry (and perhaps also across different industries) and rendering them mutually responsible for each other’s pension obligations.  The model for such pooling would be the Universities Superannuation Scheme in which over 100 UK colleges and universities currently participate.

Of course, this proposal raises potential ethical issues.  It is unclear how one could justify the unfairness of better funded employers subsidizing employers with weaker balance sheets.  This unfairness could be exacerbated by underfunded employers responding to the moral hazard by taking increased risks, knowing that their pension obligations are secured by the balance sheets of their competitors.  Otsuka contemplates that healthier employers may avoid this problem by buying their way out of participation in the pool, as Cambridge’s Trinity College did with USS in 2019.  This ability, however, could create an adverse selection problem if the most valuable members of the pool deserted, leaving the pool weaker each time.

Industry-wide regulation of pool members could address some of these potential problems but would also limit employers’ ability to experiment strategically.  At its worst, the pool members could find themselves strategically bound together as they are fiscally bound, causing a loss of freedom to experiment with potentially valuable alternative strategies.

Proposal 2: Collective Defined Contribution Plan [LINK to Recording of Lecture]

Otsuka’s second proposal is for a defined contribution plan model, applied on a collective basis instead of the typical individual basis.  Rather than allowing individual pensioners access to only the pool of investments they (and potentially their employers) had set aside, pensioners would have access to investments from a cohort of generationally similarly pensioners in the same scheme.  A sufficiently sized cohort would avoid the longevity risk of individual DC plans as the law of large numbers would establish a predictable longevity for the cohort as a whole.  The cohort could further avoid the loss of income from “derisking” its collective portfolio as members approach retirement by agreeing to redistribute savings from those dying early to those living longer.  Importantly, Otsuka’s second model does not necessarily require pooling investments or pension obligations between cohorts.  The younger do not supplement the elder, or vice versa.

Otsuka notes that his second proposal raises its own ethical issues.  While, in his first proposal, employer pools allowed for transgenerational spreading of risk, employers in his second proposal see their obligations limited to their annual contribution, if any, to the plan assets.  The version of his second proposal which he discusses at greatest length avoids redistribution across generations by limiting available assets to those within the cohort.  This limitation, however, necessarily focuses the risk from investment losses, increases in longevity, or broader economic shifts such as inflation, on the members of the cohort.  Otsuka’s first proposal’s pooling of employers raised questions of fairness within the pool.  The issue of fairness of sharing risks within the pool remains but in the second proposal it is focused on arguably more vulnerable actors, employees.  Otsuka addresses this potential unfairness with the argument that a natural, almost Rawlsian “veil of ignorance” may exist for 20-somethings entering the scheme as they enter the workforce.

Proposal 3: Unfunded Pay as You Go Plan [LINK to Recording of Lecture]

Otsuka’s final proposal involves an unfunded pay as you go plan.  This plan would be similar in structure to US Social Security and many other public sector schemes.  Payments to retirees are funded, or at least underwritten, by the government’s power to tax current workers.  These sorts of plans are generally structured to allow pensioners to retire without becoming dependent on state welfare and distributions to retirees may not significantly correlate to what those pensioners paid into the scheme during their working years.  This proposal would be preferable for protecting vulnerable retirees through economic redistribution versus Otsuka’s previous two proposals.  However, its reliance on redistribution raises questions of both intergenerational and intragenerational fairness.

The intergenerational fairness issues of the pay as you go scheme can be most extreme for the first and last participants in it.  If, at the launch of the scheme, those retiring immediately are allowed to receive payments, as was the case with the US Social Security system, those retirees receive a free ride.  That free ride could ultimately be paid for by those who are working when the scheme is discontinued.  They would pay in to the scheme while working but receive nothing upon retirement.  Otsuka proposes a potential remedy for this problem.  He hypothesizes that, if the scheme were launched by only allowing younger workers to participate, paying into the scheme, those payments could be retained for the benefit of the last group of retirees when the scheme was wound down.  All the intervening generations of retirees would be paid by current workers on a pay as you go basis, but the final retirees would be paid from funds received from the first generation of workers before their retirement.

Otsuka suggests a Rawlsian argument may support the intragenerational redistribution in the pay as you go scheme.  But he critiques his own argument with the reply that it is most readily applicable to individuals who are truly ignorant as to their own future.  Given the social and economic advantages that some workers enjoy from birth, this limitation weakens the application of the argument of mutual advantage required by Rawls.  A redistributive version of the third proposal, Otsuka maintains, is closer to modelling impartial altruism than Rawlsian reciprocity.

Convergence of Economics

Otsuka argues that his proposals tend to converge when broadened over time and space.  A state pay as you go scheme in which taxes are paid into the state’s treasury begins to resemble a nationwide defined benefit scheme in which contributions are invested in illiquid, unsecured government bonds.  A collective defined contribution plan begins to resemble both a funded defined benefit plan, and a pay as you go plan, if the scope of the plans cover the entire economy.  Otsuka suggests that it is not the exact vehicle that will determine the success of pension reform, as long as it is properly structured.  Rather its success will depend on the scope of the new scheme and the public’s acceptance of its fairness.  He argues that if the intergenerational fairness issues can be sufficiently addressed by the structure of the scheme, the intragenerational trade-offs may be found mutually advantageous to each worker at the time she enters the scheme.

Divergence of Residual Risk

But even as Otsuka’s proposals converge economically, the residual risk of the structures remains disparate.  If the scheme fails, through investment risk, longevity risk, or broad economic factors, each proposal lays the problem at the feet of different groups.  Failure of the scheme, it should be noted, is not impossible.  This mountain is steep, and there are many unknown crevasses.  Any number of underlying changes could cause pension schemes to fail.  Pension consultants XPS Pensions has estimated that this year COVID-19 has reduced the cost of pension obligations for UK companies by as much as £60 billion.  In happier times, unexpected improvements in technology, healthcare distribution, or lifestyles could just as readily increase those obligations.

Otsuka’s first proposal sets the residual risk of the scheme on employers, and disproportionately on larger, better funded employers.  In addition to potentially limiting employers’ strategic opportunities through regulation, this proposal also brings pensioners into competition with other stakeholders of the employers in terms of fairness and application of the broader social contract.  Current employees, clients, suppliers, and others may experience value being diverted from them to pensioners.  If universities were required to provide lower value education with fewer faculty (imagine all classes taught in amphitheatres) at higher tuition rates in order to fund pensioned faculty and staff, other stakeholders might step in politically to disassemble the scheme.  The societal role of universities, like most employers, requires them to continue delivering their services with a viable value proposition.  It is as if the proposal sets the employers at the base of the mountain to belay the climbers, bound together to minimize defection, and also gives them a number of competing responsibilities of at least equal importance.

By switching from a DB to a DC structure, Otsuka’s second proposal shifts residual risk from employers to employees.  The proposal somewhat reduces the risk to individual employees by pooling their longevity risk together.  It also allows for Otsuka’s goal to keep pension assets invested in higher returning equities rather than low yield bonds even as the employees approach retirement.  This increased return and mitigation of longevity risk, however, comes at the price of the liberty of the employees.  Tied together in a pool as they are, employees are no longer free to experiment with different investment strategies to satisfy their different objectives and preferences.  Like climbers roped together on the face of a mountain, they may only advance by acting in unity, even if the chosen path proves treacherous.

The third proposal differs from the previous two in that it sets the residual risk of the scheme on the state, rather than on employers or employees.  The state’s unique power to tax provides an important tool for avoiding defections from the scheme, as might be expected in proposal 1, and possibly extreme impositions on vulnerable retirees, as might occur in proposal 2.  This same reliance on taxation, however, causes the third proposal to involve the greatest loss of personal liberty, both for employers and employees.  Individuals or firms whose risk tolerance, life expectations, or other views mitigated against such a plan would presumably be un-allowed to opt out.  Their ability to experiment with alternative choices would be most limited under this scheme.  This proposal is like a climber being roped to pitons all the way to the summit.  It may or may not be secure but her path is completely laid out for her.

Further Exploration – Applying Multiple Proposals and Increasing Liberty?

Each of Otsuka’s proposals compellingly challenge some of the current thinking on pension reform.  (May his tribe increase!)  But rather than defining a single optimum approach, might not all of Otsuka’s proposals, and potentially others, be applied in tandem without sacrificing the necessary scale?  Pooled groups of employers might provide a funded defined benefit scheme in stable industries like higher education where collaboration would not necessarily dampen innovation.  Employees outside those industries might mandatorily (and employees within those industries voluntarily) participate in collective defined contribution schemes.  Government may provide an unfunded pay as you go plan designed to failsafe pensioners whose income from other schemes failed to reach a subsistence level in retirement.  Although sizing the different schemes may be complicated, combining them may actually reintroduce more individual liberty as workers become able to pursue alternative retirement goals, even when entering the workforce.  There are indeed multiple means by which to scale the pension mountain but it is unclear whether it is necessary to sacrifice allowing individual climbers to choose their own path and safety equipment to fit their individual needs and climbing style.

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