[quote=harvey][quote=SK in CV]A little lesson on the difference between defined benefit plans and defined contribution plans…
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Then the shit hit the fan a few years ago, when investment returns were sharply negative. The required amount to fund all future payments was computed just as it had been in the past, but the fund balances at year end were signficantly lower than the required funding. Employers (plan sponsors) were required to make up that difference. That’s what caused the crisis.
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I don’t disagree with anything in your explanation above. But there are a couple of observations that I think are interesting and relevant:
#1: The explanation offers no hint as to who is responsible for the crisis. (In fact the explanation actually emphasizes that the employers did nothing wrong.) Sure the market crashed, but that happens. It has happened before and will happen again. Was no one responsible for recognizing this basic risk? Did anybody do anything wrong?
It is difficult to accept that we have a crisis of this magnitude, in a system that is specifically designed to mitigate risk, and somehow nobody is to blame.
#2: We could easily take the explanation above, change a few words here and there, and replace “pensions” with “mortgage backed securities.” In other words, there was a financial model that supposedly managed risk, the model blew up, and there were massive losses.
Remember those AAA rated securities?
It’s interesting that you mention that “annuity companies do this all the time, they’re very good at it.” Remember AIG, one of the largest annuity companies in the world?
Two phrases stand out in the explanation that are noteworthy: The word “assumptions” along with the the term “fully funded.” Both are central to the problem. Who defined the standard for “fully funded?” Because, obviously, the accounts were not funded well enough to weather a downturn (and a downturn that wasn’t terribly big by historical standards.) It seems that fully funded isn’t really “fully” funded after all.
The pension system is using the term “fully funded” to mean “we are comfortable with the risk.”
It’s easy to be comfortable with risk when you can just pass it off to someone else.
I don’t see any fundamental difference between the root cause of the pension crisis and mortgage crisis. Both were based upon flawed financial models that failed to predict certain events. Both were supposedly based on systems designed to mitigate risk, something they completely failed to do. And both were based on the desire to get more out of the system without putting more in (some call this “greed.”)
And that gets to the crux of it: Who bears the risk? Why is so much of the public-sector compensation system set up so that all long-term risk in their retirement portfolios is borne by the taxpayer?
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You make some good points.
I probably should have worded the “didn’t do anything wrong” part a little more carefully. When actuaries tell a plan sponsor that a plan is fully funded, it’s perfecly reasonable (under normal circumstances) for the plan sponsor to accept that finding and not make any additional contributions for that year. I know I’ve looked at it in the past with regards to CalPERS and I really don’t remember what I found. I have no recollection whether I found the actuarial assumptions to be reasonable, nor do I recall any specific criticism that those assumptions that were unreasonable at the time they were made.
As to your point #2, not only are the two similar, they are inextricably related. Who were the biggest investors in those AAA rated mortgage backed securities? Pension funds. And more than any single type of investor, pension funds pay careful attention to those ratings. I don’t think there’s any 1 party or participant in the mortgage crisis that can be pointed to as THE culprit. There’s half a dozen at least that had significant responsibility. The ratings agencies, in any case, are pretty high up that ladder. Had they not failed miserably, the pension shortfall would have been much smaller, maybe even never reached crisis level by anyone’s definition.
But of course that’s not the entire story either. Historically, pension funds have been risk-off investors. That changed about 15 years ago, and with declining interest rates for the last decade, they moved more into the risk-on investment market. Though I suspect even with that higher risk exposure, they would have survived just fine had the fixed income market not tanked as it did. But then, had that market not failed, the equities market wouldnt have either.
