Defined-benefit pension plans (DBPPs) are ones that pay out a fixed monthly amount for the life of the pensioner, possibly with a cost-of-living adjustment for inflation. Social Security in the US is a prime example. There are thousands of other defined-benefit pension plans worldwide sponsored by governments and government agencies, corporations, insurance companies, not-for-profits, unions, financial trusts, etc. What DBPPs share in common is being financially ambushed by rapidly increasing longevity in the general population.
These plans traditionally have been designed so that income and outgo of a pension fund would balance for the population concerned taking multiple variables into account, among these being actuarial statistics for longevity of a plan’s participants. Traditionally these life-expectancy statistics have been slow-changing. So, in setting up a new plan changes in life expectancy could be ignored or accommodated by a built-in general contingency margin. That is the way it was in the 1930s and 1940s. So what happens when the plans are faced with “runaway longevity,” life expectancy growing to be far beyond that expected? The answer is financial crises and unsustainability for the DBPPs concerned.
Even without extraordinary longevity as advocated in this blog, many existing DBPPs are already having serious financial problems with their participants living longer than expected. According to an article appearing yesterday in the UK Times Online, “Directors and pension trustees have already been cruelly mauled by the British population’s habit of living longer than expected, drawing extra pension payments in the process. In the past 12 months UK longevity forecasts have risen by a year, sufficient to increase the combined FTSE 100 pension deficit by £1m an hour, according to Hewitt Associates, a firm of actuaries(ref).” If that rate of longevity increase is correct and keeps up – growing by a year in 12 months, it sounds like pension funds that expected participants to behave right and die off in 15 years might have to keep paying them off forever.
One response of DBPPs has been to close down to new participants; another has been to cap cost-of-living increases; many have gone into deep deficit. “Some groups with large deficits in their defined-benefit schemes have gone farther, stopping existing members from accruing new benefits. Others have chosen a middle course. Royal Bank of Scotland last week said it would cap increases in benefits at the rate of inflation or 2%, whichever was the lower. The news did not go down well with the 60,000 affected employees, who had watched Sir Fred Goodwin, the chief executive, leave with a £17m retirement package.” – “Longevity, however, has silently crept up on trustees and companies, and has provided a nasty surprise. — Pension schemes are, at the moment, having to deal with a “bulge” in longevity caused by the health improvements made in the past 20 years. Once this spurt has been dealt with, trustees think they should be all right if they assume perhaps an increase of 1% or 2% each year. They might not. “The problem with estimating longevity is that many of the judgments are subjective. You don’t know how long people will live,” said Martin Bird, the UK lead on longevity at Hewitt(ref).”
I also think it might be a mistake to view the current rate of longevity increase as a “bulge” or “spurt.” I suspect the rate may actually grow higher instead of going down. See the May 2009 blog entry The Social ethics of longevity. There I argued that social evolution requires that people live longer – and is in fact leading to longer and longer life spans. Also see the blog entry Average US life expectancy is up 73 days in one year. (I am not sure, by the way, the Times article was correct in stating that life expectancy in Great Britain increased a year over a year-long period even though the main point of the article is correct.)
DBPPs have been on their way out for several years now, being replaced by defined-contribution plans. These are plans like IRAs where the retiree benefits are not fixed but are based on what the retiree wishes to draw out from a pot of money put into the plan during working years and invested. In the US at least, money in such a plan can be grown tax-free. Nonetheless, DBPPs have a long history and strong supportive constituencies. A history of Social Security in the US going back to 1600 can be found here. Keeping the existing DBPPs going in the face of increasing longevity is likely to become a very contentious process, pitting “entitled” pensioners against “realist” financial managers. I expect the future political process associated with social security reform in the US will make the current health-system reform fight seem like a very tame game.
