Are There Any Bismarcks in the House?
The Iron Chancellor created the modern retirement regime. Who will reinvent it for the new century?
In 1881, the German Chancellor Bismarck, just prior to his 75th birthday, gave an historic speech in front of the German Reichstag in which he introduced what we now know as the old-age pension, to be paid by the State to all of its elderly citizens. Bismarck initially selected 70 as the qualifying age – back when life expectancy in Germany was in the late 40s. Bismarck’s cunning intention was to force children to collectively care for their parents during their golden years, in a dignified manner, akin to how families cared for their elderly prior to the industrial revolution. Alas, his idea stuck, and most countries’ social security systems, including those in Canada and the US, can trace their origins to Bismarck.
Of course, in Bismarck’s day, very few workers survived to the advanced age of 70, so the qualifying age was eventually dialled back to the classical 65. Every worker under this age contributed money to a large bathtub, which in turn was used to fund payments to everyone over this age. This is the system that we have inherited today – give or take some equilibrium adjustments made by Sir Willam Beveridge in the 1940s. The financial bathtub was officially blessed by no greater an economic authority than Nobel Laureate Paul Samuelson in a very widely cited 1958 article with an odd-sounding title about the social contrivance of money.
Fast-forward 130 years and Bismarck’s retirement plans have gone haywire. The slowest crisis in financial history is unfolding at a snail’s pace. Consider this: In Paris, public transport workers threatened to shut down the entire country’s train system in 2007 because they were not allowed to retire on a full pension at the age of 50. In New York City, the subway system was paralyzed over the 2005 Christmas holiday by the workers’ union, for similar reasons. Civil servants in Turkey, long-retired KGB agents in the former Soviet Union, and Argentinean farmers from the Pampas, have all taken to the streets to force governments to provide COLA (cost of living adjustments) to their cushy pensions.
Closer to home, General Motors has collapsed under a burden of over 500 retirees per 100 active workers. One of GM’s oldest pensionnaires was a sprightly 110 old, having worked for GM for the requisite 30 years, and having been retired with pension for 40. In California, amid much public outcry, perfectly healthy 50 year-old firemen, police officers and public servants are retiring with lifetime pensions that pay hundreds of thousands of dollars in inflation-adjusted income – for life.
The bathtub has long gone dry, but everyone is still lining up to bathe.
Back in 1985, 90 of the 100 most prestigious employers in the US offered a Defined Benefit (DB) pension, which promised a lifetime of income to each retiree, when he or she stopped working, according to data from Watson Wyatt, the consultancy. By 2008, the number had dropped to less than 20 employers. The remaining 80 or so companies now offer Defined Contribution (DC) plans, which are essentially tax-sheltered investment plans with zero guarantees and no promises. Most of the funds are invested in – you guessed it – the stock market.
The Roman Catholic Archdioceses of Chicago, the City of Fort Lauderdale and many teams in the American National Football League are just some of the entities that have now frozen their pension plans and replaced them with similar DC investment plans. Do you have a stock tip for your younger priest? How about a good fund for your new fireman? Of course, the older ones will be just fine, thank you.
And so, in the year 2020, the working world will be split between two groups: not developed versus developing, or rich versus poor, but rather the pensioned and the pensionless. Leaders will have to contend with masses who have diligently saved and invested for retirement in mutual funds and investment products that have produced returns far below what would have been expected a quarter of a century ago. The equity premium, in short, has not quite panned out as anticipated.
Bold leaders have an opportunity to act now, before the battle and fault lines have crystallized and retirements have been ruined. Regulations must be mended, priorities have to be adjusted and, most importantly, the public must realize that today’s promises – if fully kept – will bankrupt tomorrow’s children.
In the inevitable public debate, it is important for leaders to stay focussed on three core principles: (1) Pensions are about providing a lifetime of income by pooling risk across heterogeneous groups using the principles of insurance. They are not about creating financial legacies and rainy-day funds for family and loved ones. (2) A true pension guarantees predictable income starting at some advanced age, with such income necessarily keeping up with the increasing cost of living for retirees. Hope, expectations and high odds are not enough. They – current and future pensioners – need guarantees. (3) Pensions must be paid for by someone. The key is to create a framework that allows them to be offered at the lowest possible cost in today’s dollars.
In sum, we cross our fingers for a younger Bismarck – one who can recognize that the answer to selfish offspring is not perpetual servitude.
Moshe A. Milevsky is an associate professor of finance at the Schulich School of Business (York University) and executive director of the Individual Finance and Insurance Decisions (IFID) Centre.