Are Brookings and CAP Trying to Replace One Pension Free Lunch with Another?

by Jason Richwine

The Brookings Institution released a paper last month calling for a middle-ground reform of teacher pensions. The authors would replace the traditional defined-benefit (DB) pension not with a simple 401(k)-style defined-contribution (DC) plan, but with a “collective” DC plan. Although I share the authors’ desire for pension reform, part of the case for collective DC plans appears to rest on an economic fallacy, not unlike the ones that undergird DB plans in the first place.

By way of background, almost all public school teachers currently participate in a DB plan, which is a traditional pension that pays a regular, fixed sum every year in retirement. DB plans have some big problems: Politicians can promise benefits now but push the cost into the future; part of the cost is hidden by accounting tricks; the non-linear accrual of benefits leads to perverse retirement incentives; and full-career teachers reap windfall benefits at the expense of teachers with less tenure.

Moving teachers to 401(k)-style DC plans would eliminate those problems, but it would also transfer the investment responsibility and risk to individual teachers. Is there some way to mitigate that risk to teachers without burdening taxpayers? Brookings’s answer is the “collective” DC plan, modeled on a proposal from the Center for American Progress (CAP) called the “SAFE” plan.

Under a collective DC plan such as SAFE, teachers would all buy into the same professionally managed fund (to prevent individual teachers from making dumb investments), and teachers’ contributions to the fund would be made with enforced regularity (to avoid the buy-high/sell-low trap).

Forcing people to have an “ideal” 401(k) — i.e., a diversified portfolio, low fees, regular contributions, no withdrawals before retirement, etc. — will probably increase their retirement savings relative to individuals who are left to their own devices. The economic reasoning there — and the attendant benefits – is not objectionable.

But then the Brookings authors veer into free-lunch territory: They include a chart from CAP purporting to show that a collective DC plan significantly outperforms even an ideal 401(k):

As best I can tell, based on CAP’s proposed SAFE plan, the superior performance is supposed to come from the way collective plans pay returns to individual teachers. Instead of always adjusting the value of each teacher’s account according to the fund’s “real time” performance — meaning if the fund goes up by, say, 1 percent on a given day, each teacher’s account immediately goes up by the same 1 percent — plan administrators “smooth” the fund’s returns over a certain period. So a teacher’s account value goes up each year by some average of the plan’s past performance.

The smoothing is supposed to confer an advantage on teachers nearing retirement. Rather than having to switch into low-risk and low-return investments as they near retirement, teachers can maintain the higher-risk and higher-return portfolio they’ve had throughout their careers, confident that any decline in the market before they retire will be “smoothed out” by the averaging.

It sounds nice in principle, but it’s actually an example of the “time diversification” fallacy. Investments do not become safer the longer they are held. Time reduces the variance in the average annual return, but it actually increases the variance in the cumulative return. In other words, smoothing won’t bring more certainty to retirement savings. For any given portfolio, collective DC plans face the same risk-return tradeoff as ordinary 401(k) plans.

Think of the issue another way: Brookings and CAP boast that, because individuals don’t need to shift their assets to less-risky assets as they near retirement, which pay lower returns, they can continue to benefit from higher-return investments throughout their career and therefore end up with bigger savings. But in order for the portfolio as a whole to ensure the same level of risk and ensure it can pay benefits to retirees, some of it will have to be invested in lower-risk assets, which will lower returns for retirees on average. The size or duration of the investments won’t change that.

Helping workers invest responsibly for retirement is certainly a worthwhile goal, and collective DC plans could be one tool for doing so. But a collective plan cannot offer a free lunch relative to a well-run 401(k).