Friday, 20 March 2009

The Pensions Casino - an alternative.

Until recently, I had very little idea of how pensions worked, but when I looked into it carefully, I realized it was enforced gambling! And the more I thought about it the more I realized how incredibly unfair and stupid the entire pensions system was. The reason it is so bad is that there are so many ways your pension could be dramatically bigger or dramatically smaller than you planned for, in ways that you can not reasonably control. To illustrate this consider two people born 5 years apart. Lets call them Mr Lucky (the older man) and Mr Unlucky. Let us imagine that they are both equally conscientious, equally hard working, equally intelligent (averagely intelligent), equally everything.

Now Mr Lucky starts his working life and starts saving towards his pension. Just by chance, this is at a time which is the end of a recession when stock prices are low. He's already off to a good start because his early pensions investments are likely to rise nicely.

5 years later Mr Unlucky starts his working life. He does a similar job, and saves the same fraction of his income toward his pension. Unfortunately now is the beginning of a stock bubble. His early pensions investments will turn out to be a disaster.

For several decades to come both men have investments in the stock market at the same time. Unfortunately Mr Unlucky's fund manager was not as financially savvy as Mr Lucky's. This was not really his fault - neither men are financial experts. How can anyone possibly expect your average man in the street to determine the different skill levels of two different fund managers? They can't. Mr Unlucky's fund gradually drifts even further behind Mr Lucky's... but it doesn't stop there...

The fund managers make their choices based on their knowledge of the markets and the fundamentals. However, a sizable component of the variability of stock prices are things that no fund manager could be expected to prepare for. Things like earthquakes, floods, political assassinations, industrial accidents etc... and you've guessed it - the floods and earthquakes just happened to be to the benefit of Mr Lucky's stocks and Mr Unlucky's fund manager's stock selections get badly hit, so his pension fund falls even further behind... and it doesn't stop there...

Now we come to retirement time... and would you believe it, Mr Lucky retires at the peak of another bubble... and oh dear, Mr Unlucky retires at the depths of a recession.

So there you have it - two similar guys doing similar jobs, saving similar fractions of their wages towards their retirements and yet their retirement incomes could be hugely different, based entirely on luck... is that fair? Is that how we want the system to work? Personally I find it extremely stressful worrying about my pension - am I going to be lucky or unlucky? What should I do? Should I just save way more than I really need just in case I'm unlucky? Or should I scrimp on my pension hoping I get lucky, then simply carry on working longer if I get unlucky?

Note that there two types of random variability between pensioners. One type is between pensioners of the same age. Lets call this stock selection variability. Another type is concerned with the start and end times of pensioners saving period. Call this bubble timing variability. Now bubble timing variability will affect entire age groups of pensioners, some of them having miserable retirements others having good ones.

Now of course the people who really pay (or rather, "pay back") for old people in their retirement are working people. These wild fluctuations in pensions are inefficient for us workers. We feel sorry for Mr Unlucky when we see him on the TV in some documentary about old people not being able to afford their heating bills. While at the same time cursing that we have to work so hard to support Mr Lucky who seems to have superfluous wealth. Just imagine if you applied the same pensions system in your own home... imagine you have your old grandma and grandpa living with you. They've both worked hard all their lives... now at dinner time you serve grandma a feast of the finest foods and champagne, while you give your grandpa a slice of bread and a glass of water. They say "what did we do to deserve this?" and you have to remind them that grandma thought Ebay was a great idea and grandpa liked Betamax. Now you may say that this is simply how life is - if you get lucky then you do better in life if you're unlucky then you do worse. But that's not true in all aspects of life, and people can usually select the degree of risk they want to take. If you want to be a professional stock broker then you may get rich or you may go bust -it goes with the territory. People choose to be stockbrokers. Nobody who loses on the stock market ever says "gee, nobody told me there was any risk involved". But we can choose to take a less risky career. Say you become employed as a plumber. there's not much risk in that. If business gets bed then, you can always retrain as something else. There's no chance of ever suddenly being wiped out as a plumber. So you see there are some choices in our working lives which are inherently risky and some inherently safe. Now when it come to designing a pensions system, is it so obvious that we should select a mechanism so full of risk? I think not. I think its possible to design an inherently safe mechanism.

Now the first characteristic I wanted for my system is that people who save more in their working lives should get more - and roughly speaking if you save twice as much as the average guy in your working life then you should get twice as much in your retirement.

The second characteristic of the system is that people must be forced to save for at least a minimum standard of living in retirement. Now some people may say "how dare you take away our freedom! Its up to us to individually decide what we save for retirement". To which I would say, "but not saving throughout your life puts a blatantly unfair burden on the rest of society when you retire. We can't just stand by and watch you become homeless and starve. We'll be forced to give you a certain minimum standard of living for free". I would also add that the amount we are forced to save for retirement will be very small. Just enough so that you could have a bare minimum quality of life.

My system to achieve all these things is the following:

The government invent a new type of tax (but of course we don't want to call it a tax!), call this compulsory elderly-support. Say its X%. This is the minimum. People can optionally also put whatever extra they want in to the elderly-support system. The continuous flow of elderly-support money that comes in from workers is used to pay money to the retired. Note that this is all happening at one instant - there is no pretense that some investment is being put in storage for future use. Its plain and simply workers-now-support-retired-people-now. So the next question is how to apportion the money - this is where we need to do a little mathematical jiggery pokery. The money is not distributed evenly amongst retired people, instead it is (roughly speaking) distributed in proportion to the amount of money those retired people fed in to the elderly-support system during their working lives. The maths required to achieve this is not trivial, but it is certainly doable.

So what are the advantages of this system?
  • Nobody is being forced to predict the stock market. People who save similar amounts will be similarly comfortable in their retirements.
  • If a country develops well and has a boom, then the retired population will automatically benefit from the boom.
  • If the country has a recession then retired people will take their share of the burden, rather than requiring an unbearably large fraction of the now-poorer nations GDP.
  • The whole system will be far more predictable for pensioners, workers and government.


  1. Nice post. I just hope I am not with Mr. Unlucky.

  2. All goes to pot as the country ages and there become as nearly as many retirees as taxpayers.

    At one for one the tax would be getting on for say 50% of someones salary, plus 40% other taxes, leaving them with 10%.


    The rest of your post is pretty good. The answer is to manage your own financial future and not leave it to fund managers. If you cock it up at least you know it was your own fault. It is quite possible to make money in a recession in the markets.

  3. Re: CityUnslicker's comment...

    The ratio of retirees to workers will tend toward the ratio of working-life-years to retirement-years so there will never be "nearly as many retirees as taxpayers".