A few days ago, I was reading Felix Salmon's piece Pension politics. (Nice title, the type that Tadas likes - the shorter the better.) I wrote a short response in the comments, largely agreeing with Felix. Here it is:
Here are the facts:
1) DB pension funding accounting rules are more liberal than life insurance accounting rules.
2) Pension actuaries have long assumed investment earnings rates well in excess of what can be achieved.
3) Longevity has long been increasing for those that buy annuities, and take pensions.
4) Average people are lousy investment managers, they panic and get greedy at the wrong times. Pension asset managers aren't great, but they largely avoid panic & greed.
5) The PBGC is horribly underfunded, as are most municipal pension plans.
6) Overseas, things can be bad, like Poland, Argentina, India, etc. In those cases being on your own is better. Our custodial systems here are pretty good. (Please ignore MF Global.)
7) Fees are generally too high in asset management, and most people should go for passive management, or a few clever value investors.
8) Hedge funds, commodities, and private equity are not the answer. Analyze the returns on a dollar-weighted [IRR] basis and they will be much lower than the illustrated buy & hold returns.
9) Highly paid workers lose out in bankruptcy. Multi-employer trusts are prone to a run on the pension plan if a major employer goes BK.
10) The average person is at best a budgeter, and not an investor. That said, buying inflation insurance is very expensive, if you can achieve it at all.
Summary: In general, you are right, Felix, but it is a question of cost to the corporations funding the DB plans. I think the cost is worth it, but maybe it needs to be shared with workers, taking pre-tax dollars to buy more future DB plan payments. How many people would do that? Sadly, not many.
Pensions have always been a bit of a compromise. In order to get employers to create Defined Benefit [DB] pensions, the government allowed for funding methods that were liberal - a plan sponsor wouldn't have to put in as much at the beginning; it can catch up over time. More than that, the assumptions that DB pensions could use were far more liberal than what life insurers could use for similar contingencies. Life insurers had to use best estimates and then add risk margins. Pensions could dream of returns, with no risk margins.
The 401(k) was an accident. It was tossed into a much larger bill, and no one noticed. After passage, some benefits consultants, notably Ted Benna, found ways to use it, creating the boom in Defined Contribution [DC] plans.
Corporations initially added DC plans to their DB plans, but as the 90s ended, and equity performance sank, many terminated their DB plans. Part of it was the asset markets, but another part of it was aging workforces, because the funding rules were weak (unlike life insurance). Sponsors realized that they would have to spend a lot more on DB plans in the future than they would otherwise want to. Now stingy corporations cut back on their DC matches, or accept kickbacks out of investment manager fees.
There are two great virtues in defined benefit plans: 1) Investing is handled by professionals. 2) Level payments are made. Most people can budget. Few can invest. Yes, there is the problem of inflation, should it occur, but pensioners should have assets outside of their pension to deal with inflation. They need longevity insurance, so that they avoid outliving their assets.
Though it might be hard managing a fixed income versus uncertain inflation over an uncertain lifespan, it is much harder to manage a lump sum over a full retirement. When finances are tight, it is much harder to make the right decisions. Hope biases average investors in favor of taking chances, whether the market favors taking chances or not.
Add in the troubles with defaults of DB plan sponsors, and significant benefits can be lost, particularly if you have been highly paid.
I would want to tell most asset allocators that there is little to no magic in alternative investments. The alternatives face the same risk factors as ordinary investments, and they are not underinvested by pension investors.
Sorry, I forgot to blame the IRS for limiting overfunding for tax reasons, when the overfunding was really funding, and would have been useful today.
Even without the introduction of the 401(k), corporations would have cut back on DB pensions because of costs. A lot of that was due to bad funding methods, but without those bad funding methods, many DB plans would never have been done.
Just be grateful you don't live in other parts of the world, where governments are more graspy, and pension assets are a target to plug holes in the government deficit.