For much of the 20th century, the United States led the world in private pension provisions. Its private defined benefit pension system not only provided retirement income supplementing Social Security for millions of workers, but also served as a mechanism for efficiently channeling the flood of retirement savings through the capital markets to the most promising users of the capital.
Unfortunately, in a more competitive world, companies can no longer accept the fixed long-term obligations the defined benefit system creates.
But so far, the system that has evolved to replace the defined benefit system is far from perfect. Too few companies offer 401(k) plans, and too few employees participate in the defined contribution plans that exist. In addition, the 401(k) savings flow almost exclusively into domestic stocks and bonds.
Maybe it's time for the U.S. to learn from other countries. Chile, which privatized its equivalent of Social Security by establishing defined contribution plans, is often mentioned as a possible model, although generally in the context of Social Security reform.
Australia might be a better model. Australia had defined benefit plans, but they covered only a small fraction of the work force, mostly white-collar workers, forcing everyone else to rely on the equivalent of Social Security and personal savings. In 1992, the Australian government required all employers to contribute 3% of pay into a pension plan for all employees; that has increased to 9% of pay now. The employee can choose the plan to which the contribution is directed — the employer's plan, if there is one, or one offered by a bank, a trade association, a union, etc. The employee also can choose how the assets are invested, although many default to funds of funds offered by the plan sponsor.
Upon retirement the employee receives the value of his or her personal account, which will depend on how the contributions were invested.
Thus, the Australian system is a defined contribution system, very much like the 401(k) plan in the U.S., except that participation is mandatory and employees can opt out of the employer's plan for another plan.
As described in the Feb. 6 issue of Pensions & Investments, the system has had profound effects on the Australian capital markets, and has made its financial services sector one of the fastest growing outside the U.S.
Assets under management in Australia have grown to almost US$750 billion, which has sparked development of the asset management industry in Australia. More is to come as the Australian government has set up a Future Fund to invest some of its budget surplus for the future.
Because the Australian stock market would be easily distorted by the flows from the retirement plans, fund sponsors and money managers have been forced to invest more in real estate and offshore markets than the typical U.S. defined contribution plan, and even many defined benefit plans. Australian funds have 11.7% in real estate and 18% in non-Australian investments; the funds also have 39.2% in domestic equities and 17.7% in domestic fixed income.
Australian plans also invest in infrastructure investments. The flow of savings and the limited size of the capital markets have forced the funds and their managers to be innovative.
Many will argue the Australian model cannot work in the United States because U.S. employers and employees never will accept a mandatory system. That is an attitudinal problem that should be overcome; if not, 50 million (and growing) Americans will be depending solely on Social Security for their retirement income.
Some will also claim U.S. employers could not afford the 9% annual contributions. But if employers can afford it in Australia — a country with a gross domestic product $11,000 per year less per person than U.S. GDP — why can't U.S. employers?
The U.S. needs a second-tier retirement system that doesn't leave more than half of its private sector work force uncovered, and while its current system is being restructured, the Australian model is worth examining.