Pension-fund

Davis's book provides useful data on a variety of aspects of pension funds: size, benefit determination, taxation, regulation, performance criteria and investment allocations. The discussion is well summarised, although the views are largely unoriginal and uncontentious (for example, the chapter on tax treatment is wholly based on work at the Institute for Fiscal Studies). It is interesting to see divergence in portfolio composition and fund performance in private pension plans across countries, although care must be taking in drawing any conclusions on the investment strategy of different managers. Although Davis generally synthesises, on one issue he takes a strong position: he regards defined-benefit pension plans as clearly superior to defined-contribution plans. Given the way that defined-contribution schemes are becoming ever more popular in theory and in practice (witness the World Bank's Averting the Old Age Crisis), this is an archaic position to take and is hardly justified by Davis's reasoning. He asserts that 'members of [defined-benefit plans] trade wages for pension at the long-term average rate of return in the capital market'. Since, he argues, employers bear investment risk in defined-benefit plans and employees in defined-contribution plans, then if both earn the same average rate of return, the insurance properties of defined-benefit plans are clearly superior to defined-contribution. But this is misleading numerous respects. There is plenty of evidence, especially in the United States, that agency problems preclude defined-benefit plans from earnings the long-run average rate of return. Secondly, defined-benefit plan members obtain widely differing returns on their contributions, depending on vesting conditions, the extent of indexation of preserved or deferred benefits, incomplete earnings averaging procedures in determining pension benefits etc. Earnings and job tenure uncertainty mean that many defined-benefit plan members will earn substantially less than the average rate of return on their contributions. Furthermore, final salary defined-benefit schemes have frequently been used of boosting the remuneration of senior executives to the detriment of ordinary members. In all these respects, defined-contribution plans are superior. Even the alleged weakness of defined-contribution plans (investment risk) is unconvincing as suitable portfolio strategies should exist which permit such plans to earn the risk-free return. It is the substantial equity premium which has induced fund managers to go for a different risk-return trade-off and thus expose plans to investment risk. All this may seem arcane to those who are not pension specialists. But defined-benefit coverage is declining in countries such as the Untied States and the United Kingdom. The only feasible means of expanding private pension coverage in the future is through defined-contribution schemes, even if the mis-selling of personal pensions in the Untied kingdom provides important lessons for regulation. With the bleak prospect of declining social security pension provision in many countries, policies towards private pension provision are of increasing importance. (This is an edited version of a review from the Economic Journal, vol. 105, no. 433, pp. 1653-4.)