Ensuring Adequate Retirement Saving in the New Millennium
Bruce A. Wolk

Introduction Demographic Challenge Increased life expectancy In 1940 a male age 65 could expect to live 11.9 years. But in 2000 a male age 65 can expect to live 15.8 years. Women tend to live longer than men (4+ years at age 65) Decreased retirement age In 1940 average age at which workers began receiving social security benefits was 68.7. In 1995 it was 63.6. Average married couple will have 15 retirement years together and wife will live 6 years longer than husband. Result: Even more must be saved over fewer working years Current Retirement Savings Inadequate Social Security Broad coverage but low benefits Average monthly benefit (2000): $804 Average retired couple monthly benefit: $1,348 Unlikely to be increased Fund projected to run out in 30-40 years Too few workers will be contributing for too many baby boomers Number of covered workers per beneficiary 1965 - 4.0; 1999 - 3.4; 2030 - 2.1 No current interest in raising taxes to fund an increase Private savings Studies show savings rate at an historically low level Wide variation Some are saving quite nicely But the poorest one-third of baby boomers have average household net assets of $1,000 Private pensions Participation has stagnated Less than 50% of all workers participate in pension plans 60% of full-time, full-year workers participate in pension plan, but that percentage has been nearly the same for the last 6 years. Participation rates decrease with decreasing income Participation rates decrease with decreasing firm size Average pension benefit is small 1997 mean annual pension income for persons 61-74 was around $10,000 GAO study found that 18 million current retirees have NO private pension and most of them are single, female, nonwhite, and uneducated Plans are still permitted to forfeit benefits of employees who work less than 5 years Outlook Many boomers will face a dramatic decline in living standard Enormous intergenerational tensions will be created by those who need assistance Many will be compelled to continue working longer than they had hoped Data show that percentage of people over 65 still working (12.8% in 2000) has been rising since the mid-90's, following decades of steady decline The Transformation of the Private Pension System Two Major Types of Plans Defined Benefit Typically pay a monthly benefit for life under a formula based on worker's final average compensation and total years of service Advantage to the worker Constant stream of income that cannot be outlived Risk spreading Employer absorbs the risk of investment decline But, because of their longer time horizon, employers can afford to invest in a riskier portfolio and earn a greater return Fair annuity pricing Compelled annuity means that the annuity is fairly priced-i.e., person with an average life expectancy gets a fair return. But voluntary annuities present an adverse selection problem. People who are ill or with family histories of short life expectancies do not purchase them. Purchasers tend to be long-lived types. Insurance companies price annuities accordingly. DB plans avoid this by mandating the annuity-i.e., no adverse selection. Disadvantage to the worker Inherently backloaded-i.e., long-term workers and older workers favored No portability Inflation risk Advantage to employer Employer can benefit from investment success of plan Natural incentive for older workers to retire when they reach normal retirement age Disadvantage to employer High administrative cost Investment and actuarial risks Mandatory minimum funding obligations PBGC insurance cost Defined Contribution Individual account for each employee, with contributions usually based on a percentage of pay Advantage to the worker Transparency Portability Can hedge against inflation Often can control investments Disadvantage to worker No annuitization Investment risks Advantage to employer Lower cost of administration No investment risk Disadvantage to employer No natural retirement incentive for older workers No possibility of investment gain Dramatic Shift to DC plans In 1975 just 13% of active participants had DC plan as primary plan. That number is now 42%. Total assets in DC plans surpassed total assets in DB plans in 1997 Largest source of DC plan growth is 401(k) plans Why the Shift? Changing career patterns-more mobile workforce Increased cost of DB plans: Increased employer liability PBGC insurance premiums Stricter funding rules Reduction in employer's ability to share investment gains Hyper-regulation Popularity of 401(k) plans Low cost to employer Flexibility for employees Implications of the Shift Increased risk of inadequate retirement saving Many invest too conservatively But many also take excessive risks-e.g., investing bulk of assets in employer stock Some will respond to the risk by oversaving 401(k) plans more likely to result in less saving by lower paid workers Current consumption needs outweigh perceived need for retirement saving, especially in early years Given choice of cash or savings, low paid workers prefer cash Women particularly disadvantaged by shift More likely to outlive their retirement savings Benefited from DB plan annuity, which was more valuable than same annuity for a man DC plan "leakage" reduces level of retirement saving Most plans allow borrowing against the account Many plans (except for 401(k) plans) allow for withdrawals even while working All plans allow account to be withdrawn when employee terminates employment Most plans will automatically cash employee out on job termination if account is less than $5,000 Although distributions can be rolled over into an IRA account or another retirement plan, less than half of all retirement distributions on job termination are rolled over. Only 1/3 of distributions to employees in their 20's are rolled over. Penalty on pre 59 1/2 distributions is low (only 10%) and has significant exceptions Vulnerability to post-retirement squandering and unsophisticated investment (including fraud) Recent Legislative Proposals Pension Reform Bill Almost certain to be enacted in some form Main feature is a large increase in contribution and benefit limits and relaxation of discrimination rules Pamela Perun ("The Limits of Saving") study found that main beneficiaries would be high-income individuals and those who are already able to maximize saving Will do little to increase overall pension coverage Bill will simply not increase retirement saving of workers who have no coverage or are not electing to participate in 401(k) plans at the current maximum level Basic flaw of current system remains: the tax subsidy (nearly $90 billion per year) for pensions provides the most benefit to those who need it least Tax subsidies offer little or no incentive to low income workers Social Security Reform Main feature of most proposals is some type of individual account But unless tax rate is increased, accounts would reduce flow of income into main social security account, making funding situation that much worse Individual accounts raise many of the same issues as DC plan accounts Investments either too risky or too conservative No annuitization Minimum Universal Pension System (MUPS) The Role of Paternalism Autonomy v. adequate retirement saving Social security is paternalistic Current mix of paternalism and autonomy is not likely to ensure that low and moderate-income workers will have adequate retirement income Why Not Just Expand Social Security? Social Security is too redistributive Low earners subsidized by high earners Married couples subsidized by singles One earner married couples subsidized by two-earner couples Elderly workers subsidize elderly retirees Social Security redistribution is funded regressively Because of wage-base cap (currently $80,400), redistribution is not based on ability to pay and thus redistribution is proportionally lower for high-income earners People who live off investments do not subsidize social security benefits for low-paid workers at all Mandatory Minimum Pensions Compel a certain percentage of income to be saved Basic principle is that each age cohort will fund its own retirement income No intergenerational transfers Level would be set at whatever was needed to meet target of paternalistic minimum retirement income Would have a yearly cap Paternalistic replacement rate for $30,000/year earner might be 80% Those earning $1,000,000 can fund an 80% replacement rate mostly on their own No pre-retirement distributions-i.e., no leakage Distribution only in the form of an annuity Annuity can commence anytime after specified age, but delaying annuity increases the future annual payment actuarially Nothing passes to the next generation No redistribution, beyond that inherent in annuities (i.e., people who live longer get more of a benefit) DB v. DC Model DB model preferable for reasons already noted Each year employee is credited with an annuity amount to commence at a specified retirement age Amount of the future annuity is determined by equating its present value to the employee's compelled savings, based on current actuarial assumptions Example: Employee, age 30, has $5,000 withheld and contributed to minimum pension plan. At current interest rates and mortality, this is equivalent to, say, an annuity of $7,250 commencing at age 65. Each year a similar calculation is made and the annuity amount is added to the existing amount Investment Risk In DB plan, employer bears the investment risk, but can spread it over a long time horizon, assuming employer is stable Economically it is borne by the employer's workers, since they bear the cost of the plan in the form of lower wages In MUPS, investment risk must be born by the various cohorts of workers By adjusting actuarial assumptions to match investment and mortality experience, losses (and gains) are spread among all the cohorts still working Over a cohort's working lifetime (40+ years), such gains and losses are likely to cancel one another, minimizing intergenerational transfers Inflation Risk If annuity is fixed, retiree bears the risk of inflation This is inconsistent with the goal of the MUPS, which is a an adequate stream of retirement income Projected and current annuity payments should be adjusted for inflation Risk of inflation adjustment can be borne just like investment risk Actuarial assumptions include inflation's effect on plan assets and future benefits Initial projected benefit will be lower, but will increase each year for inflation Public or Private? Public plan Will assets be invested for the greatest possible return? Will public ownership of large amounts of stock give government too much control over economy? Will politics skew investment decision-making? Who will make the investment choices? Efficiency concerns Private plans Will private plans accept the long-term risks, particularly the inflation risk? How would the private plans be compensated? Would there be competition based on annuity price? Cheaper might mean more risk (e.g., Executive Life fiasco) Would require PBGC to police the operation and protect against default Higher record-keeping, portability, and other transaction costs when workers shift jobs Current anti-government sentiment in Congress, plus power of the private investment lobby, makes a private plan approach more likely Family Issues Spouses and partners If there is to be no redistribution, partnered workers cannot be subsidized by singles Solution #1: Ignore marriage (or partnership) entirely Surviving partner who has no pension may be left with inadequate income Solution #2: Require equivalent of current law qualified joint and survivor annuity (QJSA) if participant has partner Enormous difference between partnering one year before retirement and one year after retirement Current law qualified preretirement survivor annuity (QPSA) involves a substantial subsidy to married workers Solution #3: Contributions by married (or partnered) workers are allocated 1/2 to each Both partners accrue an annuity amount each year based on their individual ages Divorce rule is simple: Each keeps his or her accrued benefit Might require partnered workers to make a higher contribution Premature death of a partnered worker Consider withholding mandatory life insurance premiums to cover additional annuity for partner. How paternalistic do we want to be? Again, mandatory insurance reduces cost of insurance since no adverse selection Children No benefits for next generation MUPS is designed to allow each individual to self-fund a minimum level of retirement income at a low cost "But what about the 45-year-old parents who die and orphan their 15-year-old children?" This is not a retirement issue Other goals should be accomplished by other systems (note that Social Security mixes them all up, hence all the (arguably often unfair) redistribution) Those who wish to accumulate inheritances for their children are free to do so outside the MUPS system Tax Policy Once a MUPS is in place, there is no longer any reason to provide a tax subsidy to any other retirement saving IRAs, Roth IRAs, 401(k) plans would all be eliminated On ability to pay grounds, the contributions to the MUPS should not be included in income and all distributions from the MUPS should be taxable