Saturday, November 07, 2009

US retirement system: insufficient benefits, underfunded and mainly run by amateurs

The United States is far from the worst place in the world to retire. Social Security, the main component of the retirement system, provides the majority of most people's retirement savings. It also has life insurance functions for spouses and disability insurance functions. This chart from the National Academy of Social Insurance's report on fixing Social Security shows how big a role Sociel Security plays:

In other words, for the lower-earning half of the population, it provides at least half of their retirement income. For the upper-earning half, it still provides a significant chunk of income. Unless the U.S. government defaults on its obligations, Social Security won't run out - and if things get that bad, we'll have more pressing things to worry about than retirement.

Social Security is also progressive. Generally, low-earners get back quite a bit more than what they put in. Middle-earners get back about what they put in. High-earners get back less. However, it's important to remember that Social Security also provides important insurance benefits. These charts from the Congressional Budget Office give a brief explanation. Focus on the dotted lines; they represent expected benefits if the trust funds' shortfall is dealt with.

Social Security does have financing challenges. However, they are fixable.

Perhaps a bigger challenge is the adequacy of Social Security's benefit. Marketwatch links to a study by Mercer, a financial services consulting company based in Australia, which did a comparative analysis of 11 countries' retirement plans. The U.S. came in 6th with a C grade. No country got graded A, but the Netherlands, Australia, Sweden, Canada and the UK came in ahead of the US, with the UK receiving a C grade and everyone else getting Bs. Mercer graded the countries on the adequacy of their benefits, the sustainability of the benefits and the integrity of their retirement system. The U.S. got a poor score on adequacy, actually coming in third last (ahead of Chile and far ahead of Japan).

The adequacy section of Mercer's report deals with the following questions:

1. What's the minimum pension as a percentage of the average wage that a single aged person is guaranteed? Mercer suggests that while this question is difficult to answer due to variations in costs of living, pensions below 27% of the average wage won't sufficiently meet poverty alleviation goals. Here, the U.S. is ahead only of Singapore, which does not guarantee a minimum retirement benefit at all. The U.S. does guarantee a specific minimum benefit in the regular Social Security program that is funded through payroll taxees. It does guarantee a very low (sub-federal poverty level) benefit in Supplemental Security Income for the very poor (or disabled).

2. For someone who earned the median income while working, how many percentage of that income does the retirement system replace? Mercer says that ideally, retirement systems should replace 70-100% of income in retirement. No country scored within that range, but Sweden did score the second highest at 64% and Japan scored a low of 40%. The US scores in the middle among the sample. Interestingly enough, the Netherlands scored 105.5%, which Mercer criticizes - over-saving may preclude individual flexibility, in that perhaps individuals could have used some of that money while they were working for immediate needs.

3. What's the household savings rate? In other words, what's the difference between what households spend and save? Mercer found scores between minus 17% (Chile) and plus 20% (Singapore). Negative savings rates indicate that households are going into debt. The U.S. is in the middle. Mercer notes that savings tends to be distributed among middle and high income households, so the poor still need a guarantee of retirement income.

4. The other questions are whether individuals receive any tax benefits for voluntary contributions (e.g. deduct an IRA contribution from income), minimum access ages, transferability of accrued retirement savings to different employers and whether part of retirement benefits are required to be taken as an income stream (an immediate annuity).

Mercer's recommendations for the US are to:

1. Raise the minimum pension for the poor. One proposal I've heard in Social Security is to guarantee a minimum benefit of 125% of the official poverty level to anyone who's worked 30 years.

2. Adjust the level of mandatory contributions to increase the net replacement rate for median-income earners.

3. Introduce a minimum access age for retirement benefits. The U.S. allows the use of IRAs or 401ks, usually with penalties, before retirement. This seems a lower priority to me.

4. Require that part of one's retirement savings be taken as an income stream.

There are additional problems with the U.S. retirement system. Only about 20 million active workers are covered by traditional pension plans, and fewer than half of all workers have access to traditional pensions or 401ks, as Marketwatch reports. While anyone can contribute to an IRA (Individual Retirement Arrangement), automatic enrollment in a retirement program makes it a lot more likely that people do so.

Additionally, Beth Almeida and William Fornia, who wrote a report titled Better Bang for the Buck: The Economic Efficiencies of Defined Benefit Pension Plans, found that compared to defined contribution plans (basically retirement savings accounts where you choose your own investments, like IRAs and 401ks in the US), defined benefit or traditional pension plans provide a significantly higher amount of retirement income for the same amount of money invested. Traditional pension plans allow people to pool their longevity risk - for a given pool of people, some will live to 60, some to 85 and some to 100. If you're an individual, you need to save as if you'll live to 100 (or perhaps less, if you figure you're in poor health). However, in a sufficiently large pool of people, actuaries can predict statistically that the pool will die at an average age of 85, and plan accordingly.

In other words, the demise of traditional pensions definitely hurts workers. Companies that claim they are saving money by moving to 401k (defined contribution) plans are actually just cutting their benefits.

In their defense, companies are required to maintain minimum funding levels for their pension plans. When the market value of the pension investments declines, companies are on the hook for the difference. That, combined with increasing mobility of the workforce, is contributing to the decline of traditional pensions.

Readers will note that Mercer recommends that the US (and other countries) require some retirement savings to be taken in the form of an income stream. Individuals without traditional pensions can buy an immediate annuity, which is a contract with an insurance company. In exchange for a lump sum payment, the insurance company guarantees payments for your lifetime. The insurer pools longevity risk among its annuity clients. Purchasers can opt for contracts that guarantee income to a spouse if they die and/or contracts which are adjusted for inflation, although they will obviously have to pay more.

The U.S. should certainly make annuity contracts more widely available in IRAs and 401ks. However, individual purchasers have less market power than group purchasers and they might not get as good a deal on an annuity as a large company could. The U.S. could also expand Social Security to increase the amount of annuity-like income that people receive.

The U.S. also needs to do something about private-sector plans. As I recall, neither IRAs nor 401ks were designed to be primary retirement vehicles. They were designed to be secondary retirement vehicles, to which people who were getting a traditional pension contributed any excess cash they wanted. As stated earlier, many people aren't covered by a 401k or a traditional pension at work, especially temporary employees. People in large companies are more likely to be covered than small companies, which is an inequity that needs to be addressed. An MSN Money article notes that many 401k plans at smaller companies are probably run by amateurs: investing is a complex world, many people aren't equipped to pick out the best deal in terms of selecting cheap funds, and the brokers who "help" companies pick funds don't have the company's best interest at heart. A Wall Street Journal article also notes that pensions for top executives, known as Supplemental Executive Retirement Plans, are alive, well and thriving even as companies cut matching contributions for the rank and file.

The U.S. will always be a good place to retire. However, there are a number of levers the government can pull to facilitate retirement security for Americans. President Obama intends to address Social Security's funding challenges at some point. There have also been proposals to expand private accounts as a supplement to Social Security.

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