We Need a New Retirement System

Posted by Jeffrey Brown on Oct 20, 2009

Filed Under (Health Care, Retirement Policy, U.S. Fiscal Policy)

The past year has not been good for 401(k)s and other retirement plans.  Among many implications of the financial crisis and deep recession, we have seen the dramatic, correlated losses across nearly every major asset class underscore the fragility of a 401(k) system that is focused predominantly on wealth accumulation rather than secure retirement income.  In essence, the 401(k) system was exposed for what it truly is – a promising supplemental savings plan, but an inadequate vehicle for ensuring a secure retirement.  

 

I’m not alone in this view.  I spend much of my time interacting with people who specialize in thinking about retirement income security – academic researchers, policymakers on both sides of the political aisle, insurance companies, financial advisors, consultants and consumers.  Over the past 12 months I have noticed a striking degree of commonality in their thinking around the fact that we need a better retirement system in the U.S.  This is not to say there are not still important areas of disagreement – for example, I find proposals to increase Social Security benefits, to return to a defined benefit system, and/or to have the government guarantee retirement income to be a combination of naive, reckless and fiscally irresponsible.  But when it comes to the future of private sector retirement plans, I believe there are a number of common themes emerging that make very good sense.

 

Yesterday, I had the opportunity to speak at the annual conference of the American Council of Life Insurers (www.acli.com) about my proposal for encouraging plan sponsors to use guaranteed lifetime income products as the default distribution option.  Before my session, I had the privilege of hearing Dr. Roger Ferguson, President and CEO of TIAA-CREF – one of the largest providers of retirement income in the world – speak on this issue.  (In the interest of full disclosure, I should note that I am a trustee of TIAA). 

 

Dr. Ferguson outlined 5 areas that need improvement in our system.  (I should note that I am paraphrasing here and including some of my own thoughts – so please do not interpret this as an exact representation of his remarks!)

 

  1. We need to return to a focus on providing guaranteed income.  During the shift from Defined Benefit (DB) pension plans to Defined Contribution (DC) pension plans like the 401(k) and 403(b), we somehow lost sight of the fact that the point of saving for retirement is to provide income security.  We need to get the focus back on annuitized, lifetime income.  This does not mean a return to the old style DB systems.  It does mean looking for innovative ways to convert 401(k) and 403(b) wealth into income before, during, and after retirement.
  2. We need to broaden coverage.  Millions of households do not have access to any employer sponsored retirement plan.  Somehow, someway, we need to fix this.  While it is true that individuals can save on their own, the evidence is overwhelming that “employers matter” in promoting saving.  Social Security alone is sufficient to replace adequate income for only a minority of households.  Indeed, given the poor fiscal trajectory of the program, the rising normal retirement age that will reduce benefits for those who claim at earlier ages, and rising Medicare premiums, its adequacy will only diminish further.    
  3. We need to ensure that individuals are broadly diversified.  I, personally, would love to see us put together individualized retirement plans that include a life cycle portfolio trajectory that gradually converts into annuitized income the closer one gets to retirement.  The investment options need to include not just stocks and bonds, but also real estate and other asset classes.  
  4. We need to ensure that individuals have access to good information and advice.  Our current regulatory structure – designed to protect consumers from tainted advice by those who might have a conflict of interest – has had the unfortunate effect of making plan sponsors go through a torturous and administratively complex route to provide good advice to participants.  We need to find sensible ways to streamline this process. 
  5. We need to provide vehicles for individuals to be able to save for retiree health care expenses.  Health Savings Accounts and other similar tools have a useful role to play here.

 

To get there from here, we do need some regulatory and policy changes.  I suspect that we may see this discussion rise closer to the top of the agenda after health care reform is behind us …

9 Responses to “We Need a New Retirement System”

  • Tom Humes says:

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    Tom Humes

  • Amanda Funkey says:

    I think that given what has happened to many private 401(k) accounts this past year, converting to an annuity-type default distribution is crucial to secure retirement income. Although I think that this is an extremely pressing issue, healthcare reform and Social Security reform seem to be at the forefront of discussion these days.

  • Jenna Mehalic says:

    I agree that the retirement system in the United States is in need of reform. I personally feel that a large part of the problem in the U.S. is that a majority of individuals are either incapable of making good retirement planning decisions or choose not to make a proactive effort to make good retirement planning decisions. This is specifically a problem if the retirement system is a 401(k) (or similar defined contribution) system because the only way this type of system could work would be if individuals took a proactive approach to ensure that they have a steady stream of post-retirement income. This proactive approach would include making sure that as one ages, the portfolio is allocated appropriately to be consistent with one’s risk preferences. As one ages, the financial portfolio becomes larger relative to one’s remaining (bond-like) human capital. Providing individuals with better information/advice may help improve investment decisions. Furthermore, I also agree that we need to shift the focus away from accumulation of wealth to a focus on lifetime income. And if individuals cannot do that on their own, a default annuity might be a good idea. However, I think that, ideally, individuals would learn more about retirement planning to make good decisions on their own. This would promote a more efficient allocation of capital.

  • Sarah Stahl says:

    I also agree that there is a clear need for reform in the US retirement system. Both defined benefit plans and defined contribution plans have problems. Defined benefit plans have been exposing problems including an inability to maintain funding and the PBGC’s inability to price the insurance they provide. Whereas, defined contribution plans really showed their inability to provide secure retirement income in the recession as mentioned above. I think that you the 5 key points made are really important and capture the things about both DB and DC plans that need to be maintained in the retirement system. We still have a long way to go but increasing knowledge of retirement saving is one step in the right direction.

  • Michael Yam says:

    In my opinion, any system that does not guarantee income security needs to be reformed. I agree that the current system is quite flawed and I believe the reason why is because people are using it for the wrong reason. Retirement vehicles should be something that guarantees at the very least what you initially put in, plus a little more. If you use this principal, than there would be very few options left, mainly CDs, government bonds, savings accounts, etc. Sure, you might not get a great return but at least you expect to have what you started with plus a little more whereas vehicles like 401(k)’s have shown their vulnerability in the recent recession.
    However I agree that with rising costs in health care and living expenses, many retirees are going to need more than just the minimum and will need greater returns to help cover these costs. To do this they will need to bear risk in their investment choices but they can mitigate these risks at least by improving investment information and diversifying even more.

  • Julie Valentyn says:

    Michael,

    I agree that the recent economic crisis has demonstrated some of the underlying problems with 401(k) plans, an important vehicle for retirement savings for many Americans. It is clear that participants often made unwise investing decisions with too much risk. However, do you think that the average participant has the financial sophistication to understand the risk of their investments? Furthermore, I do agree that diversification is sufficient to mitigate the risk of equity based investments, especially for older participants.

  • Jeffrey Brown says:

    Hi Julie and MIchael,

    There is indeed mounting evidence in the academic literature documening widespread financial illiteracy and its impact on financial decision-making. This is one of the reasons that I feel strongly that plans need to be designed so that individuals who are not financial wizards can be put into sensible portfolios without having to understand efficient frontier analysis. As for diversification – it is obviously a good thing, but it is not sufficient to ward off bad outcomes. Even the most diversified portfolio took a beating in 2008 as “systematic risk” confronted everyone up close and personal.

    Jeff

  • Adam Rose says:

    I heavily support the inclusion of whole-life insurance policies carrying cash value as a viable candidate for an addition to retirement savings and planning. Working with industry leaders such as the top mutual insurance companies (Northwestern Mutual, New York Life, etc.) effectively achieves the following retirement objectives:

    1) Protects against the risk of an individual passing away unexpectedly and no longer being able to provide for their family

    2) Collect the cash value of the insurance policy at the desired age of retirement in the form of a lump-sum or as an annuity

    3) Utilize tax advantages when collecting on either a death benefit or cash surrender value as premium payments are made having had taxes already paid for

    and much more….

    As expected with any sound plan for retirement savings, it is important to diversify amongst several vehicles. Until 401(k) plans start to recover, whole-life insurance can serve as a simple and safe alternative.

  • Ying Cui says:

    I strongly agree that the retirement system in the United States is in need of reform, since it is having a retirement-security problem. There are hundreds of news saying the financial crisis wiped out plenty of 401(K)s, and many families had to borrow against-or withdraw from-their retirement savings to stay afloat.
    In my view, this is really a depressing situation. However, it really warns us and brings us attention to an important issue—a secure retirement and income security. I might say the unguaranteed money at retirement is somewhat due to the cons of defined contribution plan. Like 401(k)s, funds are not protected by the Pension Benefit Guaranty Corporation and the funds are largely dependent on the positive growth and performance of the stock market, which offers higher risks. Even though 401(k)s have above disadvantages, I do not mean that we have to give up 401(k) plan and turn back to defined contribution plan. I do mean that some changes are necessary. We could make diversification to mitigate certain degree of risks by making investment on money fund, etc. For the other, I think proper guidance is very important too. From my personal experience, I have some financial background, yet I could not always make wise decision. For average participants, I do not expect they have professional financial knowledge to understand the risk of the investment. In this situation, guidance is especially effective.