A Prescription to Save the American Retirement System?

For the next few weeks, Scott Cooley will be filling in for John Rekenthaler, who is on sabbatical.

Americans are accustomed to hearing about the problems with their retirement system. Social Security faces a long-term deficit. Most private-sector workers lack access to a defined-benefit plan. Too few people save for retirement in defined-contribution plans, and those who do, frequently save too little.

There may be a book that challenges this conventional wisdom, but Falling Short: The Coming Retirement Crisis and What to Do About It is not it. Indeed, authors Alicia Munnell, Charles Ellis, and Andrew Eschtruth make a strong and familiar case that all the things we think are wrong with our retirement system truly are flaws. But they also provide a helpful how-to guide for investors to navigate the current, problematic retirement system, while they attempt to jump-start a conversation about how policymakers can fix it.

As befits a book written by authors with a strong academic bent--Munnell and Eschtruth are researchers at Boston College's influential Center for Retirement Research, while Ellis is the former managing partner of Greenwich Associates and the author of 16 books--this volume provides considerable historical context for the development of the current retirement system. In short, no one designed the overall structure of our American retirement system--and if someone had, it would probably look quite different. Rather, key developments occurred on an ad hoc basis in the 1950s, when a tight labor market and strong unions produced a proliferation of defined-benefit plans, and in the 1980s, when defined-contribution plans gained in popularity. Although initially meant to supplement defined-benefit plans, 401(k)s and other defined-contribution plans ultimately came to supplant them, especially when companies sought to offload risk following the 2000-02 bear market.

At many companies, then, there has been a shift from compulsory, privatized retirement savings--workers could not opt out of their defined-benefit plans in exchange for higher pay--to a voluntary defined-contribution system in which most workers have no idea how much they should save, and often favor current consumption over saving for retirement. There is not much new in the authors' story of the historical development of the American retirement system, and in fact, the topic is covered in much greater detail in two of Jacob Hacker's books, The Divided Welfare State and The Great Risk Shift.

At the same time that workers are losing access to the (mostly) secure income stream provided by defined-benefit plans, Social Security has come to replace a lower share of preretirement income, according to Munnell, Ellis, and Eschtruth. In part, that is because the official Social Security retirement age is gradually rising from 65 to 67. Also, as a percentage of Social Security benefits, Medicare Part B premiums are expected to rise to more than 10% in 2030 from about 5% in 1990. Finally, because tax-free thresholds for Social Security benefits have not risen in line with inflation, 50% of recipients will owe taxes on their Social Security benefits in 2030, versus just 10% in 1985. As a result, a typical Social Security recipient in 2030 will find that the program replaces only 31% of preretirement income, versus 40% in 1985. Obviously this replacement rate will fall further if Social Security's finances are not stabilized; in the absence of reforms, future benefit cuts will occur.

So, how do we fix this? The authors offer a set of prescriptions for both individuals and for policymakers.

For individuals, one key is to accept that they will need to work longer, until age 70. Munnell, Ellis, and Eschtruth write that Americans should consider 70--the age at which monthly Social Security benefits reach their maximum level--the true retirement age. Delaying retirement from 62 to 70 produces a 76% increase in monthly Social Security benefits and a projected doubling of 401(k) assets. Due to rising life expectancies, the authors argue, a later retirement age does not necessarily mean having to spend fewer years in retirement than past generations enjoyed.

Unsurprisingly, the authors also exhort Americans to save more, and earlier. They point out that a 25-year-old who starts saving for retirement with an eye to retiring at age 70, needs to save only one tenth as much, as a percentage of income, as an individual who begins saving for retirement at 45 and hopes to finish up work at 62.

Consistent with her previous interview with Morningstar, Munnell and her co-authors also advocate tapping home equity as a means of providing income in retirement. While not an ideal solution, perhaps, the authors note that many individuals have few other assets--and therefore may have no other choice. (It should be noted that Munnell has a financial interest in a firm that provides reverse mortgages.)

The authors' prescriptions for policymakers will likely prove even more controversial. With the continuing decline in defined-benefit plans and the fall in the Social Security replacement rate, they argue that Social Security benefit cuts are illogical. Rather, they suggest using income-tax revenue to bolster Social Security's finances. In effect, this would shift a portion of the Social Security tax burden onto upper-income taxpayers, given that income taxes are more progressive than payroll taxes. They would also end the current tax preference for contributions to retirement plans and replace it with a government-matching grant that would provide the same benefit, as a percentage of contributions, no matter one's income level. (The current system provides a larger tax benefit to those with higher income levels, who face high marginal tax rates, than those lower-income citizens who pay little or no income tax.)

Munnell, Ellis, and Eschtruth also call for policymakers to mandate auto enrollment in defined-contribution plans at companies that offer them. Although the Pension Protection Act of 2006 promoted auto enrollment, half of companies with 401(k) plans still do not provide it--and far fewer provide for the auto escalation of contribution amounts that would be necessary to ensure an adequate retirement. The authors would like to mandate that, too. Employees would still be able to opt out of their defined-contribution plans, as they are able to in countries that have mandated auto enrollment, including the United Kingdom and New Zealand. The authors also suggest that companies that lack defined-contribution plans would have to at least direct employee contributions into a retirement vehicles like President Obama's proposed myRA.

Finally, the authors would like to reduce the amount of "leakage" from 401(k) plans; currently about 1.5% of 401(k) assets are withdrawn each year for reasons unrelated to retirement. Munnell, Ellis, and Eschtruth would end people's ability to make an early withdrawal of retirement assets for "predictable" expenses, including the purchase of a home, while retaining the ability to take hardship distributions for "unplanned" expenses resulting from a job loss or unusual medical expenses.

The authors are clear that they have focused on making the existing retirement system work better, rather than contemplating more wholesale changes. Therefore, they spend little or no time on alternative retirement systems that exist in other countries. For example, they do not mention that in the Netherlands, where the government mandates defined-benefit plans in most industries, more than 90% of workers are still covered by defined-benefit plans. They only briefly touch on the case of the wildly popular Australian Superannuation Guarantee, in which companies currently must contribute 9.25% of worker pay to private 401(k)-type accounts. If there is a missed opportunity with this book, it is that it did not fully contemplate those alternatives, which were seemingly considered too radical for the American context.

However, Falling Short: The Coming Retirement Crisis and What to Do About It still has considerable merit. If it provokes discussion about ways to shore up our creaky, incomplete, and probably inadequate American retirement system, then it will have achieved its objective--even if, as a policy manual, it leaves many alternatives undiscussed.

A Reminder About the Tax Petition ... In last week's column, I wrote that it's high time for our political leaders to work together to provide tax fairness for mutual fund investors. If you agree with this position, please take a few moments to click here and sign a White House petition. Then forward the White House petition link to your friends, family, and colleagues. If we can obtain 100,000 signatures in 30 days, it will not only trigger an official White House response, but it will place investor interests front-and-center for our political leaders.