Confronting America's Retirement-Savings Crisis
Understanding investor behavior is key to reining in the problem, says investment expert Charley Ellis.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many Americans are hurdling toward retirement without enough savings. Joining me to discuss some prescriptions for the impending retirement crisis is Charley Ellis. He's an investment expert and an author. Charley, thank you so much for being here.
Charles Ellis: Thanks for the invitation.
Benz: Your latest book, Falling Short, is about the retirement crisis--not just the impending retirement crisis, but arguably the one that we're in right now. You offer some, I think, really great prescriptions for solving that crisis. Let's talk first, though, about why you think an incremental approach makes sense, rather than one that would be what you call a "big-bang approach," where we completely upend the system and start over.
Ellis: If you wouldn't mind, I'd like to change one word. When you said "solve" the problem--how about "manage" the problem? Bring it under control, because solving is a little bit too ambitious for me.
Benz: So, you have some ideas for bringing the problem under control, but let's talk about why you think we don't need to completely upend the system or why we shouldn't have that as a goal.
Ellis: Well, I start with just being realistic. You don't have to read the newspapers too carefully to realize there's a lot of, "We're not going to get action on this, and we're not going to get action on that in Congress." So, instead of, "Let's get action on a really complicated, politically difficult, very challenging [issue]," why don't we just say that we're going to accept things the way they are on the big, main structures, and we're going to make some modifications that would be easy to make, but would do an enormous amount of good in the long run?
Benz: So, you tackle the problem from a variety of different angles in the book. You look at Social Security, you look at the role of home equity for some retirees, but let's focus specifically on retirement plans, specifically 401(k)s, which are a real thrust for the book. Let's talk about some of the so-called nudge features and why you think they're so valuable, but also why you think we could push them even, perhaps, a little bit further.
Ellis: Well, I think all of us ought to vote for Richard Thaler getting the next Nobel Prize because he's done us all so much good by saying that people don't behave quite rationally, but predictably. If you pay attention, you can see how people do, again and again, certain kinds of things." So, let's respond to that. And in a very, very nice way, he said that you can set things up in a way that makes it easy for people to do the right thing. For example, instead of having cigarettes out and available for anybody at the checkout counter, put them somewhere you have to go out of your way to get. Or if you want to make it really easy for people to do something, set it up for them. The food that's good for you is easy access. The not-so-good-for-you food is a little bit harder access. He just encourages you to do the "right thing." The same applies--and he's done a wonderful job of making that clear--in 401(k) investing.
So, you say to people, "You're going to be in the plan, unless you'd rather not," so that people are free to make a decision if they really want to. But most people don't know very much about investing because most people don't have any experience with investing, and it makes sense that they wouldn't be comfortable answering difficult, complicated questions like, "How much do you want to set aside? How much do you want to save each year? How do you want to invest it?" But you could turn it around the other way and say, "The company that's sponsoring [the plan] has people who know a lot. They've spent a long number of years working on it, they probably studied it, they've read books about it, and they've got access to all kinds of experts who can help them." So, let the company's experts set up what I'd call a "blue plate special." It's good for you; it will work out fine for almost everybody. But if it isn't quite right for you, for some reason or another, you're free to say, "No, thank you--I'd rather not have that." So, it starts with you being in the plan automatically unless you say, "No, I really don't want to be in the plan." Then, you don't have to be in the plan; you can opt out.
The way it is today, you have to say, "Yes, I want to be in the plan," and you opt in. It's a little bit more difficult of a decision. So, fewer people make the decision to be in the plan when it's an opt-in than would make the same decision to be in the plan if it's an opt-out. They have the same freedom, but the outcome is a little bit better for them. The same thing goes for matching the company's contribution. If you say to somebody, "Surely, you would like to get the match that the company sets up; it's 4% or 5% or 6%--whatever the company has set--and it doubles your money immediately. Surely, you would like to do that." Well, you could argue that some people say, "Yeah, but I've got a lot of expenses at home. I really don't think I can do that. Maybe I'll do that next year or maybe the year after," and they lock themselves into a never, never, never, never, never.
So, you say automatically, "You're going to be in the plan, and you'll be in it enough to get the match and get that free money." And if you say, "No, I don't want it--I've thought about it carefully and I don't want it," you opt out. Fine. But you increase enormously the number of people who will get the benefit of that match. The same thing with what's called auto-escalation. Every time you get a raise, either one fourth or one third or whatever is the number that works for the company's experience goes into savings, which you can spend later in your retirement years and build up enough savings so you can have a secure retirement. You could always say, "No, I don't want that. My rich uncle died and I'm a very wealthy person, so I don't want to do that." Fine. But if you're just a normal American person working for a living, you probably ought to have it, and it would work out fine.
Benz: Another thing that you discuss in the book is some of the default contribution rates in use currently. You and a lot of other investment experts argue that they're too low in many cases, with 3% being kind of the standard. You think that they should start a little higher. I guess the risk, though, is whether the participants start to feel a little bit of pain at, say, 6% when that much of their paycheck is going [into their 401(k)].
Ellis: Well, where it's been tried, it's worked very comfortably, and there's no sense of distress. So, it's a hypothetical that it would be somehow distressing.
Benz: So, you think higher default contribution rates make a lot of sense.
Ellis: To the people who've experienced it, it makes a lot of sense. And anybody standing back and looking at it as a economist or a social scientist would say, "Yes, it makes a lot of sense," because later on in your life you will need that money.
Benz: Let's discuss investment options within the 401(k) confines. You are on the board of directors for Vanguard Funds--
Ellis: I was; I'm no longer. I've aged out. [laughs]
Benz: So, you were on the board of directors for Vanguard Funds. Let's talk about the role of low-cost products and why you think they're so important within the confines of 401(k) plans.
Ellis: If you study investment results over a long period of time, across a large number of investment managers and across a large number of individual investors and institutional investors, you find over and over and over and over again that the main secret to success is low fees.
Benz: So, index funds, you think, should have a prominent role and should be the basis for target-date funds?
Ellis: Low fees should be the prominent role. And low fees can be obtained in actively managed funds--not as easily, by any stretch, and not as low as you would get with indexing. And for what it's worth, in my family, my wife and I index. My two sons index, and their four children, in small amounts, index.
Benz: So, you're true believers.
Ellis: Yes. [laughs]
Benz: Let's discuss so-called leakage from 401(k) plans. This is another topic that you talk about in the book. What do you think is the prescription there? Because we do see money passing out of company retirement plans, leaving altogether the retirement-savings confines. How do you solve for that issue, or attempt to address that issue?
Ellis: I'm going to take a little bit of time here because I think it's fun to get back into history a little bit. My first job was working for the Rockefeller family. And John D. Rockefeller was a very serious-minded Baptist, who believed deeply in savings or thrift. And his children, growing up, all had to save money every month, and they had to report that they had saved. He believed it so deeply that he wanted to have that for the people working for "the Standard," as he called the company. So, he developed, in addition to a pension, a system in which people working for the Standard could put some extra money aside in what was called a "thrift plan." He wanted to make it easy for people to do that. So, he encouraged them by saying, first, "I will match you--whatever you put aside, up to a certain amount." That was pretty good encouragement. Secondly, he said, "If you ever need the money back, you can take it back." He didn't want to have people afraid that they would lock their money away and couldn't touch it when they really needed it.
Third, he said, "I will let you invest in the company--in the Standard--so that you'll know when you're working for the company, you're working for yourself." As a concept, that really made great sense, and it was very successful. Same thing with AT&T (T), who looked over their shoulder and said, "It's working for the Standard--we should do it, too." 401(k)s got their legitimacy, in part, by getting AT&T and the Standard Oil companies to come together and convert their thrift plans into 401(k) plans. So, people said, "If the best companies in the world are doing it, it must be fine for us." And that was the beginnings of the acceptance of 401(k). And then people made it a little bit easier and a little bit easier and a little bit easier to have access to those funds--just in case you ever needed it. I think we've gone too far. I think it's a shame that, today, you can say, "Here are my purposes: I want to make an addition on my home, or I want to remodel my kitchen." You can take money out.
"I want to pay for my children's education." There, I would think that was a good reason. But then if you had too much in credit card debt, you can pay off your credit cards by saying, "I'm going to take money out." That's part of the problem. The second part of the problem is that it used to be that people worked for one company for their careers. Now, many people work for five, six, or seven companies over a series of different times, and in the space of time between working for company A and company B, some young people are financing that interim period, having a wonderful time going on vacation, doing things they've always wanted to do, but they're spending the money that was set aside by them for their retirement. When they get to be 75, 80, 85, or 90, that money is not going to be available--and that worries me. So, yes, it's a little bit of paternalism. Yes, it's a little bit of mother-knows-best, but I think it may make a lot of sense to make it a little bit harder here, there, and in other places to take money out. If you have a really good reason, fine. If it's a not-so-good reason, it's better to work toward the long term.
Benz: You made the point your the book, actually, that it's kind of perverse that we penalize people who do have true hardships, such as a medical need or something like that in which they need to tap their 401(k). You say that maybe they shouldn't face a penalty, but for more mainstream expenditures, there should be tighter limits.
Ellis: The idea of slapping people on the hand when they've got a terrible financial crisis that there's a solution to, it doesn't make sense. We say, "Yes, but we're going to hurt you on the way out." That's not America. That was a mistake, and we ought to correct that mistake. The penalty was intended to keep people from using it for less important things, but it's not working. Almost nobody pays attention to it. So, why don't we admit that's not working and set up a different set of limits on what you can do? Let's not hit people on the way out. Senator Elizabeth Warren did a very nice study when she was in law school on bankruptcies, and it turns out that half the people who go bankrupt, go bankrupt because of medical expenses. It just overwhelmed them financially. Well, avoiding bankruptcy might be a darn good reason to tap your 401(k).
Benz: Charley, this is such an important topic. You've written such a valuable book with a lot of, I think, terrific insights. Thank you so much for being here today with us.
Ellis: It's a real pleasure.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.