ONE OF LIFE’S BIGGEST decisions is when to leave the labor force and enter retirement. The traditional age for this transition has been sixty-five. But in the past few decades the underlying factors have changed dramatically. People are healthier, wealthier, and living longer. Many leave the labor force before they turn sixty-five.
These facts highlight the importance of the sources, adequacy, and dependability of retirement income on decisions about when to retire. Social Security will be a special focus of our attention later in this chapter and in subsequent chapters, but the elderly also have income from their own resources and from employment-based pension programs of various kinds. Like the Social Security system, these programs are under strain, and they are changing. These developments are important in their own right, but because they are key components of retirement income, they also bear on what should be done about the problem of Social Security.
During the Great Depression of the 1930s, central preoccupations about the economy obviously included not only the high unemployment levels of the time but also the lack of income by many Americans who could no longer work. The Social Security system has its roots in this era. It was developed partly as a way to take older people out of the labor force to make jobs for younger workers and partly as a system to provide income for people over sixty-five years of age.
Similarly, pension programs for the employees of state and local governments and of private employers got started at this time and became common as the post–World War II years moved along. As noted in chapter 2, all these promises to pay employees a flow of defined benefits in their retirement years have created a large part of the iceberg ahead.
The federal government, with its ability to run substantial deficits year after year, can, even if unwisely, kick the Social Security can a little farther down the road, but many others are unable to do so. State and local governments, many private entities, and governments of some other countries have no such alternative. They are already working on this issue.
In Japan and many Western European countries, where the demographic weight of older populations is already powerful and growing rapidly, the problem must be addressed. Similarly, the pension programs of many states and cities in the United States are far more generous than the capacity of those units of government to finance them. Usually their pension promises are supported by dedicated funds, but generous benefits and unanticipated longevity have made these funds inadequate. Because state and city governments have to balance their budgets, they are forced to confront the problem.
Private employers are also feeling the weight of pension program costs because they operate in private markets and are up against global competitors that often do not have these costs to carry. They, too, seek alternatives.
The structure of the pension issue is the same everywhere and stems from two inexorable realities related to the shifting demographics of the population: (1) An increasing proportion of individuals are of benefit-receiving age and a decreasing proportion of people are of paying-in age, and (2) there is every prospect that longevity will continue to increase. These developments were typically not anticipated when retirement plans were first established.
Defined benefit pension systems have historically been similar at the federal, state, and private-sector levels. They promise a specific amount of money every year for life, usually beginning at age sixty-five, but many systems have incentives that encourage retirement at even earlier ages. It is easy to see how this structure leads to inevitable problems; the system is financed on the basis of paying current costs out of current revenues while simply ignoring the rapidly mounting costs of commitments to be paid for in future years, the pay-as-you-go system. The problem exists even in cases in which funds were established for investments on behalf of future benefit obligations because current longevity trends were not taken into account in the funding assumptions.
Private employers in the United States face growing pressure to meet their commitments and restructure the plans they offer their employees. A brief summary of this developing problem will give a sense of the kinds of solutions that may emerge in response to this pressure. The experiences of other countries as well as those of private American employers will be instructive.
Private Employers
The structure of pension plans provided by private employers has changed markedly over the last quarter century, and the pace of change has accelerated in recent years. Most new companies have adopted defined contribution (DC) plans instead of traditional defined benefit (DB) plans, and some older firms have switched to defined contribution programs. DC plans include the 401(k) plans of private employers, 403(b) plans of nonprofit organizations, and 457 plans for government employers. All defined contribution plans are characterized by a tax-deferred retirement account established by the employer, who promises some formula of employer contribution to it. Some employers offer to match employee contributions. There are no promised retirement benefits. The retirement proceeds will be whatever can be financed by the contributions and their investment returns. The participants bear whatever risks are inherent in the underlying investments. Nevertheless, defined contribution plans are popular with both employers and employees. Employers like their simplicity and the fact that the costs are known. Employees like the portability inherent in the plans. Even if they change jobs, they keep their accounts, including the employer contributions, provided that they have stayed with the employer longer than the vesting period.
DB plans, on the other hand, provide participants with a retirement benefit that is determined by a formula and paid for life. The formula varies from employer to employer, but it generally depends on the employee’s age, salary, and number of years of service with the firm. For example, a company may promise its employees an annual benefit equal to 2 percent of their final year’s salaries multiplied by their years of service once they have attained normal retirement age, as defined by the plan. An individual who works at this firm for thirty-two years will therefore receive 64 percent of his or her final year’s salary from the pension plan at the plan’s normal retirement age. The benefit amount may be reduced if the participant retires earlier to account for the fact that he or she is expected to receive benefits for a longer time. However, benefits are rarely augmented for later retirement. Thus, these individuals are often penalized for working beyond the normal retirement age. Employees are typically not required to make contributions into the plan’s fund, nor do they make investment decisions; the employer bears the risks associated with funding the plan. Unlike DC plans, DB plans are not portable across firms. A participant who leaves his or her employer before five years of service may not receive any benefits from the pension plan.
The change in the relative importance of defined benefit and defined contribution plans is nothing short of remarkable. The number of defined contribution plans has always well exceeded defined benefit plans, inasmuch as that was the only reasonable approach for small employers. But when it comes to covered participants, the picture is sharply different.
In 1975, there were almost 2.4 times more participants in active defined benefit plans than in active defined contribution plans.1 The numbers became about the same by 1985, but by 2002 the number of participants in defined benefit plans had diminished to about 40 percent of those in defined contribution plans. By now, in other words, the situation has totally reversed, with participants in defined contribution plans outnumbering those in defined benefit plans by 2.4 to 1.
This movement toward defined contribution plans has continued in recent years because of the growing costs of complying with defined benefit plan regulations and the uncertainty of those costs created by fluctuating markets and increasing longevity. In some cases, companies have gone bankrupt and their defined benefit plans have wound up in the hands of the Pension Benefit Guaranty Corporation (PBGC), the government agency that insures those plans. The PBGC is financed by required insurance premiums from defined benefit plans, but as defaults have risen, the revenue from the premiums has not been sufficient to offset the costs. In a recent spectacular case, United Airlines defaulted on its pension obligations when it declared bankruptcy and handed its inadequate pension assets and underfunded liabilities over to the PBGC. Because the maximum benefit guaranteed is $45,000 per year for those who retire at age sixty-five, some United employees took a beating. For example, United pilots with pensions over $100,000 per year received pension cuts of 50 to 75 percent. After the airline emerged from bankruptcy, it offered its employees a 401(k) defined contribution plan.
Although United Airlines had the biggest pension default in the history of the United States, its case is not particularly unusual. The PBGC has taken over the pension liabilities of US Airways, Bethlehem Steel, and Huffy Bicycles, to name just a few. Between 2002 and 2005, more than twenty companies defaulted on pension plans of more than $100 million in size. An even greater number of plans are underfunded; that is, their liabilities exceed their assets. Moreover, the PBGC itself is in trouble; in September 2004 the CBO estimated that its costs will exceed its premiums by $141.9 billion over the next twenty years.2 Current law limits PBGC payouts to the assets it controls plus premiums. If projections become reality, individuals receiving pensions controlled by the PBGC will face another round of benefit cuts. The alternative is a bailout from the taxpayers.
The 2006 pension reform bill attempted to address the funding shortfalls of some corporate defined benefit pension plans and of the PBGC itself. By some estimates, the bill reduced the PBGC’s unfunded liability by about one-third by raising the premiums that companies offering defined benefit plans pay to the PBGC and by imposing stricter funding standards for the plans. The added premiums and regulations likely make DB plans even less attractive than before to corporations. There is every reason to believe that the movement away from defined benefit plans and toward 401(k) offerings will continue and even accelerate.
Beyond private employers who are in financial trouble, perfectly healthy companies are also reviewing their posture on benefits. IBM, a robust company, has frozen its defined benefit plan and switched all future provisions for retirement to defined contribution plans. IBM will automatically deposit from 1 to 4 percent of an employee’s pay into his or her 401(k) account and match dollar for dollar up to 6 percent of salary deferrals. Verizon has also switched to a defined contribution plan and will match employee contributions up to 6 percent of an employee’s salary.
Evidently, private employers are reacting to pressures on their retirement systems by moving to defined contribution plans, the costs of which can be predicted. But how are employees affected by these shifts? Some argue that this development transfers risks from employers to employees, whose eventual benefits will reflect the uncertain returns of the financial marketplace. There is another side to this coin, however. As the preceding discussion shows, there are plenty of risks in defined benefit plans. Furthermore, employees gain a significant measure of protection because defined contribution plans create an asset that belongs to them. In the case of defined benefit plans, employees who change employers lose financially, but those with defined contribution plans take their accounts with them. Furthermore, if sizable contributions are made over an extended period of time and are prudently invested according to an age-related allocation of assets, experience shows there is a high probability that sufficient money will be available for retirement.
Pressure on the defined benefit plans provided by private employers has yielded a clear result: The defined contribution plan is the wave of the future. What is the federal government’s role in this shift? Money put into a defined benefit plan by an employer is a deductible expense for the employer and is not taxable income for the employee. The employee eventually pays taxes, presumably in a lower tax bracket, on the income from the pension plan at retirement. The counterpart in the case of defined contributions is, in effect, a choice. Employees can put pretax dollars into their 401(k) plans, which contain employer and employee contributions, and pay tax on the money taken out. Alternatively, an employee can use Roth IRAs and Roth 401(k)s as savings vehicles. For these types of plans, individuals pay tax on the money they put in, but withdrawals are tax free.
One feature that has been lost in the switch away from defined benefit plans to defined contribution employment-based pensions is automatic enrollment. Under the old defined benefit plans, employees were automatically enrolled, so participation was 100 percent of those eligible. By contrast, defined contribution plans usually require employees to sign up for a 401(k) plan or its equivalent in order to participate. Employer-sponsored retirement plans have attractive tax features and frequently offer employer matching of employee contributions, an important benefit. But encouragement to enroll is uneven across employers, and follow-through by workers is much lower than might be preferred or expected. There is ample evidence that outcomes are different if employees must opt out of, rather than sign up for, participation. Researchers Brigitte Madrian and Dennis Shea found that in a private firm that switched its new employees to automatic enrollment in its 401(k) plan, participation increased from roughly 40 percent to more than 80 percent although no other changes had been made in the plan’s characteristics.3 This dramatic increase can be attributed both to participant inertia and to employees’ acceptance of implicit investment advice from their employers. Clearly, given the tax advantages of this form of saving for retirement, enrollment in such a plan is a good deal for the vast majority of employees. Companies should be encouraged to make participation automatic unless employees actively choose to opt out, a step that would ensure much higher participation rates.
Particularly as automatic enrollment becomes universal among employers that offer defined contribution pension plans, the composition of the investment portfolio should be examined. Many employees will end up with what is called the default portfolio, into which the company puts the assets of those employees who do not make an active choice of investments. Ideally, default portfolios should be composed of a so-called life cycle fund (a balance of indexed stock and bond funds that is adjusted according to the age of the participant) or a broadly diversified equity portfolio. Neither money market funds nor the employer’s stock should be designated as the default choice; these investments are inappropriate for most retirement savers. Firms that automatically put participants into money market funds have found, twenty years later, that some of those employees never changed their asset allocations. Money market funds have a role to play in the financial universe, but being a retirement accumulation vehicle is not one of them. Long-haul investments that are broadly diversified or indexed portfolios of stocks and bonds have a track record of superior returns over the long run.
Evidence of investor inertia is so strong that it could be used in other ways so as to institute a set of policies that encourage saving in this country. For instance, tax refunds could be invested in individual retirement accounts (IRAs) unless a taxpayer instructs otherwise. Also, employers could be encouraged to offer systematic saving plans over and above their pension plans through payroll deduction into tax-deferred accounts. Evidence shows that people usually do what is easy and automatic, and that is how saving plans should be offered.
In summary, private companies, always conscious of the bottom line, face mounting competitive pressure, in many cases on a global basis, and they have been among the first to act. Aware of the pressing need to balance their budgets, states and cities are also stirring. The federal government must follow.
Social Security
The Social Security system has been in effect now for almost three-quarters of a century. It operates as a pay-as-you-go system; the payroll taxes it collects from today’s workers are used to pay benefits to today’s beneficiaries. The original idea was that the benefits an individual received would reflect the contributions he or she made, as in an insurance policy. This relationship holds even though a degree of progressivity has always been present. Over most of its history, Social Security’s revenues from payroll taxes have exceeded the actual benefits it has paid out. But instead of using these extra funds to back promises of future benefits, the government has used the money to make benefits increasingly generous or has simply spent the money as though it were part of general revenues. All attempts to fund future promises have failed. At this point it is widely acknowledged that the income stream generated by what is now a 12.4 percent payroll tax will start falling short of the benefits to be paid out by the time another decade passes. Compellingly, the gap between revenues and benefits has begun to narrow sharply, so the budget squeeze is now upon us.
The Social Security trust fund contains the surpluses, invested in government bonds, that have been generated by the system since its inception. One purpose of this trust fund is to help pay for future benefits. However, it will not be of much help for the eventual solvency of Social Security because the money that Social Security has transferred to the Treasury has not been saved but rather used to pay the day-to-day expenses of running the government. The bond purchases have built up to a bundle of federal government IOUs. In testimony before the 1994–1996 Social Security Advisory Board, Barry Bosworth of the Brookings Institution said that policy makers had been “playing games” with the money. He used the analogy of a family that saved for future college expenses by setting up a special savings fund. Each year they made the appropriate deposits into the fund, but during the year they kept borrowing from the fund and replacing the money with IOUs. By the time the children were of college age, the only thing in the college savings fund was a pile of IOUs.
Since the 1983 Greenspan Commission reform of Social Security, the Social Security Administration has been transferring its excess funds to the rest of the federal government. Apparently not a penny has been saved. A decade from now, these excesses may look like an accumulation of $4 trillion in bonds. The problem is that the federal government will have spent the money on other programs. The pile of IOUs will no more finance the retirement of the baby boomers than would the stock of college savings IOUs help the family just described send their children to college.
The inability of the trust fund to provide relief to future generations has been known for a long time. In 1937, Senator Arthur Vandenberg said:
What has happened, in plain language, is that the pay-roll taxes for this branch of Social Security have been used to ease the contemporary burden of the general public debt or to render painless another billion of current Government spending, while the old-age pension fund gets a promise-to-pay which another generation of our grandsons and granddaughters can wrestle with, decades hence. It is one of the slickest arrangements ever invented. It fits particularly well into the scheme of things when the Federal Government is on a perpetual spending spree.4
More than sixty years later, in 1998, Senator Bob Kerrey testified: “We are not prefunding! The idea in 1983 was that we would prefund the baby boomers. We began to use it immediately for the expenditures of the general government. We didn’t prefund anything.”
The picture is clear. One government program, Social Security, has tried to save for and prefund the retirement of the baby boomers. Congress and the executive branch have spent it all. No saving has taken place, and all we are accumulating is a pile of IOUs. This situation must change, and the introduction of individual accounts is an appealing alternative. Participants would be allowed to own and control some part of their Social Security assets by channeling their contributions into individually owned investment accounts. If surplus Social Security income were put into individual accounts and invested in indexed stock and bond funds, then other government programs would have to get by without Congress’s putting its hands into the Social Security cookie jar. The country’s saving rate would be higher and future generations of Americans would be better off.
The system’s financial problem can look somewhat better or worse according to the assumptions that are made about prospective increases in longevity, but the basic problem remains: If the current payroll tax rate remains unchanged and if the system is to be solvent in the long run, changes in the benefit structure must be made. The current surplus of revenues over benefits, which is predicted to continue for about a decade, provides a cushion for transition costs, but that cushion is more like an hourglass: The longer you wait to use it, the less remains to be used.
Under these circumstances, you would think that the federal government would be energized to work on the problem, but this is hardly the case. Presidents Bill Clinton and George W. Bush have agreed, to a remarkable degree, on the need to do something and on the advantage of doing it sooner rather than later. Here is what one of them said to a group of Georgetown University undergraduates:
This fiscal crisis in Social Security affects every generation…. It’s very important that you understand this…. If you don’t do anything, one of twothings will happen—either it [Social Security] will go broke and you won’t ever get it; or if we wait too long to fix it, the burden on society of taking care of our [the baby boom] generation’s Social Security obligations will lower your income and lower your ability to take care of your children to a degree that most of us who are your parents think would be horribly wrong and unfair to you and unfair to the future prospects of the United States.
He went on to say, “Today, we’re actually taking in a lot more money from Social Security taxes enacted in 1983 than we’re spending out. Because we’ve run deficits, none of that money has been saved for Social Security.” Finally, he warned that if nothing is done until the trust fund runs out of money, the choice will be “a huge tax increase in the payroll tax, or just about a 25 percent cut in Social Security benefits.”5
Which president was this? It was President Clinton in a 1998 address. But President Bush expressed similar thoughts in 2005 as he sought to generate momentum for change in the Social Security system. Social Security’s solvency problem, recognized by both presidents, is not a fundamentally political or partisan issue. Unfortunately, neither president has succeeded in spurring Congress to tackle this pressing problem. Time is slipping away, and it is more urgent than ever to change the course of Social Security in the next few years.
Urging the federal government to initiate changes in its programs is daunting, and implementing these plans will be difficult. Action can be expected when the costs of government programs are forced to the attention of the American body politic.