CHAPTER 7
AMERICA’S RETIREMENT SYSTEM IN A GLOBAL CONTEXT
It says something about this new global economy that USA Today now reports every morning on the day’s events in Asian markets.
In the leading global league tables of national retirement systems (Figure 7.1), Uncle Sam doesn’t seem to have much to brag about (We’re number 13!), or so these pension experts would have us believe.
FIGURE 7.1 2016 Global Pension Index: How did each country fare?
Source: Melbourne Mercer Global Pension Index, 2016.
So let’s widen our lens and take a brief look at how the retirement savings system we’ve built in this country actually ranks in a global context. Despite our shortfalls, as we will see, we’re very much on the right track.
Global retirement finance surveys typically rank the United States in the middle of major nations’ retirement systems, with their focus mainly on the 25 largest nations and economies. The retirement savings systems of the next 150+ countries are simply too small to merit serious attention.
But even though these analyses judge the U.S. retirement system to be at the midrange of their qualitative rankings, due to our well-known coverage shortfalls and unequal income replacement ratios, the United States takes top billing in any quantitative ranking because of the staggering, multitrillion-dollar scale of the funded assets that back both our traditional DB pensions and our DC workplace savings plans.
For example, actuarial consultants Willis Towers Watson inform us that the world’s top 22 retirement finance markets comprise some $36 trillion in funded pension assets. But while the United States accounts for a bit less than 40 percent of those nations’ combined economic output, we have accumulated fully 62 percent of the developed world’s retirement assets.
These numbers alone suggest that we take the litany we hear from media and academic naysayers with a grain of salt. Too often, the message is that the United States is uniquely vulnerable to an imminent retirement “crisis” while better-prepared economies around the world are somehow immune. As we’ll see, a closer look at the data suggests quite the opposite.
America’s public and private retirement systems do have imperfections, some of them quite serious, but all of them are eminently correctable if we simply spread the best practices in these existing plans system-wide. So if we want to decode the true significance of global pension rankings, we need to unpack their underlying data and their assumptions about the future and draw our own conclusions.
In this chapter, we’ll talk about pension architecture (defined benefit vs. defined contribution structures), about real funding versus political promises, about national styles of asset allocation (stocks, bonds, alternatives), and about actuarial sustainability. What we’ll find is that far from being the “sick man” of global retirement finance, the United States, on a relative basis, and over the long term, is one of the best-prepared nations on earth.
The most striking feature of global retirement system rankings is that many of the best-regarded systems are found in a handful of small, wealthy countries in Northern Europe—the Netherlands, Sweden, Denmark, Switzerland, Norway, and Iceland. These are some of the most prosperous economies on earth, as measured by per capita income, economic stability, and income equality. It stands to reason that they should have well-organized retirement systems, and they surely deserve high marks for their far-sighted preparation for retirement.
The United States can certainly learn from their experience and adapt some of their best ideas. But it’s totally unrealistic politically to think this country would ever import whole-cloth the retirement models of these small, ethnically homogenous nations to a continent-straddling colossus with a multi-ethnic population of 330 million people, high legal immigration, vastly varying regional economies, and a GDP of $20 trillion. By contrast:
- Sweden’s entire population would fit into Los Angeles County; its GDP is smaller than that of Massachusetts.
- Norway has socked away roughly $1 trillion in an oil-fueled pension fund for its 5 million citizens; its GDP is slightly smaller than that of North Carolina.
- Iceland’s population of 332,000 is the same size as metropolitan Lincoln, Nebraska; its GDP is less than that of Vermont.
There are some substantial economies to be found on these pension rankings—for example, the United Kingdom, Australia, Canada, France, Germany, and Japan, with their widely varying ways of saving for and financing retirement. There are also some surprising no-shows on these lists, including Brazil, Russia, India, and China—the BRIC countries that were until recently touted as the key drivers of global growth in the twenty-first century. To date, though, these nations simply haven’t developed substantial retirement savings systems.
We can see very clearly that pay-as-you-go pension systems all over the world face rising pressure from the relentless forces of global aging. Rising life spans are lifting the number of retiree recipients, while the number of active young workers paying taxes stalls or even shrinks. The “support ratios” in many nations are becoming steadily heavier every year. This will inevitably force either massive tax hikes (among already highly taxed nations such as France or Italy) or the kind of deep benefit cuts that aggravate social tension and may foment political crises.
As Figure 7.2 illustrates, nations like France, Germany, the United Kingdom, and Japan, whose systems rely mainly on tax flows from current workers, not on investments, face pension liabilities two to three times larger than their total national output. Meeting these liabilities poses a huge challenge. And there’s ample reason to expect that many of these nations’ seemingly generous public pay-as-you-go pension programs will have to be cut back substantially. In very sharp contrast, Australia’s mandatory national retirement savings system leaves that country with the lowest future retirement liability-to-GDP ratio among major nations.
FIGURE 7.2 Some governments face huge liabilities
Source: Kaier and Muller (Freiburg University), DNB, OECD, Citi Research from Global Perspectives & Solutions, March 2016.
With retirement liabilities roughly equal to our annual GDP, the United States does face serious challenges from rising longevity and an aging population; the need for action to make Social Security solvent is the most salient example. But America’s retirement liabilities are far lighter as a share of our economy than those facing most of our major trading partners and rivals. What’s more, America enjoys another advantage almost unique in the developed world. We have a relatively younger and still-growing population. Much of the rest of the developed world faces a “baby bust,” and some countries face absolute population decline, even implosion, over the course of the twenty-first century.
Retirement Finance Architecture
The compilers of these global retirement tables are generally agnostic on the questions of whether pension systems are funded by real investment assets or depend on pay-as-you-go tax transfers. They also don’t distinguish between DB and DC models.
What’s critical is whether DB plans are fully or only partially funded. But there is a major difference between pay-as-you-go systems based wholly on taxes from current workers and prefunded retirement systems (DB, DC, or hybrid) that draw their future income from real savings invested in stocks, bonds, and other financial assets.
Taken at face value, it may seem that many national pension systems, like public sector DB pensions for state and city workers in the United States, offer both broad coverage and generous income replacement ratios. But too many of these promised benefits are not backed up by any tangible assets. They are pay-as-you-go systems dependent on future taxes, or, in the private sector, future earnings. Pay-as-you-go systems are not pension funds, they are pension promises that politicians and future generations of workers are on the hook to keep, or not.
This variety of global pension systems is healthy in the sense that having these varied policy approaches provides an ongoing global laboratory that’s currently testing which plan design and funding practices work best. We can, and should, draw lessons from the lived experience of other nations, their retirees, and their system designs so we can adopt their best features—and avoid their pitfalls.
America’s Demographic Advantage
As we move to and through the 2020s, America’s demographic advantage over global competitors will become much more pronounced than it is today. Simply put, the United States enjoys vastly more promising long-term demographic trends than most of our major trading partners (Figure 7.3).
FIGURE 7.3 As key trading partners age, America will remain (relatively) young well into the twenty-first century
Source: U.S. Census Bureau, International Database, 2010.
America not only enjoys a higher birth rate than Europe, Japan, Russia, and China, the country allows more legal immigration—well over 1 million a year—than the rest of the developed world combined. As a result, America in 2020 will have a still-growing working-age population and will be heading toward a total population well over 400 million people by mid-century.
By contrast, the populations of China, Japan, Russia, and much of Europe will be in decline by 2020. China will almost surely become old before it becomes rich—with an internal “nation” of nearly 340 million people over age 65 by mid-century and a per capita GDP still likely to be less than one-third of America’s. Japan, China, Italy, Germany, and some other advanced nations may well experience a dramatic population collapse by century’s end—but not the United States.
Demographers tell us that by 2050, roughly one in three citizens of developed nations in Asia and Europe will be over 65 but only one in five Americans will be. All through the twenty-first century, in other words, America will be relatively younger than our major global rivals. We will be better able to sustain both a robust Social Security system and a strong, near-universal system of private retirement savings.
Retirement System Change Is Glacially Slow
As with any longstanding economic architecture, most nations’ retirement systems change slowly; inertia is as powerful a force in national system design as it is in individual savings behavior. So while the United States long ago shifted a majority of its retirement assets to defined contribution plans, pension plans in Canada, Japan, and the Netherlands are still over 94 percent DB. Even in the United Kingdom, where DB pension shortfalls are substantial and a government-supported migration toward DC is well underway, fully 82 percent of retirement assets are still in DB plans.
Only a handful of countries have so far shifted the majority of their retirement assets to the defined contribution model, notably Australia (87 percent) and some smaller nations like New Zealand and Switzerland, which has a unique collective DC/DB hybrid system. A few emerging market countries like Chile, South Africa, and Singapore are also moving to adopt mainly DC structures. And Australia is particularly noteworthy because it has achieved near-universal pension coverage through a mandatory defined contribution savings system called “superannuation” that looks very much like our Workplace Savings 4.0 reform proposals.
One often-cited flaw in current DC systems is that many workers now entering retirement have failed for a variety of reasons to accumulate enough money to replace their preretirement incomes for life. Some entered into DC savings systems at midcareer and had only 15 or 20 years for their assets to build up. Others saved at too low a rate or saw their investment balances eroded by high fees. Some also made damaging investment choices that were either too bold or too cautious. Some withdrew funds prematurely or opted out of savings plans altogether.
Another fair critique of global DC systems may be that the transition to a defined contribution structure was financed through substantial cuts to traditional pay-as-you-go state pension systems. That, however, is not what happened in the United States.
The American migration from DB to DC was evolutionary, with competitive market forces and service innovation driving down costs without drawing a dime away from the fairly robust traditional pensions that Social Security provides for lower-income workers. With no explicit planning, the United States evolved a fairly well-balanced public/private retirement finance architecture that drew on both human and financial capital—the “twin-engine” hybrid we discussed in Chapter 2.
Asset Allocations Vary Widely Among Nations
Retirement systems are also heavily influenced by the financial structures of the nations that sponsor them. For example, in East Asia and Continental Europe stock and bond markets are not nearly as deep, widely owned, liquid, or reliable as those in the United States. All but the largest, most global companies in these countries rely mainly on the banking system, not on capital markets, for financing. So if most private companies in a country sell relatively little equity, and issue few fixed-income securities, what can their pension funds invest in?
By parsing the data, we see that retirement savings in these bank-dominated financial markets are largely allocated to debt securities issued by governments and, to a lesser degree, banks and insurance companies. But many governments, banks, and insurers in these nations face long-term challenges to their own solvency and creditworthiness.
In the wake of the global financial crisis, governments have issued record volumes of debt. Meanwhile, most banks in Europe and Asia have not been substantially recapitalized, and insurers in these regions are likewise under stress, notably from near-zero or negative interest rates. Well-grounded concern about the sustainability of these debts is straining sovereign debt credit ratings, driving currency valuations, and stoking fears about whether these national retirement systems can keep their pension promises to their people without huge tax hikes or benefit cuts.
Traditionally, pension funds typically have “laddered” fixed-income securities to match their liabilities with the income streams produced by these bonds. DB systems in the Netherlands and in Japan, for example, allocate 54 percent and 59 percent of their assets respectively mainly to bank and government bonds. DC systems in the United States and Australia, by contrast, have limited their fixed-income exposure to 22 percent and 14 percent respectively.
Today, of course, we’re living through very abnormal, even unprecedented times.
On top of the pressures of demographics, public and private sector retirement funds now need to consider growing interest-rate risks. With interest rates at record lows, pension managers who traditionally relied on “safe” fixed-income investments are taking increasing risk themselves to generate sufficient income to meet their funds’ liabilities.
Pension funds have long preferred to invest in bonds over stocks, because they were perceived as a safe asset class. And government debt has long been seen as the safest investment of all. But with over $13 trillion in fixed-income instruments worldwide actually delivering negative yield (as of late 2016), these once-safe investments can actually erode pension funds’ principal.
And government debt is famously subject to political risk. For example, the sharp uptick in interest rates that followed the election of Donald Trump in November 2016 cut more than $1 trillion from the value of the global bond markets within days—some “safety”! No wonder those responsible for securing future retirement income streams are looking for alternatives and taking greater risk.
With interest rates at multidecade lows, and public and private debt soaring, pension plans around the world have, through their massive purchases of government debt, exposed themselves to historically unprecedented risk concentration. Many nations have small, less-liquid stock markets that limit their ability to invest in equities. So pension managers in these nations have now responded by going further out on the risk spectrum. Over the past two decades, many pension managers around the world have cut back on both stock and bond allocations in favor of higher-yielding but potentially more volatile alternatives such as real estate assets, private equity, and other nontraditional investments.
Twenty years ago, pension funds globally were 90 percent allocated to stocks and bonds, with allocations to alternative investments limited to the high single digits. Today, alternatives account for nearly a quarter of global pension fund assets, and this allocation is rising as plan sponsors, struggling with low interest rates, reach for yield in an attempt to keep their pension promises.
Sustainability, Anyone?
At the end of the day, the ultimate determinant of success for any retirement finance system is its economic sustainability—its long-term ability to deliver reliable lifelong income for retirees.
But retirement finance surveys are generally a snapshot of the here and now, not of a system’s long-term viability. This may be why the United States tends to end up in the middle ranks in many surveys. America gets dinged because of the high number of workers who lack any workplace savings options and because our replacement ratios vary widely among workers who do have plans. What’s more, our system is a patchwork of Social Security and DB and DC plans for both public and private sector workers.
The American retirement finance system is improvised, iterative, and evolutionary. But far from being a liability, this diverse mix may prove to be its greatest asset because such a large share of Americans’ future income will be drawn from investments in productive private businesses.
Our defined contribution system is based on individual ownership of financial assets. The asset allocation of participants in these plans does need to be guided over a working lifetime from high-risk/high-return equities to lower-risk/lower-return fixed-income investments. Participants should be guided along a glide path that extends from their first job up to and beyond their retirement date.
We all know that investing in capital markets inevitably entails risk. Yet over multidecade time frames, that risk can be carefully calibrated and reduced as workers draw closer to retirement and need to convert life savings into reliable lifetime income. This is what the workplace savings industry exists to do.
With governments around the world (ours included) strapped for cash and taking on massive debt in the wake of the global financial crisis, many observers view their unfunded, or underfunded, pension liabilities as a growing source of systemic risk, not only for retirement finance systems, but for national economies and governments’ own solvency. The American system, by contrast, rests on a strong foundation of real investments in private industry.
Pay-as-you-go pension systems have no choice but to draw assets out of the productive economy and apply them immediately to meet current pension obligations. By contrast, DC systems gather assets through worker deferrals and channel them into investments that power the capital markets that drive the national economy. In the United States today, workplace savings plans now channel hundreds of billions a year into productive capital investment. And my sense is that nations that successfully mobilize the savings of their entire workforce, and direct those savings into dynamic securities markets, will enjoy a growing competitive advantage in the twenty-first century.
Governments around the world appreciate this dynamic. This is why so many of them are following the lead of the United States and Australia and scrambling to promote defined contribution workplace savings plans of their own. In this respect, the United States retirement finance system has a 20- to 40-year lead on other developed economies, most of which are just getting started on significantly growing their people’s DC retirement savings.
This trend toward bolstering DC savings is quite strong across the world’s seven largest pension markets—Australia, Canada, Japan, the Netherlands, Switzerland, the United Kingdom, and the United States—which account for nearly 92 percent of global retirement savings. Data from Willis Towers Watson’s most recent global survey show that DC savings in these nations have been rising 5.6 percent a year for the past decade, well over twice as fast as the growth of traditional DB assets.
Many policy makers today clearly recognize that there are real and powerful advantages to shifting from DB to DC. All too often, traditional pension architecture can cause business, labor, and government to engage in a zero-sum competition for limited supplies of capital. In predominantly DC systems, all three tend to pull in the same direction, with government providing tax incentives through which workers save and invest capital for industry, and then, down the road, share in profits when they retire and draw down their savings.
That is why the U.S. DC retirement savings system has already had a strongly positive impact on U.S. savings and economic growth. As we will see in the next chapter, America’s workplace savings system is not a drain on the economy the way pay-as-you-go systems are in much of the world. In fact, if we act to strengthen it and shore up its gaps, our DC system—401(k)s, IRAs, and the like—can support a virtuous circle of mass-based investment, economic growth, and broadly shared capital ownership, a “people’s capitalism.” Done right, the next generation of workplace savings can help us reboot economic growth and keep the American promise.