CHAPTER 9
SIGNS OF THINGS TO COME
Change is the law of life. Those who look only to the past or present are certain to miss the future.
Most of this book describes the remarkable evolution of the workplace savings system that I have witnessed over the course of my career, together with a look at where I believe we’re headed if we enact the reforms we’ve advocated in Workplace Savings 4.0. But if we cast our gaze just a little further, we can already see emerging demographic, social, political, and market trends that foretell dramatic improvements to, and expansion of, our private retirement system.
Taken together, these trends promise quite good news—broader coverage, greater worker engagement, adaptation to emerging economic trends, and the embrace of new financial technologies that dramatically improve plan quality while continuing to lower costs. Taken together, they will give rise to a markedly superior workplace savings system. And they also promise real gains on broad economic challenges like wealth inequality, capital formation, and economic growth. We’ve come a long way, and we’re about to move ahead by leaps and bounds. Here are some signs of things to come.
The Millennials Shall Inherit the Earth
The millennials are taking over. While 10,000 boomers turn 65 every day, the 75.4 million millennials (born between 1982 and 2004) have just surpassed the 74.9 million boomers to become the largest generation in our history.
By almost any measure, the millennial generation will prove historic. They are, collectively, the best-educated generation ever. They will likely become the wealthiest and longest-lived as well. And the experience of millennials will ultimately prove the utility of our workplace retirement savings system.
First off, most will spend their entire career in defined contribution workplace savings programs. Many boomers began their careers in the DB world and then were moved into DC plans in stages over the past generation. As a result, many retiring boomers will have spent only a fraction of their careers accumulating retirement savings in workplace plans. By contrast, most millennials will spend their entire careers saving through on-the-job payroll deduction.
Second, millennials will have better and less costly retirement savings plans. Millennials will never experience the suboptimal plan designs of Workplace Savings 1.0 and 2.0. Instead, they will spend their careers in more advanced Workplace Savings 3.0 plans (and, I hope, in the Workplace Savings 4.0 designs now emerging).
This means they will benefit from auto-enrollment, auto-escalation, and guidance to post-Pension Protection Act “default” options—typically, target date funds (TDFs) and managed accounts. And they will take advantage of new financial technologies such as cloud computing, asset allocation algorithms, and mobile apps, all of which drive costs down and quality up.
Even the global financial crisis of 2008–2009 seems to have had at least one thin silver lining. Multiple wealth management industry surveys suggest that the downturn actually inspired millennials to focus intently on their own retirement savings. Today, over 70 percent of millennials are already saving.
And millennials don’t seem to mind a firm “nudge” in the right direction. A survey done by Natixis shows 82 percent of millennials think employers should be required to offer retirement plans. More surprisingly, fully 69 percent of millennials (as compared with 55 percent of boomers) think retirement savings should be mandatory for individual workers.
Critically, they are getting into gear on saving for retirement early in their careers. According to the Investment Company Institute, the median age at which boomers began purchasing mutual funds was in their thirties, and for generation X (born between the mid-1960s and the early 1980s) the median age was 27. But millennials began buying mutual funds at age 23.
This may prove to be the best news of all because the three most important factors for accumulating retirement assets—the amount saved, the duration of savings across worker careers, and the allocation of savings into risk-managed glide paths—are all totally within investors’ control.
On the other side of the ledger, millennials are contending with negative pressures that weighed far less on earlier generations. These include over a trillion dollars in student loans, soaring healthcare costs, credit card debt, flattening wage growth, and steeply rising real estate valuations that make it harder for millennials to take their first steps on the property ladder.
As of 2016, U.S. home ownership, at 63.6 percent, was at its lowest level in 50 years, down from over 69 percent prior to the 2008–2009 financial crisis. This drop in home ownership is almost entirely due to the financial travails of millennials, who also face stiff competition and high prices for rental housing.
So while the retirement savings industry is clearly offering superior products and services at steadily falling prices, the need to pay for healthcare, education, and housing all crimp millennials’ ability to save. Continuing economic recovery and an improving job market could help mitigate this challenge, especially if it leads to higher wages that could enable greater retirement saving.
Longer term, though, millennials stand to inherit the earth—or at least $30 trillion of it. That’s trillion with a capital T.
For decades, boomers have been busy acquiring substantial real estate and socking away over $15 trillion in DC retirement savings and IRA savings. According to the consulting firm Accenture, boomers will pass down $30 trillion to their millennial and generation X children.
So American millennials may have it tough now. But they stand to benefit from the greatest intergenerational wealth transfer in the history of money. DC workplace savings plans will play an important role since they allow workers to accumulate substantial wealth that can be inherited, unlike DB plans, which only provide an income stream until a retiree dies.
This cascade of wealth will be unequally concentrated, and some millennials will benefit far more than others. This very predictable disparity may be the best argument for expanding both the depth and breadth of workplace defined contribution savings coverage.
If the U.S. economy grows, and if our workplace retirement savings system is expanded to cover nearly all American workers, then the even greater intergenerational wealth transfer to come—when the millennials eventually pass assets on to their children and grandchildren—will not only be larger by an order of magnitude, but will be shared by a much broader cross-section of American families.
Closing the Coverage Gap
No question about it, we have a retirement coverage gap. Roughly half of American workers who work at small firms—some 50 million, mostly working at small firms or self-employed—have no savings option on the job. Any meaningful solution to this challenge should be comprehensive—offering a payroll savings option to every worker who pays Social Security tax.
For some time, a bipartisan group of retirement policy experts and legislators has sought to do just this by giving workers without access to 401(k)s and other ERISA-approved DC plans access to an automatic-enrollment IRA, an Auto-IRA. This idea gathered momentum in the optimistic period after passage of the landmark Pension Protection Act in 2006 but lost speed amid the mandate fatigue in the wake of the Affordable Care Act.
In response, several U.S. states—notably Illinois, California, Maryland, Connecticut, and my home state of Massachusetts—took up the idea themselves. As of this writing, some two dozen states are at some stage of developing new workplace Auto-IRAs that would be sponsored by state governments and managed by private investment firms.
All of these plans are universal. Virtually all employers would be obliged to offer either one of these plans or a traditional DC plan. Employees would be free to opt out. And all would offer automatic enrollment—the critical mechanism, proven over a generation, for steeply increasing worker participation. So far, so good.
But these plans are seriously flawed. They generally propose default contribution rates in the range of 3 percent—too low by half. While some proposed plans would default workers into target date funds, others have suggested more conservative allocations unlikely to provide sufficient returns. And most would limit expenses to between 0.5 percent and 1 percent, which is not egregious, but certainly no bargain for a bare-bones plan. (According to the Investment Company Institute, 401(k) plan participants pay just 0.48 percent on average for equity mutual funds.)
The idea of offering broader access to workplace retirement savings plans is of course laudable. But the proposed patchwork quilt state government-sponsored plans raise a number of questions.
- They suggest a two-tier system in which employees of large firms enjoy state-of-the-art ERISA plans, while workers at small firms (where new jobs are increasingly created) are relegated to stripped-down plans beyond the reach of ERISA protections and best practices.
- There is concern that the state plans might erode our successful private retirement savings system by encouraging small employers that might otherwise offer private ERISA-compliant 401(k) plans to opt for lower-quality state-sponsored options.
- It’s fair to ask why the emerging state plans are being granted an exemption from ERISA regulations while substantially similar private workplace savings plans are not. Simple principles of fair play suggest that payroll deduction programs administered by states should compete on a level playing field with private savings programs.
- Since some of these emerging state plans may include various forms of guaranteed income, state and local governments, already struggling with a multitrillion-dollar pension funding gap, might find themselves on the hook for billions more.
- Finally, there is the perennial question of economies of scale. A national Auto-IRA system would almost certainly deliver better quality at lower costs, avoiding what Alicia Munnell, director of the Boston College Center for Retirement Research, has called the “laborious, time-consuming, and expensive process of setting up 50 different plans.”
But do we really need government plan sponsorship? Many industry experts believe that it would be simpler, cheaper, and more efficient to offer workplace savings through new private plan structures aimed specifically at small business.
One leading proposal, long buoyed by bipartisan support, would be to expand access for small employers and their employees to multiple employer plans (MEPs) that would enroll employees from hundreds or thousands of small firms, even including self-employed contingent workers.
For many years, MEPs have been used to sponsor 401(k) offerings for closely related organizations like trade and professional associations. But small firms outside these industry groups have lacked access. MEPs would allow small employers without the ability to administer their own plans to enroll their employees into professionally managed workplace plans that offer all the best practices and administrative economies of scale found in the 401(k) plans of large companies.
This would, in turn, offer the small-firm employees who today struggle to save in their own IRAs everything we have come to associate with Workplace Savings 3.0—auto-enrollment, auto-escalation, and automatic allocation to TDFs and managed accounts. MEPs would also allow for employer matches and give workers the opportunity to save up to $18,000 per year as compared to the $5,500 allowed by 2016 IRA limits.
MEPs offer employees a workplace savings experience that is qualitatively superior to the plans contemplated by the states, at equal or less cost. The prospect of potentially dozens of new state-level plans should be a wake-up call to the retirement services industry and to Congress to get to work on Auto-IRAs and MEPs in order to extend the benefits of our private savings system to small-business, lower-income workers, and the emerging freelancers and consultants of the “gig economy.” It seems only right that we extend the coverage of our ERISA-regulated workplace savings system through national solutions open to as many American workers as possible.
Contingent Workers and the “Gig Economy”
One of the greatest strengths of the defined contribution workplace savings model is its extraordinary flexibility and portability. Over the decades, as job tenures grew progressively shorter and the number of jobs per career increased, DC plans allowed workers to pick up and take their tax-incented savings with them. Economists routinely cite this labor flexibility and dynamism as a critical asset of business in the United States.
But the latest round of employment evolution—contingent labor and the gig economy—has thrown a wrench into our plans for next-generation savings plans. After all, what good is a Workplace Savings 4.0 savings plan for workers who are outside the formal workplace?
While the use of freelancers, short-term temporary workers, contractors, and self-employed entrepreneurs has been growing for years, it really took off after the Great Recession of 2008–2009. The year 2015 saw the fastest year-over-year increase in the number of new freelance entrepreneurs in two decades. According to some estimates, by 2020, some 40 percent of the workforce—60 million workers—may be freelancers, contractors, or temp workers.
The challenge is to offer the benefits of a more perfect workplace savings system to every kind of worker. We need to find ways to give these gig economy workers, who already pay double into Social Security, the opportunity to save on the job without the payroll support of a full-time employer. Certainly this growing sector of the workforce deserves something as simple as access to a savings plan.
Individual tax credits to match contributions could help incentivize workers to enroll in retirement savings plans. Congress may consider providing matching tax credits—perhaps 50 percent up to the first $1,000 saved—to encourage young contract workers to get started.
To reach workers beyond the traditional workplace, we should engage them with the kind of cloud-based mobile apps that have become ubiquitous. To effectively communicate, educate, and support transactions, let’s take a page out of Uber’s playbook and create an easy, frictionless retirement savings vehicle where independent workers can engage an advisor online and arrange for a percentage of their income, from any employer, anytime they get paid, to be automatically diverted to a retirement savings account.
This digital plan design should include all of the automatic features seen in traditional payroll deduction plans, together with behavioral finance “nudges” that tell savers when it’s time to act and encourage choices that ensure adequate savings deferrals. In the twenty-first-century economy, the pace of working, saving, and spending is accelerating. We need to act now to create savings options that support the nontraditional worker in an increasingly nontraditional workplace.
The World’s Largest DC Plan May Soon Reach GI Joe and Jane
The $458 billion Thrift Savings Plan (TSP) is by far the world’s largest workplace DC savings plan, and arguably one of the best. The fund offers federal government civilian employees automatic enrollment at a 3 percent deferral (this should be higher!) in low-cost funds with minimal administrative fees subsidized by the agencies for which they work. While the plan is sponsored by government agencies, it is managed and administered by the private asset management industry.
The TSP offers a lean, streamlined set of just five funds—a U.S. government debt fund, a fixed-income investment, a common stock index fund, a small-cap stock index fund, and an international stock index fund—together with target date options constructed from these core funds.
And the TSP may soon grow substantially. Today, members of the armed services have only a traditional DB plan which, while generous, only delivers for “lifers”—the 20 percent of enlisted personnel and 50 percent of officers who complete a full 20-year vesting period. Most men and women in uniform accrue no DB retirement benefits whatsoever. TSP options for members of the uniformed services are strictly limited to deferrals from designated special pay, incentive pay, and bonuses. But in the near future, retirement finance for our military may change dramatically.
Like private employers, the U.S. military wants a nimble, flexible workforce. Rather than maintain an expensive standing army, the military needs to staff up or down in accordance with need. And, as with the private sector, a flexible and portable DC system may be the best way to achieve this.
As a result, the Department of Defense is contemplating a blended retirement system with reduced DB benefits and a new DC plan roughly in line with leading private sector workplace DC offerings like the TSP or private sector 401(k)s. The new system would provide service members with retirement assets equal to or greater than the current DB-only plan. And it would be very large.
Assuming an 87 percent participation rate (as with the existing TSP), the new military DC plan could double existing annual TSP inflows. That’s good news for our service members and their families, and good news for the financial markets.
Convergence: DC plans, DB outcomes
Private sector retirement finance has been shifting from defined benefit to defined contribution for over a generation. While this evolution is often described as a shift of risk from plan sponsors to plan participants, the reality is more complex.
DC plans are continuously evolving. A new trend emerging in recent years is the inclusion in DC workplace plans of lifetime income provisions that mimic the annuitized income streams more typically seen in DB plans. Specifically, this means DC workplace plans can offer participants the option to invest some of their payroll deductions to secure the types of lifetime income streams delivered by DB plans. As this trend gathers steam, it promises to do much to mitigate the notion of DC plans as risky and replicate the certainty of traditional pensions.
At the same time, many firms have opted to convert their defined benefit plans into cash balance plans. These are technically DB plans, but they are managed on an individual account basis, like DC plans. Cash balance plans are, however, required to offer life annuities with benefits guaranteed by the Pension Benefit Guaranty Corporation. But many workers choose just to take the cash.
Roughly half of DB plan providers also offer their employees the option of cashing out their future income benefits and taking a one-time lump sum. Aon Hewitt studies show that most workers actually prefer cash now to income later—either because they’re not sure how long they may live or they are concerned that employers may renege on paying lifetime benefits.
All of these options—DC, cash balance, and DB—leave many employees owning and managing substantial assets that they eventually need to convert into income. So a retirement finance system long perceived as bifurcated between DB and DC models is, in fact, converging, obliging workers to plan for and manage their income in retirement.
Over the long term, retirement savers who purchase some form of guaranteed lifetime income—annuities, guaranteed asset drawdown schemes, or deferred income annuities that pay out in later old age (say at age 80 or beyond)—stand to benefit by ensuring income in late old age. This is no sure thing for those that self-manage their assets without guarantees. The more we can do to encourage workers to choose at least some guaranteed income choice, in plan and beyond, the better.
Evolving Allocation Strategies—Target Date Funds and Managed Accounts
When target date funds (TDFs) emerged in the mid-1990s, they offered an investment option with advice effectively baked in. By selecting a single future retirement (or target) date, a retirement saver could invest in a dynamic portfolio that began with a weighted exposure to high-risk, high-return stocks, then gradually shifted—without the investor needing to take action—to more conservative bonds and even cash as the retirement target date approached.
Rising workplace savings plans created a vast market for TDFs by the turn of the new millennium, and this demand accelerated dramatically with the passage of the Pension Protection Act of 2006. The PPA recognized TDFs as one of four qualified default investment alternatives (QDIAs)—along with stable value money market funds, balanced funds, and managed accounts—for plan sponsors who chose to offer automatic enrollment.
Since then, TDFs have become the hands-down favorite for plan sponsors and workplace savers. Fully 88.2 percent of QDIA assets now flow into TDFs, with money market funds coming in a distant second at 4.2 percent. Managed accounts, so far, have played a smaller and declining role. One industry survey stated that between 2013 and 2016, managed accounts shrank from just under 5 percent of the workplace market to the low single digits.
But the best days for managed accounts may yet lie ahead. The 22 percent annual surge in TDF assets since the adoption of the PPA—from $116 billion in 2006 to $880 billion by the end of 2016—seems to suggest that they will dominate future retirement savings. But that’s by no means inevitable.
For one thing, not all TDFs are created equal. Even among those aiming at identical retirement dates, there are wide variances in allocations among stocks, bonds, and cash along the glide path. Some TDFs are designed to just go “to” retirement, producing a final allocation portfolio at the target date. Others go “through” their target date, maintaining a substantial allocation to stocks and then gradually reducing risk in the years after retirement. Debate between “to” and “through” proponents can be intense—and arcane. But one thing is clear: In the 2008–2009 financial crash, TDF owners with large equity positions close to their target dates experienced far more volatility than they had expected.
It also turns out that most TDFs have been neither leaders in investment innovation nor outperformers. Large endowment funds, for example, now invest over 50 percent of their holdings in nontraditional asset classes like real estate, commodities, and various hedging strategies. State pension funds put 25 percent of their assets into these alternatives. But TDFs are still 95 percent allocated to traditional long-only stock and bonds.
In terms of investment returns, in the decade from 2003 to 2013, endowments returned 8.2 percent per year, and state pension funds returned 7.2 percent, while TDFs returned only 6.3 percent—a bit lower than returns from a simple 60/40 stock/bond allocation.
But the toughest challenge ahead for TDFs could be that their basic selling point may no longer be valid. For much of the past century, stocks and bonds were negatively correlated. This meant that retirement savings portfolios could manage risk by rotating allocations from equities to bonds as workers approached retirement.
But since the late 1990s, stock and bond market movements have been more highly correlated, especially in the low-interest-rate environment that has followed the global financial crisis. This undercuts the historic diversification benefits of investing in fixed-income assets late in the glide path, as retirement nears.
So despite the huge growth in TDFs, many retirement planners have begun exploring better ways to manage their clients’ investment risk. Innovations based on behavioral finance theory, and falling costs for developing financial algorithms and allocation models, suggest that a new wave of innovation may be gaining enough traction to challenge TDF dominance in the same way that TDFs edged out other models from the 1990s forward.
Fine-tuned, cost-efficient managed accounts may soon be coming into their own. While managed accounts today comprise only a small fraction of the market for QDIAs, more than 50 percent of workplace plans offer managed accounts today. And while managed accounts have traditionally been aimed at investors with higher account balances, new technologies and efficiencies are today making them cost-efficient for a far broader market.
Unlike TDFs, which offer a single allocation strategy to thousands of workplace savers, managed accounts can actually tailor strategies to an individual’s financial situation. They can, for example, take into account assets held outside the plan, a potential inheritance, real estate income, or other individually unique assets and liabilities. The result is a retirement savings strategy that optimizes accumulation and drawdown in accordance with unique individual requirements. In effect, next-generation managed accounts bring the “mass customization” that has become ubiquitous in e-commerce to the retirement and wealth management arenas.
This doesn’t mean that managed accounts will replace TDFs anytime soon. For example, younger investors mostly share a similar goal—simply to build assets. So they may find that target date funds provide a perfectly adequate, low-cost option when they’re just getting started.
But as workers’ careers and their financial lives grow more complex, they may need a more precisely targeted managed account that takes into consideration variables such as outside assets, the state of the person’s health, expected Social Security benefits, marital status, and other circumstances.
The idea of workplace savers making a pivot between TDFs and managed accounts has been termed a “dynamic QDIA.” This suggests participants may automatically be guided to standard TDFs early in their careers and then, once a predetermined set of criteria is met, be offered managed accounts that provide more personalized investment and advisory services.
Another driver behind managed accounts is that they are not limited, as TDFs are, to providing investment allocations. They also provide product allocations beyond mutual funds and ETFs, including customized solutions for guaranteed retirement income.
By leveraging sophisticated risk models and allocation algorithms, and by extending into the drawdown phase of investing, managed accounts may more precisely (and personally) solve the complex challenges of later-stage working lives and improve retirement savings outcomes. If this concept evolves as I expect, managed accounts will begin to play a much greater role for older workers. But they won’t supplant TDFs; rather, they will complement and, indeed, complete them.
Starting at the Beginning: Birthright Retirement Accounts
The savings that anyone can accumulate to generate income in retirement depends on just three variables—total savings, investment returns, and, most critically, time itself. How much money does a person save? How long has that money been set aside? And what has been the return on the investments?
This book has offered multiple policy ideas to help raise savings rates and improve returns through better asset allocation. But America’s current retirement systems, both public and private, simply don’t capture the full value of time itself. We leave 20+ years of compounding on the table.
That’s because Social Security’s benefit credits don’t start until a person goes to work and pays FICA taxes. The same lost time limits returns to workplace savings. Most Americans, in other words, don’t begin to accumulate any retirement savings until they enter the workforce in their twenties. Many wait even longer to get going. Sadly, some never save at all.
But there is a simple, powerful, and affordable way that we could turn the time value of money to the advantage of future generations. We could simply grant each newborn child a “birthright” retirement account of $1,000—and forbid them from touching it until they reach age 70 or die. As these babies grew up, they would, of course, be free to add funds to their birthright accounts and leave them to heirs if they died before age 70.
With fewer than 4 million babies born each year in the United States, funding these accounts from general tax revenues would cost about $4 billion a year, roughly one-tenth of 1 percent of Uncle Sam’s $3.5 trillion-plus annual budget. Surely, this cost would be manageable.
Think of it, as I do, as a proactive rebate to future taxpayers. After all, the four million American babies born any given year will, as a group, pay trillions of dollars in federal taxes over their lifetimes. It seems chintzy for their Uncle Sam not to give them a head start on those obligations.
The financial, social, and psychological benefits that Americans would reap from birthright accounts would be enormous. To start with, we’d be seeding an “ownership society” in which every American owns a piece of our free enterprise economy. And every penny in these accounts would be one less penny that an individual would have to claim from means-tested government programs like Medicaid in old age. The savings to the government, as future generations age, would be substantial.
Let’s assume that the Social Security Administration, with U.S. Treasury or Federal Reserve oversight, would administer these accounts. Investment management could be bid out to private firms that could take full advantage of a 70-year investment horizon. Investment choices would be limited to low-cost, risk-managed target date funds. What might the returns be?
At 6 percent—a fairly conservative estimate—$1,000 at birth would grow to nearly $66,000 by age 70 (Figure 9.1). And remember, nearly all of that money would have to be drawn down before the account owner could seek coverage by means-tested public benefit programs. Suppose this baby’s parents decide to add just $500 a year to this account until age five. In that case, a 6 percent return would produce $204,000 by age 70—even more if the child put more into the account later in life. Those are impressive numbers.
FIGURE 9.1 What “birthright” accounts could return by age 70: 70-year projection, earning 6% returns*
* The values assume monthly compounding so the effective rate of return is 6.17%.
Source: Putnam Investments estimates.
But the social benefits would almost surely be even more impressive. Saving is not just about money, it’s the seed corn of larger hopes and dreams. Multiple studies show that children of families who have any savings at all are more likely to finish school, form stable families, find work, stay off drugs and out of jail, and generally be more productive citizens. My guess is that these birthright accounts would “pay for themselves” many times over—creating wealth in American communities that today have literally no financial assets.
Let me close this little thought experiment with a simple reflection. So long as America remains an essentially compassionate society, we are committed to making sure our elders don’t starve, go homeless, or die early for lack of medical care. That costs money. Serious money.
Today, we channel almost all that money to needy elders at the back-end of life—through tax-revenues from current workers. Maybe we should think seriously about beginning at the beginning. Doesn’t it make sense to invest more of that money as early as possible to help children and young people at the front end of their lives? Can’t we find ways to make time and compounding help our fellow citizens achieve greater self-reliance and enjoy the dignity of meeting their own needs?
I’m just asking. You answer.