How Policymakers and State Pension Funds Can Help Prevent the Coming Retirement Crisis

By Lauren Schmitz (Research Assistant ,SCEPA), Robert Hiltonsmith (Policy Analyst, Demos), and Teresa Ghilarducci (Professor of Economics at the New School and Director of SCEPA)

We’ve all heard (and perhaps experienced) how the Great Recession has battered workers and their families. However, perhaps less apparent, the recession has also exposed the inadequacy of the employer-sponsored individual retirement system. Stock market volatility has battered retirement account balances and lost jobs and income have made it harder or impossible for workers and their families to save. Combined with the decline in the traditional defined benefit system and political threats to Social Security the retirement picture is bleak for the majority of today’s workers.

Our current patchwork retirement system is held together by savings from Social Security, employer-sponsored plans, and personal savings. However, for most workers, this patchwork fails to cover their retirement needs, and if current trends continue, will leave them with lower standards of living in retirement. A closer look at the pieces of our retirement system shows why it fails the majority today’s workers:

  • Social Security is one of the most popular and successful government programs, and is the bedrock of our nation’s retirement system. Before Social Security, over half of the nation’s elderly lived in poverty; now, only 16 percent do. However, the average retiree receives less than $1,200 a month in benefits, which is enough to keep the lights on, but is barely above the poverty line, and not nearly enough for most workers to maintain their pre-retirement standard of living. Further, Social Security is under attack, and if its political opponents succeed in making cuts to the program, these benefits will be even more meager.
  • For years, many workers have relied on employer-sponsored retirement plans to supplement Social Security in retirement. But the employer-sponsored retirement system is on a decline on several fronts. Only 53% of US employers sponsored a retirement plan for their employees in 2009, and only 40% of workers are actively participating in an employer-sponsored plan.[1]
  • Even if workers do have a retirement plan through their employer, these plans have shifted from defined benefit plans, where workers were guaranteed a set payment for life based on years of service and salary, to defined contribution/individual account 401k-type plans. Defined contribution plans shift all the risks and costs of retirement onto the shoulders of workers: they charge exorbitant fees that eat away at returns, require workers to choose from a bewildering and opaque menu of investment options, and may be exhausted before the end of a worker’s life. And these accounts are already showing their inadequacy: as of 2009, only 62 percent of households approaching retirement, i.e. 55-64-year-olds, had anything saved in a retirement account, and of those households, the average amount saved was just $85,000,[2] not nearly enough for a comfortable retirement. These low balances are largely the result of the high-fee, risky, opaque defined contribution accounts that now dominate the employer-sponsored retirement system.

Why Tweaking the Current System Isn’t Enough:

The 401k-experiment of the past 30 years has failed. Workers approaching retirement are in decent shape, as many of them have defined pensions, some savings, and Social Security. However, the next generation of workers will not be prepared for retirement if current trends continue. They often have only inadequate defined contribution plans to supplement Social Security benefits that may be cut by the time they retire, and face an uncertain, depressed jobs market for years to come.

Something must be done. We could reform the private 401(k) system, applying band-aids like stricter regulations on brokers, disclosure of 401k fees, or requiring plan sponsors to offer more lower-cost index funds, but these fixes are marginal: fees would still remain high, and workers will be forced to shoulder most of the risks, including the possibility of losing your savings in a bear market, outliving your funds, and the others. The entire retirement system needs as bold reforms as the broken health care system so that all Americans get access to affordable retirement plan that meets their needs.

A Proposed Solution:

We need a way to provide a safe and secure retirement plan to all workers. The attacks on the supposedly overgenerous pension system are misguided. Instead of taking away the retirement security of some of the last few workers who have it, we need to ensure that all workers have the opportunity to retire with dignity.

In today’s competitive economy, firms are created, merged, and downsized at an unprecedented pace. We shouldn’t force employers to take on the liability of providing a retirement account for their employees, and workers should not have to constantly juggle and rollover various retirement accounts every time they change their job.

Instead, state governments could offer all workers a voluntary, low-fee, low risk, public option retirement plan.

The best policy would be an individual account that would be portable between employers in which workers and/or employers would contribute at least5 percent of pay into an account guaranteed to earn at least 3 percent above inflation. At retirement, workers would have option of converting their savings into an annuity, a guaranteed stream of income for life. This is not a radical idea: TIAA-CREF, a non-profit investment firm, and one of the largest in the country, has offered this type of fund to non-profit workers and teachers for over 80 years.

Due to the current political climate, the federal government may not be able to act, so states should step up and help their own citizens save for retirement. State legislatures could create such accounts and then take advantage of the already existing public pension infrastructure to invest the funds. States, through their employee pension plans, sponsor excellent financial institutions that, on a not-for-profit basis get the highest returns for the least cost. Public pension plans have consistently outperformed 401(k) plans or IRA accounts by 20-40% over the last thirty years.The funds use the best money managers and their bargaining power lowers Wall Street fees. The public pension fund traders are more disciplined and have a longer-term view, which stabilizes markets and protects individuals from swings in asset prices.

In effect, the state pension funds could “open a window”, much like a bank would for a new customer, for private sector workers who want their retirement savings managed by professionals and, at retirement, have the option of a stable annuity.

The biggest beneficiaries of this proposal would be workers who currently lack access to any type of retirement account except an Individual Retirement Account or IRA—accounts that are plagued by even higher fees than employer-sponsored 401(k) accounts and substandard financial advice. Allowing private sector workers to contribute to state managed funds with a limited but financially sound selection of funds with varying risk profiles would give private sector workers some of the same benefits enjoyed by their public sector counterparts.

These pension contributions would be pooled and invested professionally with an emphasis on prudent and low-risk long-term gains, shielding workers from the high fees and poor investment choices they face when they are left to fend for themselves in the retail market. Most importantly, these accounts would be portable; the account would stay with the worker from job to job. Though these funds would be kept in a separate investment pool from public sector funds, having private sector workers invested in the same system would shore up public support for State public pension funds. The system could be overseen by an independent board of trustees to ensure good governance.

How Much Would This Cost?

How much would all of this cost? Very little. Since the proposal would take advantage of existing infrastructure, there would only be some minimal start-up costs for employers and the state to implement the new system. However, if the states and/or employers wanted to defray these costs or match a portion of workers’ contributions, they could without spending another dime. Federal and state governments effectively spend billions of dollars on annual tax deductions for contributions to 401(k) and other individual retirement accounts. In 2011 alone, the Federal government gave up $100 billion in tax revenue to subsidize contributions to these accounts.[3]

Because this subsidy is in the form of a tax deduction rather than a tax credit, these expenditures are highly regressive. Taxpayers in the highest income brackets, who are likely to save without government incentives, receive the largest tax break. For higher income workers, current tax policy provides a benefit worth over $7,000 per year, while a minimum wage worker who contributes the maximum -- assuming they could somehow do that while supporting their family -- would receive no benefit from the deduction.

Because most state and local tax codes allow the same deductions as federal tax law, most states also subsidize these accounts as well. If a state were to choose to eliminate this tax deduction, they could use these funds to subsidize the startup costs of the proposed public option retirement accounts, or contribute to or match workers’ contributions to these accounts. For example, New York State’s tax expenditures in 2010 for 401(k) and individual retirement plans were $1.39 billion. If New York State converted these tax deductions into a flat tax credit, each worker would receive $158 a year to contribute into the retirement account of their choice. This might not sound like much, but it would be seed money for the workers who need it most—those who currently have little or no retirement savings.

Conclusion

Universal access to professionally managed pension funds would calm down the stock market, stabilize retiree income, raise savings rates and make the tax code a lot more efficient and fair, while giving over 60 million American workers currently with no Social Security supplement much-needed coverage. “Opening the window” for private sector workers to state pension funds would help shore up support for these funds while allowing private sector workers to reap some of the same benefits enjoyed by public sector workers.

Existing financial companies that charge high fees would have to step up their game in face of more competition, but that would be a good thing. 401(k) and IRA investors, and all of us, should demand swift and deliberate action to obtain retirement plan options and choices and get the help they need from already existing federal and stateentities to protect their financial futures.

[1] Authors’ calculations from the 2010 Current Population Survey, March Supplement.

[2] Data is from the 2009 Panel Survey of Consumer Finances.

[3] See the White House Office of Management and Budget’s 2012 Analytical Perspectives report for a complete display of tax expenditures for 401(k) and other individual retirement accounts.