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Deficit could reshape retirement funding

/ Source: Business Week

Republicans and Democrats in Washington are starting to battle in earnest over how to cut the federal government's discretionary spending. Eventually the ominous arithmetic of entitlement spending and tax revenues will require Washington to turn to the Social Security benefit formula (as well as Medicare).

While much of the focus on entitlements goes to benefits paid or taxes raised, the solution may lie in reviving an idea with a venerable history in the U.S.—and lessons to draw on from other countries: mandatory individual retirement savings accounts. The demographics of an aging America progress inexorably, while living standards for future retirees are increasingly uncertain. A mandatory savings plan would bring greater financial security in old age.

The basic outline of the mandatory pension scheme is simple, although various proposals differ in detail. For instance, the typical plan would have all workers set aside a portion of their wages, with targets ranging from 3 percent to 10 percent. The savings would be invested into a well-diversified portfolio with razor-thin fees.

Some proponents would limit worker choice, with the account administered by a government agency (such as Social Security) and the money directed into a broad market basket index—60 percent in stocks and 40 percent in bonds. Others prefer to give workers greater choice, perhaps by allowing everyone into the Federal Thrift Savings Plan, a defined-contribution pension overseen by an independent government agency and invested by private professionals. The Thrift plan offers participants a limited number of broad-based funds with an expense ratio of only 0.028 percent, compared with a 401(k) average of about 1 percent.

Workers would own their accounts, much like IRAs. Unlike the George W. Bush administration's controversial idea to partially privatize Social Security by redirecting a portion of payroll taxes into private accounts, the mandatory savings scheme is meant to supplement the existing Social Security system. It would entail savings, not taxation.

Social Security benefit cuts?
That said, once the system were up and running, the overall retirement system could be tweaked for the better. The mandatory savings requirement, for instance, could gradually be increased to offset widely anticipated Social Security benefit reductions. From the retirement system's perspective, the move could shore up the soundness of the Social Security safety net and boost everyone's pool of retirement savings. An additional advantage of the pension approach is that it would largely free management to focus on innovating for profits and markets in an intensely competitive global economy while providing increasingly mobile workers with greater financial security in their dotage.

The big knock on America's voluntary retirement system for private, government, and nonprofit workers is its limited scope. The percentage of workers over the age of 16 with an employment-based pension or retirement plan was 59 percent in 2009, according to the Employee Benefits Research Institute. The percentage of workers participating in such plans was even smaller, at 45 percent.

The value of those promised benefits is also suspect. Governors and mayors are in a mud-wrestling match with public employees over a gap between pension assets and promised benefits that might reach $2 trillion. The Pension Benefit Guarantee Corp., a government agency that backstops private pensions, estimates that it is at risk to the tune of $170 billion from underfunded defined-benefit plans in companies whose credit rating is below investment-grade. A further $20 billion in exposure comes from multi-employer plans. The 401(k) model shifts the burden of creating retirement portfolios to workers, with scholarly research suggesting that many employees are doing a poor job.

The call for pension reform is far from new. President John F. Kennedy's Committee on Corporate Pension Funds and Other Private Retirement and Welfare Programs recommended creation of a central clearing house that would, among other things, keep accounts for workers at small companies. In 1981, the President's Commission on Pension Policy suggested a mandatory universal pension system. Now-retired Democratic Rep. Richard Gephardt in 2002 put forward his own blueprint, the Universal and Portable Pension Act. The difference now is that America's aging populace increases the pressure to act.

Simulated 10 percent savings plan
The mandatory savings plan devised by University of Oklahoma law professor Jonathan Barry Forman and Adam Carasso, currently chief economist for the minority to the U.S. House, is illustrative. In a simulation that starts on Jan. 1, 2007, Forman and Carasso include all workers and the self-employed. They put 10 percent of payroll into an individual account. They are agnostic on how the money would be managed and administered, but they assume that the account would earn a 3 percent rate of return beyond inflation and that workers would get a real 1.1 percent average annual wage increase over the long haul. (Both figures are in line with Social Security trustee assumptions.) The savings account is annuitized at age 65.

Their model looks at the impact on men and women, single and married, at various income levels. In one example, a high-earning, two-income couple retiring in 2045 at 65 would have combined Social Security and mandatory savings equaling $89,466 in the first year of retirement, replacing 45 percent of pre-retirement income. For a comparable average-income couple, the numbers are $64,187 (51 percent replacement rate) and for a low-income household, $36,705 (65 percent replacement rate). It comes as no surprise that mandatory savings become even more critical to future retirees' well-being when the model factors in the assumption that Social Security benefits will be cut.

To be sure, the word "mandatory" sets off alarm bells. It should. Mandated solutions are no panacea. The transition to a new savings system wouldn't be easy. The devil lurks in the details of design. Nevertheless, the goal of greater retirement security is worth a mandate (as was Social Security). The risky alternative for future retirees is to make do with less. We'd all be worse off then—not just the elderly.

Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.