The U.S. faces a retirement crisis.
We are living longer. Defined-benefit pensions are disappearing; the ones that exist are underfunded. Forty-five million Americans have no retirement plan at all. And nobody is seriously discussing solutions.
We urgently need a better retirement system, and luckily it’s still possible to develop one.
It is a mark of advancing civilization that nations, employers and local governments now make commitments to provide security and comfort in old age, but those commitments are becoming more expensive. The increasing “risk” of living too long has made retirement liabilities unbearable for public and private employers alike.
Since actuaries first put people together to provide group annuities, the wonders of pooled risk have given millions of people a degree of security in retirement that had been unknown before the 20th century. Unfortunately, defined-benefit plans are essentially a thing of the past. Even states and municipalities are beginning to phase out those plans in favor of defined-contribution plans, such as 401(k)s.
Employers — governments and corporations — can’t withstand the pressure of these long-term liabilities. So instead we put them all on the shoulders of individual retirees.
The problem with defined-contribution plans is that the individual retiree must function as chief investment officer, pension actuary and risk officer, but with no training in those areas. And each retiree must do this alone, with no pooling of risks or benefits.
There is a middle ground between defined benefits and defined contributions. It is called a collective defined contribution plan. The Netherlands and Denmark have CDCs, and while they aren’t perfect, they offer some useful solutions to the challenge of retirement security. A CDC functions like a defined-benefit plan except that the employer is no longer on the hook for future liabilities. The employer would make the same contribution as in a defined-benefit plan.
The plan, however, would be managed by professionals whose goal is to provide a pension benefit equal to what a classic pension would offer. If the plan runs into problems, trustees would decide to change vesting schedules, decrease benefits or require greater employee (but not employer) contributions.
This allows the employer to make contributions, but to be free from long-term liability. It also provides advantages over every-man-for-himself IRAs or 401(k)s. Fees would be lower than with individual accounts since the assets in a collective plan would be larger and managed collectively. Professional managers should also do better than untrained individuals.
More important, collective plans would offer pooling for two big unknowns – longevity and generational risk. Longevity risk is the possibility that you will live too long and exhaust your savings. In an individual, defined-contribution plan, you must assume you will live to 100. That means lower annual withdrawals for yourself, or else you risk running out of money. On the other hand, in a collective plan, those who die early subsidize those who live longer.
Generational risk is the possibility that, just when you need your savings, markets crash or perform poorly for many years. If you manage your own retirement savings and markets tank right around the time you retire, tough on you. But in a collective system, those who are unlucky enough to retire when markets are poor don’t suffer that risk, while those who are lucky enough to retire when markets are rising don’t get that benefit.
To avoid generational risk, an individual would have to invest mostly in bonds at about age 65. She could live 30 more years, but she would have to give up most of the benefits of return-seeking assets for the rest of her life.
In a collective plan, professionals invest for people who are 95, 65 and 35 years old. The plan is always a long-term investor, allowing it to stay in appropriate return-seeking securities perpetually.
With a large universe of participants, the same pooling mechanism can provide similar protections for millions of Americans with no retirement plan.
So who should manage these funds? Not the government.
Today, employers decide which funds go on their 401(k) platforms and employees choose from that menu. Collective plans would work the same way. Employers would choose asset managers to oversee investments, manage risks and benefits and make actuarial calculations (similar to Australia’s well-regarded superannuation system). The company that manages the investments would have a fiduciary duty to the pool of retirees, though not to each individual in it. The government need not be involved.
Sadly, the federal government hasn’t seriously engaged on this topic, so states are attempting various solutions. Normally, state experimentation is to be encouraged. But in this case, federal action is needed to avoid inconsistent rules for eligibility, contributions and benefits, which could be a nightmare when employees switch jobs or move across state lines.
Many states are considering reforms, but with government-managed investments. It would be better if the private sector managed this money and if Congress amended current laws to allow companies to adopt these reforms.
If we get it right, we can improve retirement security for millions of Americans.