With Social Security on a fiscally unsustainable path and fewer employers offering defined benefit plans, the institutional foundations that most workers rely upon for retirement income security are beginning to show some cracks, if not already starting to crumble. University of Illinois finance professor Jeff Brown, a senior economist with the President's Council of Economic Advisers in 2001-2002 and a former member of the bipartisan Social Security Advisory Board, discusses designing a new foundation for retirement in the U.S. with News Bureau reporter Phil Ciciora.
How dire is the need for a complete soup-to-nuts overhaul of the retirement system in the U.S.?
We really do need to rethink the overall retirement system. The public systems - meaning both Social Security and public employee pensions - are facing serious financial problems. The private system suffers from the fact that too many people are not participating in it, and many of those who do participate are not skilled at making the decisions required.
From a policy standpoint, we know a lot about how to improve the system. Let's start with Social Security. We have known for many years that the system needs to be fixed financially. And we know how to do it, such as by making people work longer before claiming benefits, reducing the level of average benefits, or having workers contribute more money to the system. But politically, it is not clear that our elected officials have the will to make the necessary changes.
Even if we do decide to tackle these issues, I doubt that we will do a "soup-to-nuts" overhaul. Our experience with health care reform shows the tremendous difficulty in doing major policy overhauls. Rather, I suspect that we will proceed one piece at a time. I would not be surprised if the first step involved further increases in the Social Security normal retirement age.
It is important to remember, however, that Social Security is only one piece of the puzzle. We have a fundamental problem in that at any given point in time only about half of the workers in the U.S. are actively participating in a retirement plan from their current employer. That's a big problem, and one that requires a policy response to fix.
In addition, over the past quarter-century, we've witnessed a pretty dramatic shift away from defined-benefit pension plans in which the employer bore the responsibility for the investment decisions, and the individual received a monthly check. We've shifted primarily into a defined contribution system, where individuals have to make most of the decisions on their own. That shift has had many advantages: It's taken funding uncertainty away from employers, it's made retirement plans more portable, and it's given individuals more choice.
But what the financial crisis and the recession really underscored is that our current defined contribution system, as exemplified by the typical 401(k) plan, is severely lacking from an individual risk-management perspective. A growing body of research has clearly shown that the typical participant isn't really well prepared to make the somewhat sophisticated decisions they need to make in order to manage those plans well.
What are the common mistakes people make?
Owning too much stock in their company is one such mistake, and that remains true even after the lesson from the collapse of Enron, when the stock dropped 99.6 percent in a matter of weeks. The people who worked there lost their job and their retirement money all on the same day. Yet there are still companies that match an employee's contribution through company stock, and we find that employees in those companies tend to respond by investing more of their own money in company stock as well. There are plenty of other mistakes people make. Take portfolio allocation. People make mistakes at both extremes. Some of them have too high of an equity allocation, especially as they are nearing or are in retirement; others, who may have been defaulted by their plan into a money market fund, may have too little equity exposure.
Another important issue in the typical 401(k) plan is that most people do not effectively insure against the uncertainty of outliving their resources. Defined benefit plans and Social Security pay out as a life annuity, meaning you'll get income for the rest of your life. But most 401(k) plans don't even offer annuities as a payout option.
Across the board, we've been shifting the risk from employers who didn't want to bear the cost of funding pensions to the one group in the economy who was less prepared to deal with it: the average employee. What should we do?
First, I don't think it's realistic or desirable to think in terms of returning to a world dominated by defined benefit plans. Nor do I want to increase Social Security given its significant funding problems.
Rather, what I would like to do is think about building smarter defined contribution plans that have built-in diversification, that shift portfolio allocation in a sensible way as workers approach retirement, and help facilitate the automatic conversion of wealth into guaranteed lifetime income. If we can also incorporate adequate inflation-protection as well as better protection against the cost of long-term care, all the better. We have the financial technology in place to do these things, but public policy, business practices, and the financial planning industry need to change in pretty important ways in order to get us there.
I should note that no system would ever get rid of all the risk. Nor would that be desirable, because some risk is necessary in order to generate higher expected returns. But there is a difference between good risk-taking and bad risk-taking, and we ought to be able to build a better system that makes it more likely that the typical worker or retiree will be guided into avoiding the bad risks that just don't make sense for them.
And we can do all of this while still preserving a high level of individual choice and freedom. We can automatically enroll them into a sensible set of choices, but still give them the opportunity to opt out, if they want. We can default them into reasonable portfolio allocations and automatically convert part of their account balances into guaranteed retirement income.
In short, we ought to design a system that leads them down a path of sensible choices, so if they choose a hands-off attitude, the system will lead to a good outcome. That would be a major improvement over our current system in which half of the population is not saving at all, and much of the other half is making inefficient portfolio allocations and subjecting themselves to longevity and other risks.
So, yes, we need a systematic rethinking about how we approach retirement income security in the U.S.