Throughout the second half of the 20th century, the prevailing metaphor for American retirement was the three-legged stool. Conventional wisdom held that retirees could expect to be supported comfortably throughout their retirement by a combination of retirement plans, Social Security, and personal savings. Today, that stool looks rickety at best. The balance between defined benefit and defined contribution plans has shifted, Social Security is in dire need of reform, and many people are saddled with record levels of personal debt.
Economic, social, and political factors have created an ocean of insecurity. As millions of American workers find themselves increasingly responsible for planning their own retirement, they are left to wonder if they can successfully navigate the rough waters of retirement planning. Accordingly, these workers should view their plans not as a stationary stool, but as a boat that they can pilot into retirement. As captains of their own vessels, employees will have different destinations and their course and speed will be determined by the stalwartness of each boat’s components: retirement plans, Social Security, and personal responsibility. Ultimately, success will depend on several factors, including the assistance of an experienced crew of retirement plan sponsors, providers, and Congress.
The keel: Finding stability
Historically, American workers have benefited from a paternalistic attitude toward retirement. The federal government offered pensions to military personnel as far back as the Revolutionary War, while pension plans sponsored by organized labor and corporations grew considerably in the early 1900s. Recent changes in attitudes toward retirement plans were initiated in part by a need to curb corporate spending and boost competitiveness. This trend took hold in industries across America and around the world, and affected private and public employers alike. Efforts to increase corporate financial transparency have made the economic climate even more difficult, and recent regulatory changes that modify the accounting rules have put extreme financial pressures on many plan sponsors.
The result is a major shift in thinking about employee benefits. The traditional understanding—which holds that an employer is responsible for providing healthcare and other benefits to employees during their working lives and throughout their retirements—is no longer the prevailing model. Over the past two decades, employers have increasingly changed their core retirement program from a defined benefit (DB) plan to a defined contribution (DC) plan, because of a number of factors including reduced administrative and regulatory requirements, less volatile funding costs, and a more transient workforce.
Although DC plans are popular with the American workforce, actually assuming responsibility for planning your own retirement can be daunting. Many plans suffer from poor investment decisions and a general lack of participation. However, the winds appear to be changing. Thanks to recent congressional action, behavioral finance research, and lessons learned in education programs, today’s employees have many new options and opportunities previously unavailable to them in planning for a secure retirement.
With the passage of the Pension Protection Act of 2006 (PPA), Congress acknowledged the need for assisting workers in preparing for their retirement. While the PPA has caused uncertainty with respect to the long-term effects on DB plans, key elements of this legislation provided opportunities to create a more successful DC plan. A few of these are listed below.
- Key provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, scheduled to sunset in 2010, became permanent.
- Plan sponsors received fiduciary relief in allowing for default investment elections and clarification of fiduciary oversight in providing for participant investment advice.
- Additional disclosures related to participant statements are now required.
- The Employee Retirement Income Security Act (ERISA) was amended to preempt state garnishment laws, clearing the way for automatic enrollment arrangements.
With the enhanced features for DC plans, more fiduciary care demonstrated by plan sponsors, and continued refinements on the management of DB plans (such as liability-driven investment strategies), the keel of our boat should provide much-needed stability.
Social security: The lifeboat?
Started in 1935 as a means to provide pension benefits to people not covered by a pension plan, the Social Security system is currently facing a crisis. In the 1950s, workers outnumbered retirees approximately 17 to 1. This has dropped to fewer than 4 to 11. Social Security is projected to take in more money than it will pay through 2017. However, because it is funded by payroll taxes, the expenditures of this pay-as-you-go system are expected to outpace its revenues when Baby Boomers begin to retire en masse. As a result, the trust fund is expected to run aground after 2040, at which point Social Security will only be able to finance 74% of promised benefits2.
The overall benefits of the Social Security system are also being questioned today. According to a recent Heritage Foundation study, the rate of return from payroll tax investments in Social Security pales in comparison to what most consumers could yield from conservative private investments within 401(k) accounts or U.S. Treasury bills. And Social Security taxes themselves are not small; they take a significant bite out of every paycheck and make it more difficult for Americans to amass significant personal retirement savings.
Although there is no quick fix in sight, several options continue to be debated. Many discussions center on increasing the retirement age at which benefits may begin, reducing benefits, or raising the payroll cap on wages subject to Social Security tax.
Like a lifeboat on a larger craft, Social Security can be a useful supplement but may not be suitable as a primary vehicle. Accordingly, workers should take extra precautions to ensure that their retirement plans have other resources to rely upon.
Setting the mainsails
A boat cannot function properly without its captain. Likewise, successful retirement planning cannot happen without individual commitment and personal responsibility. By taking control of the helm, workers take control of their financial futures.
A combination of bad habits or bad judgment may be the best way to describe today’s record levels of consumer debt. The Commerce Department recently reported that the savings rate for all of 2006 was a negative 1%. Essentially, not only did people spend every dollar they earned last year, but they also dipped into savings or borrowed, making it the lowest savings rate since the Great Depression. The methodology to calculate the savings rate does use a fairly simple equation, with no recognition given to capital gains on investments or increases in the value of home ownership. Household net worth, a figure calculated by the Federal Reserve, provides additional insight. This metric, which includes all assets held by individuals less their total liabilities, was estimated at $54.1 trillion at the end of third quarter of 20063, representing an increase of more than $3 trillion over the previous four quarters. This could be an indication that people may be expressing overconfidence in a consistent and unrealistic appreciation in home values or stock market returns. In any event, one thing is clear: Americans like to spend.
Compounding the problem of poor spending habits is the apathy many workers demonstrate toward employer-sponsored retirement plans such as 401(k) plans. Whether as a result of intimidation, confusion, or disinterest, many participants choose inaction. Fortunately, the PPA has given plan sponsors a compass by which to guide the boat. By implementing "autopilot" plans (auto enrollment, default deferral levels, periodic deferral increases, properly diversified investment allocations, and periodic rebalancing of investments), the PPA ensures that proper navigation occurs without constant oversight.
Even though these DC plan tools are making retirement plan choices easier for many people, there are still decisions that should be evaluated by each person as they relate to his or her own personal situation within these plans. For example, what makes more sense from a participant contribution standpoint: Roth 401(k) deferrals or traditional pretax deferrals? This has long-term tax implications that will affect each retiree differently, depending on personal financial goals and objectives.
While these decisions can guide us on our journey, we must still make adjustments along the way. Our plans for retirement may be driven off course by factors like education expenses, increasing healthcare costs, and aggressive spending habits, which can undermine personal savings and slow down our boat. By periodically trimming the sail to compensate for these headwinds, the captain increases the chances of safely reaching the ultimate destination.
Charting the course
Retirement means different things for each of us. Some of us may decide to continue working a reduced schedule as a lifestyle choice, while others may need to keep working deep into their golden years. Given today's ever-changing retirement climate and an uncertain economic environment, it is clear that individuals must become the stewards of their own retirement plans. No longer can they afford to look toward a pension entitlement and Social Security as their primary means of retirement. It is imperative that people individually accept responsibility for their own retirement planning and start saving for this eventuality early on.
Unlike the outdated stool that sits on its three wooden legs, our new retirement metaphor is a maneuverable vessel with a vast array of navigational tools. A future retiree can sit comfortably at the helm of this sturdy boat and sail it in any direction. By carefully managing retirement options and taking advantage of planning techniques such as autopilot plans, retirement income guarantees, and phased retirement, each individual can chart a customized course to retirement security.
GERALD ERICKSON is a principal and benefits consultant with the Midwest Employee Benefits Practice of Milliman. His consulting experience is focused in the areas of design and implementation of defined contribution retirement plans. Gerald is currently a member of Milliman’s Employee Benefits Steering Committee and chairman of the Marketing Focus Group.