Solutions to the Middle Class Retirement Crisis

As I have noted in three recent posts, retirement security for those currently or recently in the middle class is no sure thing. 49% of the private work force has neither defined benefit (traditional pensions) or defined contribution (401(k)) retirement plans, while public sector pensions are coming under increasing attack. The United States has the highest elder poverty rate, 25% (measured as 50% of median income), of any industrialized nation bigger than Ireland. An estimated $6.6 trillion shortfall in retirement savings shows how the shift from traditional pensions to 401(k) plans has been totally inadequate to meet people's future needs.



Yet what passes for wisdom among the Very Serious People (VSP) is that we need to make a stealth cut to Social Security via a less generous inflation adjustment, while Republican plans for Medicare would shift an astounding $34 trillion in medical costs on to seniors whose income would be falling in real terms. This is a recipe for disaster.



So what do we really need to do now? Several different proposals are currently in the mix, all of which would address the income shortfall to varying degrees.



Iowa Senator Tom Harkin, chair of the Health, Education, Labor and Pensions (HELP) Committee, released a report in July 2012, "The Retirement Crisis and a Plan to Solve It." It proposes a fairly small increase to Social Security benefits (about $60 monthly to the lowest earners) and replaces the current inflation factor (CPI-Urban wage earners) not with the chintzy "chained CPI" the VSP want, but with the more generous CPI-Elderly, which recognizes that seniors consume a larger share of rapidly rising cost products, most obviously health care. The other innovation in the Harkin plan is the introduction of "USA" (Universal, Secure, and Adaptable) retirement funds which would require both employer and employee contributions, with special tax credits for low-income workers. These funds would provide what might be called a "semi-defined benefit" that could be adjusted downward if there were a prolonged stock market slump, but otherwise would provide a predictable level of benefit to its recipients.



As pension expert Jane White contends, this proposal is vague when it is not simply inadequate. She argues for a plan like the Australian "Superannuation" plan, where employers are required to put in 9% of the worker's income. Her proposal for the U.S. would be a 9% contribution for large companies and 6% for small firms. It would be portable among companies, and employees would immediately own their employer's contribution (vesting), in contrast to the current situation where that can take years. She argues that the big problem with U.S. pensions isn't that not enough people have 401(k)'s (though with 49% of private workers not having one, I'm not sure I'm persuaded), but that the employer contribution is so small. By contrast, Harkin's USA plan does not specify a level of employer contributions, which is definitely a drawback when the savings shortfall is so severe.



Of course, White's proposal still subjects retirement funds to market risk that Social Security does not, and gives Wall Street a huge new pool of funds to play with. One logical alternative is simply a dramatic expansion of Social Security. Obviously, it is already portable between employers, and companies already have to deduct FICA and Medicare taxes, so there would be no difference administratively from what firms already do.



The funding would come from an end to the cap on earnings subject to the Social Security tax, currently $113,700 for 2013. A little-known fact is that while the payroll tax is regressive (flat to the cap, then 0), the payout structure counteracts this by reducing the share of earnings replaced in retirement the greater the person's income. As the Harkin report  explains:

The replacement factor for a person’s first $767 of Average Indexed Monthly Earnings (“AIME”) is 90%. The replacement factor drops to 32% for AIME between $767 and $4,624 and 15% for AIME between $4,624 and $8,532.

 The report goes on to propose a replacement factor of just 5% for income over the current cap. It further reports that Social Security only replaces an average of 40% of people's pre-retirement income, rather than the 65-85% that is widely recommended for retirees.



This suggests an obvious solution: increase the replacement factor substantially for middle-income people. While the numbers would need to be worked out precisely, middle class workers would be much more secure with, for example, 100% replacement of their first $2000 per month in income, 50% replacement of their next $2000 per month in income, 25% for the rest up to the current cap, and then Harkin's proposed 5% over the current cap.



When I say "obvious," that's not to say that it will be easy. Republicans still want to gut Social Security, even though it is supported by most Americans. But a deeper problem is that few people realize just how severe the retirement crisis will be, first for younger Baby Boomers, but much more so for their children and grandchildren. As a first step, you should follow White's suggestion to contact Harkin's committee asking for hearings on the coming crisis. The email is Retirement_Security@help.senate.gov



But we will need many more steps to ensure that the crisis is solved in our lifetimes.



Cross-posted at Angry Bear.

$6.6 Trillion Retirement Savings Shortfall Shows 401(k)'s No Replacement for Pensions

Last week the Washington Post ran a story on the weaknesses of 401(k) retirement accounts, focusing on the the fact that 1/4 of Americans with 401(k)'s have used them to meet current income needs. Among people in their forties, the share rises to 1/3,  an astounding figure considering how close this group is to retirement. In the wake of the Great Recession and continuing job market problems, it is perhaps not surprising that 28% of 401(k) account holders presently have loans against their accounts.



As the Post delicately puts it,

Many employers have embraced 401(k) and other defined-contribution
accounts as a way of helping workers save for retirement while relieving
themselves of the financial risks that come with managing a traditional
pension plan. In theory, 401(k) accounts are better suited to an
economy in which workers are changing jobs more frequently than ever
because the accounts can be rolled over from previous employers.

A more accurate way of saying this would be that employers have embraced 401(k) plans because they are less expensive than providing pensions, thereby "cut(ting) overall employee compensation," and that 401(k) plans don't take into account the stagnation of real wages, points well made by commenter "Sean2020."



Moreover, as I reported before, 49% of private sector worker have neither a 401(k) or a defined benefit pension plan. Thus, they have no supplement to their eventual Social Security benefits unless they are able to save outside of a 401(k).



And they aren't saving. At least, they're aren't saving nearly enough to maintain their standard of living after retirement. As a report from the Senate's Health, Education, Labor, and Pension (HELP) committee states, there is a  $6.6 trillion gap (methodology here) between what people need to maintain their current standard of living and what they've actually saved for retirement. This is equal to the combined assets of defined benefit pensions and 401(k) type plans, more than total state/local/federal government retirement plans, and more than twice as much as the Social Security Trust Fund. There's a reason I've been using the word "crisis"!



Total Assets



Social Security Trust Fund      $2.7 trillion (12/31/2012)

Defined benefit pensions         $2.3 trillion (9/30/2012)

Defined contribution 401(k)    $4.3 trillion (9/30/2012)

State/local gov't employee      $3.1 trillion (9/30/2012)

Federal employee retirement  $1.5 trillion (9/30/2012)

IRA's                                    $4.9 trillion (6/30/2011)





Sources: Social Security Administration; Federal Reserve, tables L-116, L-117, and L-118 (financial assets only), for DB, DC, and government employee programs; Investment Company Institute for IRAs



This gigantic hole shows that the current model, based on 401(k)'s rather than true pensions, is not working. In a future post I will discuss ways to fix the crisis.