By
Allison Schrager,
Quartz
Few things get people to riot faster than pension cuts. Recent protests in France and Chile were largely about retirement benefits. Even if they don’t take to the streets, around the world people are worried they won’t have enough money to retire.
By some estimates, the world is short $400 trillion
to pay for its aging population. Chile and France finance retirement in
different ways, but suffer from dangerous shortfalls nonetheless.
Chile
has a defined contribution (DC) system where individuals contribute to
an account and bear the investment risk of financing their retirement.
The French government offers a generous defined benefit (DB) plan, where
the state pays its citizens a set income each year. Both systems are
falling short, because no matter how you finance retirement you can’t
escape one fundamental truth; retirement is expensive and there is not
enough money for it. Or, at least, there is not enough money to finance
the length of retirement at the standard of living people have come to
expect. As Baby Boomers retire, they are putting every type of system to
the test, and we are all going to have to revise our expectations.
How bad is it?
The
retirement shortfall has become more noticeable not only because a
large population is starting to retire, but because Baby Boomers are the
first generation to retire with individual accounts: the 401(k)-like
plans in the U.S., U.K., and Australia, among others. Economists at the
left-leaning Economic Policy Institute
declared the 401(k) system a disaster, citing 50% coverage rates and low asset balances that won’t cover an adequate retirement.
But
to a large extent retirees aren’t worse off compared to earlier
generations, and in some cases may be better prepared. The post-war era
is often considered a retirement heyday in America, where Social
Security was well funded and people got a generous pension from their
employer. But, in fact, at the peak only
38% of workers got a
DB pension from their employer, so most people relied on Social
Security. Now, more than half of workers have access to some form of a
retirement plan. Better coverage is why the median retirement savings
balance for workers in the U.S. doubled between 1989 and 2016,
increasing from $9,300 to about $20,000, adjusted for inflation.
Individual
retirement accounts make the shortfalls that always existed with DB
plans more transparent. The World Economic Form defines a successful
retirement as ending work in your mid 60s with 70% of your salary for
the rest of your life. If that’s the goal, any shortfall reflects the
retirement we want, not the one we ever had. Retirement is a relatively
modern concept that
only went mainstream after World War II. People now live longer and in better health, anticipating spending up to one third of their life retired.
Most
countries have a DB or DC pension system, or some combination of the
two. Each has its shortcomings and both can be made to work better to
provide something close to the retirement people need.
The problems with defined benefit pensions
A large part of the global retirement savings shortfall comes from promises made by DB plans with no money to pay for them.
One
of the two ways to finance DB pensions is the funded model, putting
money aside today to pay workers in the future. This is how workplace
pensions are normally financed, but many employers have not put enough
money aside. In the U.S., the few remaining employers who offer DB
pensions are mostly state and local municipalities. Dodgy accounting standards,
and sometimes state laws, enabled these governments to underfund for
decades. States are trying to make up the difference by investing in
riskier assets like private equity,
which promise a higher return, but increase the risk of even bigger
shortfalls. Funded pensions in the private sector tend to be in better
shape because they face more stringent accounting standards. However,
low interest rates pose a source of risk because they mean smaller
returns and larger estimated liabilities. This has also encouraged
investment in riskier assets, which could lead to underfunding if
there’s a significant market drop.
Most government-run pension
plans, by contrast, are pay-as-you-go, where young workers pay taxes to
support current retirees. This system depends on having enough young
people to keep the system solvent, and aging populations are a problem.
The U.S. Social Security program is set to face shortfalls in 2033. In
other countries with generous but unfunded pensions, like Brazil,
France, and Italy, retirement
benefits dominate GDP and crowd out other services.
Emerging
economies with large populations like China and India may turn out to
face the biggest problems. Their retirement systems have some of the
lowest rankings in a measure of adequacy, sustainability, and integrity
compiled by Mercer. China’s pay-as-you-go pension system is set to
run out of money in 2035 and
coverage is not universal. With its rapidly aging population, Chinese
workers face a great deal of uncertainty and insecurity in retirement.
DB
pensions, in theory, should provide a worry-free retirement and provide
scope to diversify risk across different generations. But promising to
pay out a benefit for life, no matter what happens to markets or the
population, is very expensive. Employers and governments always have an
incentive to underestimate the cost until it’s too late.
The problems with defined contribution pensions
After
the costs of DB plans became apparent, many employers and some
governments switched to a DC system, where workers save for themselves
and bear all the risks. Because nothing is promised, these plans can
never be technically underfunded. The bigger concern is the accounts
won’t be enough to cover people in retirement. This has caused Chileans
to take the street and generated countless articles about a retirement
crisis.
But, as economist
Andrew Biggs points out,
the typical retiree in America is better off than they used to be after
firms switched to DC pensions. People have more retirement assets under
a DC regime than they did under DB.
Economists estimate
that in America retirement income increased about 10%, after adjusting
for inflation, for the median retiree between 2000 and 2011, and even
lower-income retirees have more than before. They also estimate that the
replacement rate (the ratio of retirement income to working income) has
remained fairly stable and the move from DB to DC did not make retirees
more dependent on Social Security.
That said, it still might not
be enough to match people’s expectations for retirement. The average
balance of soon-to-be retirees in America is $300,000 (assuming they
have an account), which translates into just $15,000 a year at current
interest rates. More worrying is how Americans can pay for their
healthcare, since Medicare does not cover everything. Retirees can
expect to
spend $183,000 in health expenses, but estimates vary considerably.
And
that’s not all. The U.S., Australia, and the U.K. have not addressed
the hardest part of retirement finance. People have saved, but the
market does not provide adequate guidance and products on how to spend their money after they stop working. Low interest rates not only hurt DB plans, they also
make it more difficult for retirees to manage income risk in retirement.
In
emerging markets, like Chile, DC plans also face additional challenges.
For many years the assets were managed by high-fee managers who did not
get high returns but still took a large chunk of savers’ assets. Many
Chileans also work in the informal labor market and did not make
contributions, which leaves them with meager savings for retirement. The
Chilean case shows that DC pensions work best, in any country, when
paired with a modest guaranteed state benefit which provides a
sustainable income floor.
What is the solution?
Addressing
the retirement shortfall will take a combination of more saving and
better financial education. Both households and pension sponsors need to
save more.
In a DC system, retirement accounts also need to be
made more widely accessible. In the U.S., only half of Americans have
access to them. The recently passed
Secure Act,
which makes it cheaper for small plans to offer retirement accounts and
all DC sponsors to offer annuities, is positive step. Australia offers a
good model, where accounts are mandatory and saving rates are high.
Where
DB plans still exist, an aging society means pre-funding is a better
model. Pensions also need to be subject to better accounting standards
that require them to account for risky investments.
The bigger
issue may not be related to generating an adequate income, but paying
for long-term care. As people get older their odds of
developing dementia increase.
No country has figured out a good way to pay for long-term care without
putting a large strain on families who often end up acting as primary
caregivers. We also need to accept many people will have to work longer.
Retiring at 62, or even 68, may not be realistic. This doesn’t mean
that we all need to work full-time into our 70s, with contract or
part-time gig work potentially providing a bridge to make a full
retirement more possible.
Here’s the scariest thing: Even in the
best-designed systems, almost no one today will earn enough money in
their lifetime to not work for 20 or 30 years at the end of their life.
This is true no matter who pays for retirement — the individual, their
employer, or the government.
