A tale of unintended consequences for retirement security

It’s a tale of unintended consequences, one that upended a traditional system which provided adequate retirement income for previous generations, setting the stage for an economic and social crisis today’s policymakers are struggling to avert.

That it happened largely by accident, without anyone paying all that much attention, doesn’t make the outcome any less damaging. And even though it’s now more than three decades since the shift began, accelerating over the years, the impact of moving from a defined benefit model, mostly in the private sector, to a defined contribution structure is only now beginning to be felt.

In the United States, the transition began with the introduction of the 401(k) as a kind of a supplementary savings plan, running alongside company DB plans. While its creation was no accident, its morphing into the dominant retirement vehicle in the private sector was, Andrew D. Eschtruch, associate director for external relations at the Center for Retirement Research at Boston College (CRR), said during a recent conversation.

“Before the 401(k) there were similar plans in place, largely seen as supplemental savings plans for people who already had a DB plan. It was a way to put away a little bit of extra money.

“The 401(k) came along and somebody figured out this could be used in a certain way … they clarified that the law allowed the plans to be used in a way that was somewhat more flexible (for employers) than some of these earlier arrangements. For a number of reasons, they caught on.”

At first, large businesses, Fortune 500 companies, didn’t rush to adopt the 401(k) as a primary retirement vehicle, maintaining their DB plans while also offering the supplemental savings plans. However, loyalty to the traditional retirement system that proved so effective at delivering reliable income to retirees, didn’t last. Recent reports indicate that by 2013, only seven per cent of Fortune 500 companies continued to offer new hires entry into a DB plan.

New businesses are more inclined to offer a DC retirement scheme, if any at all, which offloads risk from employers to employees. The result, a number of studies have revealed, is a population largely unprepared for retirement.

“Certainly from the perspective of an individual, (DC plans) are much more risky than a traditional pension plan. Employees knew what they would be getting at retirement, and didn’t have to worry about outliving their income … they could have a predictable amount of money that lasted throughout their lifetime,” says Eschtruth, co-author of Falling Short: The Coming Retirement Crisis And What To Do About It.

In the book, the authors, Charles Ellis, an American investment expert, Alicia H. Munnell, director of the CRR, and Eschtruth, trace the evolution of the retirement crisis, and offer advice on how to prevent, or at the very least mitigate, it. The views expressed, he emphasizes, are those of the authors and not the centre’s. Strengthening Social Security, making retirement schemes automatic in terms of enrolment and ensuring all workers have access to a retirement plan, as well as increasing the retirement age, are all solutions the authors lay out.

With the decline of DB in the private sector, risks bourne by individuals include dealing with increased longevity and the subsequent need for income to last a longer life, low interest rates that stifles growth, and (in the United States) limitations to Social Security that forward will mean “the program is poised to provide less than it does today – not in terms of fewer dollars, but the benefits will be smaller as a percentage of people’s pre-retirement income,” says Eschtruth.

Three factors combine to reduce the replacement rate: 

• A gradual rise in age eligibility for full benefits from 65 to 67 for those born after 1960, meaning that those who retire at 65 will receive less benefits, and those who retire later will get full benefits, but for fewer years. On average, for workers who retire at 65, the replacement rate will drop from the current 40 per cent to 36 per cent, once the transition is fully implemented.

• A second factor comes from Medicare premiums, which are automatically deducted from Social Security benefits. Those premiums are rising faster than benefit levels. 

• Current tax rules allow for the clawing back of a substantial portion of benefits. Individuals with $25,000 in income and couples with a combined $32,000 in income can pay taxes on Social Security benefits of up to 85 per cent.

“The combined impact of these factors will reduce Social Security replacement rates for the average worker retiring at 65 by nearly a quarter – from a net 40 percent in 1985 to 31 percent by 2030,” the authors write.

A similar situation and discussion is underway in Canada regarding Canada Pension Plan (CPP) replacement rates – 25 per cent of a cap of about $50,000 – and the gradual increase in eligibility age for Old Age Security (OAS) from 65 to 67, as well as the related impact on collecting the Guaranteed Income Supplement (GIS).

“In addition to all of that, we have a long-term financing gap in Social Security, and if benefits were to be cut that would further reduce those replacement rates,” says Eschtruth.

On average, people between the ages of 55-64, those approaching the traditional retirement years, have about $100,000 in retirement savings, he continues, adding that’s not much to spread out over an entire retirement period – it would produce about $400 a month.

When considering solutions to the retirement crisis, “one of our goals was to do this without upending the retirement system – we did not want to say let’s tear everything apart and start a new system from scratch, so we looked at how to work within the existing system to strengthen retirement security for everyone,” says Eschtrutch.

Existing DC plans would work better if they adopted proven behavioural science principles that show that once employees are enrolled, they tend to stay in a plan. Automatic escalation of contributions would build bigger pension pots; the authors suggest 10-15 per cent of annual salary. For those without an occupational plan, some type of state-run scheme would provide coverage – Eschtruth points to the UK’s NEST program as an example. 

Maintaining current Social Security benefit levels and finding a way to increase them, working longer, and using equity in a home as a retirement asset are all tactics the authors suggest to increase retirement security.

It’s important to find solutions to the problems of inadequate retirement income, a concern that most of the developed work is facing, says Eschtruch.

“We don’t like the notion that people end up feeling they can’t have the things in retirement they were dreaming about – whether that was scaling back travel or family time. We want people to be comfortable and not surprised.”