Saving and Investing: A Challenge for Women
Thursday, April 15, 2004
by Celeste Colgan and John Goodman
Table of Contents
Resources for Retirement
Financial planners tell us that workers typically accumulate retirement assets from three sources: personal savings, Social Security and employer-sponsored retirement plans. Unfortunately, many women - because of their life choices and workforce behavior - fall short of building up these resources.
Nearly three-fourths of the elderly living in poverty are women."
Personal Savings. Saving money independent of employer-sponsored plans is a challenge for everyone, but for women - who are likely to be earning less or earning nothing -saving rarely happens. Putting discretionary income into a personal retirement savings account competes with more immediate needs: money for preschool, medical emergencies, children's college expenses or any of the many unplanned events in family life.
Tax-advantaged savings can produce more than twice as much income as comparable taxable investments, depending on one's tax bracket (see the cautions below).An Individual Retirement Arrangement (IRA) is one of the best ways to save.
For example, the Spousal IRA allows the spouse of a wage earner to set aside up to $3,000 of pretax income each year that can grow tax free until it is withdrawn during retirement.7 While this is a viable option for married couples, the contribution limit is meager compared to allowable contributions to employer-sponsored plans. So why isn't the limit higher? It should be. Because IRA deposits expand the nation's capital stock and therefore our national income, the government gets a great deal of the money back as tax revenues. In fact, several studies have concluded that IRA tax incentives more than pay for themselves.8
"Because of their workforce behavior, women have difficulty accumulating retirement assets."
Home Ownership. When interest rates are low - as they have been recently - people are often drawn to home ownership as an investment vehicle. Moreover, federal policies encourage home ownership. It is part of the American Dream. Under the current tax code, if a primary residence is sold for more than its cost basis, the sellers can usually pocket the profits from the sale tax-free. Thus, many stay-at-home moms and working couples reckon their important second job is to increase their home's value. They remodel, landscape and repair with the idea of collecting cash or trading up when they sell. Home equity is the principal asset of a large number of current retirees.9
Social Security. As a supplement to other assets, Social Security benefits are welcome, but it is a bad idea to depend on Social Security for one's primary source of retirement income. Because of the falling ratio of workers to retirees, projected benefit levels for future retirees are unsustainable with payroll tax rates under current law. The national debate about the future of Social Security has fostered well-justified skepticism.10 If current trends prevail, benefits may be greatly reduced in future years. In fact, polls show that young people are convinced they are more likely to see a UFO than receive their Social Security benefits.11
Even if Social Security keeps all its promises, the benefits are simply not enough to provide seniors with financial independence. The average monthly Social Security benefit today is about $621 for women and $810 for men. The benefit for a 35-year-old accountant who earns about $30,000 per year will be about $1,292 per month, assuming that she continues to work full time until she retires.12 This means that if she has made no other income provisions, on the day she retires she must live on 50 percent of her former wages. And things could be worse. She may have had interruptions in her employment; she may have taken maternal leave or reduced her hours to fulfill family needs. As a result, her Social Security benefit will be significantly smaller than 50 percent of her working income. It is no wonder that twice as many women as men retire in poverty. Given these prospects, it is more important than ever that we have a sound private retirement savings system - one that meets the diverse needs of American workers.
Employer-Sponsored Retirement Plans. While employee benefits are noncash compensation to the employee, they cost the employer just as much as cash wages. In fact, if there were a law that made employee benefits illegal, employers could increase all employee wages and salaries by about the same amount that they now spend on benefits.
So why don't employers simply pay higher wages and forget the benefits? One very important reason is the tax law. In general, employers can spend more on untaxed benefits than employees can spend on their own. In fact, in the area of retirement savings there are large differences between the amount of tax-free savings available to people at their workplace and what they can do on their own. Thus, employer-sponsored retirement plans have become a coveted part of employee compensation. They have also evolved from a defined monthly retirement benefit into a retirement savings plan for workers.
Defined-Benefit Plans. Following World War II, many large employers chose to provide a form of retirement support called the defined-benefit plan. Under these plans, employees acquire pension benefits, sometimes for the rest of their lives, based on a combination of wages and years of service to the company. The plans consisted of a promise by an employer to provide a specific monetary sum. Under defined-benefit plans, when employees commit their entire working lives to a single employer, their pension is typically 60 to 70 percent of final pay. Today, however, employers have virtually stopped establishing new defined-benefit plans. Four important factors have contributed to that development:
"Employer-sponsored defined benefit pensions worked well for employees who stayed at one job throughout their career."
First, although defined-benefit plans work well for people who work continuously for the same employer, they do not work well for employees who switch jobs. Why? Although they could be designed differently, most defined benefit plans calculate benefits using formulas that are "back-end loaded." That means the 40th year of employment is weighted a lot more heavily than, say, the 10th year. For example, consider a woman who works for four different companies - each for 10 years - and all four have identical pension plans. Upon retirement, she will get four separate pension checks, but her combined income will be less than half of what it would have been if she had stuck with just one company for the full 40 years. In fact, even if they remain fully employed for their entire work lives, both men and women sacrifice substantial pension benefits under this system if they switch employers frequently.
Second, for much of the post-World War II period, employers were not required to set aside funds for their pension plans. Like today's Social Security system, the pension promises of many employers were not backed by any saving or investment. This meant that many defined-benefit pensions were only as secure as the company that established them. If the employer went broke, employees could lose some or all of their benefits. For example, after Studebaker filed for bankruptcy in 1963, autoworkers received only 15 percent of the pension benefits they had been promised.13
"Defined benefit retirement plans are risky because they depend on the employer's financial success."
Third, federal legislation made defined benefit plans unattractive to employers. In response to the problem of bankrupt companies defaulting on their pension promises, Congress passed legislation (called ERISA) that required employers to fund their defined-benefit pension plans.14 The law also created the Pension Benefit Guarantee Corporation (PBGC), which insures private pension plans. This insurance does not work like insurance in a normal market, however. Federal law requires all companies with defined-benefit pension plans to pay premiums to the PBGC. However, the premiums are not risk-adjusted; thus the premiums paid by those who are at risk of default are much lower than their actual risk would warrant. Those plans that are fully funded and at virtually no risk of default are charged premiums that are too high. Thus, one way to think of this system is to see it as socializing the risks of pension default by overcharging healthy plans and undercharging sick plans.15
Not surprisingly, new companies seeking to create pension plans for their employees have had a strong incentive to avoid the PGBC scheme and its excessively high premiums.
Ironically, the very 1974 act that sought to regulate and reform the private pension system provided an alternative.16 It allowed the creation of defined-contribution plans (described below), of which the most notable is the 401(k) plan.17
Finally, defined benefit plans offer prospective retirees a promise that has become increasingly expensive to honor. These plans were founded on actuarial assumptions made up to 60 years ago, but today's retirees live much longer. In order for employers to fully fund a defined-benefit plan today, employees have a choice: accept less in wages (so that more of their compensation can go to the pension fund) or accept lower monthly benefits during retirement. Given such a tradeoff, not all employees will make the same choices. In their efforts to find a system that allows workers more flexibility and greater choice, employers found that for the same cost, they could discard the one-size-fits-all approach and create a new system that appeals to the diverse preferences of newer and younger workers in a more dynamic labor market.
Defined-Contribution Plans. Unlike defined-benefit plans, defined-contribution plans promise no specific benefit at the time of retirement; rather, benefits are linked to market behavior. The employee has ownership rights over the assets in a specific account and is entitled to the full accumulation.18 The employee chooses an amount to put into the plan, and after a vesting period, the employer typically matches that amount. For example, a common plan would invite an employee to contribute 4 percent of her gross compensation, before taxes. After a "vesting" period, say, of three years' employment, the employer matches those contributions, dollar for dollar. Federal law governs the total amount an employee is permitted to set aside before taxes. In 2003, an employee could shelter up to $12,000.19
Historically, professional managers invest the funds of defined-benefit plans. In 401(k) plans, employees make their own investment choices - although the employer typically limits the range of available options. And as long as the employees are fully "vested," they do not lose the employer match if they change jobs. The amount of compensation they have contributed always remains in their account. Today more than half of all workers with an employer-provided retirement savings program participate in a defined-contribution plan.20
Defined-contribution plans place the responsibility for saving and investing on the employee. They better accommodate a dynamic, highly skilled workforce that has no expectations of a paternalistic employer. Gone are the days when an employee expects a company to take care of her and her family in old age in exchange for her loyalty and steadfastness on the job. The last half of the 20th century produced a different employer-employee dynamic. Today's employee knows from day one that she is likely to trade up, to use her current job to gain experience for the next. All else being equal, the employer match for her 401(k) will be an important component of her decision to accept the next job. The catch is that she must do well in her investment vehicles. She is in control and she assumes the risks.
"Defined contribution plans are portable between jobs."
Which Plan is Less Risky? At first glance it might seem that the defined-benefit plan is less risky, since it avoids two problems: (1) the risk of not investing well over your work life and (2) the risk of having a longer life expectancy and outliving your accumulated assets. Defined-benefit pensions are supposed to pay regardless of the market's performance, and keep right on paying as long as you live. However, employees lose benefits if they switch jobs, and they generally cannot pass on the benefit as part of their estate. Defined-contribution plans eliminate these two risks. Aside from vesting issues (discussed below), 401(k) owners can take their total accumulation with them when they switch jobs, and if they die early, the assets in their account become part of their estate.
Richard Hinz, Director of Pensions Research at the U.S. Department of Labor, conducted a simulation for 100,000 representative American workers and concluded that when all risks are considered, defined-contribution plans are actually less risky than defined-benefit plans. Given the odds that employees will leave their employers and that their compensation will flatten out before their careers end, a plan that bases benefits on tenure with the company and final salary simply will not pay out as well as one that simply grows with capital markets.21 However, as we shall see, even 401(k) plans could be improved with just a few simple changes in federal law.
In any event, women are more likely than men to participate in a defined-contribution plan. This is because defined-benefit plans are usually found in unionized, large-employer industries where employment tends to be dominated by males. Among women with an employer-provided retirement plan, enrollment in defined-contribution plans is twice that of defined-benefit plans.22