Ten Steps to Reforming Baby Boomer Retirement
Thursday, March 23, 2006
by John C. Goodman, Devon Herrick, Matt Moore
Table of Contents
- Executive Summary
- Step 1. Improving Traditional Pension Plans
- Step 2. Improving 401(k) Plans
- Step 3. Expanding IRAs
- Step 4. Removing Penalties on Work
- Step 5. Repeal the Social Security Benefits Tax
- Step 6. Using the Roth Method of Taxation
- Step 7. Making Health Insurance Portable
- Step 8. Tax Relief for Post-Retirement Health Insurance
- Step 9. Creating Health Savings Accounts for Seniors
- Step 10. Paying for Long-Term Care
- About the Authors
Step 2. Improving 401(k) Plans
"Workers with defi ned contribution pension plans save too little and invest too conservatively"
For the past 27 years, defined contribution pension plans — such as 401(k)s, and the nonprofit version, 403(b)s — have taken the nation by storm. These plans are well suited for workers who change jobs frequently or experience gaps in employment. Unlike defined benefit plans, defined contribution plans promise no specific benefit at retirement. The employee has ownership rights over the assets in a specific account and is entitled to the full accumulation. Typically, some or all of the employee's deposits are matched by the employer after a vesting period.
Today more than 40 million workers participate in 401(k)-type plans, with total assets of about $1.4 trillion.14 While these plans are popular with employers and employees, they have their own set of problems.
Problem: Retirement Savings Mistakes . With respect to every employer-sponsored retirement plan, there are four decisions that need to be made:
- Whether to join the pension plan;
- How much to contribute;
- How to invest the assets of the plan; and
- How to receive the benefits during retirement.
Under the traditional defined benefit system these decisions were made by employers, not individual employees. Specifically, employers automatically enrolled full-time workers in their pension plans. They also decided how much to allocate to this plan (as opposed to paying wages and other forms of compensation) in order to reach the desired retirement objective. In making investment decisions, they chose diversified portfolios and managed the investments according to “prudent-man” standards that apply to all fiduciaries. During retirement, employees received a fixed monthly payment.
"Many lower-income workers do not participate in retirement savings plans."
Under the current defined contribution system, however, these decisions have been relegated to employees. And we are unfortunately discovering that most employees are ill-prepared to make them.
Failing to Save. About a quarter of workers who are offered 401(k) plans at work do not participate.15 And, the participation rate of higher-income workers in tax-deferred plans — plans in which contributions receive special tax advantages — is much greater than lower-income workers.16 As Figure II shows:
- Only 22 percent of workers with incomes of less than $20,000 participate in tax-deferred plans.
- By contrast, the participation rate is 56 percent for workers earning between $20,000 and $40,000, and 70 percent for workers between $40,000 and $80,000.
- Almost 80 percent of workers with incomes of more than $80,000 are enrolled in a 401(k) plan.
Failing to Save Enough. Those who do participate often do not contribute enough (even with their employer's match) to provide the same level of retirement income as the old defined benefit plans. The result is that many households fail to accumulate adequate retirement savings. In 2001, for example, the median balance in such accounts among all households headed by 55- to 59-year-olds was only about $10,000.17
"Workers often fail to diversify their savings, increasing their risk and lowering their returns."
Making Poor Investment Decisions. In general, workers make two kinds of mistakes in their investment decisions. They tend to invest in what they know or in what they perceive is safe. What they know is their employers' stock. What they perceive is safe is a money market fund or a government bond fund. Unfortunately, the first decision leads to too little diversification and subjects the employee to too much risk. The second decision involves too little risk and produces returns that are too low to secure an adequate retirement income.
In 2001, thousands of Enron employees lost most of their retirement savings when the company stock price fell dramatically. Enron's case is not unique. A Hewitt Associates survey of Fortune 500 companies offering 401(k) plans found 84 percent offer their own stock as an investment choice. Thirty-four percent invest their company's matching funds exclusively in company stock.18 As the Enron example demonstrates, putting all of one's eggs in one financial basket is risky. And if the basket is the worker's company, these risks are magnified, since bankruptcy endangers workers' retirement accounts and their jobs.
Many workers are invested in overly-conservative assets, such as lower-earning money market funds or bond funds, which are safe but provide a low rate of return. Often this occurs because a company chooses that type of fund as its default investment option — when an employee makes no investment choice. A ccording to a recent study by the Vanguard Group of more than a thousand retirement plans, 80 percent use a money market fund or other short-term investment fund as the default option; only 16 percent use a fund that yields higher returns.19
Lower-income employees are particularly prone to remain in lower-earning funds because many do not select an investment option and are defaulted into a money market fund. In fact, in a typical 401(k) plan, almost two-thirds of the money invested by the lowest-income quintile is in a money market fund or other fixed-type investment. By contrast, about 85 percent of the money invested by the highest-income quintile is in higher-earning, equity-type investments. 20
As workers approach the retirement years, many make another mistake: They fail to adjust their portfolios to reflect the need for less variability in returns as retirement nears. Since stocks are more risky than bonds or money market funds over the short term, workers should shift their portfolio toward less variable investments as they near retirement. This can be accomplished automatically with “lifecycle” funds. A lifecycle account invests in a premixed portfolio of stocks and bonds, and automatically adjusts the level of risk as the worker ages, primarily by changing the allocations of stocks and bonds. An example of a lifecycle account is the Vanguard Total Retirement 2045 Fund. The fund is targeted toward a person retiring in 2045; initially the fund invests almost completely in stocks, but gradually shifts to almost all bonds by 2045.
Making Poor Withdrawal Decisions. Because of healthier living and advances in medical technology, Americans are living longer. Life expectancy for males increased from 61.4 years to 74.8 years over the past seven decades, and is expected to rise to nearly 80 years over the next 70 years. Life expectancy for women increased from 65.7 years to 80 years over the past seven decades and is expected to rise to age 83 over the next 70 years.21 In the future, workers may spend up to a third of their lives in retirement. Thus, the prospect that retirees may outlive their retirement savings grows over time. Without proper planning, new retirees may be inclined to draw down their assets too quickly or take a lump-sum withdrawal from their retirement accounts. Retirees should be encouraged to consider payout options, like annuities, that will provide them with lifetime paychecks. Unfortunately, a recent study by Hewitt Associates found that the number of 401(k) plans that offer annuities actually declined from 31 percent to 17 percent between 1999 and 2003 and only 2 percent of participants in those plans chose annuities.22
"Workers should be automatically enrolled in 401(k) plans."
Solution: The NCPA/Brookings Institution Reform Plan.23 Public policies should encourage employers to sponsor plans that allow workers to build the largest possible nest egg, with a minimum of risk and reduced volatility as retirement age approaches. Accordingly, the NCPA and the Brookings Institution, a left-of-center think tank, developed a proposal to encourage employers to adopt plans with features proven to be effective in helping workers better prepare for retirement :
- Automatically Enroll Employees in 401(k) Plans Unless They Opt Out. Until recently, most defined contribution plans required workers to opt into the plan. However, there has been a trend in recent years to automatically enroll employees unless they opt out. When workers are automatically enrolled in a 401(k), participation rates are significantly higher. Studies show the introduction of automatic enrollment increases the rate of participation from about 75 percent of eligible employees to between 85 percent and 95 percent.24 Even without the legislative carrots proposed below, almost one in five employers has already adopted this reform.25
- Provide Automatic Contribution Increases Unless the Employee Opts Out. Building an adequate nest egg is easier when employers automatically step up workers' contributions each year — by saving part of their future pay raises, for example — rather than committing them to save at a higher rate from the start. As employee pay increases, the percent invested in the 401(k) plan would increase as well.
- Invest in Diversified, Balanced Portfolios Unless the Employee Opts Out. Participants' funds should be automatically invested in a diversified portfolio that includes a mix of stocks and bonds. If workers begin contributing larger amounts to their 401(k) plan, their interests will still not be properly served if they are investing in low-yielding or overly-risky assets.
- Follow a “Lifecycle” Investment Strategy Unless the Employee Opts Out. As noted above, a lifecycle account automatically shifts a worker's funds from higher-earning, but more volatile, investments to more stable, lower-earning funds as the worker ages. Thus, a lifecycle account automatically allows a worker to earn the largest possible nest egg for retirement while reducing risk and volatility as retirement age approaches.
- Convert the Funds into Annuities At Retirement, Unless the Employee Opts Out. Defined contribution plans should offer a lifetime annuity as the default payout option at retirement. As noted above, longer lifespans — and the need to draw from retirement savings for more years — will increase the risk of outliving one's retirement savings. A lifetime annuity is a financial product that can guarantee an individual a lifetime stream of income; basically, a paycheck for life.
"Protection from lawsuits would give employers an incentive to adopt 401(k) reforms."
The Quid Pro Quo. Because the NCPA/Brookings approach would be so beneficial to participants, employers should be given incentives to establish such plans. Legislation should provide that in exchange for providing a plan offering all the recommended features, an employer would have to meet only the basic coverage and nondiscrimination requirements. Additionally, the plan sponsor would receive “safe harbor” protection, exempting it from class action civil suits and similar actions alleging breach of fiduciary standards. Fear of lawsuits prompts many companies to adopt features — low-earning default options, for example — that are not in the employees' best interest.