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Failing U.S. retirement system needs to be fixed

The three-legged stool that is the U.S. retirement system — Social Security, employer-sponsored retirement plans and personal saving — is failing. All three legs need to be repaired or the whole system redesigned.

A Government Accountability Office report, published Oct. 18, argued that a comprehensive re-evaluation of the system is needed to strengthen the retirement outlook for current and future workers.

If the problems of the retirement system are not addressed, millions of workers will retire into poverty or near poverty.

The first problem that should be addressed is Social Security. It is the bedrock on which most workers rely for retirement income, but as it is considered politically dangerous for members of Congress to touch, repairs are likely to be postponed until benefits have to be cut beginning in 2035. Then, they will have to be cut by 23%, assuming no changes are made in the system before then.

The employer-based leg of the retirement system also is weak, and getting weaker because of the switch to defined contribution plans. Action must be taken to strengthen it.

In 2015, the number of corporate defined benefit plans had fallen to about 45,000 from 103,300 in 1975. In addition, many employers provide no retirement plan for their employees.

The increasing costs of defined benefit plans — caused particularly by low interest rates, the volatility of those costs caused in part by stock market volatility and the complexity of running a DB plan caused by ERISA and the many amendments to it — have conspired to push many companies to freeze their DB plans and replace them with DC plans.

According to the Bureau of Labor Statistics, defined benefit plans cost employers 70% more than defined contribution plans.

In addition, defined contribution plans give employers more control over their retirement plan costs. They can decide how much to contribute, and even decide not to contribute when economic conditions are bad. Corporate defined benefit plan sponsors are constrained by ERISA funding requirements.

As a result of ERISA's pressures, increasing costs and the advent of the 401(k) plan, the number of defined contribution plans increased to 648,300 in 2015 from 207,700 in 1975.

Unfortunately, the replacement of DB plans with DC plans shifted the investment risk, and often the funding risk, to employees. Often employers took the opportunity to reduce their costs by being cheap with their matching contributions to the defined contribution plans.

The low contribution rates for employers and employees leave current workers in danger of having insufficient retirement savings on which to base a comfortable retirement.

Most public employee retirement systems still are based on defined benefit plans, but many are weak. Figures presented at an Oct. 19-20 conference on public pension financing at the Mossavar-Rahmani Center for Business and Government at Harvard University showed public employee pension funds were underfunded by a total of between $1.9 trillion and $3 trillion, depending on the discount rate used.

According to researchers at The Pew Charitable Trusts, the shortfall in funding is the result of "lower than expected investment returns, shortfalls in making actuarial contributions, and for some jurisdictions, unfunded benefit increases that were negotiated when systems were prospering."

They noted that pension deficits matter because underfunded retirement systems can constrain spending for other essential government programs and services, including education and transportation. "Indeed, state pension costs have nearly doubled as a percent of available state revenue since fiscal year 2000, when the pension deficit reported by state and local governments in aggregate," the researchers noted.

According to a Bloomberg report based on 2016 figures, the median funding ratio for public employee retirement plans fell to 71.1% from 74.5% in 2015. New Jersey, Kentucky and Illinois had only about one-third of the money needed to pay their promised benefits.

Speakers at the Harvard seminar noted that it would be difficult for most states to take the steps necessary to improve the funding status of their plans, especially those with the largest unfunded liabilities.

In part this is because in many states, pension benefits cannot be reduced because of constitutional restrictions or contract law, but it is also because public employee unions resist changes.

Nevertheless, steps must be taken to strengthen the three legs of the retirement system.

Congress likely will eventually step in to strengthen Social Security, most probably by raising the cap on the income on which the FICA tax is levied.

The corporate retirement system seems the most likely to draw action from Congress, when it becomes clear that the current generation of workers will be retiring with too little in retirement savings because corporate and individual contributions to defined contribution plans have been too low.

If companies do not step up their contributions, Congress might mandate a suitable corporate contribution level, as Australia has done. The GAO report noted that experiences in other countries could provide useful insights.

Efforts must be made to rein in public employee pension costs.

It might not be possible to reduce the benefits promised to current employees, but new employees can be offered a new plan. Some states, notably Rhode Island and Utah, have managed to do so by introducing hybrid plans and making clear to public-sector unions and taxpayers alike the impact rising pension costs would have on public services and public employee employment.