The U.S. retirement system supposedly is a three-legged stool. Unfortunately, the stool is tottering and needs repair.
One leg is the Social Security System. A second is supposed to be the employer-sponsored retirement plan. The third is supposed to be personal savings.
The first leg continues to function, but it's getting old and will need shoring up in the near future. The second and third legs have been moved so close together they have begun to function as one. That makes the whole structure unstable.
The three-legged stool metaphor was based on the idea that one leg would be employer-sponsored defined benefit plans. But, although they will deny it, members of Congress essentially destroyed the defined benefit plan system.
The final straw was when they reduced the amount of pension that could be paid from a qualified pension plan to $150,000 a year, a figure so low it was meaningless to top corporate executives. As a result, companies simply set up or improved non-qualified plans for those top executives, and executives lost interest in the defined benefit plan. The number of defined benefit plans has declined drastically, and DB plans have been replaced by 401(k) plans.
The 401(k) plan has merged the retirement plan and personal saving. Certainly, employees may use their 401(k) balances for retirement, but many spend some or all of their balances when they change jobs.
The temptation to dip into the 401(k) plan when the opportunity or need arises is easy to understand since most of the money flowing into 401(k) plans comes from employee deferrals, not employer matching contributions. So instead of having a retirement plan and personal savings, most employees have personal savings disguised as a retirement plan. Their three-legged stool has only two legs.
That would be fine if the second leg had a broad base - if the amount of personal savings had increased dramatically as a result of the 401(k) plan, and the savings were invested in broadly diversified portfolios that included significant amounts of risk-free, inflation-indexed securities. Neither is true.
Instead, the merging of the two legs is a recipe for instability at least, and possibly disaster in the future. The national savings figures suggest 401(k) savings simply have replaced other personal savings. And the average 6% of pay contribution from employees and the 3% matching contribution from employers simply will not be sufficient to provide a decent retirement for most employees without additional savings.
For example, if a worker takes a new job at age 45 that pays $50,000 a year and receives 4% raises each year until age 65, he or she will be earning about $105,000 at retirement. He or she will need approximately 70% of that, about $74,000, to maintain the pre-retirement standard of living.
If the employee contributes 6% of pay, and the employer 3%, and the employee's investments earn (a very generous) 10% compounded annually, he or she will have approximately $375,000 in the plan at retirement. That would buy an annuity of $34,680 a year. Even after you add Social Security the employee will be well short of the $74,000 a year needed.
What can be done to shore up the stool? The preferred choice would be to rebuild the defined benefit leg. But no CEO in his right mind would take on the costs, liabilities and regulatory burdens of an old-style DB plan in today's competitive environment. Perhaps a simpler, less expensive floor DB plan might be possible. But some significant incentives will be needed.
A second option is to provide greater incentives for individuals to save increased amounts, either in a defined contribution plan or in enhanced individual retirement plans. But lower-paid employees already have problems reaching the maximum contributions now.
Unfortunately, the legislation proposed in the wake of Enron Corp.'s collapse is not likely to stimulate either new defined benefit plans or improved 401(k) plans. In fact, the legislation is likely to discourage new or more generous 401(k) plans. How does that help employees prepare for retirement?