Social Security has long been viewed as the “third rail of politics.” Touch it, the notion goes, and your political career is fried. So it is no surprise that even as the financial stability of Social Security continues deteriorate, it has failed to reach the top of the agenda during the presidential campaign.
Social Security instability is not the only challenge faced by Americans seeking retirement security. American retirement stability has long been supported by a “three-legged stool,” comprising governmental benefit programs such as Social Security and Medicare; employer-based programs including pension plans; and individual savings, including home equity and individually managed direct contribution pension plans. Each of these is under tremendous strain.
Recently we conducted research to measure the effect on retirement security resulting from an unexpected shock to government programs as well as to more accurately account for home equity in retirement. The results of this research were sobering.
Our research shows that modest, perhaps easily predictable, reductions in Medicare benefits and more accurate accounting of home equity values could reduce the retirement wealth of middle to wealthier groups of Americans by 20% to 28%. On Medicare, our model assumes a benefit reduction of $7,000 per year in net income for middle- to high-income households. Regarding home equity, we calculate that only 40% to 50% of home equity will be available for non-housing consumption during retirement. And this does not include any calculation to reflect current falling home prices.
Given these possible shocks, what about employer-based support or increased individual savings picking up the slack? The trends in the employer community are not encouraging. Faced with rising benefit costs and perverse regulatory and accounting systems that encouraged poor risk management, many employers are opting out of defined benefit programs in favor of participant-directed ones, such as defined contribution plans. But in their current form, DC plans underperform DB plans by two to four percentage points annually while forcing investment and risk management decisions on individuals who vary widely in their ability to manage such accounts.
Given the inferiority of DC plans and in the context of governmental program instability, one might expect that personal savings would be increasing. Yet the evidence points to an opposite trend: the -1% personal savings rate for 2006 released by the U.S. Department of Commerce was the lowest since the Great Depression.
What can we do to address these problem areas? We make three suggestions.
First, encourage a national debate on the health of the American retirement system. We must ensure that political leaders are prepared to address the challenges we face with honesty and openness. Stabilizing Social Security will not help countless Americans manage their retirement if Medicare becomes a fiscal albatross. These programs are linked not just in theory but in reality for the generations facing retirement over the next 20 years.
Second, employer-based plans can and must be improved significantly. DB plans, which provide retirees with a secure and predictable form of post-retirement income, should be cherished and maintained as long as possible. Recognizing that the shift from DB is probably irreversible, however, plan sponsors need to design more effective DC plans that optimize investment choices and provide efficient annuitized payout products. The Pension Protection Act of 2006 and related Department of Labor regulations provide fiduciary protection to DC plan sponsors adopting the kinds of practices we recommend, including automatic enrollment, high default contribution rates, and default investment options that are properly diversified across asset classes. Interestingly, one overlooked opportunity in this area is the sponsor's matching contribution, which could be a focal point to improve overall investment results for participants and address longevity risk.
Third, individuals need to become more actively involved in managing their retirement security, and institutions such as ours must become better at educating them. For example, most individuals are unprepared to manage their personal longevity risk: deferred fixed annuities would be an efficient investment option if available in a cost-efficient format. Additionally, quantifying the trade-off between market risk and return can be challenging, particularly in the face of increasingly volatile markets: better asset allocation vehicles would help.
We worry daily about the health of the American retirement system. Our research demonstrates two things: that many of the economic assumptions guiding retirement planning should not be universally assumed and that the best way to respond to changing assumptions is to plan for them, immediately and comprehensively. Certainly, the complexity of the issue makes it difficult to develop a coherent dialogue. But as we enter the home stretch of the run for a new president, we hope that the candidates speak openly about the challenges we face and their plans for addressing them.
Matthew H. Scanlan is managing director and head of institutional business, Americas, at Barclays Global Investors, San Francisco.
