How to survive the coming retirement crisis

In France, pensions are going up in smoke
In France, pensions are going up in smoke
Image: REUTERS/Jean-Michel
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Few things get people to riot faster than pension cuts. Recent protests in France and Chile were largely about retirement benefits. Even if they don’t take to the streets, around the world people are worried they won’t have enough money to retire.

By some estimates, the world is short $400 trillion to pay for its aging population. Chile and France finance retirement in different ways, but suffer from dangerous shortfalls nonetheless.

Chile has a defined contribution (DC) system where individuals contribute to an account and bear the investment risk of financing their retirement. The French government offers a generous defined benefit (DB) plan, where the state pays its citizens a set income each year. Both systems are falling short, because no matter how you finance retirement you can’t escape one fundamental truth; retirement is expensive and there is not enough money for it. Or, at least, there is not enough money to finance the length of retirement at the standard of living people have come to expect. As Baby Boomers retire, they are putting every type of system to the test, and we are all going to have to revise our expectations.

How bad is it?

The retirement shortfall has become more noticeable not only because a large population is starting to retire, but because Baby Boomers are the first generation to retire with individual accounts: the 401(k)-like plans in the US, UK, and Australia, among others. Economists at the left-leaning Economic Policy Institute declared the 401(k) system a disaster, citing 50% coverage rates and low asset balances that won’t cover an adequate retirement.

But to a large extent retirees aren’t worse off compared to earlier generations, and in some cases may be better prepared. The post-war era is often considered a retirement heyday in America, where Social Security was well funded and people got a generous pension from their employer. But, in fact, at the peak only 38% of workers got a DB pension from their employer, so most people relied on Social Security. Now, more than half of workers have access to some form of a retirement plan. Better coverage is why the median retirement savings balance for workers in the US doubled between 1989 and 2016, increasing from $9,300 to about $20,000, adjusted for inflation.

Individual retirement accounts make the shortfalls that always existed with DB plans more transparent. The World Economic Forum defines a successful retirement as ending work in your mid 60s with 70% of your salary for the rest of your life. If that’s the goal, any shortfall reflects the retirement we want, not the one we ever had. Retirement is a relatively modern concept that only went mainstream after WWII. People now live longer and in better health, anticipating spending up to one third of their life retired.

Most countries have a DB or DC pension system, or some combination of the two. Each has its shortcomings and both can be made to work better to provide something close to the retirement people need.

The problems with defined benefit pensions

A large part of the global retirement savings shortfall comes from promises made by DB plans with no money to pay for them.

One of the two ways to finance DB pensions is the funded model, putting money aside today to pay workers in the future. This is how workplace pensions are normally financed, but many employers have not put enough money aside. In the US, the few remaining employers who offer DB pensions are mostly state and local municipalities. Dodgy accounting standards, and sometimes state laws, enabled these governments to underfund for decades. States are trying to make up the difference by investing in riskier assets like private equity, which promise a higher return, but increase the risk of even bigger shortfalls. Funded pensions in the private sector tend to be in better shape because they face more stringent accounting standards. However, low interest rates pose a source of risk because they mean smaller returns and larger estimated liabilities. This has also encouraged investment in riskier assets, which could lead to underfunding if there’s a significant market drop.

Most government-run pension plans, by contrast, are pay-as-you-go, where young workers pay taxes to support current retirees. This system depends on having enough young people to keep the system solvent, and aging populations are a problem. The US Social Security program is set to face shortfalls in 2033. In other countries with generous but unfunded pensions, like Brazil, France, and Italy, retirement benefits dominate GDP and crowd out other services.

Emerging economies with large populations like China and India may turn out to face the biggest problems. Their retirement systems have some of the lowest rankings in a measure of adequacy, sustainability, and integrity compiled by Mercer. China’s pay-as-you-go pension system is set to run out of money in 2035 and coverage is not universal. With its rapidly aging population, Chinese workers face a great deal of uncertainty and insecurity in retirement.

DB pensions, in theory, should provide a worry-free retirement and provide scope to diversify risk across different generations. But promising to pay out a benefit for life, no matter what happens to markets or the population, is very expensive. Employers and governments always have an incentive to underestimate the cost until it’s too late.

The problems with defined contribution pensions

After the costs of DB plans became apparent, many employers and some governments switched to a DC system, where workers save for themselves and bear all the risks. Because nothing is promised, these plans can never be technically underfunded. The bigger concern is the accounts won’t be enough to cover people in retirement. This has caused Chileans to take the street and generated countless articles about a retirement crisis.

But, as economist Andrew Biggs points out, the typical retiree in America is better off than they used to be after firms switched to DC pensions. People have more retirement assets under a DC regime than they did under DB.  Economists estimate that in America retirement income increased about 10%, after adjusting for inflation, for the median retiree between 2000 and 2011, and even lower-income retirees have more than before.  They also estimate that the replacement rate (the ratio of retirement income to working income) has remained fairly stable and the move from DB to DC did not make retirees more dependent on Social Security.

That said, it still might not be enough to match people’s expectations for retirement. The average balance of soon-to-be retirees in America is $300,000 (assuming they have an account), which translates into just $15,000 a year at current interest rates. More worrying is how Americans can pay for their healthcare, since Medicare does not cover everything. Retirees can expect to spend $183,000 in health expenses, but estimates vary considerably.

And that’s not all. The US, Australia, and the UK have not addressed the hardest part of retirement finance. People have saved, but the market does not provide adequate guidance and products on how to spend their money after they stop working. Low interest rates not only hurt DB plans, they also make it more difficult for retirees to manage income risk in retirement.

In emerging markets, like Chile, DC plans also face additional challenges. For many years the assets were managed by high-fee managers who did not get high returns but still took a large chunk of savers’ assets. Many Chileans also work in the informal labor market and did not make contributions, which leaves them with meager savings for retirement. The Chilean case shows that DC pensions work best, in any country, when paired with a modest guaranteed state benefit which provides a sustainable income floor.

What is the solution?

Addressing the retirement shortfall will take a combination of more saving and better financial education. Both households and pension sponsors need to save more.

In a DC system, retirement accounts also need to be made more widely accessible. In the US, only half of Americans have access to them. The recently passed SECURE Act, which makes it cheaper for small plans to offer retirement accounts and all DC sponsors to offer annuities, is positive step. Australia offers a good model, where accounts are mandatory and saving rates are high.

Where DB plans still exist, an aging society means pre-funding is a better model. Pensions also need to be subject to better accounting standards that require them to account for risky investments.

The bigger issue may not be related to generating an adequate income, but paying for long-term care. As people get older their odds of developing dementia increase. No country has figured out a good way to pay for long-term care without putting a large strain on families who often end up acting as primary caregivers. We also need to accept many people will have to work longer. Retiring at 62, or even 68, may not be realistic. This doesn’t mean that we all need to work full-time into our 70s, with contract or part-time gig work potentially providing a bridge to make a full retirement more possible.

Here’s the scariest thing: even in the best-designed systems, almost no one today will earn enough money in their lifetime to not work for 20 or 30 years at the end of their life. This is true no matter who pays for retirement—the individual, their employer, or the government.