The size of the retirement crisis – and what to do - depends on where you’re standing
By Chip Castille
2014 may be remembered as the year of the retirement crisis. Not the year when retirement funding reached a critical level or when retirement savings rates reached a new low; concerns about the sustainability of the retirement system have been growing for some years. But 2014 is the year when the crisis finally began to move center stage —especially once President Obama made it one of the focuses of his State of the Union address.
Once talk of a crisis begins, the question most people want answered is what to do about it. The President, and many others, have made specific proposals. Rather than consider specific proposals, however, we’d like to step back and look for some important perspective. The first is that the retirement crisis is not a single problem. In reality, it is a wide range of often interrelated challenges that affect different segments of the population in very different ways. And that is actually good news.
The more we can break down the crisis into its component parts, the clearer the actions that we—as providers, plans sponsors and individuals—need to take. A proper perspective, grounded in a sense of where retirement is heading, can inspire both action and optimism. With that in mind, here are five perspectives on retirement crisis management, followed by suggestions on how DC plans can help participants avert their own personal crisis.
1. Grow the economy; shrink the crisis – at least a little bit
Whether and to what extent the Financial Crisis, a sluggish recovery, a less than robust job market and government debt have exacerbated the retirement crisis would require speculation far beyond the scope of this article. Nonetheless, it seems clear enough that a growing economy, along with job growth, can only help.
Consider the expiration date for the Social Security Trust Fund, the date after which Social Security would be able to meet only 77% of its projected obligations from current cash flows1 . What’s often overlooked is that the expiration date tends to move with employment and wages. During a recession, the expiration date tends to move nearer, and during boom times, with increased cash flows into the system, it gets extended. That’s just one example of how a growing economy can take some of the edge off the crisis.
By the same token, economic growth may lead to increased 401(k) participant contributions, larger employer contributions, and reduced leakage in terms of loans and hardship withdrawals. Economic strength can help stabilize pension funds and individual retirement savings. Of course, a cyclical upswing will not solve structural problems or eliminate tough choices, but it can buy extra time and help us make smart choices.
2. Let’s solve TODAY’S retirement crisis – not the retirement crisis of 80 years ago.
The so-called traditional image of retirement, in which our working lives end at the stroke of 65, was defined almost 80 years ago by the Social Security Act. At the time, the expectation was that Social Security payments would be made over the handful of years most people were expected to live after they retired.
Today, however, people are living longer —much longer. Life expectancy at 65 is now close to twenty years2 , placing a burden on a system designed to fund retirements that were less than half of today’s projected length. But that is not the whole story.
While people are living longer, what is overlooked is that people at age 65 are generally healthier today. Many are not only able to work past 65, they want to keep working. The change from an industrial and agricultural-based economy of 80 years ago to a service-based economy extends the scope for meaningful activity well beyond normal retirement age of generations past. That means a 60 year old today has far more human capital (i.e. future earning potential) than his or her counterpart from 80 years ago.
Recognizing that retirement in today’s terms doesn’t necessarily begin at 65 doesn’t “define away” the crisis, but it does change the parameters of the problems we are trying to solve. And the numbers do show an increase in the number of people working past 65. For some, of course, it is an economic necessity. For many others, it appears to be a choice, a chance to redefine themselves in a new phase of their career. Whatever the reason, it translates into more time to prepare for retirement, more time to pay into retirement systems and a shorter retirement to fund.
3. For people currently in retirement, yesterday’s solutions may no longer work.
We suggested at the beginning of this article that the impact of the crisis depends a great deal on where you are standing. The next three perspectives address that directly, beginning with people already in retirement who face a two-fold challenge.
First, greater longevity may require more exposure to growth assets in retirement portfolios. And second, the traditional standby of retirement investing, the core bond fund, faces an uncertain future. Core bond funds have benefited from nearly two decades of declining rates. The prospect of rising rates at some point could potentially undermine total return.
Both of these challenges point to the same conclusion: we need to rethink retirement investing—and that there is a risk to doing nothing. That may mean more equities for increased growth potential. It may mean more actively managed fixed income approaches to find more opportunities. It may even mean thinking about solutions that take investment and longevity risk off the table for individuals.
Whether or not we make changes in our approach is not the point. What is necessary is to reexamine retirement portfolios through the lens of the demographic and economic changes we are currently witnessing.
4. The DC system has evolved and is worth saving – and strengthening.
Decades of practical experience and behavioral finance research have driven the evolution of DC. Today a person entering the work force is very likely to be automatically enrolled in a DC plan, at a reasonable deferral rate and defaulted into a diversified fund.
This is a far cry from the supplemental system of twenty or thirty years ago, with a frequently dizzying array of investment choices. Simplifying and automating plans, we believe, has created a system that gives younger workers an excellent chance at building an adequate retirement savings.
Unfortunately, there has been a tendency for some in the media to focus on the challenges faced by the first generation of DC savers and declare DC a failed experiment. Clearly, the 401(k) was introduced as a supplemental savings plan and grew in retirement importance beyond what many foresaw. This has left many in the generation now approaching retirement facing a very different retirement than they imagined. This has created an urgent social question that needs to be addressed.
But a regulatory overreaction that ignores decades of evolution may only put another generation at risk without solving problems for anyone. DC can be improved. There are global lessons to be learned and applied, and many ways that the system can be strengthened, including regulations to encourage savings outside the DC system. But what is most likely to drive DC forward is the same combination of evolution in the market place and thoughtful government regulation that has helped create a system that has every chance of creating successful retirements for people in mid-career or earlier.
5. Let’s focus on the toughest problem: pre-retirees.
If the first generation of 401(k) savers did not realize how central DC would be to their retirement, then it is not surprising that many find themselves in the last 10 or so years before the traditional retirement age of 65 with inadequate savings. It is this transition phase, which we refer to as pre-retirement, that may be the heart of the Retirement Crisis.
Fortunately, our research shows that the greater clarity pre-retirees have about their retirement readiness, the more willing they are to take action. That means serious conversations and straight talk are absolutely necessary. Whether you are an advisor or a plan sponsor, or whether you are talking to a friend or family member, here are some of the things we need to talk about:
- Focus on what we can control. Yes, there is a broader social problem that needs to be addressed. Meanwhile, pre-retirees need to focus on what they can control—and that is their savings. They need to get serious about maximizing their retirement savings, starting today.
- They need to think about encore careers3. By some estimates, over 9 million people are currently in encore careers. Working beyond the traditional retirement age, either in a reduced way or in a new field, can extend the time to prepare for full retirement. Thinking about potential encore careers now, rather than reacting to economic necessity later, can make the encore rewarding and emotionally satisfying.
Retirement is changing. Some will be better positioned for the changes ahead, while others will need more help and guidance. The better we are able to understand where retirement is going, the more we will be able to take targeted, effective action.