America’s Broken Retirement System?

Knowledge@Wharton recently put out a research comment, The Time Bomb Inside Public Pension Plans:
Sanitation workers, firefighters, teachers and other state and local government employees have performed their duties in the public sector for decades with the understanding that their often lackluster salaries were propped up by excellent benefits, including an ironclad pension. But Moody’s Investors Service recently estimated that public pensions are underfunded by $4.4 trillion. That amount, which is equivalent to the economy of Germany, accounts for one-fifth of national debt. It’s a significant concern for public employees who were banking on a fully funded retirement to get them through their golden years.

But the issue has wider implications for all taxpayers, who likely will be tapped to make up the shortfall. The Knowledge@Wharton radio show, which airs on Wharton Business Radio on SiriusXM, asked two experts to explain how governments dug themselves into such a deep hole — and whether they can ever get out. Olivia Mitchell is a professor of business economics and public policy at Wharton. She’s also director of both the Pension Research Council and the Boettner Center on Pensions and Retirement Research at the school. Leora Friedberg is a professor of economics and public policy at the University of Virginia’s Frank Batten School of Leadership and Public Policy. The following are key points from their conversation.

Not Enough time, Not Enough Money

There are plenty of reasons why state and municipal pensions are sorely underfunded, and those reasons sound unnervingly familiar. Mitchell and Friedberg ticked off a list of ingredients reminiscent of other financial stews, including the collapse of the housing market. Like that event, the pension problem has been simmering for decades. Government administrators believed their investment returns would be bigger, and they believed retired employees would die sooner. They used overly optimistic actuarial assumptions, and they thought the long-term nature of the investments could handle higher risk.

They were wrong.

“It seems like there’s enough blame to point to everyone,” Mitchell said. “All of those different approaches proved wrong, especially after the financial crisis where state and local pensions lost 35% to 40% of their money. It’s true that things have been doing a little bit better in terms of their investments, but still the fundamental flaw is that over the years employees were offered a future benefit that was not properly collateralized.”

Mitchell said the problem is worsening because state and local governments have neglected to take corrective action.

“Every year that goes by leads to more red ink and more concern because the state and local plans across the country have clearly not done what they should have done to contribute the right amounts, to invest their assets in their pension plans carefully and thoughtfully,” she said. “Older folks are living longer and needing more medical care, needing longer retirement benefits. It’s a series of challenges that, frankly, nobody is paying much attention to.”

Friedberg said the problems with pensions are often inherent in the system, and they only compound.

“There aren’t strong incentives for the governments to actually take care of this … before it becomes a problem…,” she said. “After years of underfunding, some combination of taxpayers and state and local government workers bear the cost of that. We’ve already seen that going on for the last 10 years.”

In addition to the pension overhang, Friedberg noted, many states also face health insurance obligations that they aren’t adequately funding. Elected leaders are forced to increase taxes or cut spending to balance budgets thrown out of whack by pension debt, and the public workers are often vilified in the process.

“Politically, that ends up easier than dealing with the funding,” Friedberg said.

Money Problems Run Deep

Mitchell and Friedberg warned that the pension hole will swallow public- and private-sector employees alike, because all income earners will pay for it. Mitchell ran a simple calculation to illustrate her point: If the shortfall were $5 trillion, divide that amount by the 158 million workers in the American labor force for an obligation of about $32,000 per worker.

“That gives you a concrete sense of the shortfall that we’re facing,” she said. “A lot of people don’t have $32,000 for their own retirement, much less to pay for state and local workers.”

Mitchell also said that governments are probably underestimating pension debt because they are allowed to use whatever actuarial assumptions “that they feel like without any oversight from the federal government.” While states and municipalities are reporting that they are 72% funded, the real rate is closer to 45%, she said.

Broaden that to the federal level, where the impending shortfall in Social Security is well-documented, and the scope of the problem grows. Instead of $32,000 per worker, it’s about $171,000, according to Mitchell.

“I think the problem is one of political non-transparency and also of population aging,” she said. “You keep running unfunded or underfunded plans as long as you have a growing workforce. Our workforce is not growing as quickly as it should be or could be. Our productivity is not what it could be, and what it means is we are going to be supporting more and more retirees on fewer and fewer workers. That gets very expensive quickly.”

Save Your Pennies

The professors have some advice for public-sector workers who are counting on a pension — don’t.

They said workers should take control of their own retirements by saving often and early.

“I think they need to be aware that the benefits they’ve been expecting may not be there,” Friedberg said. “It depends on those states and how tight those legal obligations are. In some states, it’s written into the constitution. In other states, it’s not. And it’s not legally protected by the federal government in any way as private-sector pensions are.”

Governments sometimes manage pension debt by cutting benefits, postponing cost-of-living adjustments or extending the vesting period. Many states are also starting to require employee contributions, similar to a 401k.

“There’s some advantage to that because it makes workers aware of their own savings and it familiarizes them with investment in the stock market,” she said. “But we know from the history of the private sector and moving away from defined benefit plans toward 401ks that voluntary contributions often fall well below what workers need to replace their recumbent retirement.”

Governments have turned to other coping mechanisms, including shedding employees before they are vested or not filling vacant positions.

“I think it is undercutting the competitiveness of the public sector as a place of employment,” Friedberg said. “It was already the case that pay was often lower for comparable jobs, especially for high-skilled workers. The promise of the pension benefit was supposed to make up for that. If that promise is no longer being fulfilled, talented people will certainly go elsewhere.”

Indeed, some cities and states have turned to outsourcing items once thought of as strictly in the public domain. Mitchell pointed to the privatization of prisons and emergency services as examples. Governments that outsource don’t have to deal with a pension payout at the end of a worker’s career.

But those measures still aren’t enough, Mitchell said.

“The bigger issue is the so-called hidden borrowing problem that, when folks that hired teachers and firefighters and so forth 30 years ago, they didn’t pay them the full amount that would make their salaries as well as their pensions robust,” she said. “Instead, they underfunded the plans, leaving today’s taxpayers to pay for services that were rendered 30 years ago.”

Start with Transparency

Mitchell and Friedberg strongly believe that governments need to be more open with employees, citizens and investors about how they handle their pension plans. In turn, those stakeholders need to engage.

“I think the place to start is to begin with transparency,” Mitchell said, citing federal regulations that require corporate plans to report their financial promises and set aside money to meet those obligations. But decentralization means the federal government has no power to compel states to report liabilities and assets or to follow similar protocols.

Mitchell reiterated the point that, ultimately, everyone will pay. She referred to a recent study that contended property owners will be held responsible for unfunded liability through what could be considered a “stealth tax.”

“Twenty percent of your property value is already going to be liable to be covering these state and local pension shortfalls,” Mitchell said. “So, you can sell and move out of Chicago or Detroit, but there’s already that capitalization of the underfunding in the value of your house.”

Friedberg said insolvency comes down to constitutional issues. Citizens need to start asking the right questions, because it’s easy for politicians to “pass the buck.”

Sharing a personal example, Friedberg noted that her home city of Charlottesville, Virginia, operates its own pension fund for police and municipal workers.

“There’s not much information about it, so it’s hard to know [how it’s performing],” she said. “I’d be happier if the city of Charlottesville didn’t have to do this very complicated financial operation of running a pension fund.”

The professors agree that many of the proposed solutions being floated are unlikely to fill the pension hole because the only way to get bigger investment returns is to take on greater risk. The stock market is just too volatile for that.

“There’s no magic investments that states can make here to recoup the money. Just like we saw with the financial crisis, high risk means that at some point there are going to be big declines and they won’t be able to pay their bills,” Friedberg said. “The other problem with bonds is it pushes the problem off to the future, then it makes it harder to understand what the future obligations are.”
Wharton's Olivia Mitchell and Leora Friedberg of the University of Virginia discussed the $4.4 trillion public sector pension shortfall in a podcast which is available here. Take the time to listen to it.

I agree with the points raised by the professors. State and local plans have done a lousy job managing these public pensions and the federal government has no say in how they manage these pensions or how they estimate their liabilities using rosy investment forecasts that will never materialize.

I'm going to add to the discussion, however, because there are solutions to the looming pension crisis that need to be brought forth. These are structural solutions to shore up these plans over the long run:
  1. Eliminate contribution holidays, make them constitutionally illegal no matter how well funded the plans are.
  2. Stop using rosy investment forecasts or 20-year inflation averages to discount future liabilities. US public pensions need to get real, the 10-year Treasury yield now stands at 2.88% which tells you at best, you'll be lucky to earn 5%-6% annualized rate-of-return over the next ten years (and that's assuming there's no major bear market in stocks which lasts a couple of years). 
  3. Implement Canadian governance model: There's a reason why Canada's pensions are in great shape, they are overseen by independent and qualified boards that operate at arm's length from the government and they pay their senior pension executives extremely well to manage public and private market assets internally. While some think this is a gravy train, the long-term results and more importantly, the fully funded status of Canadian public plans speak for themselves.
  4. Adopt conditional inflation protection so the plan's risk is equally shared among active and retired workers. In Canada, when public pensions run into trouble, they share the risk by increasing the contribution rate and cutting benefits (typically by partially or fully removing  inflation protection) until the plan's fully funded status is restored. This is trivial cut to pensioners' payments but it's meaningful in terms of shoring up a plan, especially when there are as many or more retired members than active workers. Conditional inflation protection has the added advantage of making a more mature plan like the Ontario Teachers' Pension Plan young again.
One last piece of advice, avoid shifting public sector workers to a defined-contribution plan at all cost, that's not a real pension, it's a recipe for disaster because the brutal truth on DC plans is they're too vulnerable to the whims and fancies of volatile stock markets and will expose millions of workers to pension poverty down the road.

What else? The problem in the US isn't just public pensions, private pensions aren't doing well either despite the "longest bull market in history" (such nonsense, take away global central banks pumping liquidity like crazy in these markets so corporations can continue buying back shares at a record pace and it would have the shortest bull market in history).

Fidelity likes pointing out that the number of 401(k) plan millionaires hit a new high, making it seem like everything is fine, but the truth is there is a lot of pain out there, especially among America's seniors, many of which are declaring bankruptcy in their golden years.

In fact, Lynn Parramore, Senior Research Analyst at the Institute for New Economic Thinking, recently interviewed professor Teresa Ghilarducci, Chair of the Department of Economics at The New School’s New School for Social Research and a nationally-recognized expert in retirement security on why America’s broken retirement system is a recipe for political chaos:
As stocks go up and unemployment comes down, an increasing number of older Americans find themselves dodging bill collectors and spiraling into debt. Many warn of severe economic repercussions if this continues. But there’s more—large swaths of downwardly mobile seniors who thought of themselves as middle class is also a recipe for political chaos. Economist Teresa Ghilarducci, an expert on retirement security and Director of the Schwartz Center for Economic Policy Analysis at The New School, explains what’s happening and what’s at stake if we don’t fix it.

Lynn Parramore: A new report shows that American seniors are filing for bankruptcy at three times the rate that they did in 1991. But headlines say the economy is humming. Why are older people so broke?

Teresa Ghilarducci: The rise of the elder bankruptcy rate is no surprise, even if unemployment is low and stock values are up. Poor elders have terrible job prospects and very few households hold significant amounts of stock, bonds, and other financial assets. The erosion of retirement income security started decades ago.

LP: Can you explain what happened?

TG: In 1983, Congress and the President [Reagan] decided to restore Social Security solvency by cutting benefits and raising revenues equally. The FICA tax [Federal Insurance Contributions Act tax] was raised slightly and benefits were cut by raising the age people can collect full benefits from 65 to 70.

LP: As a Gen-Xer, that has always stuck in the craw because those years of collecting Social Security were taken away before I was old enough to vote!

TG: That’s correct. Though the political principal of equal revenue boosts and benefits cuts sounded fair, it was a nonsense way to make policy. Cutting the solution in half makes as much sense as King Solomon’s solution to cut the baby in half.

In 1983, the system needed much more revenue and not benefit cuts since there was no sign that voluntary actions by employers and workers would make up for the cuts. “Raising retirement ages” is a benefit cut. People can collect Social Security at age 62 and for every year they wait until 70, benefits increase on an average 6.34% per year. Therefore, those who can wait get a large boost and those who have to collect before 70 have a lifetime cut of over 11%.

Also, all the signs that private plans would fail were right. Instead of employers making pensions more available, generous, and widespread, more and more companies shifted financial risks of retirement savings to workers through a cheaper and less generous kind of pension: the 401(k).

Despite the hope that the do-it-yourself retirement accounts—401(k)-type plans and individual retirement accounts (IRAs)—would mean more workers would have some source of income besides Social Security, the retirement plan coverage rates of prime- aged workers has fallen from about 70% to close to 50%.

LP: So half of all workers don’t have a retirement account of any kind?

TG: That’s right. Another sign our retirement system has failed is that the median account balance of all people—including those who have an account from their current job or a past job; no account at all on the eve of retirement (age 55-64); or people who worked a full career under the defined-contribution employer pension revolution with ever-increasing tax breaks—is only $15,000. The low median account balance is because half of older workers have no retirement account balances at all, no 401(k)-type plan or IRA.

Let me repeat: almost half of all workers nearing retirement age will have nothing but Social Security to rely on.

For the lucky half who have some account balance in a 401(k) type plan or IRA, their median balance is $92,000. Spread that amount over a person’s retirement life and it will pay for a cheap dinner and a movie once a month.

LP: What’s going to happen if large numbers of people run out of money in retirement?

TG: If we do nothing to reform the current retirement system, the number of poor or near-poor people over the age of 62 will increase by 25% between 2018 and 2045, from 17.5 million to 21.8 million. That means real hardship and expensive responses by state and local governments through emergency housing, food assistance, and Medicaid costs.

There is another effect if we do nothing that could have serious political ramifications: middle class workers becoming downwardly mobile. Inadequate retirement accounts will cause 8.5 million middle-class older workers—a whopping 40% of all middle class older workers (aged 55-64) and their spouses—to be downwardly mobile, falling into poverty or near poverty in their old age. This is unprecedented since Social Security was formed.

Boomers and G-xers will do worse than their parents and grandparents in retirement.

LP: What do you say to those who argue that the answer if for people to just work longer?

TG: Working into your mid-sixties and beyond is not going to save many people from poverty and downward mobility. The unfriendly labor market for older workers with low incomes and nonprofessional degrees tells a different story.

My research lab’s report documents the growth in older workers’ unstable and low-wage jobs from 2005 to 2015. By 2015, nearly 25% of older workers were in bad jobs—defined as those that require on-call work and low-wage traditional jobs that pay less than $15,000 per year. The share of workers ages 62 and over in bad jobs grew from 14% in 2005 to 24% in 2015.

LP: The American workplace is changing, with union membership in the private sector in the single digits, earnings of workers lagging behind gains in labor productivity and temporary, contract, and on-call work on the rise. Meanwhile, fewer workers get health or pension benefits through their jobs. How are we supposed to save for retirement in these circumstances? What ideas are out there?

TG: Richard Thaler just won a Nobel Prize for his work in behavioral economics, which has been very influential in shaping thinking on pension policy.

He advises that the government engage in “libertarian paternalism.” Instead of mandating pension coverage, Thaler proposes voluntary design changes to the current U.S. “do-it-yourself” system, which is spotty because it is voluntary on the part of employers and employees and requires individuals to direct their own commercial accounts.

But his “design” suggestions are more of the same. He proposes to have employers automatically enroll workers in a retirement plan the employer may (or may not) sponsor. Remember, less than half of employees have a retirement plan offered at work. Workers could opt out and many of the people who need coverage the most opt out for economic reasons, for instance women, and never get an employer contribution.

The second major design change he wants is voluntary “auto-esclation.” The idea here is that employers would automatically contribute all or a portion of their workers’ salary increases in their account. Unfortunately, auto-enroll and auto escalate only works for employees with stable jobs, no breaks in service, continual raises, and high incomes. According to many studies, one from the Urban Institute and a recent one of mine with graduate student Ismael Cid-Martinez, these voluntary features ensure that the tax breaks for retirement plans disproportionately go to the top 20% of workers.

The current voluntary, individual-directed, commercial system design leaves low and middle-income workers behind. Why? Because employers don’t want the expense and hassle of providing a retirement account to workers and may be afraid to offer one if their competitors don’t—a classic collective action problem. Unfortunately, unions are too weak to help employers coordinate and universally provide pensions.

LP: So despite his Nobel Prize, you think that Thaler has got it wrong. How would you help people save?

TG: I propose a retirement plan for all plan — a federal plan that mandates a prefunded layer on top of Social Security. A universal public option for retirement saving. The plan would be portable, accountable, low-fee, pooled and ensure a steady return. A mandated pooled plan is the best way to provide social insurance because no worker can go it alone or insure against employment, financial, investment and longevity risk by themselves.

The idea is to enhance the best features of the decentralized system while making up for its deficits. Hamilton James and I propose Guaranteed Retirement Accounts (GRAs) in our 2018 book Rescuing Retirement. A version of the same proposal was in my 2008 book (When I’m Sixty Four) and in a paper I published for the Economic Policy Institute in 2007. GRAs are universal individual accounts whose investments are pooled and they are funded throughout a worker’s career by employer and employee contributions and a refundable tax credit.

If the GRA plan were implemented today, we could prevent over 8 million elders from falling into poverty. But GRA wouldn’t be enough; we need a stronger Social Security system.

LP: Important that you also mention the need to expand Social Security. Can you explain how it would be possible? What do you say to people who argue that “we can’t afford that” or that Social Security is “running out of money”?

Social Security is fully funded until 2034. The Social Security Board of Trustees estimates that we will only be able to pay three-fourths of current benefits promised after that date if there are no adjustments. That is not insolvency or going broke. It is a potential shortfall, which depends heavily on wage growth and inequality, productivity, fertility, and immigration.

Social Security is designed to be updated periodically, so as time goes on it is always “running out of money” unless it is updated. The FICA tax has been increased 21 times in its 83-year-old history, typically every 2 years. But we have not increased the FICA tax in over 28 years! It’s time for a raise. Right now, the tax rate is 12.4%, split between employer and the employees. If we raise the FICA tax now to about 15%, the system could pay promised benefits for about 75 years. If we raise the earnings cap (now only $128,700) for Old Age and Disability insurance (Medicare tax is on all earnings) then we have revenue to raise the special minimum benefit for the poorest elders and prevent abject elder poverty.

The Social Security Administration has identified the impact of several major proposals to expand and strengthen Social Security—most involve revenue raises.

The reality is that we need both an enhanced Social Security system and an advanced funded layer. No country has provided a stable pension system just on a pay-as-you-go system. The Spanish, Greek, and Italian systems tried but they have moved away from a pay-as-you-go system as their aging populations cause the tax rates to rise to unsustainable political levels.

LP: What are the biggest obstacles to addressing the looming crisis and what are your thoughts on how to overcome them?

TG: Relying on personal thrift to ensure against the financial insecurity of old age has not worked. But the biggest obstacles to mandating a retirement account for all and improving Social Security are members of the industry that thrive on voluntary do-it-yourself retirement accounts. The 401(k) and IRA industry will be challenged by the existence of low cost and high return stable GRAs that offer low-cost lifetime annuities. The industry has fought the efforts at the state level to provide public retirement plan options.

I hope that America is not locked into an extreme, voluntary, market-based retirement income security system.

The most important obstacle to change is political. Workers and, by extension, older workers, need to act collectively and militantly to spur policymakers into action. Only large scale collective action with voting and organizing can get our representatives to build a system that ensures that the retired can live financial comfortable and stable lives.
What a fantastic interview, one that opened my eyes to the origins of the problem and what needs to be done to fix a broken retirement system. I thank Suzanne Bishopric for sending it to me.

Teresa Ghilarducci is a very smart lady who understands the problem well. I don't agree with the revolutionary retirement plan she has been peddling along with Blackstone's Tony James because while it has some advantages over the current system, it's still way too beholden to public markets.

I agree however that's it's high time for a universal pension but I'd like to see radical reforms in Social Security to enhance it and make it more like the Canadian system where the CPP Investment Board manages the assets of the Canada Pension Plan at arm's length from the government, investing across global public and private markets.

In order to fix America's broken retirement system you need to increase Social Security benefits now and fix the system to make it better and more sustainable over the long run. This should involve some form of shared risk when it runs into trouble.

To increase Social Security benefits, you need to increase taxes on the top 1% of income earners and that's where politics comes into play.

For decades, the super-affluent were able to buy Congress to advance their agenda but the limits of inequality are being tested and if Teresa Ghilarducci is right, older Americans will mobilize to advance their agenda, and top of that agenda will be to increase Social Security benefits.

If we don't increase Social Security benefits, more people will fall into pension poverty, economic growth will be anemic, deflation will rear its ugly head, and then it's game over for capitalists and labor.

Chew on that thought as you ponder America's broken retirement system.

Below, Teresa Ghilarducci explains why it's time to kill 401(k) plans and replace them with guranteed retirement accounts (GRAs). And Tony James, Blackstone president & COO, talks about his proposal to tackle the looming retirement crisis in the US by replacing the traditional 401(k) with guaranteed retirement accounts.

I disagree with James, think enhanced Social Security based on the Canadian model (CPPIB managing CPP assets) is enough to fix America's broken retirement sytem but you need to raise taxes on the Jameses, Schwarzmans, Gates, Bezos of this world -- basically the power elite who govern the country -- and introduce real, independent governance models to ensure the solvency of Social Security for generations to come.