Needed, Now: New Approaches to Financing Old Age

Following the global financial crisis, troubled retirement systems around the world face new challenges that may result in sharply reduced income for retirees — as well as the possibility that younger workers will need to work much longer, according to Wharton insurance and risk management professor Olivia S. Mitchell.

In a recent paper titled, “Implications of the Financial Crisis for Long Run Retirement Security, Mitchell, who is director of Wharton’s Pension Research Council, outlines a series of new risks to retirement stability, from inadequate individual retirement savings to broad global uncertainty, that have surfaced since the financial collapse. Current and future generations will not be able to rely on the “old fashioned” model of providing for retirement by saving during their working years, and must begin to think about new approaches to financing old age, she says. “It’s ironic and sad that as we stand on the doorstep of global aging and the retirement of the baby boom [generation], the system we hoped would support us is looking very fragile.”

Mitchell also serves as an associate director of the Financial Literacy Center, a research collaboration between Wharton, Dartmouth College, and the Rand Corp. Created in 2009 and supported by the U.S. Social Security Administration, the center is researching the roadblocks to financial literacy and gathering data on programs that work. (For a Knowledge@Wharton interview on financial literacy with Annamaria Lusardi, who will lead the new Center, and Michelle Greene, deputy assistant secretary for financial education and financial access at the U.S. Treasury Department, see: “Tackling Financial Illiteracy — and the Costs that Go With It.”)

Numerous government agencies and nonprofit organizations are working on the problem of financial illiteracy with Social Security officials, Mitchell notes. “Social Security feels that it must be the lead on this because it is the biggest government organization focused on the elderly and concerned with retirement security.”

The End of Early Retirement

In her paper, the first level of risk Mitchell identifies is to individuals who have been called on to finance an increasing share of their own retirement as reliance on corporate pensions fades. She notes an alarming lack of understanding about important economic concepts — such as inflation and the value of compounded interest on retirement savings — in the United States and around the world. Saving for retirement becomes particularly difficult for people who lack this sort of basic financial literacy, she points out. The paper cites research showing that, in a nationally representative sample of Americans in their 50s, only 18% understood compound interest.

“Inflation risk is also very much on my mind because I’m concerned we are going to experience very high inflation in years to come,” says Mitchell, who notes that it is often difficult for people to adjust investments to compensate for inflation occurring after they have already retired. One useful asset to include in retirement portfolios in this regard is Treasury Inflation-Protected Securities (TIPS), she adds. The principal of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index. When TIPS mature, investors are paid the adjusted principal or original principal, whichever is greater.

Longevity risk, or the possibility that retirees will outlive their savings, is another issue. Research shows that many people underestimate their chances of living long into old age and, as a result, they fail to save enough money to last for the duration of their lives. Mitchell notes that some British actuaries now model survival to age 125 when pricing insurance contracts; in the U.S., the figure is age 120.

One way to avoid longevity risk is to purchase an annuity from an insurance company that delivers benefit payments for as long as the retiree lives. These plans have faced resistance because of retirees’ unwillingness to turn over their nest eggs to an annuity provider, and because of uncertainty about insurance company stability. The financial crisis has created even more reluctance to buy annuities. In fact, Mitchell says, the highly public collapse of AIG has “cast a shadow” over the insurance industry, even though the company’s problems did not stem from its traditional insurance business. Several life insurers have received regulatory relief allowing them to operate with depleted reserves and others have discussed seeking federal aid, which Mitchell describes in the paper as “a remaining area of concern.”

Mitchell suggests that one way to protect against inadequate retirement savings is to work past age 70 and beyond. Her research shows that if people can defer retirement for two to five years, they can dramatically improve their financial security during retirement. Delaying retirement not only allows workers to save and invest more during the extra years of employment, but it also delays the day when accumulated savings must be drawn down. “For younger generations,” she states, “age 75 might be a good target for early retirement, and later if possible.” In today’s heavily service-based economy, in which relatively few people hold down physically demanding jobs, Mitchell argues that workers can often continue to be employed much longer. She also notes that studies show working longer improves health in later years.

But employers will be most interested in hiring those who remain up-to-date in new skills, so education and retraining should be a life-long process. “Training doesn’t stop after college. One must retrain every year, and not stop at age 50 or 60,” Mitchell notes. “We must rethink the investment process in human capital and skill acquisition, and keep learning over our entire lives.”

Risk at Every Level

Another level of risk the paper addresses is to institutions that oversee private and public pensions. “The financial crisis put into sharp relief some deep problems with corporate pensions,” says Mitchell, who points to General Motors’ $20 billion in unfunded pension liabilities as an example of the magnitude of problems faced by many traditional defined-benefit corporate plans. Her paper notes that many of these plans were invested heavily in equities and suffered severe declines in value during the economic downturn. In the public sector, states and municipalities on average hold only about half of the money needed to meet pension obligations, according to the paper. Meanwhile, government reinsurers established to protect pensions, such as the Pension Benefit Guaranty Corporation (PBGC) in the United States and the Pension Protection Fund in the United Kingdom, are also running into financial trouble. While the PGBC has enough money to cover current retirees, it is not solvent in the longer run, and may require a future “TARP-style bailout,” Mitchell writes. “Pensions as an institution are in bad shape in many countries.”

Individual 401(k) plans will help make up the shortfall for many people, Mitchell continues, but not for others, because this savings vehicle has also been hard hit by the equity market collapse. Meanwhile, she says, behavioral factors — including the tendency to remain heavily invested in employer stock and the failure to annuitize — continue to limit the ability of defined-contribution plans to provide retirement security. “The 401(k) plans are part of the answer, but not the entire answer.”

The financial crisis and sharp decline in equity prices also are challenging traditional thinking about constructing portfolios that call for more risk for younger workers who could benefit from strong gains in the stock market, yet still have time to bounce back from a downturn. Many companies with 401(k) plans have made workers’ automatic enrollments default into the employee’s target retirement date. Funds based on such a “life cycle” model typically have more equity market exposure for younger employees, but then the fund managers rebalance their portfolios toward safer investments, such as bonds, as retirement grows near. “The fact remains that any portfolio heavy with equity in the last year has done very poorly, which is challenging the auto-enrollment strategy into target maturity date funds in the future,” according to Mitchell.

Problems at the national level are also creating threats to retirement income, says Mitchell. When deciding about how much to save and when to retire, it is critical to have some idea about future taxes, inflation and medical care costs, she writes. “But good forecasts are simply not available.” In addition, government retirement programs, such as Social Security in the United States, are creaking under the weight of aging populations combined with revenue shortfalls and higher demand from unemployed workers. She notes that because of the harsh recession, more unemployed people have elected to retire or seek Social Security benefits. As a result, the system is projected to take in less revenue than it pays out this year — a threshold the agency had not expected to cross until 2016.

In addition, Mitchell points out that Medicaid, the federal medical program for the poor, faces new stresses as a result of the economic climate, as well as new provisions of the recent health care reform legislation that mandates long-term care coverage. An economic recovery could reverse the trend for a time, she adds, “but the point is, we’re on the knife-edge.”

Beyond risk at the national level, the financial crisis has shown that the global economy is not necessarily a safe harbor for investment, either. “In the old days, we were taught that we could diversify our portfolios globally and reap the benefits of geographic diversification,” Mitchell says. “Now, we realize with the financial crisis that the tide rises and sinks all boats together. There is simply not as much benefit from global diversification as we once thought.”

Understanding the Math

An important requirement for future retirement security is improving financial literacy, Mitchell says. “If I had it to do over again, I would have started with educating kids from very young ages.” Her research shows that in states where high school students have been provided with mandatory financial literacy classes, the students reach young adulthood with more knowledge and ability to manage key financial decisions — including planning for retirement. These programs are most effective when school districts devote money to support the instruction. “It’s not enough to simply mandate financial education. You also have to put some resources into it.” She adds that she is also concerned about middle-aged workers who lack basic understanding of math and financial literacy, and elderly people who may become increasingly vulnerable to scams.

Mitchell acknowledges that her “message is straightforward and, I fear, not particularly upbeat.” She argues that the financial crisis has made it all the more apparent that retirement systems around the world are in need of major overhaul. “The 21st Century economy requires an entirely new perspective on retirement risk management,” she writes. “We need to build a new framework that will require public and private partnerships to better educate people about the risks they face, to help them work longer, to create and foster new financial institutions and contracts, and to better regulate products and markets for an aging world.”

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