Reforming retirement systems is a more urgent imperative globally as the coronavirus pandemic claims jobs, lowers economic growth and investment returns, and threatens to choke funding for already underfunded pension plans. The pandemic is also hastening the imminent insolvency of the Social Security Trust Fund in the U.S., a recent report by the Penn Wharton Budget Model has found. In two recession scenarios the report laid out, the trust fund would run out of money in 2032 or 2034 – between two to four years earlier than pre-pandemic projections.
But there is still hope for retirees, if policymakers, employers, and plan sponsors can purge retirement systems of their drawbacks and bring new financial products to fund them, according to a recent research paper by Olivia S. Mitchell, Wharton professor of business economics and public policy and executive director of the School’s Pension Research Council. Retirement systems must also provide for the long-term care needs of retirees, and build on recent moves to cover “gig economy” workers or freelancers, part-timers, and temporary workers, her paper stated.
Mitchell’s paper breaks down the to-do list into two broad categories: the “accumulation” state when pensions are funded, and the “payout” stage when retirees can begin to draw from their accounts.
Fixing the ‘Accumulation’ Stage
For the accumulation stage, to begin with, Mitchell called for separating pensions and health care from employment. That would dramatically expand coverage to all citizens, irrespective of whether or not they hold a job. The 2019 SECURE Act helped remove a related obstacle by allowing firms to band together to offer benefits to employees who may work for multiple employers.
Next, with retirees living longer, they can better fund their golden years if they also delay their retirement and work longer, she wrote. Retirement plans could be tweaked to incentivize delayed retirement, she added.
The way pension systems are designed also needs reforms. The trend of retirement systems moving away from defined benefit plans to defined contribution plans will continue to gain more traction, Mitchell noted in her paper. Defined contribution plans shift more of the onus of funding pensions to the beneficiaries, instead of saddling employers or plan sponsors entirely with that responsibility. In defined-contribution plans, a worker’s contribution is often matched by an employer contribution.
As of 2019, defined contribution plans held more than half of the $47 trillion in global pension assets, according to estimates by other researchers. Employers don’t have to bear the risk of underfunding in defined contribution plans, as the plans’ assets are made up of what they and their workers deposit, along with investment earnings, Mitchell wrote.
“If real returns remain low for years, it will be critical for workers to save far more than they did in the past to cover their golden years.” –Olivia S. Mitchell
Also, defined contribution plans allow employees to manage their investments, but this can bring risk, “given global financial illiteracy,” Mitchell cautioned. In order to overcome those limitations, many plan sponsors adopt so-called “target date funds” where portfolio allocations are aligned with the employee’s expected year of retirement, or “target date.” In the U.S., target date funds are typically the default option for plan sponsors. Nevertheless, Mitchell called for a reexamination of target-date funds, too, because even they can also have shortcomings. For instance, they do not protect retirees against “longevity risk” — the chance of outliving their asset base.
How pension plan sponsors invest the contributions, or make portfolio allocations, is critical to the funding of plans, and so that also needs fresh approaches, according to the paper. Employees and retirees could also find useful advice in portfolio allocations from fin-tech firms and robo-advisors, or algorithm-based financial advice, the paper stated. Mitchell also highlighted the role of financial education programs to strengthen financial decision-making among retirees.
Many defined-benefit plan sponsors have invested in risky assets including equities, hedge funds, and alternative investments, and the returns from those have fallen short of the benefits promised to retirees.
The decreasing returns on investments by plan sponsors could be offset by higher contributions from beneficiaries, Mitchell proposed in her paper. “If real returns remain low for years, it will be critical for workers to save far more than they did in the past to cover their golden years,” she advised. A new retirement saving system could also include features such as automatic enrollment by employees in pension plans, and automatic escalation of contribution rates.
Fixing the ‘Payout’ Stage
In planning for the payout stage, beneficiaries could convert their retirement accounts into annuities, so that they get a pre-determined annual payout, while also protecting themselves against outliving their pensions, Mitchell noted. In fact, many countries mandate doing so, and even a 10% allocation into annuities helps greatly, she pointed out in her paper. She also recommended that integrating annuities be part of plan design from the outset, for instance in the context of a target date fund, as it can be difficult to add annuities after people retire.
Policymakers around the globe could help strengthen retirement systems in several ways, according to Mitchell. First, they could help generate and make available “better quality and more granular data” on mortality and morbidity patterns. Such data will help insurers factor in longevity risk when calculating annuity premiums.
Second, they could help develop “a consistent and economically coherent set of guidelines” for measuring and forecasting social security and pension assets and liabilities through time. Also useful would be mechanisms to better assess the long-term care needs of an aging population.
Third, retirement systems could do more to encourage delayed retirement, by undoing practices that set relatively young retirement ages to qualify for benefits. This is most useful when paired with policies that discourage employers from hiring older workers, the paper stated.
Agenda for Policymakers
Delinking the provision of benefits from employment and extending benefits to gig economy workers were other important areas where Mitchell saw roles for policymakers. Some firms such as Uber and Lyft are changing the status quo by helping drivers obtain low-cost insurance, she noted. Policymakers in many cases have responded to workers’ needs in the aftermath of the pandemic, including facilitating sick leave policies for those who fall ill or have to take care of unwell family members, she added.
More broadly, policymakers could help strengthen social safety net programs that provide unemployment benefits, housing, medical care, and food security, the paper suggested. Mitchell cited efforts by Denmark in subsidizing 75% of the wages paid to workers at firms hit by the pandemic, and by Germany to extend loans to affected firms and thus help them stave off bankruptcy.
“The patchwork of state-based unemployment insurance, Medicaid, and food stamp programs in the U.S. has made it nigh impossible for millions of workers to file for payments, and many others have discovered that they are simply ineligible.” –Olivia S. Mitchell
“By contrast, the patchwork of state-based unemployment insurance, Medicaid, and food stamp programs in the U.S. has made it nigh impossible for millions of workers to file for payments, and many others have discovered that they are simply ineligible,” Mitchell points out in her paper. She cited other research which highlighted that that informal sector workers in Asia and Africa appear to be particularly at risk “with limited coverage of social insurance and many [living] hand-to-mouth.”
A Stage Set for Clashes
These reform proposals are set against the backdrop of rising tension between governments and retirees. Cash-strapped governments are eying retirement funds with an interest in using them for revenue, while retirees are concerned with how to finance their later years.
In the U.S., many employees make their contributions to 401(k) retirement accounts from their pre-tax earnings, but then they pay taxes when benefits are drawn during retirement.
In recent years, some policymakers have sought to levy taxes up front on contributions, known as “Rothification.” Advocates of such a policy note that the government currently “forgoes” about $100 billion in annual taxes on pre-tax contributions. “Some of that does come back later, when people retire and pay taxes on their benefits,” Mitchell said in a recent Knowledge@Wharton article.
The push to tax retirement contributions up front poses other risks as well, according to a research paper Mitchell coauthored with Raimond Maurer and Vanya Horneff. “Moving to a system that taxes pension contributions instead of withdrawals will lead to later retirement ages, particularly for the better-educated. It would also reduce work hours and lifetime tax payments and increase consumption inequality in retirement,” the researchers wrote.
Why the Urgency
The present time is right to revisit retirement systems, according to Mitchell. In her paper, she traced how the pandemic “changed everything” from the optimism that prevailed in the first few months of 2020. “Amid the pandemic’s spread, capital market values shuddered, health care systems staggered with millions of infected patients, joblessness shot up, retirement funding shrank, government tax revenue contracted, and unprecedented government spending had become the new normal,” she wrote. Research she cited estimated that global stock markets lost about $20 trillion in March 2020. Poorer nations will feel the economic pains more, since their health care systems are ill-equipped and their national budgets are strapped for funds, she said.
“Even before the coronavirus emerged, personal and pension savings systems around the world were actually facing deep challenges.” –Olivia S. Mitchell
Retirement systems will become increasingly important as a source of income as declining fertility and rising longevity will continue to spur the growth of aging populations around the world, she added. She cited estimates by the World Economic Forum that the retirement savings gap will grow by 5% each year to reach $400 trillion by 2050.
“Even before the Coronavirus emerged, personal and pension savings systems around the world were actually facing deep challenges,” Mitchell wrote in her paper. Retirees in developing countries face more serious problems because many of them are not covered by retirement systems, she noted. She attributed that situation to factors including informal labor markets, distrust in government and financial institutions, and lack of financial literacy.
Many of the most troubled pension systems around the world are of the “defined-benefit” variety, where benefits are based on a worker’s earnings and years of service. These plans have experienced worsening underfunding as the working-age population has shrunk: In the U.S., for instance, the employment to population ratio fell from 60% in January this year to 52% by April, the paper noted. Partly as a result, benefit payments have exceeded revenue projections. Many plan sponsors have also failed to make their share of the contributions, exacerbating the underfunding.
Mitchell’s paper lays out stark statistics to capture the depth of the funding gaps. At last count, before the pandemic hit the stock markets, public sector defined benefit plans in the U.S. were underfunded by $4 trillion, and the pandemic has seen funding drop from 52% to 37%. U.S. corporate defined benefit plan underfunding ballooned from $329 billion at the end of 2019 to $619 billion by March 2020. Even the Dutch retirement system, considered to be the one of the world’s best, has seen its funding rate fall from 105% to 70%, according to the paper.