Harry Smorenberg and Pieter Kiveron outline the options for “honest and open” solutions to America’s growing pensions problem.
National debt in the US has reached astronomical levels, while the political arena is sharply divided and incapacitated by a general sense of paralysis and apathy. Unfortunately, however, the fiscal cliff was only one of the problems facing the country, as the enormous gap in many people’s retirement provisions will create major difficulties for two generations to come. This, too, has become something of a taboo subject, and one people would prefer not to talk about. Indeed, leading national research institutes have even produced figures to show that the country’s retirement provisions are adequate. Regrettably, however, the reality for the US is different.
Retirement awareness among Americans has fortunately increased considerably in recent years. Although much of the population (32%) is still relying on Social Security to provide a basic income in retirement, the vast majority of the working population is now building up some form of a retirement account.
Adequacy still far away
Many people are going to be affected by the huge pension gap that has arisen, with a figure of $6.6trn (€5trn) being quoted for 2010, according to the Center for Retirement Research at Boston College. Over the next two generations, there will be many more ‘new poor’ in retirement. Relying solely on Social Security will be difficult, and many people will have little option but to carry on working for longer. This is already being seen in the increasing numbers of retirees returning to the workforce.
The government could respond by introducing special tax breaks to make it easier for older people to stay in the workforce longer. However, these older employees will compete for jobs with younger people entering the labour market, and possibly trigger a generational conflict. Whatever the case, and wherever possible, younger people will also have to provide more care for older members of society.
Ageing is in any event still very much an under-acknowledged issue, with the workability index showing that active participation in the labour force may rise as high as 70-72%. This will obviously require changes in the working environment, including technological and educational changes, as well as greater support and flexibility, and efforts to persuade people to accept different career patterns and outlooks.
Schools, employers and governments all have a part to play in creating a new momentum to encourage people actively and passively to continue working for longer. Citizens themselves also need to take control of their lives and accept their responsibility for ensuring sufficient financial continuity. That way, ‘pensions’ will become an outdated concept. Individual lifecycles will in future comprise more swapping between activity and inactivity to accommodate periods of study, periods of caring for children or other family members, career reorientation and shorter periods of working.
Achieving a better future?
The main aim must be to achieve greater diversity in retirement build-ups, as outlined in the five-pillar model proposed by the World Bank. Pay-as-you-go systems are of limited use in an ageing society, as active participants will be unwilling to continue paying for retired participants to an unlimited degree. Fully funded systems, on the other hand, are expensive. Effective cost management is vital as a 1-percentage-point increase in costs translates into 30 percentage points less pension.
Thanks to the increasing transparency of corporate retirement plans, the costs of these schemes for participants are falling. Still more can be gained by maximising the use of group schemes rather than individual products, as the differences between corporate retirement plans and third-pillar products such as IRAs show.
A proper understanding of retirement plans is also needed to achieve transparency. This starts in the home and at school, where Personal Finance and Economics should be a compulsory subject. More cohesive and integrated financial planning will also help. This could mean aggregating all the information individuals need to plan their future, including details of their retirement account build-up, current financial contracts, investments, home ownership and savings. All in the form of a simple standard overview showing where they stand and made available to them at the location of most relevance to them. This will demand intensive collaboration and standardisation among all parties involved, while this crucial information can also best be presented outside a competitive commercial environment.
The rapid switch to defined contribution (DC) plans has shown, both in the US and Europe, that people can easily get lost in a sea of information and need to be protected against risk and certainly also persuaded of the need to continue contributing to their retirement provisions. A degree of liberal paternalism will be helpful in protecting citizens against the dangers of building up too few reserves or starting to draw down their retirement provisions too early. Elements such as auto-enrolment, auto-escalation and the qualified default investment alternative (or lifecycle investments) have proven their value in practice. At the same time, however, specialists warn that over-reliance on such automatisms as these can make participants lazy.
The US government is very aware of the important role it has in setting the playing field and the rules applying. It has also shown it is not afraid to change the rules during the game. In 2006, for example, the rules on employer contributions were tightened in the Pension Protection Act signed into law by president George W Bush, while senators have also sponsored proposals to repair discrepancies in existing legislation. These include the Shrinking Emergency Account Losses Act, designed to counter various forms of leakage from 401(k) plans.
It may now be time to adopt (or go beyond?) the approach deployed by Sweden when it decided in the early 1990s that existing defined benefit (DB) plans had become unsustainable and that DB-based pensions should be preserved only for those born before 1979, with DC plans becoming the standard for anyone born in or after that year. The Swedish state pension is earnings-related, with years worked giving an entitlement to ‘points’ that determine the extent of any supplementary pension. The value of each point is set annually, based on the economic conditions and life expectancy rates of those retiring in the relevant year.
The US emphasis on individual freedom of choice allows little scope, however, for government involvement in compulsory pension plans, and there is no meaningful support for a wide-ranging system of compulsory pensions such as in the Netherlands. In that respect, the Australian system may be a better example for the US to follow. The government of prime minister Paul John Keating introduced compulsory Superannuation Guarantee system in 1992, and the 23m working Australians have since built up retirement savings of nearly AUD1.3trn (€905bn). Interestingly, this system started with compulsory employee contributions of 3%, funded at the time by a salary rise negotiated by the trade unions. This was increased to 9% in 2002 and will rise further to 12% of salary between 2013 and 2020.
The US, and also the UK, can certainly learn from the Netherlands, Australia and Denmark. One factor that the latter three countries have in common is that they can act as a group. This has many advantages over individual provisions, including the lower costs that result from economies of scale, improved access to investment and other expertise, more professional management, better safeguarding of continuity and the greater opportunities to share and exchange risk. These are just some of the reasons why policymakers in the Anglo-Saxon world are currently examining the collective DC schemes devised by the Netherlands.
There are many different examples of pension systems around the world, with the origins of both the current US and Dutch systems dating back to around 1875. The dramatic changes in their operating environments mean both, however, are in need of updating. They may be able to learn from more recent systems such as those in Australia and Chile, while emerging economies such as China, India, Indonesia and South Korea are also looking to these countries for inspiration.
Desperate diseases need desperate remedies, as the old proverb goes. The US needs to acknowledge its pension cliff, to identify its causes and set to work to find solutions openly and honestly. Let policymakers, employers and retirement plan providers, however, first listen to what the population needs and wants before coming up with complex, opaque answers. What the country needs are solutions that take account of participants’ residual earning capacity, while drawing their attention to the new reality and actively encouraging them to respond.
Harry Smorenberg is a strategic adviser for the Financial Sector and chairman of the World Pension Summit. Pieter Kiveron is strategic adviser in pensions and managing director at Dutch consultancy Penthievre Mondial.