AMERICAN private-sector workers face a problem. Too few of them have private-sector pensions, and the government scheme, Social Security, set up by Franklin Roosevelt (pictured) is less generous than it used to be. One study estimated that 20m elderly Americans will be living in poverty or near-poverty by 2035.
A new book* by Theresa Ghilarducci and Tony James has a plan to deal with the problem. It comes complete with a foreword and endorsement by Timothy Geithner, a former treasury secretary who had to battle the financial crisis.
The authors set out the problem in admirably clear fashion. Some 64% of women and 56% of men claim Social Security earlier than the official retirement age (which is rising in stages to 67), and thus suffer a reduction in their pensions. Those who retire at 62 get a Social Security cheque that replaces just 29% of a median earner’s income. The average monthly Social Security payment is $1,300.
That would not be a problem if recipients also had a private pension. But 24% of retired Americans have no source of income other than Social Security. Just 15% of workers have defined-benefit (DB) pensions, in which their retirement income is linked to their salaries. Most of those workers are in public-sector jobs.
More than half of private-sector workers are part of no private pension plan at all. Others are in defined-contribution (DC) plans which produce a savings pot on retirement, with no guarantee of any set income. A worker on the median income would need a $375,000 lump sum on top of Social Security payments to replace 70% of pay, often cited as a suitable target. But the median DC pot for workers aged 55-64 is just $80,000.
So what is the answer? All workers without a retirement plan would be enrolled into a scheme called the Guaranteed Retirement Account (GRA). Employees and employers would each put in 1.5% of pay and the government would add a flat $600 per year. The money would be pooled and managed collectively. No one could withdraw money from a GRA before retirement and the payments would be annuitised to provide a lifetime income. They would be guaranteed to get back at retirement at least what they had paid in.
It is not a bad plan, resembling an auto-enrolment scheme started in Britain in 2012. Since it would supplement rather than replace Social Security, it might not face much political opposition. And the government’s flat-rate contribution would go some way towards tarrgeting tax benefits where they are most needed—at the lower end of the income ladder. At the moment the most affluent 20% of Americans get 70% of the benefit from tax breaks for payments into a pension scheme.
Whether the scheme would solve the retirement problem is more doubtful. Some parts of the book induce scepticism. (It does not help that Mr Geithner seems to confuse DC with DB schemes in his foreword.) The authors suggest, for instance, that guaranteed retirement accounts “will earn higher returns with lower risk”, a tricky feat. And they assume nominal returns on investments of 6.5% a year, which they describe as “conservative”.
But that number is not very conservative at all. The authors justify it in two ways. They cite projected returns on public pension plans of 7-8%. Alas, those assumptions are widely deemed too generous and have been dismissed by, among others, Warren Buffett, a famous investor, and Michael Bloomberg, a former mayor of New York and the founder of the financial-data firm that bears his name. It is very hard to earn such high nominal returns when you start from today’s low equity dividends and bond yields.
The authors’ second justification for their assumptions—the level of past returns—invites the same objection. Thirty years ago, the ten-year Treasury-bond yield was 10%. That made it much easier to earn a high nominal return. Now that yield is less than 3%.
Conventional DB schemes, which aim to pay out two-thirds of a final salary, require contributions of 20-25% of payroll. So it is hard to see how contributions of 3% or so into the GRA, even with tax relief, could replace 40% of median income for someone retiring at 62. (Added to 29% from Social Security, that would bring them within a whisker of the 70% target).**
The scheme will only work if more money is paid into it or if people retire much later. That may make it less politically acceptable. And the first workers to benefit from 40 years of GRA contributions would not retire until around 2060. The pensions crisis will hit before that.
* “Rescuing Retirement: A Plan to Guarantee Retirement Security For All Americans” by Theresa Ghilarducci and Tony James
** Shifting the retirement age to 65 alters the maths a bit, but not enough. Nor is it clear from the book whether retirees would buy an inflation-linked annuity or not, which would have a lower starting income. All British DB pensions (and many US ones) hae some imflaiton protection built in.