Towards a New Pensions Settlement: The International Experience
108
Towards a New Pensions Settlement: The International Experience
108eBook
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Product Details
| ISBN-13: | 9781786607119 |
|---|---|
| Publisher: | Rowman & Littlefield Publishers, Inc. |
| Publication date: | 01/09/2018 |
| Series: | Towards a New Pensions Settlement |
| Sold by: | Barnes & Noble |
| Format: | eBook |
| Pages: | 108 |
| File size: | 606 KB |
| Age Range: | 18 Years |
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CHAPTER 1
THE UNITED STATES
Alicia H Munnell
A consensus is emerging in the United States that many people will not have enough money to maintain their standard of living once they stop working. The problem is that people need more retirement income than in the past because they are living longer, continuing to retire early, experiencing high and rapidly rising health care costs and facing low interest rates. At the same time, they will receive less from government and workplace retirement plans.
Social security benefits relative to pre-retirement earnings will decline as the statutory retirement age moves from 65 to 67, premiums for retiree health insurance take a larger share of the benefit, and more people pay taxes on their benefits. While Social Security's progressive benefit formula provides low earners with higher benefits relative to earnings, these workers often claim early and receive actuarially reduced amounts. The situation could be much worse if the government fails to act before the Social Security trust fund runs out of money in the early 2030s, at which time benefits would have to be cut immediately by an additional 25 per cent.
In this environment, it is crucial that everyone saves on their own through a workplace retirement plan (the second pillar) and that these plans function efficiently. Unfortunately, the balances in defined contribution accounts – the dominant type of workplace plan – are modest, in large part because the government has not mandated the automatic provisions that would make these plans function effectively. More importantly, only half of the private sector workforce has any type of workplace plan at any given time, and the federal government has failed to enact legislation that would automatically enrol these uncovered workers into some type of saving arrangement. In the face of federal inaction, the states have stepped into the breach and are in the process of setting up retirement programmes that would require that employers without a retirement plan must automatically enrol their employees into an Individual Retirement Account. Of course, 50 different retirement plans across the country is not an ideal solution.
The third pillar, individual saving, is important only for those with very high incomes. Virtually all the retirement saving in the US occurs through workplace plans. The major exception is the house, where people build up home equity by paying down their mortgage. Home equity is the largest asset for middle-income families. At this point, though, most households do not access their home equity to cover consumption in retirement, either by downsizing or taking out a reverse mortgage.
OVERVIEW OF THE DEFINED CONTRIBUTION SYSTEM
Until the early 1980s, most workers lucky enough to be covered by a workplace retirement plan relied solely on a defined benefit plan, which – at retirement – provides a lifetime benefit based on earnings and years of service. Today, most rely solely on defined contribution plans, which are savings accounts that shift all risk to the individual. These plans have four serious problems: they are totally voluntary; extremely expensive for small employers; substantial money leaks out; and they cover only half the private sector workforce.
Taking each of these problems in turn: First, the voluntary nature of defined contribution plans. Because employees can decide whether or not to join their employer's plan and how much to contribute, only about 80 per cent of eligible participants join the plans and the median level of combined employer-employee contributions to these plans are only nine per cent of earnings. Both these statistics could be improved by taking advantage of the findings from behavioural economics and making all plans adopt automatic provisions – with the ability for workers to opt out. Policymakers moved towards making defined contribution plans more automatic with the Pension Protection Act 2006, but that legislation only encouraged – rather than required – adoption of automatic provisions. As a result, less than 50 per cent of plans have automatic enrolment, and in many cases this feature is applied only to new entrants – not the entire workforce – so the impact is limited. Moreover, only about one-third of those with automatic enrolment also have automatic escalation in the default deferral rate. Without automatic escalation, inertia tends to lock people who have joined the plan by default into low contribution rates. Balances could be increased by mandating automatic enrolment for the entire workforce, with deferral rates set at a meaningful initial level and with annual automatic escalation in the deferral rate – to a combined employer-employee contribution rate of 12–15 per cent.
Second, leakages. These leakages take two forms. First, roughly half the money coming into all workplace defined contribution plans is rolled over into IRAs. Second, roughly 1.5 per cent of assets leak out of the combined defined contribution and IRA system each year. The two phenomena have different implications.
While workplace plans serve as the gateway for retirement saving, roughly half of defined contribution balances get rolled over to IRAs, making them the largest single repository of retirement plan saving in the US. This rollover activity is extraordinary, given that participants are typically passive in their interactions with their plans. Several factors are at play. One is that it is very difficult to roll over money from one workplace defined contribution plan to another. In addition, some households are attracted by a wider menu of investment options or the ability to consolidate their account holdings. Others, however, appear to be seduced by advertisements from financial services firms urging participants to move their funds out of their "old", "tired" defined contribution plan into a new IRA. But the shift from defined contribution plans to IRAs moves the employee's money to a less protective regulatory environment and potentially higher fees.
The second type of leakage is more pernicious because the money is spent and not available to support retirement. Leakages can occur through three channels: in-service withdrawals (hardship withdrawals and withdrawals after age 59 and a half), "cash out" when changing jobs, and loans. Participants cashing out when they change jobs is by far the largest source of leakage, and, again, one of the major reasons for cashing out is the difficulty of rolling over balances within the defined contribution system. Our estimates are that roughly 1.5 per cent of assets are cashed out from plans and IRAs each year, reducing balances at retirement by about 25 per cent. This estimate represents the overall impact for the whole population, averaged across both those who tap their savings before retirement and those who do not. So, for those who do take money out, the problem is more severe than indicated by these estimates.
The third problem identified at the outset is the high expenses associated with small plans. Economies of scale are very important in the defined contribution environment. In large plans (over $100m in assets) fees are generally below one per cent – the largest plans are usually below 0.50 per cent. In contrast, average fees for small plans are about two per cent, with many plans paying more. Paying two per cent or more in fees makes investing prohibitively expensive and cuts balances at retirement nearly in half compared to the situation if there were no fees.
Fourth, coverage is not universal. At any moment in time, less than half of private sector workers participate in any type of retirement plan. This statistic has been relatively constant since the 1970s. Of those not covered by a retirement plan, roughly 20 per cent work for an employer with a plan. Most of these workers are simply ineligible for their employer plan, but some of them chose not to participate. The remaining 80 per cent who lack coverage are employed by a firm without a plan and the bulk of these employees work for small employers (firms with less than 100 workers). This lack of coverage means that some workers end up at retirement with no source of income other than social security; and others cycle in and out of coverage, producing very small accumulations of retirement assets.
EFORTS TO EXPAND COVERAGE
Policymakers have recognised the coverage gap and have proposed new products and approaches for getting coverage to uncovered workers. With very little progress at the federal level, however, the states have started to undertake their own initiatives.
Federal Initiatives for Expanding Coverage
Federal initiatives to expand coverage have taken two tacks. One is the introduction of specially designed retirement plans that could be adopted by small business. The fact that the coverage rate has not improved since the 1970s suggests these efforts have had little impact. More recently, the US Treasury has introduced a starter retirement savings account (my RA) for those without coverage with their current employer, which is free of investment risk and fees, but so far has seen little take-up. President Obama and Congress both presented proposals to make it easier to set up multiple employer defined contribution plans. These plans would allow unrelated small employers to offload a portion of the administrative burdens and fiduciary responsibilities to a third party, which would substantially reduce the costs for small businesses. The second tack is comprehensive automatic enrolment proposals, the most prominent of which was President Obama's Auto-IRA for those without coverage with their current employer. Under the plan, employers with more than 10 employees and no pension coverage would be required to place three per cent of an employee's salary in an IRA. The proposal provided a tax credit to help small businesses with implementation costs. The employee could opt out of the plan. Unfortunately, no legislation has been enacted at the federal level to solve the coverage problem. Instead, the states have stepped into the breach.
State Initiatives
States have adopted a variety of approaches to expand coverage for their uncovered private sector workers. Two states – Washington and New Jersey – have adopted a "marketplace approach," which provides employers with education on plan availability and makes pre-screened plans available through a central website. The absence of a mandate and the fact that small businesses have shown little interest in adopting retirement plans makes it unlikely that the marketplace approach will have much effect on coverage. Other states, such as Massachusetts, are toying with having both an Auto-IRA system and a state-run multiple employer defined contribution plan. The drawback to the multiple employer approach in the US framework is that the state cannot impose a mandate on employers to automatically enrol their workers in such a plan.
The most prevalent and promising approach is the Auto-IRA model, similar to that proposed by President Obama. Under this model, the state imposes a mandate on employers without a retirement plan to automatically enrol their employees in an IRA. California, Connecticut, Illinois, Maryland and Oregon have all passed legislation, with plans to have their programmes up and running within the next two years. In all cases, the participants must bear all programme costs without help from the taxpayer.
In the early stage of the process, the states struggled with even basic questions about programme design. Research in Connecticut and California showed that most uncovered workers automatically enrolled in a programme would not opt out, and that opt-out rates did not vary much for contribution rates between three and six per cent. Hitherto, the states have decided generally upon: contribution rates of between three and six per cent; a "Roth" IRA where the employee puts in after-tax contributions, making withdrawals easier for a lower-income population that receives little value from tax deductibility; and administration by a third party with state oversight.
Surveys of employers suggested that they are lukewarm about the proposed programmes. They are sceptical of the state's ability to manage such a programme, citing its struggles with its own pension plans. Second, they resent the mandate. Finally, they worry about the administrative burden of enrolling employees and explaining the programme to them. However, despite these concerns, surveys suggest that employers will not encourage their workers to opt out. Nonetheless, the election of President Trump casts a shadow over this whole area of reform.
A financial feasibility study for Oregon showed that state programmes should anticipate losses due to the start-up costs and annual deficits from operations in the early years. The magnitude of the annual operating deficits depends crucially on: the record-keeper's cost per account and the money generated from participant fees on assets under management, which in turn depends on the contribution rate. The estimates for Oregon, assuming a $30 per account record-keeping cost, a six per cent contribution rate and a participant fee of 1.2 per cent, is that the break-even point will not occur for seven years. The states must decide how to finance these start-up costs and operating deficits. The two options are: hiring sellers willing to take on the risk with long contracts and having the state take out a loan to subsidise losses in the early years, which would be paid back from surpluses in later years.
Even if the states are successful in setting up a tier of retirement income for their citizens, this approach to implementing a retirement programme is clearly a second-best alternative. A national Auto-IRA plan would be a much more efficient way to close the coverage gap, offering substantial economies of scale and avoiding the laborious, time-consuming and expensive process of setting up 50 different state plans.
CONCLUSION
The US retirement system faces a large number of challenges and many people will enter retirement without adequate resources to maintain their standard of living. The situation, however, could be greatly improved with three pieces of federal legislation that would: restore solvency to the social security system; make automatic provisions in defined contribution plans mandatory; and automatically enrol uncovered workers in some type of retirement plan.
CHAPTER 2
Chile
Rossana Castiglioni
During Chile's period of military rule between 1973 and 1990, the country experienced a structural pension reform that brought to an end the pay-as-you-go system. After November 1980, a series of decrees created a privatised pension model that, in many significant respects, remains in place today. This new pension model eliminated employer contributions and introduced a defined contribution scheme that passed investment risks from the state to individuals, requiring employees to save at least 10 per cent of their taxable income in personal accounts. Membership was mandatory for all employees entering social security after May 1981, but optional for self-employed workers.
Individual savings are administered by private-sector funds – Administrators of Pension Funds (AFP) – the operations of which are monitored by the state through the AFP supervisor. AFPs replaced the former retirement funds (except for those of the armed forces and the police). They charge workers a commission to administer their savings. Workers can choose freely the AFPs to which they entrust their savings and can change to another AFP at any time.
The system provides retirement, disability and survivor pensions. Retirement income needs are met by the accumulation of the employee's contributions across his or her working life plus the profit generated by the AFP's investment of these contributions. Disability and survivor pensions are also financed by compulsory insurance, with contributions representing about 3.5 per cent of taxable income, and by the funds the worker accumulated until disability or the spouse's death occurred. An earlier decree in 1975 established a non-contributory, means-tested pension for poor people over 65 years of age, for the physically disabled over 18, and, after 1987, for the mentally ill.
Beneficiaries can select from the following retirement options: an immediate annuity that will allow people to get lifetime payments; an immediate annuity with part of the funds deducted from the individual capitalisation account and the remaining funds disbursed periodically through planned withdrawals; a deferred annuity, so that the insured person can plan withdrawals from the individual capitalisation account and define a future date for an annuity; and a planned withdrawal based on the insured person's life expectancy, unless he or she dies, in which case savings may be inherited.
For 18 years after the transition to democracy in 1990, only incremental adjustments to the system were made. These changes sought to curb the deterioration of pension's real terms value; introduced new pensions for those with a partial disability; standardised procedures for obtaining pensions from the individual capitalisation system; introduced mechanisms to increase the AFPs' investment returns; sought to improve the functioning of the existing AFP system; and advanced some modifications in the realm of annuities.
(Continues…)
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Table of Contents
Foreword – Martin Gilbert, vii,
Introduction – Gregg McClymont and Andy Tarrant, 1,
US – Alicia H Munnell, 13,
Chile – Rossana Castiglioni, 23,
Mexico – Tapen Sinha, 31,
Singapore – Mukul G Asher and Chang Yee Kwan, 39,
Hong Kong – Stuart Leckie, 49,
New Zealand – Patrick Nolan, 55,
Ireland – Shane Whelan, 63,
Denmark – Jprgen Goul Anderson, 79,
Conclusion – Gregg McClymont and Andy Tarrant, 89,
Notes on Contributors, 97,