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Savings in America and Elsewhere

RON GEBHARDTSBAUER
SENIOR PENSION FELLOW
AMERICAN ACADEMY OF ACTUARIES

Briefing Sponsored by the:


National Press Foundation
1211 Connecticut Avenue NW, Suite 310
Washington, DC 20036
Wednesday, May 18, 2005
9 am – 10:15 am
The American Academy of Actuaries is the public policy organization for actuaries of all specialties within
the United States. In addition to setting qualification standards and standards of actuarial practice, a major
purpose of the Academy is to act as the public information organization for the profession. The Academy
is nonpartisan and assists the public policy process through the presentation of clear analysis. The
Academy regularly prepares testimony for Congress, provides information to federal elected officials,
regulators and congressional staff, comments on proposed federal regulations, and works closely with state
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officials on issues related to insurance.
Topics
• How Much Is Needed?
– Social Security
– Company Pension
– Home
– Individual Savings
– Work
• Best Ways To Save
• How Are We Doing?
– Individually
– Nationally 2
Retirement Income Needed for 100%
Replacement of Spendable Income at Age 65
Single Person
140% Medigap and LTC
120% Pension Needed
Social Security
100%
80%
60%
40%
20%
0%
$10,000 $20,000 $40,000 $60,000 $80,000 $100,000
Wages just before retirement in 2005 3
Less Income Needed in Retirement
• No longer need to:
– Pay SS taxes (6.2% of wages up to $90,000)
– Pay Medicare taxes (1.45% on all wages)
– Contribute to pension plan or savings (0% to 15% of income)
– Pay work-related expenses (down 0% to ~ 7% of income)
– Pay as much for meals & home maintenance
– Pay as much in income taxes (down ~ 10% to 17%)
– Pay mortgage?
• But some expenses may increase
– Travel Costs
– Health Care (Medicare B & D premiums, Medigap & LTC)
• About $6,000/yr: 60% if income = $10,000
• 9% if income = $100,000 (extra 3% due to taxes)
– Taxes for workers who got EITC (earned income tax credit) 4
Poverty Rates For People
Age 65 and Over

40%
35%

30%
25%

20% 15%

11%
10% 10%
10%

0%
1959 1969 1979 1989 1999 2004
Year
Social Security (along with SSI , Pensions, etc.) decreased the percent of elderly below the poverty level to the same % as those for people of
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working age! The poverty threshold (for people over 65) is currently about $9,000 per person (~ $12,000 for a couple). The thresholds increase
with CPI-U (which is subject to criticism). Source: US Census Bureau's CPS (Current Population Survey) and ferret.bls.census.gov
S o c ial S e c urity Re plac e me nt Ratio s
at No rmal Re tire ment Ag e (and at Dis ability)
100%

90%

80%
P e rc e n t o f Ea rn in g s Re p la c e d

74%
70%

60%
52%
50%
45%
41%
40% 38%
34%
31%
28% 26%
30%
23%
20%

10%

0%
$10,000 $30,000 $50,000 $70,000 $90,000
Earning s Jus t Be fo re Re tire me nt in 2005
See History of Provisions at www.ssa.gov/OACT/HOP. Past wages based on National Average Wage Index7
These percentages decrease by about 2 to 3 percentage points over the next 10 years, per Table VI.F10 in 2005 rpt.
Social Security Benefits
at Normal Retirement Age (and at Disability)

$25,000

$23,482 $23,482
$22,632
$21,587
$20,000
$20,474
$19,169
Estimated Benefit

$16,423
$15,000

$13,414

$10,000
$10,400

$7,388

$5,000

$0
$10,000 $20,000 $30,000 $40,000 $50,000 $60,000 $70,000 $80,000 $90,000 $100,000
Earnings Just Before Retirement in 2005

This and prior graph show the primary goals of Social Security:
(1) Socially Adequate benefits (progressive benefits that are more important to lower wage earners)
(2) Individually Equitable benefits (important to higher wage earners - the more contributed, the more received). Progressive
price indexing eventually creates a flat benefit, and eliminates this principle. 8
Social Security Normal Retirement Age
Year of Birth Normal Retirement Age
1937 & earlier 65
1938 65 2/12
1939 65 4/12
1940 65 6/12
1941 65 8/12
1942 65 10/12
1943 – 1954 66
1955 66 2/12
1956 66 4/12
1957 66 6/12
1958 66 8/12
1959 66 10/12
1960 & later 67
Normal Retirement Age (NRA) = Age for full benefits. 62 is earliest age for benefits
Reductions for retiring earlier than NRA are as follows:
6 2/3% for each year before NRA (up to 3 years), plus
5% for each year more than 3 years 9
If you work after NRA, your benefit is increased by up to 8% per year.
Social Security Benefits
• Payable for life
– No matter how long you live
– No matter how bad the markets
• Benefits being paid increase by CPI each year
• Replacement rates maintained
– Initial benefits increase by average wages each year
• Disability and Survivor benefits (1/3 of total benefits)
rd

• Spousal benefits (at least 50% of worker’s benefit)


– Valuable for traditional family
• But SS has financial problems which we need to fix
sooner rather than later
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Other State Systems
• Old Europe
– Large, expensive, mandatory, unfunded State systems
• Raised retirement ages
• More years of work needed for full benefits
• Strengthen link between contributions and benefits
• United Kingdom
– Tier I (flat benefit)
• Change to price indexation in early 80’s improved solvency
• Now both parties find benefits too small
– Tier II (funded pay-related benefit)
• Worker can contract out to employer’s scheme or their “IRA”
• Mis-selling controversy
• Australia & Canada: some Means Testing

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Other State Systems
• Southeast Asia
– Provident Funds: fully funded, govt. managed DC funds
• Chile, other Latin American countries, Kazakhstan
– Individually managed accounts (sometimes with guarantees)
• Chile’s success led to adoption in other countries
• Problems: high expenses, less than desired participation, hidden liab.
– Sometimes with a smaller paygo DB plan (or with a choice)
• Sweden, Italy, Poland, Latvia
– Notional DC plan with specified return
• Like our Cash Balance pension plans

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Company Pension Plans
• Defined Benefit
– Promise a replacement rate based on years worked
– Contribution depends on investment returns, etc
• Risk on company, as we’ve seen lately, and some employees
– PBGC guaranteed benefits for some companies in bankruptcy
• Defined Contribution
– Promises a contribution
– Benefit depends on investment returns
• Risk on worker
– 401(k): may only promise a match
• 30% of workers contribute nothing and get no match
• Partial fixes: automatic participation at hire, automatic investment

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Why Have a Plan (particularly DB)?
• Tax Advantages
• Help employers, employees, nation
– Help employers with workforce management
• Recruit, retain, retire with dignity
– Most employees participate
• Only about 70% participate in 401(k)
– More likely to get annuity
• 401(k)s don’t require annuities or spousal consent
– Helps national retirement security
– Helped make more efficient markets
• Bucking the trend: United Methodist Church, UK
Barclays, Trans-Canada have started up new DB plans
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Tax Advantages of Pension Plans
In 20 years, $20,000 becomes:

$70,000 $61,000
$60,000
After-Tax Distribution

$50,000
$40,000 $29,000
$30,000
$20,000
$10,000
$0
Personal Savings Qualified Pension

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Assumes 8% interest rate, 35% tax bracket (fed + local), and 7.65% FICA tax from employer and employee
Pension Coverage Rates of Firms
100%
1993 CPS
Firms with Pensions (%)

76% 76%
75% 2000 CPS 69% 70%
65%
59%
56%
51%
50%
50% 40%

34%
25%
21%
25% 14%

0%
<10 10-24 25-99 100-499 500-999 1000+ Average
Firm Size (Number of Workers)
Source: March Supplement to Current Population Survey (CPS) using ferret.bls.census.gov
Coverage declined a lot among small employers in late 80’s and early 90’s, but has increased lately. 16

This is important because about half of employees work for firms with under 100 employees.
Participation Rates in Pension Plans (by type)
50%
48%

45%
40%
35%
% of Labor Force

Total
DB
30%
401(k)
Other DC

20% 19%
16%

10%
12%

0%
1975 1980 1985 1990 1995 2000
It's not a battle between DB and DC. It's a battle between 401(k) and the others, and 401(k) is far ahead.
Why? Favorable laws for 401(k), especially pre-tax contributions, match, and improved deductions.
Sources: Workers from BLS statistics: employed (FT & PT) and unemployed wage & salary workers. Coverage from
DOL/PWBA Abstract of 1999 Form 5500 data (Summer 2004) Tables E4, E8, & E20, and NCS for 2000.

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Only Half Covered by a Pension
• Why?
Plan
• Complex, Restrictive, & Conflicting Laws and Regs
• Lack of laws/clarity for Cash Balance plans
• Tax Reform is reducing tax advantage
– 15% capital gains & dividend tax rate
– Consumption tax would eliminate tax advantage
• Expensive cost of administration, compliance
• Unpredictable sources of funds of small employers
– Too Expensive
• Employees don’t value DB benefits?
• Small employers don’t know about simple alternatives

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Defined Benefit Plans Regulatory Costs
500

400 1981
1991
Administrative 300
Costs per
Worker
1990$ 200

100

0
15 75 500 10,000
Firm Size (# of Workers)

This shows why DBs make more19


Hay Huggins Company sense for larger employers.
More Problems
• Tax Reform could kill company pension plans
– Reduce 15% tax rate on Cap gains and Dividends to 0%
– Enact Lifetime Savings Accounts
– Change to National Sales Tax, VAT, Flat tax
– In all cases, they eliminate pension’s tax advantage
• Why lock up money until retirement if no advantage?
– Consumption tax won’t increase national savings, if employers drop
pension plans
• Low & middle income workers won’t save as much on their own
• Volatile pension funding rules
• Lack of clarity on Cash Balance rules
• Non-level playing field for DB plans

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Participation Rates
93%
100% All Employees
83%
Low Income Ones
75% 65%

50% 40%

17%
25%
9%

0%
IRAs 401(k)s DB plans

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Source: April 1993 CPS. DB numbers are estimates. IRA numbers are from 1983 when everyone was eligible
Individual Savings
• Many people don’t know how much to save
• Don’t save enough
• Don’t understand risks
• Don’t understand investments
• Don’t know how to pay themselves in retirement
• Boomers may have more saved dollarwise, but
less as a percentage of wages (CBO)
– So replacement wages will decrease

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How much is needed?
Female wants to retire at age 62 with inflation-indexed annuity Percent of wages
1. Annual income needed in retirement (incl LTC/Medigap) 85%
2. Your annual mortgage (if gone by retirement) 0%
3. Your annual Social Security benefit 35%
4. Your pensions from all employers 0%
5. Annual Income Needed (1 – 2 – 3 – 4) 50%
6. Assets needed at Retirement1 10times wages With risk
7. Your net assets by retirement (incl. amt of reverse mortgage?) 1 times wages 2
8. Additional cash needed by retirement (6 – 7) 9 times wages 8
9. Number of years until retirement 30 40
10. Annual savings needed as a % of pay (8 / 9) 30% 20%

1 Inflation indexed annuity price (very rough estimate): multiply line 5 by “82 minus age at
retirement” (minus 4 if level pension ok). Multiply by 50 if TIPS (22 if level pension ok)
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2 Items in red reflect an investment rate of return greater than the growth in wages
How much is needed?
Male wants to retire at age 66 with level annuity Percent of wages
1. Annual income needed in retirement (incl LTC/Medigap) 85%
2. Your annual mortgage (if gone by retirement) 0%
3. Your annual Social Security benefit 35%
4. Your pensions from all employers 10%
5. Annual Income Needed (1 – 2 – 3 – 4) 40%
6. Assets needed at Retirement1 5 times wages With risk
7. Your net assets by retirement (incl. amt of reverse mortgage?) 2 times wages 4
8. Additional cash needed by retirement (6 – 7) 3 times wages 1
9. Number of years until retirement 30 40
10. Annual savings needed as a % of pay (8 / 9) 10% 2.5%

1 Inflation indexed annuity price (very rough estimate): multiply line 5 by “82 minus age at
retirement” (minus 4 if level pension ok). Multiply by 50 if TIPS (22 if level pension ok)
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2 Items in red reflect an investment rate of return greater than the growth in wages
Best Ways to Save (it varies)
• DB/DC plan – generally employer pays 100%
• If reduces wages, compare with other firms
• If mobile, go for shorter vesting and cash balance plan
• 401(k) if has employer match
• Tax credit for low income savers
• Unless high fees or doesn’t have funds you want
• IRA vs. Roth IRA
• Regular IRA better if tax rate will be lower in retirement
• Tax rate can increase in retirement due to the way SS is taxed
• Roth can permit slightly larger deductions
• Deferred annuities & tax exempt bonds if high tax rate
• Lower tax rates on stocks and taxable bonds can make them better
• NQ Diversified mutual funds vs. individual securities
• Stocks, Life Cycle, Bonds, Stable Value, Money Market
• Bonds inside Qualified Plan and stocks outside Qualified Plan

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John Hancock Survey - 2004
• 40% don’t know what to expect for investment returns
– Remainder are too optimistic
• Majorities think:
– Employer stock in less risky than stock fund
– Bonds less risky than money market funds
• 60% don’t know they can lose money in bonds
• 45% think money market funds hold stocks
– Under 10% know they only hold short-term investments
• Under 25% know best to buy bonds before rates drop

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John Hancock Survey - 2004
• Financial planning needed
• Plans need to reflect human behavior
– Not economic theory
• Education needed?
– No, more simplification and automatic options
• Automatic enrollment at hire
• Automatic Life Cycle fund
• Automatic Rebalancing
• Automatic increases at pay increase dates
• Back to DBs?
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SOA Misperceptions paper
• Save too little
– Didn’t calculate how much needed OR calculations are low
• Retirement may occur before expected
• Half will live longer than expected
• Not facing facts about LTC needs
• Difficult to self-insure against long life
– We like lifetime income but don’t buy annuities
• Don’t understand investments
• Rely on poor advice; don’t seek out professionals
• Misunderstand retirement income sources
• Fail to prepare for inflation
• Don’t provide for spouse

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Work in Retirement?
• Some may have to work in retirement
– Part Time, Temporary, Phased Retirement
– When baby boomers retire, employers may pay
extra to retain some workers

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Average Increases in Labor Force and Population
How do demographics affect economy?
4% Labor Force (Supply)
Increase in Labor Supply > Increase in Demand for labor
Higher unemployment Total Population (Demand)
Low er w ages
More early retirements
Lots of (cheap) labor means less captial to increase productivity Increase in Labor supply < Incresae indemand for labor
3% Many young people means expensive homes Low er unemployment
Higher w ages to retain employees
Delay retirements
Increased Immigration of w orkers (w ho have higher fertility rates)
More capital to increase productivity
Will greater productivity offset few er w orkers?
Or w ill productivity not increase enough, so inflation w ill increase?
2% Many retirees increase costs of retirement homes, health care, etc
Increased emigration of retirees (in search of cheaper costs)

Market Prices and Inflation?


Accumulation caused high stock prices.
Will deaccumulation cause stock market meltdow n?See paper by Geanakoplos, Magill, Quinzii
Will low labor supply imply higher costs, or w ill increased productivity keep costs dow n?
1% Will retiree

0%
1962 1967 1978 1990 2000 2010 2020 2030 2040 2050 2060 2070

Source: 2005 SSA Trustees’ Report, Tables V.A2 and V.B2 Due to smaller increases in labor39force,
employers may encourage employees to retire later, and workers may become more productive.
US Labor Force Participation Rates - Male
100%
90% 1940
80% 1970
70% 1985
60% 2004
50% 62 63 65 70
40%
30%
20%
10%
0%
55 60 65 70 75 80
Note the dramatic decreases in labor force participation pre-1985. Much was due to Social Security and Medicare. Since 1985
participation rates have gone up a little post-age-62, possibly due to pro-work policies, fewer new workers, and economy. Labor
Force = Employed + Unemployed (those actively seeking and available) Source: 1940 data from US Census; 1965 and later 40from
Consumer Population Survey data (BLS).
Personal Savings Rates are Down
12%
% of Disposal Personal Income

Personal Savings
10%
Excluding Pensions
8%

6%

4%

2%

0%
1950 1960 1970 1980 1990 2000

While we don’t save as much thru pensions as we did in the 1980’s, without them
saving is negative. We save thru homes too, but they are heavily leveraged. Note:
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net of dis-saving by retireds. CG excluded.
Personal Savings vs. Change in Net Worth
(as a % of disposable personal income)
50%

40%

30%

20%

10%

0%
1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

-10%

-20% Personal Savings


Change in Net Worth in excess of CPI (3 yr avg)
-30%
Savings rates use to go down when Net Worth went up (& vice versa). Source: 3/2005 Federal Reserve Flow of Funds R.100
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2002 savings rates (2005 Stat Abstract of US, Table 1338): Italy & France:16%, Germany:10%, Japan:6%, UK:5%, US & Canada:4%
but we spend much more on education, research, and developement, which helps our economy grow faster.
Savings as a % of Disposable Income
30
1980
25 1990
2002
20

15

10

0
US France Germany Italy UK Japan Canada

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Net National Savings
Personal Savings (incl Pensions)
20%
Government Savings (incl State & Local)
Corporate Undistributed Profits
15% Total Net National Savings
Percent of GDP

10%

5%

0%
1950 1960 1970 1980 1990 2000
-5%

Net Savings is net of consumption of fixed capital. Sources: 3/05 NIPA


from Survey of Current Business by BEA, Tables 1.1 and 5.1 Higher if46
education and research included.
How Increase National Savings?
• Increase Productivity and/or Reduce Consumption
• Reduce US deficit
– Increase taxes (FIT and SS payroll taxes)
– Cut government programs
• Social Security: Not easy to cut benefits today
– Would Individual Accounts increase national savings?
• Carve out contributions won’t help
– Due to additional US borrowing
• Add On contributions would help
– Offset by less saving in our 401(k)s and IRAs (Substitution Effect)
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Comparisons
• Social Security
– US system less generous than many European countries
– Most will have financial problems
– UK is even less generous than US
• Gradual benefit reductions helped financial stability
• But now worry they went too far
• Pension plans/schemes
– Larger, more prevalent in US & UK due to smaller state scheme
– But some firms getting out of DBs, due to rules & risks, esp UK
• Individual Savings
– Many in US are not saving as much as in other countries
– But we spend more on Education and Research
– Have greater productivity and stock growth

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