The Shrinking Pension World
Given that today’s pension world exists only for public workers and a handful of those in the private sector, I was starting to get the feeling that this was why we need that great big annuity in the sky, call it the People’s Annuity. Actually, another speaker, Stuart Leckie, chairman of the Hong Kong Retirement Schemes Association, helped establish a vehicle with a niftier name, the Mandatory Provident Fund.
Yet political beneficence aside, defined benefit plans are much less expensive for society as a whole, as Leech pointed out. Why? Take the Arizona State Retirement System, which invests for 550,000 current and former state employees. First, unlike an individual 401(k) investor, who has to worry about living to 100, the odds of 550,000 pensioners all living that long is nonexistent. Second, when you are investing for 550,000 people distributed over the ages of 21 to 100, you can invest where the best opportunities are and don’t have to become more conservative as individuals do when they get older. Finally, institutional investors enjoy economies of scale and access to information that individuals don’t.
Another speaker pointed out, it was chief financial officers who killed the traditional pension in Corporate America because the volatility of pension funding costs occasionally forced companies to miss their quarterly earnings numbers. Other reasons include the long tail of pension liabilities, which can bring businesses in cyclical or declining industries like steel, airlines and automobiles, to their knees.
There are, of course, other alternatives, like shared risk plans with minimum and maximum caps on contributions. If public workers realized what a great deal they are getting, one suspects they’d be much more willing, maybe even happy, to contribute. Indeed, in some nations, many contribute as much as they can to increase their benefit.
However, many companies encourage employees to take their pension as a lump-sum distribution to get the liability off their books. According to the participants, many folks just fritter the lump sums away, strengthening the argument for mandatory annuitization on the orders of the High Command at, say, the Mandatory Provident Fund. Many panelists questioned whether people who didn’t take lifetime annuities were behaving rationally.
Next up was Dallas Salisbury, CEO of the Employee Benefits Research Institute, who just turned 65. Since his parents both lived to 94, he recently purchased a longevity insurance policy. (Only days after the conference ended, the U.S. Treasury approved the inclusion of longevity vehicles in defined contribution plans.)
Salisbury described his wife of 40 years as someone who could have been a Depression-era person. Before they got married, Salisbury says she demanded they save 25% of their income so they wouldn’t have to take equity market risk. Coming from a young woman in her 20s, this is someone who must have been seriously spooked by the stock market in her youth.
Salisbury is the king of studies on retirement issues. He joked he had once seen a study arguing that anyone who saved more than $2,000 had probably oversaved.
When it came to annuity phobia, he had an intriguing personal experience. His wife was only willing to give up 10% of their assets for the longevity insurance, which is essentially an annuity that doesn’t pay out money until you turn 85. She apparently viewed a 90%-10% split as one she could accept, but giving up control of her money was hardly a joy.
She’s not alone. When they get lump sums, only 2% of participants in 401(k) plans choose annuities, compared with 27% of those in defined benefit plans who do so, according to Salisbury. Unfortunately, there is a great need for emergency capital, which is part of the reason folks at the lower end of the income spectrum just spend it.
The good news is that as rollovers increase to north of $10,000, workers tend to reinvest, and the vast majority of workers reinvest when they have rollovers exceeding $20,000. A Vanguard executive also said the company expects 401(k) participants to increase the amount of assets they allocate to default options like target-date funds from the current 40% level to about 58%.
Still, that doesn’t address a worldwide trend toward favoring lump sums over lifetime annuities, with companies and financial advisors often encouraging it, and it is not clear people are making rational decisions. But individuals have legitimate reasons to fear giving up control of their retirement savings and placing their faith in an employer, government entity or insurance company.
Many foreign private and public pension schemes are pay as you go, and if current demographic trends continue, this funding method will morph from a lengthy chain letter into a Ponzi scheme. Moreover, both governments and companies have been known to dip into the plans when other short-term funding needs arise. Guarantees are great but those from the city of Detroit, Bethlehem Steel and numerous airlines never materialized.
Third parties can’t do that with 401(k) plans where there are no guarantees. As for longevity insurance, anyone who funds an annuity that doesn’t pay out income for 20 years is taking a serious gamble that the insurer will be well-managed and solvent two decades later. Remember that for decades, AIG was the strongest insurer on earth with a fortress balance sheet.
We tend to look back on the post-World War II era as one where people retired with both a pension and Social Security. But did that world really exist?
Salisbury noted that today about 17% of the people turning 65 will receive a pension, but the figure in 1975 was almost the same. Personal savings were always necessary.
Perception may be at odds with reality. “Thirty years ago, everyone thought they were going to get an annuity [or pension],” Salisbury said. But very few did. Now virtually everyone knows they won’t.
The overarching ideology in most U.S. states is moving in the direction of libertarianism and choice, not mandates and constraints, even during a Democratic administration, Salisbury observed. On a collective basis, some variant of a Mandatory Provident annuity might be much cheaper for society at large, but we’ll never see the benefits of pooling assets.
With 25% of the 76 million baby boomers predicted to live to 93 or beyond, personal savings are likely to be more necessary than they ever were. But it’s hard to see any variant of the 4.5% rule working for ordinary Americans, even many of the so-called mass affluent.
Variable annuities can be a useful instrument for higher income people who have maxed out their qualified plans and want to supplement their savings. During the financial crisis, many performed surprisingly well, but this was partially attributable to federal bailouts via TARP and other stronger insurers. Does anyone seriously believe the public or the federal government will be in the mood for another bailout in the future? Perhaps in anticipation of a different political climate when the next financial crisis arrives, many insurers have terminated their variable annuity businesses, while others have trimmed the guaranteed benefits to shorten the length of their liability tails.
Like most people, I’m an annuity skeptic, particularly of those that don’t pay out for 20 years. But given the scarcity of other choices, they are likely to surge in sales, if not popularity. So are other alternative payout vehicles.
Most Americans simply won’t have any other option. New generations of both immediate and deferred-income annuities and longevity insurance policies may address some people’s problems, but the jury will be out for decades.