Underlying the specific issues affecting our retirement plan system is that our national savings are inadequate. We are directing far too little of those savings into our retirement plans in order to reach the necessary goal of self-sufficiency. "Thrift" has been out in America; "instant gratification" in our consumer-driven economy has been in. As a nation, we are not saving nearly enough to meet our future retirement needs. Too few citizens have chosen to establish personal retirement accounts such as IRAs and 403(b)s, and even those who have established them are funding them inadequately and only sporadically. These investors and potential investors are, I suppose, speculating that their retirement will be fully funded by some combination of Social Security, their pensions, their unrealistically high expectations for future investment returns, or (as a last resort) from their families.
Broadly stated, we Americans suffer from a glut of spending and a (relative) paucity of saving, especially remarkable because the combination is so counterintuitive. Here we are, at the peak of the wealth of the world's nations, with savings representing only about 3 percent of our national income. Among the emerging nations of the world-with per capita incomes less than $5,000 compared to our $48,000-the saving rate runs around 10 percent, and in the developed nations such as those in Europe, the savings rate averages 9 percent, with several major nations between 11 and 13 percent. Our beleaguered pension system is but one reflection of that shortfall.
The Seven Deadly Sins
Let's now move from the general to the particular, and examine some of the major forces in today's retirement systems that have been responsible for the dangerous situation we now face.
Deadly Sin 1: Inadequate Retirement Accumulation
The modest median balances so far accumulated in 401(k) plans make their promise a mere shadow of reality. At the end of 2009, the median 401(k) balance is estimated at just $18,000 per participant. Indeed, even projecting this balance for a middle-aged employee with future growth engendered over the passage of time by assumed higher salaries and real investment returns, that figure might rise to some $300,000 at retirement age (if these assumptions prove correct). While that hypothetical accumulation may look substantial, however, it would be adequate to replace less than 30 percent of preretirement income, a help but hardly a panacea. (The target suggested by most analysts is around 70 percent, including Social Security.)
Part of the reason for today's modest accumulations are the inadequate participant and corporate contributions made to the plans. Typically, the combined contribution comes to less than 10 percent of compensation, while most experts consider 15 percent of compensation as the appropriate target. Over a working lifetime of, say, 40 years, an average employee, contributing 15 percent of salary, receiving periodic raises, and earning a real market return of 5 percent per year, would accumulate $630,000. An employee contributing 10 percent would accumulate just $420,000. If those assumptions are realized, this would represent a handsome accumulation, but substantial obstacles-especially the flexibility given to participants to withdraw capital, as described below-are likely to preclude their achievement. (In both cases, with the assumption that every single contribution is made on schedule-likely a rare eventuality.)
Deadly Sin 2: The Stock Market Collapse
One of the causes of the train wreck we face-but hardly the only cause-was the collapse of our stock market, on balance taking its value from $17 trillion capitalization at the October 2007 high in U.S. stocks, to a low of $9 trillion in February 2009. Much of this stunning loss of wealth has been recovered in the rally that followed, and as 2012 began, the market value totaled $15 trillion. Nonetheless, our nation's DB pension plans-private and government alike-are presently facing staggering deficits. And the participants in our DC plans-thrift plans and IRAs alike-have accumulations that fall short of what they will need when they retire.
Deadly Sin 3: Underfunded Pensions
Our corporations have been funding their defined benefit (DB) pension plans on the mistaken assumption that stocks would produce future returns at the generous levels of the past, raising their prospective return assumptions even as the stock market reached valuations that were far above historical norms. And the DB pension plans of our state and local governments seem to be in the worst financial condition of all. (Because of poor transparency, inadequate disclosure, and nonstandardized financial reporting, we really don't know the dimensions of the shortfall.) The vast majority of these plans are speculating that future returns will bail them out.
Currently, most of these DB plans are assuming future annual returns in the 7.5-8 percent range. But with stock yields at 2 percent and, with the U.S. Treasury 30-year bond yielding 3 percent, such returns are a pipedream. It is ironic that in 1981, when the yield on the long-term Treasury bond was 13.5 percent, corporations assumed that future returns on their pension plans would average just 6 percent, a similarly unrealistic-if directly opposite-projection as 2012 began.
Corporations generate earnings for the owners of their stocks, pay dividends, and reinvest what's left in the business. In the aggregate, the sole sources of the long-term returns generated by the equities of our businesses should provide investment returns at an annual rate of about 7-8 percent per year over the next decade, including about 2 percent from today's dividend yield and 5-6 percent from earnings growth. Similarly, bonds pay interest, which is the sole source of their long-term returns. Based on today's yield, the aggregate return on a portfolio of corporate and government bonds should average about 3.5 percent. A portfolio roughly balanced between these two asset classes might earn a return in the range of 5-6 percent during the coming decade.
Deadly Sin 4: Speculative Investment Options
A plethora of unsound, unwise, and often speculative investment choices are available in our burgeoning defined-contribution (DC) plans. Here, individuals are largely responsible for managing their own tax-sheltered retirement investment programs-individual retirement accounts (IRAs) and defined-contribution pension plans such as 401(k) thrift plans that are provided by corporations, and 403(b) savings plans provided by nonprofit institutions. Qualified independent officials of their employers seem to provide little guidance. What's more, they often focus on spurious methodology that is too heavily based on historical data, rather than the timeless sources of returns that actually shape the long-term investment productivity of stocks and bonds, misleading themselves, their firms, and their fellow employees about the hard realities of investing.