issues.
The golden years for most Americans appear increasingly threatened by the
global financial crisis. Retirement accounts have lost from $2 trillion to $4
trillion as stocks have tumbled nearly 50% from their peak in 2007. For
Americans facing retirement, the details of how these plans work may be fuzzy,
but the big picture is clear: whatever comfortable cushion they may have had is
now gone, and the process of building it back up will be arduous and
long—perhaps too long for employees who are nearing retirement age.
The pain isn’t limited to individuals with plummeting 401(k)s. Sponsors of
private and public pensions—which typically invest between 60% and 70% in
equities—are also finding their accounts billions of dollars below minimum
requirements. The financial crisis “is affecting all types of retirement plans
very similarly because they’re all invested in the same assets—stocks and
bonds,” says Peter J. Brady, senior economist at the Investment Company
Institute (ICI), a Washington, D.C.-based association of investment companies
and mutual funds. “People have a lot less in their accounts than they had a
short period ago.”
The ripple effect of shrinking retirement accounts and underfunded pensions
threatens to undermine the broader economy as older Americans delay retirement,
local governments raise taxes, and companies challenged with withering pension
balances lay off workers in response to the shortfall.
The crisis has many retirement experts calling for change—some for tweaks to
the existing system, others for full-blown retirement reform. To supplement
Social Security, American workers may encounter two types of employer-sponsored
retirement plans: defined-benefit plans, in which an employer promises to take
care of employees when they retire; and defined-contribution plans, in which
employers help employees accumulate their own retirement funds.
Since Congress amended the tax code in 1978 to accommodate
defined-contribution plans, the bulk of private employers have shifted to plans
such as the 401(k)—and away from traditional pensions. Most public employees,
however, are still covered by traditional pensions. “Thirty years ago, half the
workforce had a pension plan, and it was a [defined-benefit] plan,” notes Olivia
S. Mitchell, executive director of the Pension Research Council and a professor
of insurance and risk management at Wharton. Today, about half of the American
workforce is covered by an employer-sponsored retirement plan, but the majority
of them are defined-contribution plans, Mitchell says.
About 22 million workers are covered by defined-benefit plans today, while
about 66 million are covered by defined-contribution plans, according to the
Employee Benefit Research Institute (EBRI), a nonprofit research organization in
Washington, D.C.
Trouble all around
Both groups have been hit hard by the crisis, but in different ways.
Employers offering defined-benefit plans, commonly known as traditional
pension plans, must set aside money over time in order to pay employees a
promised amount upon retirement. This “defined benefit” is often based on a
formula using the number of years worked and level of salary earned. Employees
covered by a defined-benefit plan may not feel terribly worried about the
current economic crisis, because their retirement benefits are supposedly
guaranteed. But employers behind those pensions are now struggling to fund the
long-term promises they have made.
Employers offering defined-contribution plans—which include 401(k)s, 403(b)s,
457s, and a few others—shift the responsibility of accumulating retirement
income from the employer to the employee. Employers pay administrative costs and
often offer to match employee contributions, but no law or regulation forces
them to do so. Worker participation in most defined-contribution plans is
voluntary, and many workers choose not to save any money at all. Employees who
have been trying to build a nest egg have seen account balances drop
precipitously in the current financial crisis, a situation made worse in some
cases by employers opting to scale back or eliminate their 401(k)
contributions.
So far, there has been no definitive response to the financial crisis from
the millions of workers enrolled in defined-contribution plans, says Wharton’s
Mitchell. “We find some people have pulled entirely out of the stock market,
some have gone into lifestyle funds, and some think this is a buying
opportunity.”
Still, the crisis brought into focus one of the drawbacks of the
do-it-yourself defined-contribution plans: Many participants did not adequately
diversify their investments, leaving themselves more vulnerable than they should
be to market risk. “Even before the financial crisis, we have been concerned
about the ability of 401(k) plans to provide secure retirement income,” Alicia
H. Munnell, director of the Center for Retirement Research at Boston College,
testified to Congress in February. “Workers continue to have almost complete
discretion over whether to participate, how much to contribute, how to invest,
and how and when to withdraw the funds. Evidence indicates that people make
mistakes at every step along the way. They don’t join the plan, they don’t
contribute enough, they don’t diversify their holdings, they over-invest in
company stock, they take out money when they switch jobs, and they don’t
annuitize at retirement.”
Although most financial planners recommend that investors shift retirement
assets away from equities and into fixed-income investments as they age, many
401(k) investors approaching retirement were still heavily invested in stocks
before the market downturn. Nearly one in four workers between the ages of 56
and 65 had more than 90% of their account balances in equities at the end of
2007, EBRI found, and more than two out of five held more than 70% in equities.
(In contrast, the average target-date fund, which automatically reallocates
investments as a person gets closer to retirement, would have allocated just
51.2% to equities for investors between the ages of 56 and 65 at the end of
2007, according to EBRI.) In January, Boston-based Fidelity, the nation’s
largest 401(k) provider, surveyed its 17,095 corporate 401(k) plans and found
the average workplace savings account balance had dropped 27% between 2007 and
2008, from $69,200 to $50,200.
Many older workers have been left with little choice but to keep working to
make up the sudden shortfall. That’s bad news not only for workers, but also for
companies trying to stay competitive. “If all of your older workers are feeling
the pinch, they might not retire. So there is an HR aspect,” says Mitchell.
“Baby boomers think they’re never going to retire, [and many] are quite morose….
There are those who are saying the defined-contribution approach has failed and
are calling for permanent restructuring.”
It could take two to five years (assuming a 5% equity rate of return) for
401(k) balances to return to Jan. 1, 2008, levels, according to EBRI estimates.
If the equity return rate drops to zero for the next few years, recovery could
take anywhere from two and a half to nine years, EBRI says. “What we know from
past economic cycles is that if the economy turns around, then much of this will
reverse,” says EBRI CEO Dallas Salisbury. “But we don’t know when it’s going to
turn around.”
Cutting contributions
Making it even harder for defined-contribution plan participants to recoup, a
number of employers are scaling back or eliminating matching contributions in
the face of a slowing economy.
In March, a survey of employers by WorldatWork, an association of HR
managers, and the American Benefits Council, which represents companies that
provide benefits to their employees, found that 3% of the 505 responding
companies had eliminated their 401(k) match and 8% had either decreased the
match or were considering a decrease. The Pension Rights Center, a Washington,
D.C.-based consumer organization focused on retirement security, lists on its
website more than 150 companies that have either changed or suspended 401(k)
matches.
The fact that companies can scale back on their match during tough economic
times could be positive, some argue. “Unlike a freeze in a pension plan, a
freeze in a [defined-contribution] plan is not usually permanent,” says Jan
Jacobson, senior counsel for retirement policy at the American Benefits Council.
“To the extent that a company is choosing between laying off workers or stopping
their match for a while, some companies will choose to stop the match. And I
think I’d rather work for the company that stops the match.” Brady, of the ICI,
notes that “this flexibility is actually a strength of the 401(k). It might be a
way [for companies to save money] that doesn’t have a short-term cost to
employees. And I assume they’ll resume contributions when the economy recovers….
I’m sure people would rather lose their 401(k) match than lose their job.”
Participants in defined-benefit plans at private companies face a different
set of problems. Companies that offer pension plans are being squeezed by a
sudden decline in assets, an increase in liabilities, and changes in the law
that force them to make up the shortfall faster than in the past. “Many
companies might have to lay workers off, walk away from their pensions, shut
down a plant,” says Alan Glickstein, senior consultant at the Washington,
D.C.-based human resources and financial management consultancy Watson Wyatt.
“Companies [have] to make very difficult decisions.”
The nation’s top 100 pension-plan sponsors saw their pension funds drop by
$303 billion in 2008, going from an $86 billion surplus relative to the minimum
amount required by pension regulations at the end of 2007 to a $217 billion
deficit at the end of 2008, an analysis by Watson Wyatt found in March.
Aggregate funding decreased by 30 percentage points, from 109% funded—meaning
they held 9% more than the minimum-required funding—at the end of 2007 to 79%
funded at the end of 2008. A different survey by Mercer, a New York-based human
resources consulting company, found that aggregate funding of pension plans of
S&P 1500 companies fell to 74% at the end of February, with an aggregate
deficit of $373 billion. Year-end figures, which are what plan sponsors
generally use to calculate pension expenses and contribution requirements for
the coming year, showed an aggregate deficit of $409 billion at the end of
December, with funding at 75%.
The shortfall stems not only from a decline in equity values, but also from
falling interest rates, which have forced companies to increase the amount they
set aside for future benefit payments. As a result, money that could have been
spent on growing the business is being funneled into pension obligations. Mercer
estimates that pension expenses for S&P 1500 companies will jump to $70
billion in 2009, compared with $10 billion in 2008 and $35 billion in 2007.
“Companies need to put these assets and liabilities on their financial
statements,” says Adrian Hartshorn, a principal in Mercer’s financial strategy
group. “It affects their balance sheets and it affects the profits they report,
and clearly it also affects the amount of cash they have to put into the
plan.”
Changes under the Pension Protection Act (PPA) of 2006, many of which took
effect in 2008, are also making it more difficult for companies to ride out the
storm. Actuaries calculate annual shortfalls in pension funds using a method
called “smoothing,” which averages investment gains and losses over several
years. “Under the old law, we had the ability to spread ups and downs over a
four- to five-year period,” says Glickstein. “So we could sort of calm the ups
and downs to make sure it’s not just noise in the market.”
The new law limits smoothing to just 24 months, meaning the dramatic losses
of 2008 will have a proportionately larger impact on the calculated shortfalls.
In essence, the new accounting rules are forcing companies to act now to make up
for a huge financial gap, even though a quick turnaround in the economy could
ultimately negate the deficit. “The challenge is, what is the real number?” asks
Glickstein. “What is the right posture [for companies] to take in the face of a
temporary phenomenon that has created a huge amount of pressure?”
The pressure has spurred some companies to reconsider their pension
offerings. “Continuing to operate a [defined-benefit] plan is a risk and a cost
that they are no longer willing to bear,” says Hartshorn. Some companies are
freezing their defined plans voluntarily, meaning they stop making contributions
and employees stop earning benefits. (Under the PPA, a plan is automatically
frozen if it is less than 60% funded.) Phone maker Motorola, newspaper publisher
McClatchy, aerospace company GenCorp, insurer Aon, and apparel retailer Talbots
are among the nearly 100 companies that have frozen pension plans in the last
few months, according to the Pension Rights Center.
Freezing a plan can save money on contributions but does not remove the
long-term risk and volatility for the employer, notes Hartshorn. Companies will
still have to pay out on promises that have already been made and benefits that
employees have already earned.
Drastic solutions
That fact has some companies contemplating even more drastic solutions. “Many
corporations are thinking about whether they should file for bankruptcy in order
to unload their retiree promises,” says Mitchell.
If a company goes bankrupt, the plan would be taken over by the Pension
Benefit Guaranty Corporation (PBGC), a federal agency that insures
private-sector pensions. Created under the Employee Retirement Income Security
Act of 1974, the PBGC guarantees payment of basic pension benefits for 44
million American workers and retirees in more than 29,000 private-sector
defined-benefit plans. The PBGC paid out $4.29 billion in benefits to more than
640,000 people in 2008 and collected $1.49 billion in insurance premiums from
pension plan sponsors, which are its main source of funding.
But there is a limit to how much the PBGC will pay in benefits. The maximum
guaranteed pension for participants in plans that terminated in 2008 was $51,750
per year at age 65, and lower for couples or early retirees. Workers who were
promised more than that would be out of luck if their company declared
bankruptcy. “It’s important to understand what is actually guaranteed,” Mitchell
says.
In addition to taking over pensions from distressed companies, the PBGC also
takes over fully funded plans that employers voluntarily terminate. (Companies
cannot choose to terminate a plan unless it is fully funded.)
The problem, Mitchell points out, is that the PBGC itself is $11.15 billion
in the hole. PBGC’s annual report for 2008 notes, “The Corporation has
sufficient liquidity to meet its obligations for a number of years; however,
neither of its insurance programs at present has the resources to fully satisfy
PBGC’s long-term obligation to plan participants.”
Says Mitchell, “There is a big concern about that insurance guarantor. And if
any one of the big auto companies goes bust, that could double or triple the
PBGC’s underfunded status.”
PBGC spokesman Gary Pastorius says the PBGC has run a deficit for most of its
history—in fact, its deficit shrunk in 2008—and has a healthy enough cash flow
to keep things going. “On a cash-flow basis, we’re pretty strong,” Pastorius
says. “The assets are on hand now. The liabilities, we pay out into the future.
Not everybody’s ready to retire yet.”
At least the PBGC doesn’t have to worry about funding pensions for public
employees. “There is not a PBGC for state and local government pension plans,”
says Keith Brainard, research director at the National Association of State
Retirement Administrators (NASRA), which represents 82 statewide public
retirement systems for about 22 million working and retired employees of state
and local governments. “By and large, the taxpayers are the backstop.”
Like 401(k) accounts and private-sector pensions, public pension funds have
watched assets fall during the financial crisis. According to the most recent
figures from the Center for Retirement Research at Boston College, aggregate
assets for state and local pensions have dropped $1.3 trillion since the peak of
the market on October 9, 2007. NASRA estimates that its members are now about
85% funded, on average.
Cities and towns throughout the U.S. are juggling tightening budgets with
pension shortfalls, straining to find a way to make ends meet without raising
taxes and causing more economic strife. “So the question is, what happens if
they go broke?” asks Mitchell. “And it’s really unclear.”
In response to a budget crisis, the City of Philadelphia recently announced
it would suspend contributions to the city employees’ pension fund and extend
amortization of the shortfall from 20 to 40 years, Mitchell notes. “They can’t
fill the potholes and police the crime. So what it means is that we’re consuming
the services today, but we’re going to make our grandchildren pay for them.”
The other looming question, says Mitchell, is this: What would happen if a
state pension got into big trouble? Most states’ employee pension plans are
guaranteed by a combination of the state constitution and state law. That could
make it difficult for states to scale back on pension contributions, because the
only way to cut the pension would be to amend the constitution, Mitchell
notes.
Brainard calls the doomsday scenarios for state and local pensions “a distant
and unlikely event…. States and cities don’t typically declare bankruptcy,
they’re not acquired, and they don’t go out of business. Most public pension
plans have assets to continue meeting their liabilities indefinitely or for
decades.”
Besides, the true impact of the current financial crisis will not show up for
most public pensions for at least another year, because there is a lag in
reporting, Brainard adds. Since the fiscal year for most state and local
governments ends in June rather than December, most of the worst market losses
haven’t even been recorded. Also, as public pensions do not fall under the PPA,
most are able to smooth gains and losses over a much longer period than their
private-sector counterparts—from three to 15 years.
So if the economy rebounds soon, the astounding losses of 2008 could largely
fade away. And if the economy continues to sputter, the worst shortfalls for
public pensions may be yet to come. “It is really going to take a few years to
understand and recognize what effect the market decline has had,” Brainard
says.
A new system?
In the meantime, retirement experts are looking at the crisis as an
opportunity to point out flaws in the system and suggest change. Indeed, the
crisis has highlighted problems with all of America’s current retirement plans,
they say. Defined-contribution plans place too much burden on the individual;
private-sector defined-benefit plans place too much burden on the employer; and
public sector pensions shift the burden to entire communities of taxpayers and
threaten to drag down local economies.
“To me, the health of our retirement system [depends on taking] lessons from
the financial crisis and applying them correctly, making sure pension law
supports the next innovation,” says Watson Wyatt’s Glickstein. “The bloom is off
the rose to a large degree on the 401(k), and I think there’s going to be a
renewed interest in coming up with a new retirement plan design.”
Glickstein sees room for a hybrid called a cash balance plan, which attempts
to incorporate the features of a 401(k) into a defined-benefit plan. Others have
called for automatic enrollment in the target-date 401(k)s that automatically
reallocate investments as an investor nears retirement.
The Pension Rights Center has launched what it calls the Retirement USA
Initiative, which is pushing for systematic change. “Even before the current
recession, retirement income security had become a major national concern, as
companies increasingly shifted away from traditional pensions to do-it-yourself
savings plans,” the group’s website says. “In the past six months, the faltering
stock market and dwindling 401(k) accounts have turned a major concern into a
crisis…. It is critical to start now to lay the foundation for a new system to
supplement Social Security for future retirees—one that is universal, secure and
adequate.”
Munnell, of the Center for Retirement Research, has stepped up her calls for
a new mandatory, universal savings account that would replace about 20% of
pre-retirement income.
“Placing all the financial risk for the second tier of retirement income on
either individuals or on firms does not work,” she wrote in a paper published
last November. “The private sector is unlikely to revert back to defined-benefit
plans, where employers bear all the risk. But relying on a system where the
individual bears all the risk does not make much sense either. It may be time
for the United States to consider other ways of designing a retirement
system.”
One of the long-term lessons from the financial crisis is the importance of
risk management, says Mitchell. “One thing that many baby boomers are probably
aware of is that it is going to take much more money to retire.” As they see
their 401(k) account balances plummet, “people now understand risk in a real,
visceral way, more than they ever did before.”
In addition, she says, it no longer wise to rely entirely on employers to
provide retirement security. “It’s really hard to link retirement benefits to an
employer who may or may not be there. And that has been brought to the fore by
the discussion of the auto companies’ potential bankruptcy. As a young worker,
you often don’t think that this is a promise that may be 100 years long. So it
is a real challenge to try to construct both a financial system that can keep
long-term promises and a political system to back those promises.”
Going forward, Mitchell sees reforming Social Security as one of the most
important issues in retirement planning, because it is the base on which the
rest of America’s retirement system is built. “I think the biggest problem is
the near insolvency of Social Security,” says Mitchell. “The fact that it is
running out of money in six or seven years is already putting implicit pressure
on retirement plans and everything else. So that’s priority one in my
book.”
