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Challenges for the US Pension System

By

Olivia S. MitchellWharton School

mitchelo@wharton.upenn.eduhttp://prc.wharton.upenn.edu/prc/prc.html

Inauguration Ceremony, Japan Pension Research Council

18 February 2002, Tokyo

1

US retirement system is in flux…Labor market changes: Older population, more mobility

Pension system changes:• Corporate DB pensions see problems• DC plans popular: financial

disintermediation, portfolio diversification, ownership

• Social Security faces insolvencyRetirement outlook

More disintermediation – and challengesSocial Security reform

2

Population aging underway (%65+)

0

5

10

15

20

25

30Ch

ina

Hong

Kon

g

Indo

nesi

a

Japa

n

Kore

a

Mal

aysi

aSi

ngap

ore

Taiw

an

Thai

land USA

1998

2025

Source: Clark (1999)

3

US labor mobility growing

On-call/day laborers

2%Agency temporaries

1%

Other self-employed

5%

Other direct-hire temporaries

3%

Contract company workers

0%

Independent contractors

6%

Regular employees

83%

4

Related changes:• Shorter employment spells: Men

have 10 jobs in career, 6 by age 40• Downsizing: Public sector & heavy

manufacturing shrinking• Outsourcing: More common now (e.g.

benefits administration)• Earlier retirement: median age 62

5

National pension debt substantial(% of GDP to 2050; IMF)

0 2 0 4 0 6 0 8 0 1 0 0 1 2 0

UK

S w e d e n

US

Ca n a d a

Ita ly

Ja p a n

G e r ma n y

Fr a n c e

A v e r a g e

% o f G DP

6

US corporate DB pensions had 25 years of success:

DB plans manage ~ $3+ trillion US, mostly well funded (Assets = ABO)Funding, reporting, investment regulated by US Labor Department

http://www.dol.gov/dol/pwba/

Government provides DB plan insurance

7

Now DB funding outlook poor:Sponsor profitability < forecasts:– Layoffs, lack of cash to finance DBStock market performance weak– DB assets lower than expectedGovt bond rates dropping – DB liabilities higher than expectedFew entrants to mature DB system

Similar to Japan!8

How are DB plans responding?

Plan Redesign: Hybrid or Cash-Balance plansEmployer perspective:– Specifies annual contribution (% of pay)– Guarantees ROR on investment (this makes it DB

in US context)Employee perspective:– Gets annual statement on asset value– Asset portable after termination (if vested)

K market risk is employer’s (with govtsolvency fund)

9

Typical DB Accrual vs Hybrid Plan

0

1

2

3

4

5

30 35 40 45 50 55 60 65 70

HybridPrior Plan

Accrued benefit as a multiple of pay

Age

Source: Schieber 2000

Early Retirement Incentive

10

Hybrid plans have smoother funding profile than traditional DB plans

0

20

40

60

80

100

25 30 35 40 45 50 55 60 65

%

ABO as % of PBO fortraditional DB plan

ABO as % of PBOfor a hybrid plan

Source: Schieber 2000

Employee Age

11

Conversion IssuesBy law: Sponsor must pay ABO = past DB plan benefits earnedBut sponsor can change future benefit promises So many DB DC and traditional DB cash balance conversions.

Still must fund old ABO (and with low interest rates, is expensive).

12

The Broader View: DC plan growth

0

100000

200000

300000

400000

500000

600000

700000

80000019

79

1981

1983

1985

1987

1989

1991

1993

1995

1997

13

Annual Per Capita Contributions to Private Retirement Plans

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,00019

77

1982

1987

1992

in 2000 $US

14

DC assets surpass DB (US Corporate, B$)

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

1984 1986 1988 1990 1992 1994 1996 1998 2000E 2002E

DB DC 401(k)

15

Aspects of 401(k) DC accounts

Salary deferralEmployee pretax contribution rising (% of pay)Employer match popular Assets portable if change employers

Automatic enrollmentEmployee bears K market risk & expensesMultiple investment options: average 12

16

Employees contribute % of pay to 401(k) accounts

<=5% of pay4% 6-10% of pay

16%

11-15% of pay42%

16-19% of pay18%

20+% of pay3%

Other17%

17

Employers provide match as % of pay

Match<=5% of pay40%

Match 6% of pay45%

Match 7+%of pay15%

18

Expenses: TIAA-CREF Annual Charges(in hundredths of a percent, or basis pts)

Source: www.TIAA-CREF.org, 2001

Expense Ratio (bp)Stock 40Global Eq. 46Growth 42Equity Indx 36Bond 38Infl Linked Bond 39Social Choice 38M Mkt 34

19

Administrative Costs Erode Lifetime Pension Savings

Assuming ROR 12% 6%Saving decreased by:

100 basis point expense 33 % 25 %50 basis point expense 15 % 12 %

(Assumes 5% wage growth from age 21 to 65.)

Source: Schieber 2000 20

401(l) Investment Choices

0 10 20 30 40 50 60 70 80

Company stock

Common stock

LT bond

Divers. stock/bond

Guar. Investment

Money market

CD

Employee Employer

21

Overall mix similar in DB and DC (top 1000 plans)

0

1 0

2 0

3 0

4 0

5 0

6 0

7 0

Stock

s

FixedIn

come

Mort

/RE

Cash

22

BUT DC plan mix different: 66% equities, 14% company stock

Equities52%

Company stock14%

Balanced12%

Bond5%

Cash17%

23

Exposure differs by plan design

Equities45%

Company stock25%

Balanced10%

Bond3%

Cash17%

Equities30%

Company stock48%

Balanced6%

Bond1%

Cash15%

Asset Allocation (Company Stock Plans)

Asset Allocation (Plans with

Employer Directed Contributions)

24

Exposure at Plan Level

67%

19%

7%2%

5%

0%

20%

40%

60%

80%

100%

1-20% 21-40% 41-60% 61-80% Over 80%

Balance of plan in company stock

Plans

(%)

25

Participant Risk Perceptions

4.4 4.2

5.2

6.3

4.9

0

5

10

Money mkt funds Bond funds Co Stock Stock funds Individual stocks

Source: Vanguard Group (2001)

Relative risk (scale of 1-10)

26

Participant Education a Concern

• Frequency and form of reporting, to whom? – Employer? – Employees? – Govt?

• Need to know: – Expected risk &

return– Actual investment

performance– Expenses– Retirement

targets

27

Recent developments: Impact of Enron on Pensions…

Problem:– Many employees hold much

employer stock in 401(k) acct– eg Enron, Coke, Lucent

28

Policy Proposals:Legislative ideas:

• Cap contributions to stock, require diversifiable > 90 days

• Cut tax deduction for e’r stock contributions

Judicial action:• Lucent, Enron,

othersEmployer

guarantees?• Some want

minimum return from DC plan

29

Estimated Efficient Frontier for World Stock Markets

-0.004

-0 .002

0

0 .002

0 .004

0 .006

0 .008

0 .01

0 .012

0 .014

0 .016

0 0.0002 0.0004 0.0006 0.0008 0.001 0.0012 0.0014 0.0016 0.0018 0.002

V a rian ce (risk )

U S A

E u rop eAsia-P ac ific ex Jap an

Ja p an

La tin Ame ric a

E xp ec ted R e tu rn

30

401(k) Payouts

Source: Mitchell T29

25

41

91

0 20 40 60 80 100

Lifetime annuity

Installments

Lump sum

31

Adverse Selection in Annuities

o Those buying annuities (if voluntary) likely to live LONGER– Asymmetric information

o Insurers need to price accordingly– How important is this in cost of

annuity?

32

US Pop and Annuitant Age at Death: adverse selection

Population

Annuitant

Source: Mitchell et al 2000; us male

0

0 .0 2

0 .0 4

0 .0 6

65 70 75 80 85 90 95 100

105

110

115

120

125

A g e

33

Annuitants die younger in Japan?

0

0.02

0.04

0.06

65 70 75 80 85 90 95 100

105

110

115

120

Age at death

Pro

babi

lity

0

0.02

0.04

0.06

65 70 75 80 85 90 95 100

105

110

115

120

Age at deathPr

obab

ility

Men Women

Japan Japan

USUS

34

Boosting Retirement Security:

Raise DC contribution cap (tax-preferred saving)Privatize (part of) Social Security

35

Raise DC contribution caps

Contributions = MIN of [$10.5 K (‘01 indexed) or 15% of income]. New law (EGTRRA) of 2001– Raise ceiling to $11 K in ’02, – Eliminate % of income cap

to $15 K by ’06Big boost to DC saving expected

36

Reform Social Security: Commission charge

Maintain SS benefits for retirees & near-retirees. Don’t raise SS payroll taxes. No direct gov’t investing in stock market. Include individually-controlled, voluntarypersonal retirement accounts.

While enhancing fiscal sustainability.

www.csss.gov37

Problem: Current Rules Unsustainable

Cost

Rate

Income

Rate

Percent of Covered Pay

38

Implement DC Accounts in Social Security: Preferred Model

Voluntary account: 4% of pay up to $1,000 (wage indexed); offset 2% real. Index traditional SS benefits to cost of living (not wages)

Boost low-earner’s benefits to 120% of povertyBoost widow/er benefit to 75% of couple benefits (if below av).

39

Preferred Model: 4% Accounts to $1000/yr

40

Conclusions:

DB plans in decline, except cash balanceDC plans in fluxPublic pensions face insolvencyRegulatory environment needs attention

41

Questions?

Thank you very much.

42