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Challenges for the US Pension System
By
Olivia S. MitchellWharton School
[email protected]://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