Retirement’s New Normal

Baby boomers are living longer healthier lives, but paradoxically they are retiring earlier and with fewer assets. Further, those with substantial retirement savings generally are neither maximizing their value, nor taking advantage of tools such as reverse mortgages and annuities, thereby lowering their standard of living and increasing the likelihood of outliving their savings.

Those are just a few observations from Alicia H. Munnell, the Peter F. Drucker professor of management sciences at Boston College’s Carroll School of Management and director of the Center for Retirement Research at Boston College. Dr. Munnell served as a member of the President’s Council of Economic Advisors and assistant secretary of the Treasury for economic policy. She also spent 20 years at the Federal Reserve Bank of Boston, where she was senior vice president and director of research.

Dr. Munnell is the author of numerous white papers and books on retirement and pensions, including “Working Longer: The Solution to the Retirement Income Challenge,” coauthored with Steven A. Sass and published by the Brookings Institution Press.

Jim Danaher, senior investment product manager in the Northern Trust DC Solutions Group, recently spoke with Dr. Munnell about the effectiveness of defined contribution plans as retirement savings vehicles.

Jim Danaher: Alicia, thank you for joining us. What do you see as the primary factors driving the gaps we see today in individuals’ retirement readiness?

Alicia Munnell: Well there are really two factors that are important. First, we have increasing retirement needs. Life expectancy is rising; people are living longer. They’re continuing to retire much earlier than they did in the ‘60s and ‘70s, so we’ve got a very long retirement span. We have healthcare costs rising rapidly, and long-term care costs are a real wildcard for most people. At the same time, you have a big decrease in retirement resources. Social Security, which is really the backbone of our retirement system, is going to have lower replacement rates in the future than it has in the past. Second, we’ve also had this shift from defined benefit to defined contribution plans. And the balances in these defined contribution plans are modest, which means that you’re not going to get much from them — and if you want to buy an annuity, which we know nobody does, but should, you don’t get a very big annuity.

Jim Danaher: When you consider these factors, are defined contribution plans suitable, especially for low- and middle-income groups, as the sole means to a secure retirement?

Alicia Munnell: Fortunately, defined contribution plans aren’t the sole source of retirement income for most households. Really the backbone of our system, the base upon which all other things are built, is the Social Security system, and it’s a progressive system in the sense that it provides relatively higher benefits-to-contributions for low-income people than it does for higher-income people. For lower-income people, Social Security is their key component of savings. DC plans can be a supplement, but they’re not particularly significant for lower-income people.

Jim Danaher: Your research indicates that one of the biggest risks facing 401(k) participants today is longevity. Is this a challenge faced by all participants or is it particular to specific age cohorts?

Alicia Munnell: People who save through 401(k) plans are most likely going to get a lump sum at retirement. They’re going to have to figure out what to do with that lump sum, and they face two challenges. One challenge is that they spend it too quickly and exhaust their resources prematurely. The alternative, which I actually think is more of a risk, is that people are very cautious about how they spend their money and they try to preserve their capital and just live off the interest, which is very little these days, and actually deprive themselves of necessities. This longevity risk, which really comes at the decumulation phase, is big. It’s big for people retiring in the near future. It’s going to be bigger for future age cohorts, just because they’re going to have longer retirement spans over which they have to allocate their assets. It just gets tougher and tougher the longer that people live.

Jim Danaher: When we think about ways that we could shore up what plan sponsors could do, certainly features like auto-enrollment and contribution escalation are high on the list of options, but are they enough? Should there also be restrictions on areas that cause leakage from a plan, like lump sum payments, plan loans, etc.?

Alicia Munnell: My view is that automatic features are great. The evidence is clear that if you’re addressing an issue where people know what they should do, like save more, and you’ve made that the default, people like it and tend to stay where they’re put. I’m surprised that auto-enrollment hasn’t spread more than it has. My last reading is only about 50% of large plans have auto-enrollment, and only a fraction of those have auto-escalation in the default rate. My view is that without auto-escalation in the default rate, you run a real risk of locking people in at very low contribution levels; maybe lower than they would’ve been if they’d waited and signed up on their own. I would make automatic features a mandatory component of 401(k) plans.

I think restrictions on lump sums are good. I’m not sure that I would put restrictions on loans. Some studies have indicated that the presence of a loan feature actually encourages participation. The idea that people could have some access to their money in an emergency seems to make them more willing to participate.

Jim Danaher: What can plan sponsors do to specifically help the age cohort of 55 and older to close the gap?

Alicia Munnell: I think there are a couple of things that plan sponsors can do to help people 55 and older. First of all, just make sure that they’re contributing as much as they can, and that they’re using the catch-up contribution provisions. I just don’t know how widespread the use of the catch-up provisions are, but that really gives people an opportunity to boost their savings. The other issue is that I think people 55 and older need to be told that there’s more to life than the assets in their plan. Working longer is a very powerful lever in terms of increasing the security and size of your retirement income. I think telling people to think ahead and try to delay retirement as long as they can is a very useful piece of advice. The other thing is I think — not just for people 55 and older, but for all people — it would be really helpful if plan sponsors reported not just how big the piles were in their defined contribution plan, because for a lot of people $50,000 looks like an enormous amount. If you figure you could take out 4% of that a year, that is very little. That’s only hundreds of dollars a month, and not really enough to increase your standard of living significantly.

Jim Danaher: Should the U.S. government intervene more in DC plan design? If so, what actions would you propose?

Alicia Munnell: I would make defaults an integral part of plan design. If you want to have a 401(k) plan, you default people in and you have automatic escalations in the default rate. The area where it becomes more controversial is the decumulation side — whether you should have some portion of the balances automatically defaulted into an annuity. It should always be the default, however, so that if people are ill, they can undo that and take the money immediately. I would actually encourage that approach. However, I think if we want people to have an annuity, the government is going to have to be an active player. I think the government would have to get into some part of reinsurance of annuities. I would advocate having a default for half the balances into an annuity when people retire. This may work less well than the default into the plan because people know they should save; and if the company makes them do it, they’re happy and they stay put. It’s not clear that people want their money transformed into an annuity, and if they don’t, they really will undo the default. And we’ve seen some studies recently where people have been put where they don’t want to be and they actually take the trouble to get out of it. But I would try it.

Jim Danaher: The issue of the deficit that individuals are facing is going to have to be addressed. If it’s not addressed now, in the upfront stage, then where does that fall out?

Alicia Munnell: I think employers have a big stake in this, because employees don’t have adequate balances. Employers are going to find a lot of older workers who really would prefer to be retired — and whom the employer would prefer to be retired — hanging on, just because they don’t have the money to retire. I think that both parties have a big interest in this game.

Jim Danaher: That’s a perfect segue into some research you’ve done recently and in the book you published in 2008, “Working Longer,” which addresses the retirement income dilemma by proposing individuals prolong their career past normal retirement age. Given the rise in unemployment and the continued consolidation across industries, is working longer still a viable option?

Alicia Munnell: I think the way to think about working longer is to consider two states of the world. What I call the “normal” state, and this “great recession” state, that, even though the recession has been technically declared to be over, we have very high rates of unemployment and it’s very hard for older workers to get a job, and even to keep jobs. Right now, the prescription to work longer is not a meaningless direction, but it’s really a harsh instruction to follow. I assume, at some point, that unemployment rates are going to return to something like normal. In that kind of environment, we have a world where people are not only living longer, but they’re healthy. The jobs that are available to do are increasingly less physical, so they should be able to work longer than they have in the past. That is important. The place where people can do the best for themselves, in terms of income, is the job they’re currently in. If that’s too stressful, then step down to a job that’s less demanding and with less benefits, but a better fit for you in the long term. The question is, “How do employers feel about older workers?” I don’t think employers are mad for older workers. They’re worried about their physical stamina, and about their ability to learn new things. That’s why staying with your current employer is best. Getting a new job when you’re older just takes a very long time. I think that working longer has to be a central part of any solution to ensuring that people have adequate retirement income in the future.

Jim Danaher: The challenges facing retirees and plan sponsors are great and growing, as is the likelihood of diminishing Social Security benefits for future age cohorts. With defined contribution plans now the norm for many workers, plan sponsors will need to increase their efforts to educate participants while also making auto-enrollment and automaticcontribution escalation part of the default plan provisions.

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