Retirement 20/20: What’s It All About? Where Have We Been? Where Are We Going?
What's It All About?
Where Have We Been?
Where Are We Going?
By Andrew Peterson and Emily Kessler
It used to be that retirement issues and pension and 401(k) plans were a back–page story in the media. However, that has changed in recent years spurred by a number of factors including the baby boom generation's arrival at retirement eligibility, the trend away from traditional defined benefit (DB) pension plans to 401(k) defined contribution (DC) plans and most recently, the ongoing financial crisis. A recent Wall Street Journal headline reads, "Big Slide in 401(k)s Spurs Calls for Change," while a Washington Post headline declares, "2008 Leaves Pensions Underfunded: Stock Losses Leave $400 Billion Deficit; Shoring Up Funds May Be Costly."
What's It All About?
Actuaries have been consulting with retirement plan sponsors about these significant demographic and economic issues for a number of years. However, often this work involves solving problems among the trees rather than looking at the forest as a whole. It was with this viewpoint of taking a step back and looking at the macro picture that the Society of Actuaries' Pension Section started the Retirement 20/20 initiative in late 2005. It was started in reaction to the shortcomings of both traditional DB plans and DC plans, shortcomings that have been further accentuated during the current financial crisis. Retirement 20/20 seeks to find new retirement solutions that meet the economic and demographic needs for the 21st century in North America.
Why Do We Need A New Retirement System?
The private employer–sponsored DB plan has been around more than 100 years yet declining in prominence over the last several decades. So what has changed?
Railroads were among the first companies to adopt plans, to move older workers off the railroad and into retirement when they were no longer physically able to do the job. In the United States, employer–sponsored plans increased in prominence during WWII as introducing pension benefits was a way of attracting employees during a period of wage and price controls. After WWII, U.S. politicians and corporations saw employer–sponsored DB plans as a way to stem the rise of communism.
The DC plan, better known in the United States as a 401(k) plan, is also a bit of an accident of history. 401(k) refers to the section in the Internal Revenue Code which permits employees to forgo taxation on compensation deferred. 401(k) plans in the United States were introduced in the early 1980s as a way to supplement retirement savings, and today dominate traditional DB plans among private employers (in the United States in 2002, private trusteed DC assets were $2.0 billion versus $1.5 billion for private trusteed DB plans. Source: EBRI).
So what has caused the shift from DB to DC? Is it because DC is so much better than DB? We recognize that the global marketplace makes private employer sponsorship of DB plans a risky business—for employees and for shareholders. A mature DB plan in a company that has shrunk can represent a significant burden, if the plan had not been properly funded and maintained. Much of the difference in the hourly wage rate between U.S. autoworkers at GM, Ford and Chrysler versus U.S. autoworkers for foreign automakers is the cost of the pension (and post–retirement medical benefits) promised to previous generations.
Today the risk of a traditional DB plan is seen as too much to bear for many private sector employers. And this makes sense in a rapidly changing economy where the long–term life viability of even apparently solid companies seems to be in question. Why then would a company take on the long–term liability of a traditional pension? From an ERM standpoint, taking on this long–term liability that is outside their core business is of questionable value.
DC plans have risen to fill in the gap. For many people, at least if you asked them before the market decline of 2008, DC plans were seen as preferable to the traditional pension plan. Participants got to see a large lump sum of money grow, stock market returns in the 1990s were spectacular, and the market was coming back after the burst of the tech bubble. While these plans are magnificent savings vehicles, their effectiveness in providing predictable retirement income is being questioned.
Why Retirement 20/20?
In recent years, research coming from the SOA and other sources has highlighted the lack of understanding that most individuals have about risk. The SOA's series of Post–Retirement Risk Surveys, started in 2001, showed that most individuals had no idea of the risks faced in retirement—not just regarding declining health status and ability to live independently, but the risks associated with managing a single sum of money to last a lifetime. These risks—investment, inflation, interest rate, longevity, just to name a few—make the process of managing a single sum to death through periodic withdrawals nearly impossible. While annuities can help many people, most individuals won't purchase them for various reasons (including the desire for a bequest motive and loss of control). We also saw that the typical DC plan balance was woefully inadequate. In addition, the new field of behavioral economics—and specific research on the behavior of DC plan participants—showed that educating plan participants to make better choices was highly ineffective. It was becoming clear that most people, if all they had were small DC plan balances and Social Security, would not be able to manage the money for a lifetime. This could create a significant social crisis for the 21st century, as the baby boom generation started running out of money in retirement.
Retirement 20/20 was born in an "A–ha!" moment when we realized that we essentially live in a binary regulatory structure, as far as pension plans are concerned. Pension plans are either employer–sponsored DB or employer–sponsored DC; there are a few exceptions in the United States and Canada, but not many. The analogy that we drew was a world of two flavors of ice cream: vanilla and chocolate. For whatever reasons, many people decided that chocolate—the DB plan—wasn't what they wanted. If you don't want chocolate, and you only have two choices, vanilla becomes a very popular option. But it's not because you prefer vanilla over a range of other flavors—if strawberry, butter pecan, rocky road, mocha and peppermint were offered, one of those might be more to your liking. Retirement 20/20 was born to explore the third (and fourth and fifth) way—what else could we do to design a retirement plan that did a better job of protecting individuals from the risks of retirement without putting the risk of a long–term liability solely on the employer.
Some have asked where the 20/20 name came from, thinking that it is perhaps referring to a goal of having a new retirement system in place by the year 2020. This is not the case; the 20/20 title is a reference to perfect 20/20 vision and our desire to bring an uncertain retirement future into focus. If our employer–sponsored DB/DC system was more an accident of history than the result of careful planning, we thought if we stepped back, we could develop something that directly met the needs of retirement system stakeholders. Stepping back and looking at the problem with 20/20 vision allows us to design solutions to directly meet needs.
The goal of creating a better retirement system is an ambitious one, but we believe that as actuaries who deal with retirement plans every day we are uniquely positioned to lead this discussion. However, the strength of this initiative to date has been the involvement of a wide variety of retirement professionals from policy experts, to academics, to economists and others participating with actuaries as we seek to develop these principles and new ideas for the future. Working together we have been developing ideas that we hope will transcend political biases and ultimately lead to fruitful discussions about how to improve the retirement system in North America.
To date we have held three annual conferences, starting in 2006, exploring different themes. The initiative did not start by looking at specific designs or risk sharing ideas, but rather started with the idea of developing core principles.
Where Have We Been?
2006—Building The Foundation
The goal of Retirement 20/20 was to design a retirement system that went beyond DB or DC. Therefore, we had to start with a blank .sheet of paper. The 2006 Conference1 was a discussion of needs, risks and roles for stakeholders in the retirement system, which we defined as:
- Society—This is society as a whole (all taxpayers and citizens). This includes both current and future generations since there are intergenerational costs and risk–bearing issues.
- Individuals—Individuals are the ultimate users of retirement income and have the need to prepare for retirement and then manage retirement income while negotiating various risks.
- Markets—Markets have the dual roles of retirement asset accumulation and de–accumulation and also provide hedging opportunities. Markets include both the capital markets and insurers and others who provide products and solutions for retirement needs.
- Employers—Employers hire individuals and need to attract, retain, motivate and retire individuals.
While the 2006 conference defined needs, risks and roles, there were six themes that participants kept coming back to throughout the conference:
- Systems should align stakeholders' roles with their skills;
- Systems should be designed to self–adjust;
- Systems should consider new norms for work and retirement and the role of the normative retirement age;
- Systems should be better aligned with markets;
- Systems should clarify the role of the employer; and
- Retirement systems will not succeed without improvements in the health and long–term care systems.
Participants at the 2006 Conference discussed the fact that individuals aren't the best suited for retirement planning or deciding how to invest retirement assets, and an employer's goal in business usually isn't to operate a pension plan. This misalignment of roles with skills creates problems in today's retirement system. Therefore, the proper alignment of stakeholder skills with roles is critical to the success of any new retirement system.
2007—Aligning Roles With Skills
The seed for the 2007 Conference,2 was found in the first theme from 2006 of aligning roles with skills. We set out to determine the optimal roles for our various stakeholders. Proper role definition is critical for the system's success. The correct role would be one that uses each stakeholder's knowledge and talents optimally. For example, market experts would work in the markets, and employers could focus on their core business. Defining the stakeholder roles is also necessary before beginning to design the features of the new retirement system.
For 2007, we focused on role definition. Particularly:
- Which stakeholder is best suited to take on what role?
- How do you allocate roles based on stakeholder skills?
- How do these role assignments affect other stakeholders?
The stakeholders discussed in 2007 were society, markets and employers. Individuals, while still an important stakeholder, were not discussed explicitly, but referenced often in the discussions.
From the 2007 Conference, the key role for society was seen as providing structure.
Part of that structure was the traditional role of governments in providing regulatory oversight. The other half was in making social choices to ensure that most individuals made decisions that worked the best for them. Conference participants saw these social choices focused on a few key issues, including the accumulation of assets and provision of lifetime income. This also can be through encouraging standardization among choices (e.g., standardizing simple annuity and longevity insurance products to facilitate consumer choice).
Markets, particularly capital markets, serve as the place where retirement assets are accumulated and from which retirement income is drawn. Much of the discussion of the role of markets became a discussion of how markets are used. For example, most individuals don't use markets well because they don't have the right knowledge; they are better served by markets if they are part of a group that uses an agent with better knowledge to make market decisions.
Finally, the role of the employer needs to change significantly. Participants agree that most employers play a valuable role in educating and advising employees. But, most employers don't want to take the responsibility—both legal and financial—that comes with plan sponsorship. Employers should be able to participate within the system at various levels, including providing access to plans they may not sponsor. University employers in the United States already can do this through participation in the TIAA–CREF system.
2008—Defining The Characteristics
In 2008, we shifted the focus to drill into some of the key objectives or features identified in 2006 as important for a new retirement system. This most recent conference, Defining the Characteristics of the 21st Century Retirement System, was held in November and included a focus on several major themes including:
- Changing signals.
- Default distribution options.
- Self–adjusting mechanisms.
- Market hedging opportunities.
An additional idea wrapping around the other themes was how the findings of behavioral economics impact participant decision making when it comes to retirement planning and decisions. A number of the conference sessions included presentations of papers written by various authors in response to several calls for papers issued specifically for Retirement 20/20. In addition there were several speakers from Europe that added to the diversity of discussion.
Changing Signals And Default Distributions
Signaling within retirement plans refers to design elements or other factors that direct participants' behavior. These signals can be specific plan features or can be external factors such as policy statements or even cultural norms. For example, an early retirement age can send signals to participants about an appropriate age for retirement. The discussion of changing signals focused on signals that currently exist and how they might be changed to impact participant behavior and what signals should or shouldn't be included in future systems. In addition, much of the discussion focused on the signals that impact when people retire and their expectations with respect to what retirement is or should be like.
The topic of default distribution options within retirement plans is also closely related to signaling because the distribution options that individuals choose at retirement are often a function of the signals they receive. Much of the discussion centered on the topic of annuitizing retirement assets—why it should or shouldn't be done, why it doesn't happen more and what can be done to encourage it. Consistent with the 2007 Conference discussions, there was a general consensus that at least a certain level of annuitization is valuable and should be encouraged to insure against outliving retirement assets.
Self–adjusting mechanisms in retirement plans are plan features which adjust automatically to correct for changes in economic and/or demographic conditions that cause financial imbalance. Examples of self–adjusting mechanisms are social insurance systems that adjust retirement benefits based on longevity for particular age cohorts (as is done in Sweden) or defined benefit retirement plans that base cost–of–living improvements on plan funding ratios. A key aspect of these self–adjusting mechanisms is that they are based on pre–determined rules, which generally eliminate the need for human intervention at the time when adjustment is needed. They can allow a plan to remain viable as demographic and economic changes occur and ensure that problems are fixed before they develop into a crisis situation.
One system that was examined in detail was the Dutch industry–wide pension funds. Dutch industry–wide pension funds are often viewed as a model for other systems. These plans typically provide a career average pay benefit formula, but incorporate self–adjusting mechanisms that can change the contributions made by employees and employers, post–retirement indexation of benefits, the asset allocation, the amount of accrued benefits and even the retirement age. These different provisions are changed based on the funding ratios (assets to liabilities). This system is innovative for several reasons. First, risk is shared between employees and employers and across generations. Second, these plans are typically set–up as industry–wide plans, providing many benefits including greater coverage and low transaction costs. The criticisms relate to whether there is really good inter–generational equity and whether the self–adjusting mechanisms are sustainable, particularly in a financial downturn as currently being experienced. But overall, there are many lessons to be learned from the Dutch with respect to their design.
Market Hedging Opportunities
A final theme of the 2008 conference was the role of markets in providing market instruments needed for new retirement systems. A key question is whether the appropriate raw tools exist within the markets to deal with the challenges of longevity and inflation risks. Much discussion focused on the fundamental characteristics and effectiveness of markets, particularly in light of the current financial crisis, in developing products that can hedge retirement–related risks.
The markets are generally the best place to create efficient prices for particular risks, but only to the extent that there is sufficient liquidity. So, for example, creating a product to trade mortality or longevity risk would only be effective if there is sufficient market demand from enough participants on both the long and short side of the trade. Ultimately it becomes a chicken and egg argument about whether you generate supply or demand first, with discussion leaning toward institutions creating products or systems that create demand first.
An additional key topic of discussion was that of informational asymmetry; a good example of this is in the retail annuity marketplace. In this case informational asymmetry exists because the buyers of products (like retail annuities), lack information or knowledge versus the seller. The role of education was seen as limited; one argument was made that if the information asymmetry is structural, it may require public choice (through defaults, mandates or strong framing).
The role of markets in hedging retirement risks and providing good product solutions will be an ongoing discussion area within the Retirement 20/20 initiative, particularly as the markets potentially evolve in the aftermath of the financial crisis.
Where Are We Going?
To date, we've gathered a lot of input on the stakeholders, objectives and characteristics for a new retirement system. We believe that 2009 will be a transition year for the initiative as we move from creating the foundational ideas to developing blue prints of what a new retirement system(s) might look like. With the change in the U.S. presidential administration and the ongoing financial crisis creating challenges for retirement plans on both sides of the Canada/U.S. border, the time is ripe for new ideas.
While we would like to come up with a perfect solution, we recognize that is not a realistic option. Also we recognize that multiple solutions may provide more choices. Our plan for 2009 is to consolidate and summarize the work to date, with respect to objectives and design criteria, into one report. We have also developed a Measurement Framework (see sidebar, pg. 33) to evaluate existing designs and to illustrate how certain designs do or do not meet the fundamentals and where tradeoffs lie.
We will use this consolidated report as the backdrop for a call for new designs. The Pension Section Council will ask individuals or organizations to construct new alternative retirement system designs that could achieve the goals of Retirement 20/20. (The contest will be announced on the Retirement 20/20 Web site.) We hope the design submissions will vary on a number of characteristics such as use of existing insurance products, use of groups (employer, non–employer, etc.), cost structure, choice options and so on. We will encourage authors to think beyond the constraints of our current regulatory environment when developing their proposals. Submissions will be evaluated by a panel of experts and selected entrants will have the opportunity to present their ideas at a future Retirement 20/20 conference. In addition, we will feature all submissions in a conference report including evaluations of the submissions based on the Measurement Framework.
Our goal is to develop a collection of concrete ideas that we can bring to the public forum for ongoing discussion and debate. We anticipate that this will in turn allow us to reach out further to additional stakeholder groups that have not been well represented in our discussions to date. As stated, the goal of creating a better retirement system is an ambitious one for our profession, but we believe an important one worth pursuing.
Special note: If you would like to learn more about this initiative please review the Retirement 20/20 Web site for more information. If you are interested in volunteering on this initiative, please contact Andrew Peterson or Emily Kessler.
Andrew Peterson, FSA, EA, MAAA, FCA, is senior fellow, Retirement Systems, at the Society of Actuaries. He can be contacted at firstname.lastname@example.org.
Emily Kessler, FSA, EA, MAAA, FCA, is senior fellow, Intellectual Capital, at the Society of Actuaries. She can be contacted at email@example.com.
1A copy of the 2006 Conference report can be found at Retirement2020.soa.org.
2A copy of the 2007 Conference report can be found at Retirement2020.soa.org.