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The Solution to the Retirement Income Challenge
By Alicia H. Munnell Steven A. Sass
Brookings Institution Press
Copyright © 2008 Brookings Institution Press
All right reserved.
Chapter One Introduction
Every morning more than 100 million Americans wake up and head out to work. They grab a bite, get the news, then turn their attention to the issues they'll face that day. At times, however, it becomes necessary to look beyond this workaday routine and deal with issues that could disrupt one's life if not addressed. This is one of those times, and the issue is retirement.
A wake-up call regarding one's retirement should come as no surprise. The press is filled with calls to fix Social Security, shore up employer pensions, and make 401(k) plans work better. Indeed, Social Security benefits-relative to earnings-are declining. Employer pensions have become increasingly scarce. And 401(k) balances are generally inadequate. At the same time, longevity is steadily rising. The retirement challenge is typically framed as a financial problem, requiring more saving and better asset management or cuts in promised benefits. The challenge, however, is in many ways better framed as an employment problem.
According to the standard life-cycle model, rational actors respond to a rise in longevity and decline in Social Security and employer pensions in three ways. They spread the burden across the life cycle by consuming less and setting aside more of their income while working; they remain in the labor force longer; and they live on less in retirement. But the baby boom generation has not set aside more of its income while working. Nor do subsequent cohorts seem to be saving much more. This lack of saving puts more weight on the other two responses: working longer and consuming less in retirement. A failure to work longer shifts the entire burden to lower retirement consumption, implying a steep reduction in living standards upon exiting the labor force. Alternatively, the most effective lever for securing a comfortable retirement, especially for the baby boom generation now at the cusp with little opportunity to save, is to remain in the work force longer.
At first blush, it may seem strange to say: "You need to reduce your retirement to ensure your retirement." But it's not nearly as bad as it sounds. Because life expectancy has increased dramatically over the past several decades while the average age of retirement has fallen, working longer does not mean having fewer years in retirement than workers earlier in the postwar era. The working-longer prescription is not about no retirement at all; it's about beginning your retirement somewhat later.
Spending a few additional years in the labor force can make a big difference. It directly increases current income; it avoids the actuarial reduction in Social Security benefits; it allows people to contribute more to their 401(k) plans; it allows those plans to accumulate more investment income; and it shortens the period of retirement. By and large, those who continue to work until their mid-60s or beyond should have a reasonably comfortable retirement.
Working longer, however, will not be simple. It requires thought and planning on the part of individuals. It also requires employers to retain, train, and even hire older workers. Government also has a role to play. And the sooner everybody realizes that staying in the labor force is the best way to ensure a secure retirement, the better.
The Retirement Income Challenge
The major reason that people have to work longer is that the retirement income system is contracting. This system-Social Security and publicly subsidized and regulated employer-sponsored plans-is the major source of support for people as they withdraw from the labor force and as earnings decline. But Social Security and employer-sponsored retirement income plans will provide relatively less in the future than they do today. Employers have also backed away from offering retiree health insurance, leaving households exposed to rapidly rising health care costs. In addition, life expectancy is rising: for men, life expectancy at age 65 was less than fifteen years in 1980 but in 2020 is projected to be nearly eighteen years. Workers in the future will thus need more resources, not fewer, if they continue to retire at the same ages as they do today.
The Outlook for Social Security
At any given retirement age, Social Security benefits will replace a smaller fraction of preretirement earnings than in the past. Today, the hypothetical average earner retiring at age 65 receives benefits equal to about 41 percent of previous earnings. After payment of the Medicare part B premium, which is automatically deducted from Social Security benefits, the replacement rate is 39 percent. But under current law Social Security replacement rates are scheduled to decline for three reasons. First, the full retirement age is currently in the process of moving from 65 to 67, which is equivalent to an across-the-board cut. Second, Medicare part B premiums are slated to increase sharply due to rising health care costs. Finally, Social Security benefits will be taxed more under the personal income tax, as the exemption amounts are not indexed to inflation. These three factors alone will reduce the net replacement rate for the average worker who claims at age 65 from 39 percent in 2002 to 30 percent in 2030 (figure 1-1). This percentage does not include premiums for the part D drug benefit, which will also claim an increasing share of the Social Security check. Nor does it include any additional benefit cuts enacted to shore up the solvency of the Social Security program.
The Outlook for Private Sector, Employer-Sponsored Pensions
With a diminished role for Social Security, retirees will be increasingly dependent on employer-sponsored pensions. At any moment in time, however, less than half of the private sector workforce ages 25-64 participates in an employer-sponsored plan of any type. This fraction has remained virtually unchanged since the late 1970s and is unlikely to improve. Since pension participation tends to increase with earnings, only middle- and upper-income individuals can count on receiving meaningful benefits from employer-sponsored pension plans.
While the level of pension coverage has remained flat, the nature of coverage has changed dramatically. Twenty-five years ago, most people with pension coverage had a traditional defined benefit plan that pays a lifetime annuity at retirement. Today the world looks very different (figure 1-2). Most people with a pension have a defined contribution plan, typically a 401(k) plan, which is like a savings account. In theory workers could accumulate substantial wealth in a 401(k) and offset the decline in both Social Security and employer-provided pensions. Simulations suggest that the worker in the middle of the earnings distribution, who contributes regularly throughout his work life, should end up at retirement with about $300,000 in his 401(k) or individual retirement account (IRA). (Most IRA assets are rolled-over balances from 401(k) plans.) This amount, when combined with Social Security, could easily provide an adequate retirement income. But reality looks quite different. The Federal Reserve's 2004 Survey of Consumer Finances reports that the typical household head approaching retirement (ages 55-64) had combined 401(k) and IRA balances of only $60,000. Nor do younger cohorts seem to be on track to accumulate sufficient wealth to support themselves in retirement (figure 1-3).
The Outlook for Individual Saving
Given the decline in Social Security and employer-provided pensions and the rise in longevity, the standard life-cycle model would expect the working-age population to decrease the share of income it consumes and increase the share it saves. This saving does not have to be in a 401(k). Workers could set aside more of their income for retirement in bank deposits or investments in businesses, securities held outside a retirement account, home equity, or investment real estate. But a study estimating saving by the working-age population, based on the U.S. National Income and Product Accounts, shows that this has not occurred. Both the personal saving rate of the working-age population, which includes 401(k) saving and employer contributions to defined benefit pension plans, and a broader private saving measure, which includes business saving (retained earnings) by businesses owned directly or through equities, have declined. The study also finds that virtually all personal saving occurred in pension plans and that saving outside such plans, in recent years, has actually been negative (figure 1-4).
This disconcerting finding is corroborated by a study based on the Survey of Consumer Finances. It finds that median household wealth, excluding Social Security and employer-defined benefit pensions, has remained remarkably constant relative to household income (figure 1-5). Households have not increased their accumulation of wealth to offset the demise of employer-defined benefit plans or the scheduled reduction in Social Security replacement rates.
Retiree Health Insurance
The preceding discussion focuses on the decline in cash benefits. Employers have also cut back on postretirement health care benefits. Between 1989 and 2006 the percentage of large firms offering such benefits dropped from 66 percent to 35 percent. The decline in participating firms actually understates the extent of the cutback, because the generosity of the benefits has also been reduced. In response to the rising costs of health care, employers have increased retiree premium contributions, copayments, deductibles, and out-of-pocket limits. Moreover, many of those providing postretirement health benefits today have terminated such benefits for new retirees. Thus workers will need more income than they did in the past to cover health care costs that were previously borne by the employer.
In summary, the outlook for retirement income for future retirees is dismal. People are not going to be able to continue to retire at age 63-the average retirement age for men today-and maintain their preretirement living standards over an increasingly long period of retirement. Moreover, dramatically rising health care costs are going to erode already diminished pension income. Working longer is the obvious solution for the baby boom generation, which has little time to accumulate more retirement savings. Even if saving rates in subsequent generations increase, working longer will continue to be an effective lever for securing a comfortable retirement.
Will We Have to Work Forever?
Future retirees need not panic. Although the replacement rate reductions are significant, a few years of work can make retirees in 2030 as well off as those in the current generation. In other words, working longer does not mean working forever.
Each additional year in the workforce increases income directly through earnings from work and investments. It also actuarially increases Social Security benefits by 7-8 percent a year and produces a similar increase, on a risk-adjusted basis, on income from balances in 401(k) plans. The implications on the need for retirement savings are striking. The Congressional Budget Office estimates that in 2004 a married couple earning in the middle of the income distribution could reduce the assets needed to achieve their target replacement rate from $550,000 if they retire at age 62 to $325,000 if they retire at age 66 and to $130,000 if they retire at age 70.
So, how much longer do most people need to work? The easiest calculation is the required response to the increase in the full retirement age. By definition, a worker in 2030 will have to work until age 67 to receive the same replacement rate as a worker retiring at 65 today. Similarly, those who would have chosen actuarially reduced benefits at age 63 in 2002 will have to delay claiming benefits to age 65 in 2030 to receive the same replacement rate.
With a simple model, it is possible to calculate the increase in required work life to offset the projected increase in the Medicare premium and taxation of Social Security benefits. In 2030 the reduction from the Medicare part B premium can be reversed in about six months, and that from taxes can be reversed in about thirteen months. To compensate for all the foreseeable changes to the Social Security replacement rate, workers will need to extend their work lives by about four years.
Workers who reach retirement with significant assets in their 401(k) plans or other accounts will have to work less than four years to offset the projected reductions in Social Security replacement rates. The reason is that additional years of work, assuming financial assets are left untouched, increase the ultimate annual income that can be derived from 401(k) accumulations. Part of the increase comes from the additional investment income. The other part of the story is that by working longer, expected years in retirement decrease, raising the income available for each retirement year. To make income from 401(k)s comparable with Social Security benefits, which are indexed for inflation, 401(k) proceeds would be used to purchase an inflation-indexed annuity. Thus a medium earner who reaches age 63 with 401(k) assets that could buy a real annuity that would produce a replacement rate of 20 percent will only need to work for about twenty-eight months to offset reductions in Social Security. This increase is significantly less than that for workers without financial assets, because the additional income from the 401(k) assets makes up for some of the loss.
The important message is that continued employment means two to four more years of work to maintain today's level of income replacement. This prescription is equivalent to moving the current average retirement age-the age at which half the cohort is out of the labor market-from 63 to about 66. Interestingly, 66 was the average retirement age for men in 1960. This book explores the potential for making such a change.
Organization of the Book
This book is organized around the notion that working longer requires older workers to be healthy enough to work and willing to work. But the decision is not one sided. Employers also have to be willing to hire them. Since both sides of this equation appear uncertain, the question is what individuals, employers, and the government can do to make continued employment more likely.
To set the stage for labor supply decisions, chapter 2 explores whether future generations of workers will be healthy enough to work beyond the current retirement age of 63. Intuitively, people's health affects their ability and desire to work, an intuition that is confirmed by a substantial body of research. People's health can also affect their attractiveness to employers. This chapter explores the extent to which health today compares to health in 1960, when the retirement age for men was 66.
Certainly life expectancy for both men and women has increased since the 1960s. But the relationship between increases in longevity and improvements in health is complicated. If medical advancements keep frail people alive, the overall health of a population can look like it has deteriorated. Indeed in the 1970s, when health trends appeared to be worsening, experts accepted the outcome as the "failure of success." Therefore, it is important to look closely at health trends for both older people (those 65 and over) and for older workers (those 55-64). The trends for these age groups are likely related because presumably if those 65 and over are healthier, those 55-64 should also be healthier.
The evidence suggests that the health of older people, as opposed to older workers, showed little improvement in the 1970s, mixed results in the 1980s, and marked improvement since the 1990s. The improvement for older workers most likely began earlier, in the 1980s. Today, the health of older workers appears to be at least as good as it was forty years ago. And today's jobs are less physically demanding. Thus if half of the male population was healthy enough to work until age 66 in 1960, the same percentage should be able to do so today. Two notes of caution are needed. First, 15-20 percent of the older population will not be able to work that long. Second, some studies suggest that the improvements seen to date may not continue and might even reverse.
Given that improved health should enable most people to work longer, chapters 3 and 4 turn to the question of whether older men and older women are likely to want to work. It is necessary to deal with men and women separately, because women's work patterns reflect the increasing participation of cohorts over time as well as the factors that affect retirement behavior. Putting the two together muddies the waters.
Excerpted from Working Longer by Alicia H. Munnell Steven A. Sass Copyright © 2008 by Brookings Institution Press. Excerpted by permission.
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