Monday, September 24, 2012

Unintended Consequences

Unintended Consequences

It’s fairly well acknowledged that American’s are ill-prepared financially for retirement.  Experts lament the low savings rate and urge Americans to increase the amount of income they set aside: great advice if you make a high enough wage to forego current income.  While Americans do indeed save too little, the lack of adequate nest eggs is actually the byproduct of unintended consequences.

Nearly 4 decades ago in the mid-70s, Congress enacted two provisions with laudable purposes.  First, they allowed people without retirement plans to create individual retirement accounts (the IRA).  Second, they allowed taxpayers to defer a portion of their current income under a new provision called section 401(K).  So far so good.

Napkin #3 (1999)

In 1981, the 401(K) was expanded as a supplemental retirement plan, and the IRA was expanded so that people with retirement plans could also contribute to IRAs (and get the tax deduction).  Again, these changes seemed fairly enlightened.  However, these changes were really the beginning of the end of America’s progress toward retirement security.

Wall Street pitched a win-win-win strategy.  I don’t think their goal was to intentionally destroy the retirement safety net.  Rather they saw an opportunity to make a lot of money.  First, the investment bankers convinced corporate executives to discontinue or freeze defined benefits plans, which guarantee retirees a fixed amount of income.  This move freed up cash for the company and the executives’ bonus plans.  Second they pitched 401(K) plans to shift the retirement risk to employees.  Third, they sold the new 401(K) plans to employees as portable vehicles that would give the employees control over their assets. The supplemental retirement plan was becoming the primary vehicle.

Wall Street was the big winner as rapidly expanding 401(K) and IRA programs became incredible marketing opportunities, created new services and generated higher fees than those available from traditional retirement plans.  Truth be told; I participated in this bonanza. 

For the next twenty years, one traditional defined plan after another was eliminated until virtually the only remaining guaranteed retirement plans covered public employees and unions.  And now these remaining plans are under attack as the general public is envious of the relatively superior security afforded civil servants and organized labor.  This attack is extremely misguided, because as these workers lose their defined benefit plans, they too will fall into the retirement crisis that will unfold in the next couple of decades.

Here's the problem in a nutshell for those without a defined benefit plan.  Even folks who were reasonably diligent about their retirement are likely to have a problem if they live into their eighties (we’re talking average life expectancy).  Suppose you and your spouse are about age 65 with an average retirement balance of $250,000 (according to Fidelity this is the average for folks at this age, although the median is probably lower since wealthy folks skew the average), and earned about $100,000 per year when you retired.  You’ll get somewhere around $40,000 per year from social security, which means you’ll need another $20,000 to $30,000 live.  So you’ll have to draw from your 401K, and in the absence of other savings or equity in your home, you’ll have depleted your 401K by the time you reach age 75, and that assumes you don’t face some type of extraordinary health or personal crisis.  This is the situation facing millions of aging baby boomers.  If you have some other savings you might get into your 90s, but it could get ugly in your final years.

As a country, our collective situation is dire, as 37 million households have no retirement plans of any kind.  Now some of those folks are many decades from retirements, but millions of folks are headed into retirement with only social security as their source of income.  Someone is going to pay for the hardship, disease, and social unrest that comes with a growing cohort of impoverished elderly.

The traditional solutions favored by Republicans and Democrats won’t work.  Increasing the amount you can contribute to retirement accounts or creating new types of individual savings plans only helps the folks who are already in decent shape and allows Wall Street to make more money.

Although it’s incredibly unpopular in this day and age we need to go back to the days before the mid-seventies when defined benefits were the rule instead of the exception.  Every developed country in the world has such a system, and as long as their overall population isn’t aging (and our population isn’t aging), these retirement systems work.  The day-to-day nature of capitalism doesn't leave any room for the value of a dignified retired.

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