June 2004
A fundamental shift in how individuals save and invest for their retirement years has been taking shape over the past two decades. In our view, the structure that has emerged is presenting some serious problems. Millions of employees are now fully responsible for their own investment decisions through their employer-sponsored retirement plans, while at the same time the government-sponsored Social Security System is expected to feel the strain of the Baby Boom retirement wave. At work is a larger issue of the type of role that both government and employers will choose to play in the financial lives of employees and citizens. The political ideologies that both business decision makers and government officials will play a huge part in this discussion and society's resulting conclusions will impact millions of financial lives for years to come.
After studying the typical structure of most retirement plans offered today - that is, the usual 401(k), SEP-IRA, SIMPLE IRA or Profit Sharing Plan sponsored by employers - it comes as no surprise that over the recent past, the burden placed on most employees has been overwhelming. As investment professionals, we have heard it first hand. In past generations, employers made a financial promise to their loyal, long-time employees that a set amount of money - a defined benefit plan - would be paid to each worker throughout their retirement years. Keeping this huge promise was solely the burden of the employer, and they obviously didn't like it all that much! In fact, old-style pension plans still exist only for our nation's largest employers. Since the early 80's, with the advent of the self-directed 401(k)-like plans - a defined contribution plan - the bulk of US workers have been transformed into their own investment managers. This shift of responsibility matters, especially when viewed in its greater societal context.
Social Security & The Baby Boom Generation
Hundreds of books have been written about the coming retirement of the Baby Boom generation and its financial impact on the health of social security systems throughout the industrialized world. From Japan and Europe to the United States, millions of new entrants will begin to draw from social security systems that have not properly adjusted to the new financial realities. Politicians fear the solutions and for very good reason - they will simply not win elections on a platform of benefit reductions or tax increases. But after seeing the repercussions of some of the huge investment mistakes people made a few years back, the importance of a strong social security system cannot be overstated. It has met its promise and saved many from serious financial trouble.
The raw numbers tell the story of Social Security and the original design in 1935 is far different than the program in place today. In 1940, about 200,000 people received benefits compared to around 45 million people getting monthly checks today. And partly for political reasons, new benefits have been creeping in. In the 60's and 70's, automatic cost of living adjustments were enacted and the earliest retirement age was actually lowered to 62. And perhaps most important from a financial perspective, a new and very expensive benefits program called, Medicare, was created in the 1960's. These changes all enhanced the benefits, but sharply raised the overall cost of the program. It is important to note that in the face of these changes a retiree's life expectancy when Social Security was created was around 65 years old - and not coincidentally, benefits began then - but on average today's retiree can expect to draw benefits into their early 80's. It almost goes without saying that medical technology will likely continue to boost that number northward over the next 50 years.
Another 77 Million On The Horizon
But what is on the horizon is the key worry for government planners. The current system is going to be adding around 77 million relatively healthy boomers to the rolls over the next 10-20 years and the number of workers supporting each retiree is expected to drop from three to just over two by 2025. This problem is just not going to disappear on its own. Instead it will take strong political will and real sacrifice to right the ship sooner rather than later.
With these significant demographic shifts underway, either benefits will need to be reduced or taxes increased to sustain the program. Looking out over the coming decades, an unaltered "pay-as-you-go" program - in other words, current workers paying for the current retirees - will simply create too huge a financial burden on our economy. Already a 15% tax on all wages is needed to fund the system. Estimates for funding today's accruing benefits for the long, long term are literally multiples of that tax rate. Don't worry, we can all expect that Social Security will provide for millions of people over the next 50 to 100 years, but the level of benefits the program will provide and who it will be provided to are still open questions. It is on the minds of many, including Federal Reserve Chairman Alan Greenspan who recently gave testimony stating his real concerns. Predictably, especially in an election year, it is safe to say that he was met with deep and strong resistance from both parties.
Sink or Swim - It Is The American Way
Which brings us back to the ever shifting burden on current workers to manage their own retirement savings. While the government sponsored Social Security System is stretching itself thin and politically we seem unable to take the needed action today, at the same time we have employers embracing the idea of shifting the investment management responsibility onto their employees. A large number of them rightfully put a retirement plan in place, possibly make matching contributions and then let employees sink or swim on their own. Perhaps this has been driven by the ideology that everyone should take care of themselves or maybe it is guided by the belief that our market driven economy has produced strong investment professionals to make up for the public's lack of financial training. In either case, it isn't difficult to see the growing importance of our nation's employer-sponsored retirement plan. And the stakes are higher now than ever before. Unfortunately, what we see out there isn't very promising.
In our view, the primary reason a retirement plans exists is to make money on your money - but our findings show that most employers sponsor plans treat the investment side as nearly an after-thought in the whole process. Instead the focus and definition of satisfaction comes from good plan design and accurate record-keeping or administrative services. Plan design and administration are near givens in the process, but the investment management underlying the plan gets the short-end of the stick. To be fair, this makes sense considering the challenge in finding a good investment professional to begin with. But that doesn't mean it isn't worth the work.
During the bear market from 2000 through the beginning of 2003, millions of participants lost billions of dollars in their retirement plans. In many cases, the poor investment returns of the past few years were partly due to a lack of consideration by employers about which investment professionals should be given the job of providing advice, education and investment management for the plan. Sadly, the default choice was to just provide a menu of mutual funds sold by mutual fund salespeople. And the results have been rather predictable.
Without trying to sound alarming, we do feel deeply about the larger societal issues at hand regarding private sector retirement plans. Considering the growing importance of retirement plans in the face of the long run condition of the public sector's Social Security program, demanding more accountability, responsibility and actual management from real investment managers is needed. We have heard it time and time again from people over the years - "What am I supposed do with my 401(k)?" Well, it looks like corporate America has bluntly and implicitly replied, "Become your own money manager - whether you like it or not!"
"This dramatic demographic change is certain to place enormous demands on our nation's resources - demands we will almost surely be unable to meet unless action is taken." - Alan Greenspan, Fed Chairman
Jason P. Tank, CFA
jason@frontstreet.com