Reforming the Second Tier of the U.S. Pension System: Tabula Rasa or Step by Step?
George A. (Sandy) Mackenzie
Jonathan Barry Forman
University of Oklahoma College of Law
December 4, 2013
John Marshall Law Review, Vol. 46, No. 3, 2013, pp.631-679
Employer-sponsored pensions, the second tier of the United States retirement system, ought to be a major source of lifetime income in retirement for many, if not most, Americans. However, while employer-sponsored pensions are mandatory or quasimandatory in many countries, they are voluntary in the United States. That is, employers are not required to offer pensions, and when they do, they have considerable leeway about whom to cover and how much to contribute on their behalf. Not surprisingly, at any given time, only about one out of two American workers has a pension, and few can be confident that they will have enough income to meet their economic needs throughout retirement.
Moreover, 401(k)-type plans offered by employers have largely displaced traditional defined benefit plans as the dominant type of plan. Membership in a 401(k) plan, however, does not guarantee that retirement savings will be adequate; in fact, many 401(k) plan participants do not take full advantage of their plans in that they neither contribute the maximum nor take full advantage of employer matches. These days, the median balance of these plans is only around $77,000, which is enough to finance a stream of before-tax annual income of about $5,000 a year for life at current interest rates. Yet, 401(k) plans are not required to offer annuities and very few do. Indeed, there has been a significant decline in annuitization of retirement savings by workers. The shift to 401(k) plans is a large part of the story, but it remains true that people rarely choose to buy annuities voluntarily, even though annuities could provide them with very valuable insurance against living too long.
How much a household should save for retirement and how much of that accumulated saving should be used to purchase an annuity are extremely difficult to determine. Economists assume that the basic goal of retirement saving is to generate a nest egg large enough to sustain the standard of living in retirement that the saver enjoyed while working. It is generally assumed that the ratio of income in retirement to income in working life, known as the replacement ratio, needed to achieve this goal is less than one hundred percent. In fact, it is more like eighty percent, because certain expenses like commuting, lunches, and other various expenses would not be needed.
Even if we can be very precise about the replacement ratio a household should target, determining the share of income that ought to be put aside to finance retirement is no mean feat, given how uncertain the rate of return to saving and household income can be. Further, even if we can predict incomes and rates of return exactly, the mathematics involved in calculating the targeted saving rate would be beyond the means of most people. In any case, simply maintaining the needed saving regimen is itself a challenge, given the number of temptations that the American consumer faces. All in all, there is reason to believe that many, if not most, American workers are not saving enough for retirement.
This article focuses on how to reform America’s employer-sponsored pension system. It begins with an overview of the current retirement system, which includes both Social Security and private pensions. Next, this article considers how much retirement savings workers will need to ensure that they have adequate incomes throughout retirement. Finally, the article offers some recommendations about what a good, second-tier (employer-sponsored) pension system would look like.
Number of Pages in PDF File: 50
Keywords: pensions, Social Security, retirement
JEL Classification: G23, H55, J11, J26
Date posted: February 5, 2014