PROJECT M
 
Stacy L. Schaus
David Wray
Olivia S. Mitchell

Conference Call: What lies ahead for DC?

Defined contribution plans such as 401(k)s are expected to be the dominant saving scheme in the near future. But, if contributions are voluntary, will people save enough? That largely depends on the industry’s success in financial education, both Olivia S. Mitchell and David Wray agree.

Conference Call: What lies ahead for DC?

Defined contribution plans such as 401(k)s are expected to be the dominant saving scheme in the near future. But, if contributions are voluntary, will people save enough? That largely depends on the industry’s success in financial education, both Olivia S. Mitchell and David Wray agree.


Stacy L. Schaus

David, as retirement saving enters a new era, do you consider defined contribution (DC) an appropriate strategy to achieve savings needs?

David Wray

People in DC plans can accumulate adequate assets, but the system is not yet fully mature. The amount of total assets in DC grew from $1.4 trillion in 1994 to $4.1 trillion in 2009 and the number of participants increased as well. Even so, I do not expect defined contribution to be mature for another 15 years, when a significant percentage of workers have participated in plans for 30 or 40 years.

Stacy L. Schaus

We’ve heard government estimates that only half of American workers are covered by defined contribution plans. Olivia, how can we increase the number of participants?

Olivia S. Mitchell

The number of workers covered by employer-sponsored pension plans is lower than it should be, mainly due to the inability of low-income workers to save. In addition, since the US Social Security system currently offers them a generous replacement rate, low-income workers do not always see the need to save. Financial education would help increase the number of savers.

David Wray

I believe the 50% coverage estimate is inaccurate. The Bureau of Labor Statistics’ National Compensation Survey found that 67% of all workers employed by the private sector, including part-time workers, are covered by an employer-sponsored retirement plan; according to the report, 76% of all full-time private-sector workers are covered. And this percentage has been increasing. Since virtually all government workers enjoy employer-sponsored retirement plans, the percentage of coverage for all employed workers exceeds 70%.

Stacy L. Schaus

A study by the Employee Benefit Research Institute (EBRI) found that less than 25% of retirees have ever had a defined benefit (DB) payout and, at that, the median payout amount was less than $10,000 per year. Would you say people are better off investing into a defined contribution plan?

Olivia S. Mitchell

Nostalgia for “the good old days” can be misleading. A significant part of the workforce has never had a DB plan. With turnover, job changes and layoffs, only 10% of employees with access to DB plans received a benefit payment. Given our mobile labor force, DC will enable workers to accumulate assets better than traditional DB.

Stacy L. Schaus

Defined contribution poses a lot of questions: Will people have the discipline to save and not cash out? Will they successfully manage their savings to provide a steady stream of income?

David Wray

The expected salary of a typical US worker shortly before retirement is approximately $50,000; Social Security replaces 40% of that income at full retirement age. Given that most people can comfortably live on 80% of their final salary, they still need another 40% to supplement Social Security. Saving to meet that 40% income replacement clearly is within reach via the DC system.

Stacy L. Schaus

Olivia, do you agree?

Olivia S. Mitchell

In theory, yes, but the question is one of leakage from the system. Options for accessing the money early with loans, hardship withdrawals and lump sums after changing jobs potentially must be limited. In addition, if people do not buy an annuity or longevity insurance at retirement, they run the risk of outliving their assets. We may have to think about encouraging annuitization of DC balances at retirement.

Stacy L. Schaus

David, are people likely to reach their retirement income goals?

David Wray

EBRI reports that people in their 40s have approximately $40,000 in DC assets and that sets them on the right track. Younger people who participate in DC for another 20 to 25 years are in good shape. Since the system depends on voluntary contributions, it will never be leak-proof, but we do not want the perfect to be the enemy of the good.

Stacy L. Schaus

Yet cash-outs, which are disallowed in some European plans, are taken by up to 50% of US workers when they change jobs. Are we too focused on offering choice?

Olivia S. Mitchell

According to plan sponsors, lower-paid employees are reluctant to give up liquidity, but the broader concern is financial illiteracy. My daughters’ response to retirement saving is that investing in financial market instruments is likely to lose money, while the return on risk-averse investments is negligible, so why not go and buy a car? The crisis has made educating the next generation more challenging.

Stacy L. Schaus

David, can DC plans be successful without loans?

David Wray

They will not be as successful. When I was a plan sponsor, I sat across from single mothers trying to buy shoes for their kids. The only way to convince them to participate was to say “Put your money in the DC plan, and if your car breaks down, you can borrow it to fix your car.” Loans were the only argument to attract these younger and lower-paid workers.

Stacy L. Schaus

How can we improve financial education in a spending-focused culture like the United States?

Olivia S. Mitchell

We need mandated financial education in high schools, which should be custom-tailored to target groups. Young adults are more likely to be financially literate and there is a positive correlation between financial literacy and retirement planning.

Stacy L. Schaus

Let’s turn to market risk and inflation. How do we ensure savers have the returns and the risk hedging they need?

Olivia S. Mitchell

“The DC plan is the only solution to the challenges facing the US retirement industry.”
David Wray
I personally put most of my pennies in TIPS [Treasury Inflation-Protected Securities: fixed-income securities whose principal value is adjusted to inflation. Repayment of the adjusted principal on maturity is guaranteed by the US Government]. Since the deficit we face is high, it will be difficult to avoid inflation in the future. Another option is to include principal-protected products like guaranteed minimum benefits or annuities from 401(k) schemes. Plan sponsors are considering insurance products, but understanding and evaluating these complex products can be difficult.

Stacy L. Schaus

David, do you agree?

David Wray

We need to increase people’s confidence in the system. The recent crisis has sown a serious seed of distrust in the future that will take a long time to repair.

Stacy L. Schaus

More companies encourage employees to remain in their plan at retirement. Does that make sense compared with the retiree rolling money into an Individual Retirement Account (IRA)?

Olivia S. Mitchell

That is hard to say. Since employees may have access to more efficient investments in a larger plan than in an individual IRA, it does. Yet with an IRA, they may receive the service of a financial advisor. David, what is your view?

David Wray

While people were literally booted out of plans when they retired 15 years ago, most companies have come to realize that participants taking out large balances impact the economics of the plan. This is true especially for the largest plans that offer institutionally priced investments, which are better than IRA fees.

Stacy L. Schaus

Should guaranteed products be mandated?

David Wray

In the wake of a crisis that has severely diminished confidence in the government and financial service industry, both participants and plan sponsors are reluctant to give up control. A mandate would not be supported.

Stacy L. Schaus

So what lies ahead?

Olivia S. Mitchell

I may sound gloomy, but we face significant challenges: Government budget deficits are growing, the national debt is going through the roof, and taking Social Security and Medicare obligations into account, the US financial situation is not that different from Greece’s. We have to implement reforms, and I am concerned that maybe we won’t in time.

David Wray

Retirement must be prefunded. The DC system will be the solution for most. It alone can build the significant personal assets we need.

Stacy L. Schaus

Thank you both for your time.

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