When it comes to planning for retirement, we’ve been setting US workers up to fail.
From Social Security to pension plans to defined contribution (DC), Americans keep aiming to build a better mousetrap, only to find it sprung on themselves.
When we want so badly for this to go right, why do we keep getting it wrong?
We haven’t asked that question lightly. At its core are the principles for designing a better model for retirement planning—one that is inherently more flexible and more adaptable to future needs, and that successfully honors the social contract that lies at its heart.
Flying Lessons: Social Security and Defined Benefit
The earliest retirement systems were pay-as-you-go plans such as Social Security. Underpinning such plans is an implicit social contract: if you live a long time, your country will take care of you.
That has been a wildly popular idea—so popular that any politician who has tried to put the brakes on Social Security has been voted out of office. When Otto von Bismarck introduced the first of such plans in the 1870s in what is now Germany, average life expectancy was a little under 50; benefits kicked in at age 70. It was a sustainable system, but it didn’t benefit many people.
But 70 years old today is about equal to 46 in the days of Bismarck. And if you’re part of a couple living in the US, there’s a 50-50 chance one of you will live past the age of 92. There’s a one in five chance one of you will live to 100.
Longevity risk has reached crisis proportions for Social Security. In combination with generational demographics, this means that there are more and more retirees being funded by fewer and fewer working-age people. In a pay-as-you-go system, that’s unsustainable.
The social contract in defined benefit (DB) is a bit different: in exchange for working for a stretch, your employer will take care of you with a pension after you retire. The pros to DB are the same as the pay-as-you-go system—it provides income for life, and it pools risks.
The cons? For one, you can’t take it with you. For Grandpa’s generation, that wasn’t considered a drawback, but modern-day employees do not spend their entire lives with one company.
In addition, DB funding is very procyclical: it’s most required at those exact times when the plan sponsors are least able to afford it. That is a serious structural flaw.
And that’s where the DC story starts.
The Vanishing Social Contract: DC 1.0
Defined contribution began as a supplement to DB—giving employees an option to do something on top of their other retirement plans. But it’s now Americans’ primary retirement savings vehicle.
There’s a lot to like about the DC system in its 1.0 incarnation. It is portable; it doesn’t lock employees to an employer. It’s also pretty low-cost and low-risk to plan sponsors, though not necessarily low-cost to participants.
But there are some huge cons that have held DC back. The first is that the outcomes participants have been able to achieve by deciding on their own whether to participate and how to invest have not been adequate to fund a dignified retirement.
Not even close.
Because my 401(k) is for me—it’s my money and it’s for my life—I don’t benefit from risk pooling. The investment problem of figuring out how much I need to retire on is therefore “my problem”: and it’s an even more complex problem than a DB sponsor faces.
To assume that every participant in America is going to figure out his or her own solution to this problem—when it’s incredibly hard for someone like me, who spends my whole career trying to figure out answers to these kinds of problems—is simply…wrong. As well-intentioned as it might be, freedom of choice is setting employees up to fail.
The result has been that DC 1.0 isn’t a social contract.
That’s what we all, collectively, must change.
Next week, I’ll share with you our vision for a better future that will restore confidence in retirement for American workers. Because I am optimistic that a bright future lies ahead. Indeed, change is already afoot.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.