M E R I D I A N M A G A Z I N E
A recent article in the Wall Street Journal began this way:
Employees of large companies are getting a wake up call from corporate America: It’s time you learn to take care of yourself.Pension Pain: How to Protect You Retirement, WSJ February 8, 2006
Baby boomers are facing the perfect retirement storm.
This confluence of events will sink some retirees.
Just how did we get in this mess? And who is to blame? (Actually wanting to know who is to blame is symptomatic of the problem that has gotten us into this mess.)
As I spend a few minutes on each of the elements of the approaching storm I believe you will find a common theme running through each problem. People at all levels want to put off paying until tomorrow. All these problems are quite complex when examined in detail. I will try to brush over the highlights.
Who is to Blame?
Just about everyone. Workers, managements, unions, politicians, voters, Wall Street, banks savers and spenders. Did I forget anyone? (Oh, Church leaders have been preaching and practicing thrift and savings since at least Brigham Young’s day so we probably can’t blame them.)
The Social Security system has always been a pay-as-you-go system. Taxes taken from your check today are not invested to pay for your retirement tomorrow. Rather they go to pay the benefit of a person already retired. This means some future worker must pay your benefit.
At times the social security system has run a surplus, collecting more taxes than were being paid in benefits. That is the case today. Unfortunately, the government has not saved those surpluses. For decades our presidents and congressmen have spent the surplus dollars on current needs such as roads, defense and welfare. U.S. treasury bonds have been put in the trust like an IOU.
This is not all bad, treasury bonds are considered the safest investment on the planet. But it requires your taxes to pay them. And in this case they will need to be repaid when social security has swung to a deficit, meaning taxes need to be raised just to meet current obligations. Sounds like a mess and it is. They have all done it--Republicans and Democrats. And they did it because they were representing us and we wanted government services but didn’t want to pay for them, so they borrowed the Social Security surplus to help balance the budget. Let’s have the services now and we’ll figure out how to pay for it later.
It would have helped if the surpluses had been saved, but it wouldn’t have solved the Social Security problem. The problem is much more fundamental than that. This is a pay-as-you-go system. Demographically, we are facing a time when we will have too few workers supporting too many retirees and the promises made to those retirees have been growing.
The baby boomers are at the very heart of this demographic storm. Some difficult political choices must be made and politicians do not yet seem willing to make them. This is unfortunate because as with everything dealing with retirement the faster, you can address the problem the better. The laws of compounding work everywhere when it comes to retirement.
A year ago President Bush was proposing a program that would make a small start toward moving away from pay-as-you-go. What followed was politics at its ugliest. There are politicians that want the issue to remain an issue because they campaign on it year after year. Heaven forbid that it should actually be solved because then the politician’s issue would go away.
Further, many do not want the other side to get credit for solving a problem no matter how urgent it is. You can tell this is one of those issues because the critics never proposed any solutions of their own.
One of the most disgusting groups to get into the fray was AARP. The facts are this; AARP went out of their way and spent large sums of money to scare the wits out of their members, namely retired senior citizens. AARP lead them to believe that the proposed changes would mean seniors would lose their social security.
The truth is, and AARP knows it, no proposal changes anything relative to the benefits of people 55 years of age and older. AARP, as one of the most powerful lobbying organizations in the country, for some reason, was willing to mislead their members and frighten them into opposing change.
Note, neither AARP nor the politicians that lined up with them, have offered any reasonable alternative. AARP’s position is all the more baffling because, as you remember, the President’s proposal involved putting a portion of your taxes into a private account that you own and invest. AARP saw this as disastrous because you are too stupid to manage your own affairs. (They point to the same facts that I point to in the 401k section of this article. But the social security proposal was not open to any of the same abuses that are common with 401k’s.)
AARP takes this “you’re too stupid to manage your own affairs” position while at the same time they are one of the bigger sellers of mutual funds in the country. If people can’t handle their private social security accounts how can they handle a mutual fund account that AARP sold them? Go figure. Only in politics.
Pension plans, or defined benefit plans, promise to pay the employee a certain amount of money each month after retirement. Law requires that the employer contribute a certain amount of money each year into a trust, usually administered for the employees by a bank. Then, when the workers retire, the money will be available whether the employer is still in business or not.
Unlike Social Security, these plans are intended to be “invest-now-spend-in-the-future” plans. Further, the employer cannot use the funds for its’ own purposes. The money belongs to the employees not the employer. Generally, the company can’t even buy its own stock with the money in the trust.
Many employers offer these plans. Pension plans have been a mainstay of employee retirement benefits for many years and many baby boomers have been counting on them.
Recently there has been a lot of news about some major corporations eliminating their pensions. The fact is most pension plans in the country are still OK and will meet their obligations to their retirees. However, there are some high profile plans that are in trouble and beyond those, there is now a trend toward freezing pension plans by otherwise healthy companies. Freezing the pension can hurt some employees and they tend to be “boomers.” Here’s a bit of history.
Unions and managements made mistakes. You will note that most of the plans making big news are associated with companies that have powerful unions and have had difficult labor relationships for years. These include industries like airlines and automobiles. All these issues are complex with many points of view. However, one thing that has occurred is a “settle-it-now- and-we’ll-pay-for-it-later” approach.
During strikes and difficult labor negotiations, at times the solution has been to provide new pension benefits for existing and retired workers. Retired medical care has been another popular item. These actions often created huge unfunded liabilities for the companies.
The thinking was, we can settle this strike now and figure out how to pay for it later on. And what the unions won was generally extended to non-union workers. “Later on” is here in many cases and the companies cannot figure out how to pay for it. This has resulted in some plans being substantially under funded. The costs associated with these unfunded liabilities leaves the company uncompetitive with competitors who have not made such agreements.
Management and Wall Street made mistakes. The law requires that the employer contribute an amount into the pension fund trust each year. How much they are required to contribute is the result of highly complex actuarial calculations. One of the key figures in these calculations is the assumption of how much the fund’s investments will earn. The higher the assumption the lower the required contribution. The lower the immediate contribution, the higher the reported earnings for this quarter.
In the late 1990’s the stock market was roaring. Helped along by Wall Street’s assurances many managements increased their actuarial assumptions to unrealistic levels. It was sort of we will report lower pension expenses now and figure out how to pay for it later. When investment reality set in, the market slumped and some plans were left with a substantial under funded liability.
Most corporate pension plans are insured by the Federal Government. The problem is that the Pension Benefit Guarantee Corporation (PBGC), that government entity that insures them, has never been adequately funded and premiums for the insurance have never been high enough. Now large bankrupt corporations like United Airlines are dumping their plans on the PBGC. Taxpayers will wind up holding the bag.
Many companies are trying to figure out how to get out from underneath the expense and burden of their pensions plans. One solution has been to freeze the plan. This does not mean the company takes all the money back and employees get nothing. The money already contributed to the trust belongs to the employees not the employer. But it does mean that in many cases the employee will not get what he thought she would be getting at retirement. Their benefit stops growing now and often that is a fraction of what the employee might have reasonably expected to get if the plan remained in effect and the employee had become fully vested.
Much of the news has focused on large companies in bankruptcy or facing serious financial challenge. Companies like General Motors and United Airlines have received considerable attention. However, the idea of freezing pension funds is catching on and we are likely to see many more financially healthy employers follow-suit.
Often companies are replacing the pension benefit with an improved 401k benefit. Some employees might actually make out better in the long run. (But see the section on 401k’s below.) Those employees that stand to do better are younger workers. Those who stand to be hurt are older workers especially if they have been job hopping and have not built up much of a vested benefit in the employer’s current pension plan. In this case they get little from the pension and have little time to build much wealth in a 401k. This is the situation for many baby bombers.
The popular 401k retirement benefit is a defined contribution plan. This means the employer contributes money to an account for the employee based on a formula. The company does not guarantee the outcome. That is the company agrees to put money in but how much that money will be worth when the employee retires is not guaranteed by the employer. In this way the employer shifts the risks of market volatility and poor investment decisions from the company to the employee. Many people working for government or not-for-profit employers have similar plans with different names like 403b. These little acronyms represent the section of the tax code that creates them.
In theory the 401k is one of the brightest employee benefit ideas to come along and I have been enthusiastic about them for decades. The law allows the employee to be far more involved in his/her own retirement decisions. This is something I personally believe in deeply. The problem is sometimes people really do make dumb short run decisions and we’ve seen a fair amount of that when it comes to 401k’s. (It must have been a very hard decision for God to give us agency knowing how many of us would use it badly.)
Failure to use the 401k. Most 401k plans provide an employer match. For example, if the employee will have 4.5% of her salary withheld the company will put in 4.5%. In this they are giving away free money and great tax benefits. Many feel they need all their money now and elect not to participate fully or at all. I need the money today, I’ll figure out retirement later on.
Failure to roll the 401k over. One great advantage of the 401k is that the employee can take it with him when he changes jobs. Usually this is done by rolling it into an IRA. These days people change jobs frequently. Unfortunately, large numbers of these job hoppers look at the check representing their 401k benefits they receive from their former employer and decide to keep it and spend it rather than roll it over. This is an especially poor decision because the government hits them with a 10% penalty plus current income taxes on the full amount for doing this but people do it anyway. Spend it now and figure out retirement later.
Taking a loan from the 401k. Many plans allow the employee to borrow from her 401k. Most of these get paid off properly with some modest loss of investment return to the account. However, if the employee is laid off or quits the loan is due and payable immediately. In that case the many simply don’t pay and the value of their 401k declines accordingly. This event is also viewed as a premature withdrawal by the IRS with exactly the same penalties and taxes as described above. The actual effect is to borrow from your retirement today with penalties for doing so and figuring out how to take care of your retirement later on.
Investing too conservatively.This is a long subject but studies show many employees are too conservative with their investment selections thus hurting their accumulation of retirement dollars.
401k’s are truly one of the best employee benefits to come along when the employee understands the intent is to accumulate retirement dollars and handles it well. Too many make short-term decisions that can mean they have little or nothing in the 401k when retirement actually comes.
In January we all heard the news; 2005 was the first year since the Great Depression that American’s spent more than they earned. The cumulative national savings rate was negative. Faithful MoneyWise readers saw this coming since I have written on this subject several times and included the statistics. Our economy is not in a great depression. Economically, 2005 was a very good year with low inflation, low interest rates, solid employment and rapidly expanding GNP. However, unlike the Great Depression, there was in 2005 a national mind-set of buying now and paying later.
Way back in 1980 I wrote a piece that argued essentially that just the opposite would be occurring right now. Historically, young adults must consume and borrow more than their current earnings to accumulate their first cars, their first homes, their first babies, etc. That’s where the boomers were in the 70’s and 80’s. Over the years this has always reversed itself with people in their forties and fifties paying down their debts and saving for retirement.
With the huge post war baby boom entering these traditional savings years in the late 1990’s and early 2000’s, it seemed like a safe calculation that the national savings rates would be rising. I was wrong. The boomers have lived their entire lives in a period of amazing affluence with more and more things always available to buy. Many boomers have never had anyone tell them “No” and many boomers have never developed the ability to tell themselves “No”. For many there has always been an attitude that I deserve what I want now and I will figure out how to pay for it later on.
Of course, many boomers have handled themselves very well and will do well in retirement. Unfortunately, the statistics show many have not. I do not wish anyone bad luck or hardship I truly don’t. But some baby boomers are facing the perfect retirement storm.
Social security, which has always been hard to live on, may be even less than expected, corporate pensions may come in well below past expectations, 401k’s and IRA’s may have been used up or never invested in to begin with and retirement is at the door with large credit card debts, a refinanced home and a leased car. If that is your forecast I encourage you to begin today to do everything you can to point yourself in a different financial direction.
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