How to Fix the Retirement Savings Crisis
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 497. It's titled, How to Fix the Retirement Savings Crisis.

Recently, I read an article written by Michael Steinberger in the New York Times. The article was titled, Was the 401k a mistake? 401k being the U.S. version of defined contribution plans, which have, for most of us, replaced defined benefit plans or traditional pension plans where you're guaranteed a certain payment for the rest of your life. The article came out

kicked off featuring a woman named Jen Forbus. She turns 50 this year, has good health, used to work as a school teacher, but now is an editorial supervisor at an educational publishing company. She makes high five figures, so I assume around $90,000 a year. She anticipates paying off her mortgage in the next decade and recently made her last car payment. She doesn't have any other debt.

She has $200,000 in savings and she would like to stop working when she's 65. She lives a modest life. She understands the investment options in her 401k plan and has a 60% allocation to stocks, 40% to bonds. She saves 9%.

of her salary and then her employer kicks in another 5%. So she's saving 14% of her income per year going into her 401k. The author of the article says, even if the stock market delivers blockbuster returns over the next 15 years, her

Her goal of reaching a million dollars, that's what she thinks she needs to retire, is going to be difficult to reach. Now, she's not planning on Social Security. I think that's a mistake. I think she can assume that she will receive, based on her salary, a couple thousand dollars a month in Social Security benefits.

But she says, I feel like it's too uncertain and not something I can depend on. So she wants to fund her entire retirement out of her savings, her personal savings. She doesn't participate in any type of defined benefit program.

pension plan. So Steinberger said even if the stock market delivers blockbuster returns over the next 15 years, her goal is going to be difficult to reach. And this assumes that she doesn't have a catastrophic setback like losing her job or suffering a debilitating illness. Jen's entire retirement is based on her personal savings, her ability to continue her

to save, get the company match, and what the market does. So I thought, well, I'll go through the analysis. One of the tools on Money for the Rest of Us Plus, our premium membership community, is we have a retirement planning calculator and a retirement spending calculator. And so I...

went through and put in some assumptions. We assume a $200,000 starting savings for an individual age 50. I used some assumptions I got from AcidCamp, our stock and bond market research tool, to come up with an expected return for global stocks of 7.2%.

For bonds of 4.5%, so a 60% stock, 40% bond allocation would have an expected return of 6.1%. I put that into the calculator, assumed that she increased her contribution as her salary increased by 3% per year, and that inflation was at 3% per year. Given that savings, 40% of income going into savings, a 6.1% annual return,

After 10 years, her nest egg would grow to $556,000. In 15 years, when she turns 65, she will be short. Her nest egg, $852,000. But if she worked another two years, she would have just over a million dollars in 17 years. Look at the big difference between year 15 and year 17, $150,000 difference.

increase due to the compounding, which is why Jen is incredibly vulnerable, like all of us, to sequence a return risk. What returns do we earn on our investments in those final years leading up to retirement or even the first few years of retirement if there's a major market sell-off? That is a flaw in our current retirement policy.

funding mechanism, a flaw that didn't exist previously before defined contribution plans became the default choice for retirement. Back in 1975, 98% of public sector employees and 88% of private sector employees were covered by defined benefit plans. Again, a defined benefit plan is you accrued benefits over time

And then once you were vested, when you retired, based on your income, based on the benefits that you've accrued, you would receive a fixed payment each month for the rest of your life. And depending on how you structured it, potentially the life of your spouse. Defined benefit plans are managed by professionals. There's a pension board made up of senior management of the company. They

They have outside consultants to assist with the investments. They have actuaries. They have professional money management. And it's pooled. It's risk pooling. Some of those retirees will die in the first years of retirement. And those benefits that they accrued will go to those that live longer. And that pooling reduces the longevity risk. The other benefit of defined pension plans is they can invest more.

with a very long time horizon. Because it's not like a defined contribution plan where this is your nest egg and whatever the returns are during your life, that's going to fund your retirement. With a defined benefit plan, yes, they're subject to market risk, but they can ride out a lot of those longer-term declines in the stock market and they've diversified away because they can hold illiquid assets in the private capital space. It

It's just better run and better risk managed compared to what a typical employee is doing with their defined contribution plan. Many grossly unqualified to be managing investments. It's not easy. Why do defined benefit pension plans hire outside advisors to assist them with the asset allocation?

and all of the assumptions to figure out how much to contribute to make sure that the obligations are met. Now, there were issues with defined benefit plans. In the 1960s, for example, Studebaker, a car manufacturing company, defined benefit plan, and they went bankrupt. And at the time, there was no pension guarantee corporation, no insurance mechanism. So you had in

employees that had worked for Studebaker for decades and they were out of retirement. That was a risk also with defined benefit plans. You were with one employer for most of your life. And if that employer went under, you didn't have a pension. So in 1974, Congress passed the Employee Retirement Income Security Act. It created the Pension Benefit Guarantee Corporation. So every pension had to

contribute to an insurance fund to basically meet the pension obligations of corporations that went bankrupt so that their pension plan could continue so that the workers were protected. That was an important change. But it also required additional bookkeeping, additional cost to protect those employees. And that was burdensome for corporations.

Companies could also offer profit-sharing plans, which were like defined contribution plans, but it wasn't until 1978 that the IRS made a change that employees could take cash wages and set them aside in a defined contribution account, that employers could match those contributions, and in the U.S., a 401k plan was born.

I used to consult on pension plans as part of my work as an institutional investment advisor. I saw the work that these corporations did to manage the pension plan. It was a lot of work because the risk...

was on the employer to make sure it met the obligations to its employees. And they took that responsibility seriously. But with the 401k, it had some additional advantages. The workers could take their account with them and they could roll it into the 401k plan of their next employer or they could roll it into an individual employer.

retirement account. The costs were less because the risk was then put on the employees to figure out which option to choose to manage their investments. I had

One client that had both defined benefit plans and defined contribution plans, and the CFO was incredibly worried about his employees and them making the wrong choices with their 401k plan, but he was also worried about getting sued by providing investment advice to them.

employers provide education, but suddenly with a 401k, employees had to decide where to invest it. How does the stock market work? What's a bond? I used to provide 401k education to some of my clients. I'd show up at seven in the morning

After the third shift of a chemical plant, they were done working. We would move into the break room. I'd bring donuts and I'd try to provide some basic education while they were nodding off to sleep. It's a challenge. Still, 401k plans became incredibly popular, both for the employees, but also for the employers. Between 1975 and

and 2019, the number of defined contribution plan participants in the private sector increased from 10 million to 85 million. It's an 850% increase. Meanwhile, the number of defined benefit plans decreased 43% over the same period. This is for private sector employees and employers. What didn't change that much, though,

were public sector employees. The number of public sector defined benefit plans only decreased 12% in the 45 years between 1975 and 2020. And partly it was because the public sector wasn't covered by ERISA. Their cost burdens to administer the plans weren't as high as the private sector. And so now when we look at how much is invested

in defined contribution plans in the U.S., $8.1 trillion. This is as of December 2022, according to the U.S. Census Bureau, compared to $3.7 trillion in defined benefit plans. That's for the private sector. $8 trillion in defined contribution plans, $3.7 in defined benefit. It's reversed for state and local government. $9.5 trillion in defined benefit plans, less

less than $500 million in defined contribution plans.

Defined contribution plans changed the relationship between employees and employers. It was less paternalistic. Employers didn't feel an obligation to make sure that their workers had a stable retirement. And workers didn't feel as loyal to their employers. Gen X and millennials tend to switch jobs a lot more than baby boomers ever did. Millennials can have up to 20 jobs in their career, respectively.

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So there's some reasons why 401k plans became popular. Popular for employees, popular for employers. And it didn't help that by 1982, when more than half of private companies offered 401k plans,

that it was an absolute marvelous time to start investing in the stock market. I wrote about this last week on LinkedIn. In 1982, the dividend yield for U.S. stocks was 6.6%. That's because there was a tremendous bear market for stocks for the previous decade, from July 72 to July 82. Excluding dividends, U.S. stocks fell significantly.

1% per year annualized for that 10-year period. Inflation was very high, over 8%. Earnings were growing at 8% per year and with a dividend yield of 6.6%. Generally, those two combined, if valuations didn't change, that would lead to a 14% return for the stock market over that decade, except stocks plummeted in value. The price-to-earnings ratio went from 17.8% in

in July 1972, down to 7.3% in July 1982. And so these 401k plans were starting and employees were saving at a time when the stock market was incredibly cheap with dividend yields over 6%. And bond yields were also high. Bond yields in 1982 were over 10%. They had reached over 16% in 1981.

And so that first decade from 1982 to 1992, when 401k plans were proliferating in the U.S. and other defined contribution schemes around the world, U.S. stocks returned 17.7% annualized over that decade. And U.S. bonds returned 13.3% annualized. Baby boomers investing during that time, building up their 401k balances had a huge

huge tailwind which contributed to the popularity of 401 plans.

We can take another 10-year period from December 1998 through December 2008, the end of the great financial crisis. During that period, the U.S. stock market returned negative 2% annualized and non-U.S. returned 1.2%. Over that 10-year period of time, if you were getting ready to retire, not so great. Bond market returned about 5% annualized over that time period. Now, most workers, but not all,

have the opportunity to participate in a 401k plan, but they all don't. In 2020, working-age baby boomers ages 56 to 64, only 58% had some type of retirement plan to find benefit, a 401k, or an IRA. So over 40% didn't even have a retirement plan, didn't participate

56% of Gen X ages 40 to 55 participated in a retirement plan. Almost half didn't. And now it's been over 40 years since 401k plans were rolled out. And if we look at the amount of savings that individuals have, it's not enough.

Here's some data from Empower, which is a financial dashboard that aggregates his data. They tend to be more sophisticated employees. For those in their 60s, the median is $207,000. That's the middle. So half have less. If you have $200,000 and you're 65 and you're ready to retire, if you want to spend 4% of that,

to live on, that's $8,000 per year, plus whatever you get for Social Security. That's the median. So half have less than that when they're ready to retire, which is why many don't. They just keep working because the balance isn't what they would hope would like it to be. The median retirement account size for households in the 20th

to 39th percentile is only $20,000. Below that, 20th percentile and below, they don't have anything or very, very little. And when you look at these 401k balances, it can be discouraging for workers.

mainly because of the compounding and the biggest impact of compounding occurs in those later years. We gave you the example of Jen. She's 50, only $200,000 in her 401k, which is slightly below the median for people in their 50s. She could get to a million dollars if the stock market returns 6% per year, depending on whether the market crashes

crashes or not in those final years up until she turns 65 to 67. One of the other things with 401k plans is the ability to take out loans for either a hardship or non-hardship withdrawal. And

And because the balances are so small and the workers aren't terribly sophisticated in understanding the concept, despite all the education they're given, because investing is not easy, 401k plans end up being like an emergency fund. After I took my first job in corporate finance, I worked for AT&T Capital for three years before joining this advisory firm. I had a self-directed 401k at AT&T Capital. I could invest in anything I want.

I put way too much money in a closed-end fund, the Mexico Fund, after the peso crisis in 1994. I didn't really understand closed-end funds. It was selling at a premium, and I lost money. I think my 401k balance was only about $20,000 after I left AT&T Capital in 1995. And then during the internet bubble, I said, well, I'm just going to put it in the most expensive growth stocks I could find.

Now, it was stupid, and I knew it was stupid at the time, but I invested in JDS Uniphase and some other networking company. And then...

And after the bubble broke, it was worth $8,000. So I just pulled it out. I didn't even roll it over. I was frustrated. I said, I'll just, I think we paid off some student loans with it. And I have an MBA in finance and I'm doing stupid stuff with my 401k. Now I wisened up and invested my 401k with my existing employer.

my advisory firm, much more conscientiously. But all the risk was on me, and it's on you to figure this out. Is it any wonder that 76% of millennials and 68% of Gen Xers feel like they'll not have the same retirement income level as retirees of the previous generation? Well, no kidding, because the previous generation had defined benefit plans. And now, after 40 years of 401k, we have aging parents, millennials,

that don't have enough retirement savings. And so their adult children are having to assist, and that keeps them from saving as much as they could in their 401k. Larry Fink, CEO of BlackRock, said in his annual letter, as a society, we focus a tremendous amount of energy on helping people live longer lives, but not even a fraction of that effort is spent helping people afford those extra years.

Now, 401k plans have worked out tremendously well for high income individuals. It's worked out well for me because

Because I got my act together, I was contributing tremendous amounts, maxing out my 401k every year. We had a profit sharing plan. There are all kinds of incentives in place to encourage individuals to save more. There's catch-up provisions. There, the Internal Revenue Service has a retirement savings contribution credit. So there's a tax credit for your first investments in 401k or an IRA. We're not lacking incentives to save. The

The problem is the structure is flawed because there is no risk pooling. Each individual is on his or her own, subject to the whims of the market, subject to their financial literacy and their

their behavioral control, to have the discipline to keep savings and not tapping that savings when there is a crisis, a health crisis or something else. And that is incredibly difficult to do. So if we were going to restructure, we need personal retirement accounts that are similar to defined benefit plans that have the

the risk pooling that have a very long-term time horizon because everybody can be pooled together. And there are countries that have this. Canada has the Canadian pension plan, the CPP, where it's mandatory. Individuals contribute 5.95% to it each year. The employer also contributes that amount. The money is pooled together. It's professionally managed.

And then when you retire or you're disabled, you get a payout every month based on what was contributed. But there's a pooling aspect of it that makes the money last longer. That's why Jen, when she's 65 or 67, if she takes her 401k balance and rolls it into an immediate annuity, she would get around $6,500 a month, just under $75,000 a year.

to live on. Then she would have Social Security and she would basically have her retirement set. She's one of the disciplined, more knowledgeable participants in the middle class, but she understands it. But she's also very aware that that outcome is dependent on what the returns of the market is and that she doesn't get sick and that she doesn't lose her job. She wishes that her retirement wasn't dependent on her ability to invest. It

It makes me very nervous, she said. And she sees her parents and grandparents that have pension plans and she's a little envious. She says, I wish that were an option for us.

Hopefully, there will be that Congress, the government will get together and realize as this generation retires, with most not having enough, many facing homelessness, that just letting individuals be responsible completely for saving and investing their retirement, it does work for a small subset, the minority. But for most, it doesn't because of the lack of risk pooling, because of the lack of

because it's not mandatory to participate, because the assets aren't professionally managed as a pool, every person for themselves. And that's incredible pressure to manage for most individuals. Now, I'm not aware of what's in the works now. I'm sure there's been proposed changes by Congress. But as it becomes ever more clear that we're in a retirement savings crisis, hopefully we can put something together in the U.S. like other countries have done today.

so that individuals can have a more secure retirement. That's episode 497. Thanks for listening.

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