(Bloomberg Opinion) — As a retired economist — not to be confused with a retired economist, which are rare — I often find myself talking to Wall Street guys who are responsible for a lot of other people's money. Conversations vary, but eating almost never does. As a senior executive at a major asset management firm recently told me with startling candor: “We don't know how to solve the pension problem.”
By “problem,” he meant falling part of Americans who see their retirement plans as on track. And by “we,” he meant the financial industry—which, to be fair, has made some progress in offering different types of accounts and ways to save. But the big things are still going wrong.
People have no idea how much money they need to retire. Their estimate of retirement costs increased by 50% in the past four years, even though life expectancy barely changed. If anything, they should have revised their estimates down because higher interest rates mean they need less money to retire. This shows how badly the financial industry has educated people about retirement costs and what kind of assets they need.
There is some good news. More employers than ever offer retirement benefits, and automatic enrollment has increased worker participation and improved the way investments are made. 2022 Safe Act should extend the coverage even further. Americans today they have more money saved than previous generations.
At the same time, Americans are now living longer and there is no political appetite to encourage people to retire later. This means that the number of years Americans are spending in retirement will increase, so they will need more income.
There's no getting around the fact: A well-funded pension without financial risk is too expensive. Larry Fink, CEO of BlackRock, points out in his annual shareholder letter that the shift to defined contribution plans like the 401(k) meant that individuals rather than corporations bore all the risk. This is partially true, although defined benefit plans had more risk than realized many of their beneficiaries and firms often underestimated the cost of bearing this risk. This is why defined benefit plans have become so rare in the private sector.
Employers who offered defined benefit plans, however, had one thing right. They understood the risk problem they faced: securing a certain income in retirement.
Defined contribution pensions do not have such a clear purpose. Often their brochures talk about income, but the strategies seem more geared towards achieving a certain level of wealth. Most investors—and the retirement industry—judge the success of their retirement portfolio on its value on any given day, or over an arbitrary period, or on how much money it will have on the first day of retirement.
But the goal of retirement funding is not the level of your wealth on a given day. It is predictable income for the duration of your retirement. Getting this basic premise wrong exposes retirees to a huge and difficult risk.
Take the target-date mutual fund, which invests young savers in stocks and moves them into bonds (whose duration shrinks) as they age. This strategy aims to grow their money and keep their assets from depreciating too much as they approach retirement. But that doesn't help them know how much they should spend each year, let alone how to maintain that level of spending. The present one the most popular spending rules leave retirees with large annual fluctuations in income and vulnerable to the risk of running out of money.
Solutions exist. They begin by redefining the retirement problem as one of future income, not current wealth. That means different standards that treat retirement accounts as mini defined-benefit plans and assess how close clients are to achieving an income stream over years.
What might these standards look like? They would involve converting the balance of assets into income using a long-term interest rate. The original Safe Act requires that retirement account statements show an estimate of income, but it is often secondary to showing a balance of assets. How well a saver is doing and whether the plan has provided suitable investments is still compared to a wealth goal.
Revenue, as a goal, should be more prominent from the start – and should be how success is primarily measured. The investment menu should also offer more income-oriented investment strategies. The idea is to give people a sense from the start of how much income they can expect when they retire. It would help ease the transition from work and saving to retirement and spending.
There should also be more and better annuities, both immediate and deferred. It is impossible for people to predict how long they will live and what their care needs will be. The best way to manage this risk is through insurance. Through the magic of risk pooling, people who need care or will live to 105 are subsidized by people who don't or don't want it. Everyone has more security and it's cheaper than taking this risk individually.
People fear annuities for good reason. They've gotten a bad reputation also because the low-fee environment made them very expensive, and there are also many expensive products with hidden risks and features that people don't need. People also don't like to give up their hard-earned savings on an insurance company.
Finally, America must start thinking more creatively for work. One reason the conversation about raising the retirement age has become so politically toxic is that many people see work as a binary: you're either working full-time or you're not working at all. This doesn't make sense. The US can find ways to subsidize people who physically cannot work into their 60s and still strongly encourage everyone else to work longer. It can be part-time work, which many people can do well into their 70s. Staying partially engaged in the workforce is extremely rewarding both financially and mentally.
But proposing solutions, I've learned, is the easy part. Making actual changes is almost impossible. Risk aversion and perverse incentives are so embedded in the pension industry that unearthing them would require a whole other column.
To give just one example: Even changing what a statement says is difficult. Record keepers, who have the tedious and more difficult task of keeping track of what's in everyone's accounts each month, have no desire or incentive to change the way anything is measured. And they are very powerful.
In my conversations with people on Wall Street, I often say that I like being a retired economist because it offers satisfaction and security. It's satisfying because figuring out how to make retirement work better for more people isn't really that complicated. And it's safe because, while there's always an audience for “how to solve the retirement problem” ideas, no one has much incentive to act on them.
More from Allison Schrager on this issue:
For more Bloomberg Opinion, subscribe in our newsletter.
To contact the author of this story:
Allison Schrager at (email protected)