As the large Baby Boomer generation enters its golden years — 10,000 people a day are now turning 65 — twin retirement crises have emerged.
In the private sector, defined benefit pensions have largely vanished. Meanwhile, most employees have no defined contribution retirement account at all, or their account balances are too small to generate significant retirement income. One rule of thumb suggests that retirees plan to withdraw 4 percent of their retirement account balances each year to avoid running out of money before death. Under this rule, a retiree who has accumulated $100,000 in her 401(k) plan would only be able to withdraw $333 per month. This barely supplements her Social Security benefits, and Social Security was not intended to be a retiree’s primary income source.
In the public sector, most workers are eligible for defined benefit pension plans, and those who hold down government jobs for 20 years or more can usually look forward to a secure retirement. Unfortunately, the cost of these benefits is producing a strain on many local governments and crowding out other services. In a recent study of California cities and counties, I found 26 entities that were devoting 10 percent or more of total revenue to pension payments, leaving less money for repairing roads and maintaining adequate police and fire protection. Meanwhile, California school districts are expected to see their pension contributions double between 2016 and 2023. These costs are contributing to a new round of teacher layoffs despite the state’s strong economy.
Innovations in the financial technology sector can help us meet both of these challenges — if we make smart policy changes. If individuals could save more money on their own, private sector workers could enjoy a secure retirement and the public sector could scale back some of its costlier defined benefit pension commitments. But, historically, individual investment accounts have done more to enrich financial services businesses than to enable savers to reach the critical mass of assets necessary for retirement.
Commissions and fees create major barriers to accumulating sufficient retirement savings. Traditional mutual funds levy sales commissions (or loads) when shares are purchased or sold. While no-load funds have become more popular in recent years, many funds still have annual expense ratios of greater than 1 percent — which means that the fund manager is taking 1 percent or more of each investor’s money each year. Funds charge high fees to cover the salaries, benefits and expenses of portfolio managers and other employees — and Wall Street professionals aren’t cheap. Portfolio managers often fly first class to visit companies they are evaluating and stay in high-end hotels while on the road. Fund management companies offer employees expensive perks such as annual off-sites and free gym memberships.
Equally troubling is that research shows most professional investment managers are unable to consistently outperform stock market indexes, which helps explain why investors have flooded into low-cost alternatives such as index funds and ETFs. Investors can avoid high fees by using these passive investment vehicles; many index funds offered by Fidelity, Schwab and Vanguard, among others, have no sales loads and annual expenses of less than 0.1 percent.
Although investors now have more low-cost options, they often don’t use these options properly due to lack of knowledge, interest or time. As a result, investors often invest too little, choose the wrong mix of investments or buy and sell at the wrong times. The classic case of the latter came in 2008 and 2009, when many investors bailed out of stocks due to sharp losses, missing the historic bull market that started shortly after Barack Obama’s inauguration and has continued into the Trump administration.
These so-called robo-advisors use algorithms to make savings and investment choices for their users. For an annual fee of 0.25 percent these services invest your cash into their diversified portfolios, rebalance holdings as needed and (for taxable accounts) reduce IRS liabilities though tax loss harvesting. The two companies invest client funds in ETFs and other passive vehicles to reduce management fees.
Betterment also offers a SmartDeposit feature that automatically sweeps excess checking account balances into a client’s investment portfolio. This is the type of “nudge” individuals often require to invest optimally. In their 2008 behavioral economics classic entitled “Nudge,” Cass Sunstein and Richard Thaler argued that companies should automatically enroll new employees into their 401(k) plans. Employers have started taking this advice, with about half now implementing automatic enrollment. Many of these employers are also automatically choosing default investments and deduction rates tailored to an individual employee’s life circumstances.
Unfortunately, the default investments are often actively managed funds with high expenses. Also, 401(k) plans have significant management fees. Finally, because 401(k) plans are employer-specific, many employees can end up with several accounts as they change companies (employees can consolidate old 401(k)s into rollover accounts, but often neglect to do so).
To help private sector workers save for retirement and achieve other financial goals, the federal government should simplify the tax-advantaged savings landscape. Rather than employer-specific 401(k) plans, each worker should be able to maintain a single Individual Retirement Account holding all of his or her savings, employer matches and investment earnings. Account holders should be able to take advantage of the lowest-cost passive investments and the services of robo-advisors. Policymakers could go further by allowing IRA holders to withdraw funds for down payments and college tuition without a tax penalty. Enabling employees to invest in diversified bond and stock portfolios at minimal expense is a much better option than the one currently being pursued by the U.S. Treasury and the State of California, which are nudging employees without retirement plans into low-yielding government bonds.
Once we have a low cost, easy to use retirement saving system for private-sector employees, it could also be adopted by the public sector — at least in certain cases. As I’ve suggested previously, high-income earners working within the government could be transitioned to a hybrid plan under which a basic level of income is guaranteed, and anything above that would depend on the amount of employer and employee contributions as well as investment returns. This option would be more palatable to government employers and employees if fees and expenses absorbed by financial intermediaries are minimized. Migrating public employees toward defined-contribution plans will make government budgeting easier by reducing the size and variability of unfunded pension liabilities.
Decades of academic research, deregulation and entrepreneurial innovation have created an environment in which small investors can access state-of-the-art portfolio management services at very low cost. Now is the time for policy innovations that will allow many more small investors to avail themselves of these options.