What has been less talked about is that over the last decade or two, the increase in self-directed retirement accounts like 401(k)s have not offset the decline in traditional pensions. Among private-sector workers in particular, a very small percentage are covered by traditional pensions. And yet, the percentage participating in self-directed retirement accounts like 401(k)s has not changed substantially over the past two decades. With pension-less employers becoming more and more common and low participation rates with retirement plans like 401(k)s, nearly half of workers are not covered by any retirement plan. Including the Americans who are not in the workforce fully two-thirds of Americans are not participating in any company retirement plan.
In 2011, 54% of working Americans were participating in either a traditional pension plan or defined-contribution plan - 401(k), 403(b), 457, etc., according to a study from the Schwartz Center for Economic Policy Analysis, using data from the U.S. Bureau of Labor Statistics, This percentage declined by more than 10% from twelve years earlier. The percentages of Americans covered by retirement plans were higher for those in government, professional and managerial workers, higher earners, full-time workers and those working for larger businesses. For example, at the time of the study just 22% of part-time workers participated in a company retirement plan (traditional pension or 401(k)-equivalent) versus 65% of full-time workers. And just 24% of those workers in the bottom quarter of wages participated in a company retirement plan while 79% of individuals from the highest-earning quarter did so.
Including non-working Americans, the number of Americans under the age of 65 who are not participating in company retirement plans is substantial. The Schwartz Center study found that in 2011, 68% of those ages 25-64 did not participate in an employer retirement plan, either because they were not working, working for an employer who didn’t offer such a plan, or they chose not to participate in a plan that was offered. The study found that the percentage of the population covered by a company retirement plan fell from twelve years earlier regardless of race or gender, age, company size or industry. Even government workers, traditionally offered the highest level of retirement benefits saw coverage rates fall.
Are 401(k)s a substitute for traditional pensions?
The move from traditional pensions to self-directed plans like 401(k)s was mostly the result of company risk. With traditional pensions companies were on the hook for the promised retirement benefits and at the mercy of the stock and bond markets to achieve promised returns, as well as increasing longevity. Over the past 15 or so years especially, very high health care costs have been added on the risks for employers and substantially added to their costs for their traditional pensions (which often include healthcare coverage).
Substituting defined-contribution plans like 401(k)s for traditional pensions shifted that risk to employees and retirees. Not only do such plans generally not cover medical costs, they lift the burden of promised returns and promised benefits from employers. While they are sold as a way for individuals to “take control” of the retirement assets, the primary benefit for employers is to decrease employee costs and company risk.
Undoubtedly, on the whole, the switch from traditional pensions to self-directed retirement accounts has not provided the same level of financial security. On average, the tens of millions of Americans whose traditional pensions have been replaced with 401(k)s and similar retirement accounts are not in the same position that they were in before. There will be a few that accumulate a high level of retirement assets and translate that into a high retirement income, but those are the outliers, not the norm.
In general, traditional pensions replace a high percentage of workers’ pre-retirement salary, typically 60%, 70% or even 90% of their working income. Compare a $30,000, $40,000, $50,000 or more yearly pension income to the average account balance of those with self-directed retirement accounts, such as 401(k)s or IRAs. The median account balance of near-retirees, those aged 55-64, with such accounts was $104,000 (see graph below). A lifetime annuity that promised 6% yearly during retirement would only provide a little over $6,000 per year for the typical retiree account balance.
Why are the average account balances for defined-contribution plans so modest? Several reasons. First, participation is voluntary, and typically 20% or so of eligible workers don’t participate. Second, employees set the own contribution level. The typical “default” 401(k) contribution level is usually only around 3%, far below what is necessary to provide adequate enough growth rates for retirement. It’s also far below the equivalent at a typical traditional pension, which is typically fixed and mandated at higher percentages of withholding, often 6%, 8%, 10% or more.
The average defined-benefit plan also generally outperforms the average self-directed account. According to consultant Towers Watson, from 1995 to 2011, defined benefit plans outperformed defined-contribution plans in 13 of the 17 years, and about 0.75% a year for all years analyzed. Over decades, those performance differences will add up, particularly in an era of low interest rates and investment returns.
Retirement accounts like 401(k)s also make it easy to either cash out of the plan upon leaving a job or to take loans from the plan, which either halts the accumulation of assets or surrenders them altogether. The Employee Benefit Research Institute finds that in a given year about 20% of eligible 401(k) participants will have loans outstanding against their 401(k) balances. Worse is the high percentage of 401(k) holders that cash out when leaving their employers. Hewitt Associates found that generally, 40%-45% of 401(k) holders cash out of their accounts when leaving their job, including more than a third of those with balances of more than $10,000. That is despite the extra tax and penalties they will pay on such withdrawals.
While the number of working Americans not participating in company retirement plans is substantial, so too is the number of working-age Americans who aren’t participating in company retirement plans because they’re not employed. According to the Bureau of Labor Statistics in 2014 there were about 35 million men and women ages 25-64 not in the workforce, an increase of about 6 million from ten years earlier. There are millions of other workers that work full-time, but because the employer doesn’t offer any retirement plans to its employees or employees don’t participate when offered.
By the way, as an aside and a follow-up to my last article, I had talked about the fact that at least half of Americans don’t actually retire when they intended. Some retire later than they anticipated, while some retire earlier than anticipated, often due to disability. On this point, the Bureau of Labor Statistics reports that back in 2004 about 3.2 million Americans age 55-64 were not in the labor force because of illness or disability. By 2014, this number had increased to 5.1 million, a 60% increase. In fact, by 2014 the number of Americans not in the workforce because of illness or disability was nearly as high as the number who reported not being in the workforce because of retirement (5.5 million). Another 7.3 million younger Americans (25-54) were not in the labor force due to illness or disability. That is a large segment of the working age population not adding to their retirement capital.
Historically, traditional ”defined-benefit” pensions have been a cornerstone to retirement in America, along with Social Security and income from savings and investments. With the number of Americans covered by such traditional pension plans in decline, modest rates of participation in self-directed retirement accounts like 401(k)s, coupled with equally modest account balances and extremely low interest rates, a high percentage of retirees will be overly dependent upon Social Security income. According to the Social Security Administration, more than a third of Americans over 65 receive more than 90% of their income from Social Security, and two-thirds receive more than half their income from Social Security.
Despite the current reliance (or over-reliance) on Social Security income for retirees, in the middle of the 20th century, retirees were more reliant on pensions for their incomes than either Social Security or savings. The decline of traditional pensions, along with modest retirement account balances and low interest rates, will cause tens of millions of retirees to rely primarily on Social Security for their retirement security.
Traditional pensions will continue to decline
In my last article I mentioned that seven out of eight Americans believe that all Americans should have a traditional retirement pension to provide retirement security. I agree that for most, having a traditional pension will be the difference between retirement security and not. Except for those willing to live a Social Security lifestyle on a Social Security paycheck, the vast majority of Americans will need a private pension to provide a “comfortable” standard of living. Unfortunately, the number of pensions has been in decline for decades and will continue to decline (see chart below).
Yet simple arithmetic indicates that a pension plan with half bonds and half stocks earning 3% a year on its bonds will need to earn 12% per year on its stocks in order to provide a 7.5% average return. This is far in excess of the average stock market return over the past ten, twenty or thirty years. In addition, bond market returns have been boosted by the decline in interest rates over the past three decades which resulted in a concurrent gain in the value of bond assets. However, if bond interest rates have reached a floor, or close to one, the investment return tailwind by declining interest rates is over and pension funds (along with the rest of the investing public) will have to rely on bond yields alone, meager as they are, instead of the capital gains from them by declining interest rates. This will be a structural change affecting the investment world for at least a decade or more.
In the current and coming generation of retirees there will be a sharp line separating those with financial security and those with much less. That line will be the presence of a traditional pension. Quite simply, with modest financial account balances and negligible interest rates, the vast majority of those without traditional pensions will live different lifestyles than those fortunate enough to have a traditional pension.
In the words of those at the Schwartz Center: “With the exception of those with access to a defined-benefit plan at work, most U.S. workers will find themselves realizing low income replacement rates despite their best efforts to save for retirement. ...the declining sponsorship and participation rates identified in this report are not a temporary artifact of the 2008-2009 recession, but a product of persistent structural trends. If these trends continue, it is likely that retirement plan sponsorship and participation rates will continue to sink and the retirement readiness of U.S. workers is likely to get worse in the absence of efforts to improve the situation.”