Friday, May 27, 2016

Retirement Insecurity in America - The Defined Contribution Debacle

Updated April 2017

A report by the Government Accountability Office looks at the challenges facing both present and future retirees in the U.S., particularly the state of retirement savings in the form of defined contribution pension plans.

As we know, there are two main types of pension plans:

1.) defined contribution (DC) plans: a pension plan where an employer, employee or both make contributions on a regular basis.  These plans are designed to help individual employees accumulate a sufficient level of retirement savings during their careers, often through deductions from an employees salary and contributions by an employer; these funds are deposited into an account in the individual's name.  DC participants shoulder the responsibility for any gains or losses in plan values since they decide how the accumulated funds are invested.  Under DC plans, taxes on both contributions and investment earnings are deferred until the benefits are received during retirement.  At retirement, the employee may take the assets of the plan as an annuity or as a lump sum.  

2.) defined benefit (DB) plans: a pension plan where an employer and employee contribute a percentage of an employees salary.  Rather than depositing the funds into an individual account, the funds are pooled and deposited into a pension fund that is used to pay its members a lifetime pension.  DB participants shoulder no responsibility for any gains or losses in plan values since the funds are managed by professionals.  Ultimately, it is the company that is responsible for any shortfall in pension funding.

In the United States, there are now five times more active participants in DC plans than there are in DB plans.  In 2013, DC plans comprised 94 percent of all employer-sponsored plans and active DC participants outnumbered those in DB plans 76.7 million to 15.2 million.  This means that there is no guaranteed post-retirement income for a very significant number of future American retirees and, given the low savings rate in many of those that actually do have investments in DB plans, it's looking like a very sad future for millions of older Americans.

The GAO report focusses on defined contribution plans and looks at how the participation in these plans varies by ethnicity and income group and the challenges that are posed by low participation rates.  Here is a summary of their findings.

The GAO estimates that, in 2013, 40 percent of all American households had some form of defined contribution (DC) pension plan leaving 60 percent with no savings in a DC plan from either a current or former job.  Since 2007, the number of Americans with no DC plan has increased by 3 percentage points since 2007.  Interestingly, an estimated 34 percent of working households (households with at least one person working but not self-employed whose head is between 25 and 64 years of age) have neither a DC or DB plan from a current or former job and, of households aged 55 and older, 29 percent had neither type of pension plan which means that Social Security along with any potential savings outside of a pension plan are their most significant source of retirement income.

Household income levels have a significant impact on DC participation and savings.  Among working prime-age (25 to 64 years of age) households, only 22 percent of low-income households (income less than $39,200) have any DC savings compared to 76 percent of high-income households (income greater than $109,200) as shown on this graphic:

The authors also note that the participation in DC plans changed markedly from 2010 to 2013 (the post-Great Recession period) for low income working households, dropping from 31 percent in 2010 to 25 percent in 2013 while the participation rate for all other household income levels remained constant as shown on this graphic:

Household income levels also have a significant impact on the percentage of households that participate in DC plans when those plans are available to them as shown on this graphic:

Again, notice that the participation rate for the lowest income households dropped by 13 percentage points between 2010 and 2013 while the participation rate for all other income groups remained more-or-less constant.  In part, the GAO notes that this is due to the fact that low income households do not have the disposable income that would allow them to participate in DC plans.  As well, some studies suggest that low income households have lower levels of financial literacy and that they aren't as aware of the tax benefits of such plans.  Additionally, the progressive structure of the U.S. tax code means that it is more advantageous for high-income earners to contribute to DC plans that their lower-income peers.

There is also a significant racial and ethnic component to both participation in and access to DC plans as shown on these graphics:

You will also notice that over the period between 2007 and 2013, the participation rate and accessibility to DC plans for White households actually grew slightly whereas both the participation rate and accessibility fell for both Black and Hispanic households.  In the case of Hispanic households, the access to DC plans fell by a very substantial 12 percentage points between 2007 and 2013.

Now, let's look at the impact of household earnings on the size of retirement income that participants receive from their DC plans.  The GAO baseline projections show that an average household would save enough in their DC plan over their careers to generate monthly lifetime income of $2970 (2015 dollars).  This table shows how that monthly income varies with household income level:

Households in the low-earnings quartile would only accumulate DC plan savings that would generate $560 per month in retirement income compared to $6380 for those in the high-earnings quartile.  In addition, 35 percent of households in the lowest-earning quartile would have no DC savings whatsoever compared to only 8 percent of those in the high-earnings quartile.

While the GAO report doesn't address this issue, there is one thing that has had a substantial potential impact on the future value of DC plans for all participants of all ethnic and income groups as shown on this graphic:

Thanks to the Federal Reserve's massive and lengthy monetary experiment, any American who wishes to save for their retirement and invest in low-risk fixed income investments has seen the return on those investments plunge to nearly zero.

The GAO's report clearly shows that a significant proportion of American households will experience a very insecure retirement.  This means that millions of Americans will have no choice but to supplement their meagre retirement savings and Social Security payments with part-time employment.  The change from a defined benefit to a defined contribution pension world has benefitted one group - Corporate America.  With so many American households lacking any form of retirement security, as I've said before, it's increasingly looking like a cat food future. 


  1. For another take on this reality, see:

    If a husband works 40 years, and his spouse works 25+ years, the couple can retire on Social Security alone if they own their home, and if, upon retirement, they move into a modest home in a low cost area, and thus reduce their property taxes. Hence I am not troubled by couples who do not save for their old age.
    I also have no difficulty with over 64s supplementing their incomes with some part time employment, until health becomes an issue.
    Employers have a dismaying and persistent tendency to underfund their DB plans. Hence the gathering storm over state and local DB plans. The PBGC insures DB pensions only up to 54K/person/year. Defined contribution (DC) pension plans have a fundamental advantage over defined benefit (DB) plans: DC plans are protected by a legal and cultural device that everyone understands, namely private property.

    Interest rates have indeed been low this century, and very low since the fall of 2008. The operational implication of this fact are clear: DC plans should be invested in a mix of stocks and long term bonds.
    IRAs were created for those who do not have access to employment pension plans. The maximum contribution to an IRA should be the same as that for a 401k. It should be possible to make catch up contributions to an IRA, which has been underfunded in the past (such catch up investments would be a good use for a small inheritance).
    Vanguard will manage $5B or more of pooled DC money invested in index funds for the USA stock or bond markets, for a fee of one basis point. All state and local governments should take advantage of this ASAP. Ditto for all large corporations.
    Stocks have crashed twice this century, and will most likely crash again come the next recession. Nevertheless, the USA stock market has returned 4.7%/year, assuming reinvestment of dividends.

  2. Over the past decade, Vanguard's long term Treasury bond fund has averaged 8.7%/year. Vanguard's stock market index fund has averaged 8%/year over the same period. I maintain that investing in 50% stocks, 50% bonds is a conservative investment strategy for retirement saving.