Correction to This Article
An earlier version of this article misstated the 2007 earnings cap for Social Security contributions. The cap was $97,500, not $98,000.
A System That Needs to Be Retired

By Martha M. Hamilton
Sunday, June 1, 2008

Sure, you expect to retire someday.

But the pretty images on TV of sailing and golfing and traveling the world are colliding with a cold, hard truth: There's a good chance your retirement years could be accompanied by a drastic drop in your standard of living.

The reason: Traditional pensions largely have been replaced by retirement savings plans. As currently designed, the new plans will fail to provide adequate retirement security for many people, according to a growing number of economists, benefits specialists and policymakers.

Only about half of U.S. workers even participate in 401(k)s and other workplace savings plans. But even those who do face serious risks, including not saving enough and not investing wisely. Beyond those problems lurk the risks of retiring in a bear market and the temptation to take the money when you change jobs.

Of course, there are the risks of inflation and outliving your savings. And the chance that you may draw down your savings sooner than anticipated to cover staggering health-care costs or provide financial assistance to aging parents or your children.

Health-care costs scare me the most. Last year, Fidelity Investments calculated that a 65-year-old couple would need about $215,000 to cover medical costs in retirement, up 7.5 percent from the previous year. Medicare covers about 51 percent of medical costs, according to the Employee Benefits Research Institute. So that leaves a lot of bills for you to pay out of your retirement savings. And when it comes to how much is in those accounts, EBRI found at the end of 2006 that nearly three-quarters of participants had balances lower than $61,346, the size of the average account balance.

True, that number includes savers of all ages, some of whom have almost a lifetime ahead to save more. But given the rapid increases in health-care costs, lots of luck with that.

I don't offer this gloomy assessment to scare people into saving more (although it might be a good idea) as much as to suggest that the system needs a major change.

Brooks Hamilton, a benefits consultant and founder of Brooks Hamilton & Partners, offered a good history of how we got here in an interview with "Frontline" on PBS in 2006. He traced it back to the Employee Retirement Income Security Act and subsequent rulings that made defined-contribution plans appealing to employers. He also said that when ERISA went on the books in 1974, employers were contributing 89 percent of the funds in pension plans, but by 2000, the employers' share of contributions had dropped to 49 percent. At the same time, though, employers' costs for health care were soaring and may have offset the savings on retirement. "I don't think there's a bad guy," he said.

But there are some bad consequences from the growth of defined-contribution plans, and a lot of thought is going into the search for solutions. One effort underway is to make retirement savings plans, which is another name for defined-contribution plans, look more like traditional pensions.

Some steps in this direction include automatically enrolling workers in savings plans, rather than requiring them to opt in, and helping workers get better returns through portfolios either designed by financial experts, such as target date plans, or through third-party financial advice provided by employers. Another initiative is to offer plan participants new ways to put money in an annuity to provide income for life. All of these are improvements, but more may be needed.

Economist Teresa Ghilarducci, author of "When I'm Sixty-Four: The Plot Against Pensions and the Plan to Save Them," said creating a new plan is better than tinkering with a bad system to make it better.

Like many others, Ghilarducci points out how backward it is to design a retirement system in which the incentives to save are biggest for the highest-income individuals. Because contributions are tax-deferred, the tax break is biggest for those high earners.

Ghilarducci proposes replacing it with what she calls guaranteed retirement accounts. Participation accounts would be mandatory except for workers covered by traditional defined-benefit pensions. All other workers would be required to put aside 5 percent of earnings (although employers could contribute a portion of the amount, if they choose), until they hit the same earnings cap as for Social Security, which is $98,000. Setting aside money before it gets into workers' hands to help provide for retirement is something that occurs in both the Social Security system and traditional pensions.

To help ease the burden on workers, every employee would receive a $600 refundable tax credit. The credit would be paid for by eliminating the tax break for 401(k)s and other plans. As a result of the change, tax filers with $75,000 or less in annual income would have higher after-tax income than under the current system, and that accounts for 87.8 percent of tax filers.

The money would be invested in financial markets by professionals, such as the board that manages retirement savings accounts for federal workers, and would receive a guaranteed rate of return of 3 percent per year, adjusted for inflation. The 3 percent rate is based on real economic growth since World War II "because long-term financial returns should at least keep pace with long-term economic growth," Ghilarducci wrote.

What I like about Ghilarducci's proposal is its boldness -- the idea that it is better to create a new model than to keep retrofitting a system that presents unacceptable risk for so many workers. Even though defined-contribution plans are being improved, the changes will come too late for some and will be of no use to the vast universe of workers who do not participate in retirement savings plans, many of whom work for small businesses or for themselves.

She concedes that it might be tough politically because it would mean somewhat higher taxes for rich people. She is also up against the retirement-industrial complex -- all the businesses that have evolved to design retirement savings plans, to administer them, to sell mutual funds to participants and to provide investment advice to plan participants.

But changing the system could be helpful to more than just individuals, she argues in her book. The economy will lose an important stabilizer if people's ability to retire depends on the health of financial markets. "When older workers cannot leave the workforce . . . and cannot afford retirement during bad economic times, unemployment will get worse," she writes.

Join Martha M. Hamilton and Joel Dickson of Vanguard for an online chat on Tuesday at noon at She can be reached

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