Retirement, 20 years from now

A national organization recently asked me to write a brief piece on the future of retirement.  Here’s how I responded.

I know what retirement will–or at least should–look like 20 years from now. I’m just not sure how we will get from here to there. Unfortunately, my best guess is that we will have to experience a crisis before we land in the right place.

Why a crisis? Well, consider our current situation. We face a sharp mismatch between retirement needs and retirement resources. We need more money than ever before because we are living longer and continuing to retire relatively early (average retirement age for men is 64, for women 62), which means that we have to support ourselves for two decades on average and considerably longer for many. This extension in the retirement span has occurred as health-care costs have risen substantially and show signs of further increase. At the same time, real interest rates are at historical lows, so to produce a given stream of income we have to boost wealth accumulations.

While we need more retirement income, we are now getting less from Social Security and employer pensions. Under current law, Social Security replacement rates–benefits as a percent of pre-retirement earnings–are being gradually reduced. For many years full Social Security benefits were available at 65, but starting with people born in 1938 it gradually increases, until it reaches 67 for those born after 1959. And as the Full Retirement Age rises, Medicare premiums take a bigger bite of benefit checks, and more people are subject to taxes on their benefits. In addition, the shift to two-earner households is reducing replacement rates further. Moreover, Social Security faces a long-term deficit, so benefits could be cut even further to restore balance.

On the private employer side, traditional pensions have been replaced by 401(k) plans. While these plans could be an effective way to save, today they are clearly falling short. These plans shift all risks and responsibilities from the employer to the individual, and most are not well-prepared for this burden. The result is that for households nearing retirement with a 401(k), the typical total is only $120,000 – including any assets that were rolled over into IRAs. And those with a 401(k) are the lucky ones; half of private sector workers do not have any employer-sponsored retirement plan. The one potential bright spot in this gloomy picture is that many of us are saving through our house with each monthly mortgage payment, and we could tap this home equity in retirement to help pay the bills. But hardly anyone does.

If things continue as they are, more than half of today’s working households will not be able to maintain their standard of living once they stop working. That’s the bad news. That’s the crisis.  The good news is that we can fix the problem. We need to make some specific and doable adjustments so that we work longer and save more. Fortunately, we have both the ability and financial infrastructure to meet this challenge.

In terms of working longer, most of us are healthier and have less physically demanding jobs than our parents and grandparents. And we are living much longer. So stretching out our work lives is a sensible option. And the payoff is dramatic – delaying Social Security benefits from 62 to 70 increases monthly payments by 76%. The government should promote age 70 as the new 65.  It should also consider raising Social Security’s earliest eligibility age from 62 to, say, 64. (At the same time, we need to find a solution for those of us who simply cannot work longer due to health problems or outdated job skills.)

On the saving front, the first step is to fix Social Security. Benefits are already shrinking relative to earnings, and additional cuts could cause steep drops in living standards and higher poverty. For that reason, reforms should lean much more toward higher revenues than lower benefits. And, to temper the need to raise payroll taxes, we should consider shifting the costs of the system’s legacy burden to the personal income tax and perhaps investing part of trust fund assets in equities.

The next step is to boost savings in 401(k)s by expanding the use of the automatic 401(k), a model that is a proven success. Under this automatic approach–unless employees choose to opt out–they participate in the plan, their contributions rise each year until they reach a specified level, and their savings are invested in a balanced investment portfolio that can rely on mutual funds with low fees. While the government currently encourages employers to adopt this auto-401(k) strategy, this approach has met with only limited success. Congress should make automatic provisions mandatory and extend them to all employees, not just new hires. And employers should help raise the average combined employee-employer contribution rate to at least 12%.

We also need to solve the pension coverage gap for the half of private-sector workers without a 401(k) plan.  This could be done by providing an “auto-IRA” at either the federal or state level or automatically enrolling all uncovered workers in President Obama’s new “MyRA.”  All workers need to have an automatic saving option to supplement Social Security.

The final piece of the saving puzzle is the house. The house is a big source of saving for most and often the only saving for those without a 401(k). Most people think of their house as a last- resort emergency fund–perhaps to pay for nursing home care–or as a bequest for their kids.  But the days of ignoring housing wealth are over. Most people will need to tap their home equity–either by downsizing or taking a reverse mortgage–to help pay the monthly bills in retirement.

So that’s where we will be in 20 years. People will be working roughly five years longer than at present. Social Security will be adequately financed to provide a solid base of retirement income. Automatic 401(k) plans invested in low-fee index funds will provide supplementary income for those with coverage, and supplementary government-sponsored accounts will generate income for those without an employer plan. And people will routinely tap their home equity to cover day-to-day expenses. To get there, however, requires the political will to fix Social Security, to make 401(k)s automatic, and to expand coverage. Unfortunately, the impetus for these changes will likely require a crisis in which retirees simply to do not have enough money to support themselves.

Alicia Munnell is the Peter F. Drucker Professor of Management Sciences at Boston College’s Carroll School of Management. She also serves as the Director of the Center for Retirement Research at Boston College. She was co-founder and first President of the National Academy of Social Insurance and is currently a member of the American Academy of Arts and Sciences, the Institute of Medicine, and the Pension Research Council at Wharton. (A version of this post was previously published on the Market Watch blog.)