Pension Reform Part III
(February 14, 2008)
Dear Subscribers and Readers,
In our January 31, 2008 mid-week commentary, I asserted that the bond insurers' crisis was getting close to resolution – not only because the widening impact of the current credit crunch was forcing the regulators' hand, but also because Bill Ackman, through his assertions and ultimate loss projections of Ambac and MBIA, was essentially forcing the regulators to act quickly and decisively to end the crisis. With the new credit crisis in the auction-rate markets for municipal bonds and student loans, Warren Buffett's disappointing bid for the bond insurers' assets, and the fact that financial institutions are going to file their 10-Qs and 10-Ks by the end of this month (with full disclosures), the Federal Reserve, Treasury, and the regulators know that there isn't much time (and options) remaining for a private, market-based solution. Sure enough, we are now starting to see the first inkling of a government bailout, with Credit Suisse's latest appeal/proposal to Congress to expand the scope of loans that the Federal Housing Administration can guarantee. According to Credit Suisse, this proposal, if implemented, should pave the way for approximately 600,000 subprime borrowers (many of whom are already delinquent on their loans), or a total of $89 billion in subprime loans, to refinance into loans backed by the FHA. Moreover, various Fed and government officials, including the Chairman of the FDIC, have made it clear that should a private market solution fail to materialize, there will be a public solution. By the end of this month, we should see some of these plans start to materialize. However, in the off chance that no viable solutions materialize from either the public or private sector by the end of this month, and should the stock market (and sentiment) become overbought at that time, then we will most probably “take our gains off the table” and go neutral in our DJIA Timing System (as of the close on Wednesday, the long positions that we established on January 9th and January 22nd have returned -77.76 and +837.23 points, respectively).
Let us now get to the “gist” of our commentary. In our first commentary on pension reform (see our August 13, 2006 commentary), we discussed the Pension Protection Act of 2006 (PPA) and its most likely (adverse) impact on defined benefit plans. In our second commentary on pension reform (see our May 6, 2007 commentary), we discussed the flaws of the current U.S. retirement system. More specifically, we discussed some of the inherent flaws of the defined benefit pension plan industry – especially during the pre-PPA days – and the fact that defined contribution plans have not historically been ideal savings vehicles for retirement purposes. In response, the Society of Actuaries' (SOA) Pension Section Council came up with its “Retirement 20/20” initiative in late 2005 as a response to all these changes in the U.S. retirement system (if a combination of loosely constructed DB and DC plans, wrapped around our Social Security System, could be called a “retirement system” in the first place) – and to try to help design a system from the ground up. The first kick-off conference was held in September 2006 – with a discussion revolving around the “core needs” of the four basic stakeholders in the U.S. retirement system today, those being society, individuals, financial markets, and employers. The first conference focused around the following three questions:
- Who has what needs?
- Who can bear what risk?
- Who can play what role?
The participants concluded that any sustainable, sound, and fair retirement system (the combination of social insurance, private plans, and individual savings) should contain the following six themes:
- Should be designed to self-adjust
- Should align stakeholders' roles with their skills
- Should consider new norms for work and retirement, and the role of the normative retirement age
- Should be better aligned with markets
- Should clarify the role of the employer
- Will not succeed, in the U.S., without improvements in the health and long-term care systems
Obviously, our current retirement system is nowhere close to satisfying all six of these criteria. For example, while our Social Security System is designed to “self-adjust” in the sense of indexing retirees' payments to the CPA (in the beginning of each year, each retiree's social security payment is raised according to the CPI increase of the previous year), it is not designed to self-adjust for a longer life-expectancy of U.S. retirees or the solvency of the system. Having a self-adjusting mechanism (as opposed to “ad hoc” changes once every five or ten years) is very important, as this 1) eliminates tedious and time-wasting debates going forward, 2) gives U.S. workers enough visibility and allows them to reasonably plan for their future and subsequent retirement, and 3) guarantees the solvency of the system going forward. Secondly, there is also no doubt that we need to better align the various stakeholders' roles with their skills. E.g. Should employers simply focus on their core business and instead leave the business of providing retirement benefits for their employees to some other entity? While a company like IBM or ConocoPhillips (or for that matter CalPERS, and CalSTRS) no doubt has the ability to invest its employees' savings in an efficient and low-cost manner, the same cannot be said for many companies outside of the Fortune 1000 (even within the Fortune 1000 companies, many plan participants have also been fleeced, as some of the mutual fund fees lawsuits can attest to). More alarmingly, many companies are now essentially walking away from their previous roles as the “guardian” of their employees' retirement benefits – by freezing or eliminating generous defined benefit plan retirement benefits (not to mention close-to-lifetime employment) and switching their employees to pick-your-own-investments defined contribution (such as 401(k)) plans. While the majority of subscribers would have no problems in managing their 401(k) investments, we should note here that DC plans, in general, adds a thick layer of uncertainty to the majority of U.S. workers, in that: 1) the majority of U.S. workers are not good investors, and most don't consult a financial planner or advisor before picking their funds. Worse yet, a significant amount of participants simply go for the money market or “stable value” fund within their plans, 2) unlike a DB benefit, DC benefits are not “defined” at retirement. That is, a participant has no way of knowing how much he or she would have at age 65, 3) Because of this lack of visibility, many folks simply conclude that they will never have enough for retirement, and simply choose not to save, 4) Even if a participant has invested enough to retire at 65, it is still difficult to construct a sound withdrawal/investment strategy (even for financial planners) given the lack of a steady income going forward, and 5) the government's “leeway” of allowing participants to “cash in” on their 401(k), even though it imposes a significant amount of penalties.
The bottom line is that the U.S. has a very flawed retirement system, despite the fact that we are one of the most prolific savers for retirement in the world today (which conflicts with the fact that our “savings rate” is negative – an issue that I have previously covered and which I will cover again in a later commentary), as shown in the following figure courtesy of the ICI:
At the end of the second quarter of 2007, total retirement savings in the U.S. amounted to $17.4 trillion or close to $120,000 for each person in the labor force today (the equivalent of $60,000 for each person in the U.S. today). Aside from Australia's “Superannuation” fund, the U.S. – on a per capita basis – has one of the biggest pool of retirement savings in the world today (for comparison purposes, the Japanese Postal Savings System “only” has US$3.3 trillion in savings, or US$26,000 per capita). On an absolute basis, it is unparalleled. But again, subscribers should remember that this does not tell the whole story – as the vast majority of these savings are placed in a loosely regulated and structured combination of corporate DB and DC plans, IRAs, small business DB plans, government pension plans, and so forth. Moreover, even though the amount of savings has nearly doubled over the last ten years, it is still not enough to ensure a secure retirement for the majority (there will always be some who would never be able to have enough resources to retire, no matter what you throw at them) of the U.S. population. While the U.S. is in a better position than most countries in the world today (not to mention the fact that we also have a more favorable demographics profile then most developed countries), this is still not sufficient, although it does act as a “good base” for any future retirement system going forward.
In the second “Retirement 20/20” conference held in September 2007, conference participants focused on the role that society, financial markets, and employers should play in any new, coherent retirement system going forward. I urge you to read the entire summary of the conference – but some of the take-away points include:
- Employers should continue to have a role going forward – but a role that should be very different to the one they played today. Moreover, many conference participants argued that it should be a significantly reduced role – perhaps limiting them to simply be an educator or “facilitator” in providing retirement savings services to employees going forward.
- More importantly, there is no doubt that society should play a greater role going forward. Specifically, it needs to “provide structure to the retirement system” through the three following roles: 1) Help individuals make right decisions, 2) Set some guidelines about what “ought” to happen, 3) Provide consumer protection. At the extreme, this will also mean mandating – similar to social security payments today (or mandatory contributions by Australia workers into its Superannuation Fund) – U.S. workers to save for their retirement going forward.
- In terms of interaction with the financial markets to hedge retirement risk, conference participants agreed that any coherent retirement system going forward will need to approach this as a group – as opposed to a loosely combine of corporate, small-business, and government pension plans today – both to ensure efficiency, and more importantly today, fee transparency. Studies have shown that under this approach, participants have historically performed about 200 basis points better than if they were in a small business plan or in an IRA (with a significant chunk of this attributable to fees).
While the latest conference is still inconclusive on the final construct of a coherent and sustainable U.S. retirement system, it is starting to become more apparent – at least in this author's eyes – that a private solution will not suffice, at least if one wants to create such a retirement system going forward. The questions that we, as market participants and as members of society, need to ask going forward are: Will the U.S. government play a significantly greater role in providing retirement savings vehicles for U.S. workers going forward? If so, what is the best solution? Obviously the “pay-as-you-go” system that we have today in the form of Social Security will not suffice. Should we follow Canada's lead and fund a portion of that liability going forward, and require gradually higher mandatory contributions as well (the Australia Superannuation started with a 3% mandatory contribution and incrementally increased it to 9% today). Moreover, if such a system is created, how much of a role should the government or U.S. workers have in terms of investment decisions? Should a portion of these savings be set aside by the government to create a U.S. “Sovereign Wealth Fund,” similar to the Australia Future Fund or the Canada Pension Plan? This could be an attractive idea in light of the current “invasion” of sovereign wealth funds in the U.S. financial markets – not to mention the fact that they are projected to continue to experience exponential growth going forward. Or should we simply ditch this idea and embrace the laissez-faire approach of “anything goes?” I would like to invite comments from our subscribers.
Henry To, CFA