Opening Address: A Dialogue on Pensions

William Novelli, CEO, AARP

US-UK Dialogue On Pensions
Washington DC, USA
July 20, 2005

Good morning and welcome to this United States—United Kingdom Dialogue on Pensions. I thank all of you for coming, and I especially want to thank our conference co-sponsors, the UK Department for Work and Pensions, the Employee Benefit Research Institute and the British Embassy.

At Thomas Jefferson’s home, Monticello, there is a placard where his vegetable garden used to be, with this quote from Jefferson: “To be independent for the comforts of life we must fabricate them for ourselves.” By “comforts,” Jefferson did not mean luxuries, but what was needed to sustain daily living. Monticello produced vegetables from the garden, fruit from several orchards, nails in a small factory, furniture in a workshop, hay for the cattle, lumber from the forest, and wheat for baking bread.

Few of us live today as Jefferson did. We live in a far more complex society. We work in order to buy our comforts from others. And if we are to have the financial comforts of life when we cease to work, then nearly all of us will have to “fabricate” those comforts for ourselves. Let me explain.

The common metaphor for retirement security used to be the three-legged stool of Social Security, i.e., a public pension, then savings, and a pension from work. But as we all know, that model no longer works. At AARP we have come to believe that retirement security is built on four pillars: Social Security, savings and pensions combined, health insurance, and earnings from work. There is a reason for this that becomes clear when we compare the United States to the rest of the developed world.

Our Social Security program replaces, on average, 40 percent of a worker’s earnings. In France, Germany, and Norway, the replacement rates are between 50 and 75 percent. In Portugal and Spain, the rates exceed 75 percent, and are nearly 90 percent in Austria and Italy. But in contrast, replacement rates in the UK are comparable to or possibly lower than those in the U.S.

At the World Economic Forum in Davos a couple of years ago, European experts on pensions assured me that America’s Social Security system wasn’t broken and not nearly as troubled as theirs. That was good news. They also said Americans should take more vacations. That was better news—and it shows that it pays to get other points of view.

But, back to my main point. If Social Security is only replacing 40 percent on average of workers’ pay, what can they do to get to an adequate level of income in retirement? The obvious answer is pensions from work. But, again as we all know, this is not a simple solution…and that’s what we’re here to talk about today.

The traditional defined-benefit pension, which provided an annuity upon retirement, is vanishing. It is being replaced by defined-contribution plans. This trend is not unique to the U.S. It is taking place in the UK and other countries as well. The best known defined contribution plan in the U.S. is the 401(k), though there are others that work in essentially the same manner. The 401(k) has some advantages: it is immediately vested, portable, and tax-sheltered. Many workers see their 401(k) accounts as their savings.

One consequence of this is that Americans are not saving outside their employment. According to some economists, we actually have a negative savings rate. Others say this is exaggerated—slightly—because instead of saving in traditional vehicles like bank accounts and certificates of deposit, people are putting extra cash into equities and bonds. This is hard to measure, but we know that average Americans over 50 have less than $70,000 in cash or securities to their names. Not much money when retirement is getting close and Social Security replaces only 40 percent of prior earnings.

Many people are relying on the appreciated value of their homes, but this is not forever guaranteed— in the UK or here. I imagine many of you saw the cover of The Economist a few weeks ago which showed a falling brick labeled “house prices.”

Moreover, many people have already taken out a great deal of equity in their homes for other reasons. Thus, the value of the house may be less than it appears to be. And even if the housing bubble does not burst, but slowly deflates, the amount of saving there could be less than expected for many people.

Thus, a lot is riding on employer-sponsored pensions. Sad to say, here in the U.S. only 40 percent of eligible workers actually enroll in a 401(K). One reason is that enrollment is not automatic. Employees have to “opt in,” that is, make an affirmative effort to join the plan. Some creative employers have turned this on its head, making enrollment automatic upon hiring. Thus, a worker must “opt out.”

Recent research has revealed that this is a good idea…and at AARP, we encourage it, including within our own plan. Automatic enrollment increases participation in a pension plan by some 30 percent. And it will not surprise you to learn that participation rates climb even higher when the employer makes a matching contribution to the pension account. We like that idea, too.

Another approach that has increased savings is to encourage workers to increase their contributions to their 401(k)s whenever they get a raise — the idea being that the more you earn, the more you can and should save.

A disadvantage of 401(k)s, however, is that they are not annuitized when the worker retires, while defined-benefit plans are. That shifts much of the risk for building a secure retirement from the employer to the employee. Having the option of turning the pension into an annuity rather than making a lump-sum payment could offer many retired workers greater protection, helping to offset at least some of the risk, though not all.

A second problem with pensions is that many companies have under-funded them, while others have filed for bankruptcy and handed off their liabilities to the Pension Benefit Guarantee Corporation. This agency is itself under-funded by perhaps as much as $23 billion, even more by some accounts. And catastrophes like Enron speak for themselves.

And there is another problem: only about half of all workers in the United States have an employer-sponsored pension. The other half really have to fabricate the comforts of retired life for themselves. There are a few options worth our discussion.

In 2001, Congress created a “saver’s credit.” It offers tax credits to low earners — which is good, provided they can save up to $2,000 and provided they actually have any taxes to pay. The credit works on a sliding scale, phasing out at $25,000 for a single person and $50,000 for a couple. The law is due to expire in 2006. We are asking Congress to make the law permanent and expand it to cover more middle-class people, as well.

A second option is more creative and certainly ambitious. It is called a “universal 401(k).” This would be a government-subsidized retirement plan for all workers and would require employers to offer every employee the option of such an account, with a narrow range of investment options that would not be available until retirement.

This is not the Nanny State in action, because workers would enroll voluntarily. But the subsidy and the automatic payroll deduction should be appealing. For very low earners, there would be a subsidized initial contribution, which might work as a refundable tax credit, to jump start the account.

This idea reflects European models, especially the subsidy. It is a good example of how important it is to look abroad, as well as at home, for options that can improve the retirement prospects of our citizens. It’s almost as good as the suggestion that we take more vacations — actually better. I should also add that the “universal 401(k)” adds the value of private investment in addition to Social Security.

All this should be done without privatizing any part of Social Security, which we oppose. Chile tried that in the 1980s, and the results were proclaimed a triumph. Unfortunately, time and closer examination suggest that the initial benefits were greatly overstated. Likewise, the UK has experienced many problems with its system of voluntary carve-out accounts.

Their experience is that while state-provided social security benefits are decreasing, private sources are not filling in the gap—in fact, private pension savings are actually going down as employers switch from defined benefit to defined contribution plans. As a result, the UK is facing an increase in the percentage of low-income retirees. It pays to look around for good ideas and the ideas that turn out not to be so good, after all.

A third option for Americans without pensions at work is the Individual Retirement Account or IRA. The basic IRA allows an individual to save $4,000 and invest it in any way — bank deposits, equities, real estate trusts, and so forth. It is enticing because the IRA contribution is tax sheltered — so there is a handsome deduction at income tax time.

Then there is the Roth IRA, named for the Senator who created it and shepherded it through Congress. A Roth IRA also allows a contribution of up to $4,000 — but in after-tax money, so there is no deduction. However, everything that comes out of a Roth IRA is tax free. Unfortunately, an individual cannot put $4,000 into both an IRA and a Roth IRA in the same year. The total for one year, which can be split, is $4,000. But, those over 50 may put in an extra $500 as a “catch-up” contribution.

The fourth and last option is good old-fashioned discipline. Whether workers have a pension or not, everyone should put something aside from every paycheck. The celebrated “miracle of compounding” still works wonders. Getting people do so, however, is not always easy.

Clearly, we have a lot to think and talk about over these next two days. And, I would like to add one more, which is very important— the unique problems faced by women in building retirement security. All of the issues I have touched upon so far are even more problematic for women.

There are three facts worth noting:

• Number one, life expectancy. Women live, on average, eight years longer than men. Most women can look forward to 15 or 20 years of retirement and semi-retirement — a long time requiring a good deal of money to live on, especially if some of it has to be spent in a nursing home or assisted living facility. Yet only 40 percent of women, compared to 57 percent of men, have a pension plan through employment. And women typically don’t start saving until they are about 40.
• Second is earning power. Many women earn good salaries. But women still earn about three-quarters of what men do for equivalent work. We also know that women, especially in what could be their best earning years —between 45 and 55 — are much more likely than men to be caregivers for parents or other relatives, and work reduced hours or give up work altogether. This in turn can reduce both their Social Security and private pension benefits over time.<.li>
• And third is marital status. Figures from the U.S. Census Bureau consistently show that being single is one of the surest predictors of poverty, especially among women and particularly as they age. Thus, 20 percent of widowed women, 28 percent of divorced women and 25 percent of never-married women live in poverty. These figures are approximately twice the rates for men.

I’m not making an argument for marriage…just laying out the facts.

Let me also quote from AARP report on retirement coverage among older American workers:

“Working women were less likely than men to have retirement plan coverage across all age groups. This is probably due to the more limited access that women have to employer-provided pensions compared with men because, women work in sectors less likely to offer pension. In all age groups, working women were less likely to have dual coverage [both a 401(k) and a defined-benefit plan].”

And, the report continues, while men and women of similar ages were equally likely to have IRAs, the evidence is strong that women “are contributing less to their accounts than men are.”

We will have a chance to discuss many of these issues.

I have mentioned a number of things learned from listening to people from other countries. The industrialized economies are all graying, though continental Europe and Japan are older than both America and the UK — so we look these countries and see the future. But when considering the issues of retirement income, the similarity in what the U.S. and UK have in common is striking, both in terms of challenges and potential solutions. We’re interested to learn how the UK is overhauling its pension system and how it works out. But we also have to act in the present. We, as Americans, have a lot to learn, and I think we have a lot to teach each other.

Thank you for being here today to exchange ideas on all of these pension issues and for your willingness to examine viable solutions. We must continue to do so. After all, we are wrestling with the same problems of aging. We have too much at stake to let anything come between us and the best ideas, especially when it comes to fabricating the comforts of life for ourselves and our loved ones in retirement. Thanks very much.