Even before the coronavirus pandemic erupted, retirement savings were at risk, according to “Building Better Retirement Systems in the Wake of the Global Pandemic,” a working paper issued by the Pension Research Council of The Wharton School at the University of Pennsylvania.
The paper points out that the World Economic Forum estimates the retirement savings gap will grow 5% each year to reach approximately $400 trillion by 2050—adding an additional $28 billion to the deficit each day.
Defined benefit (DB) plans around the world have long been facing rising underfunding, in part due to an aging population and a shrinking working age population on which contributions, or taxes, can be levied. Exacerbating this, many DB plan sponsors have underestimated retiree longevity, and some have failed to add their required contributions to plans.
“Moreover,” the paper says, “DB plans have tended to invest in risky assets including equities, hedge funds and alternative investments—none of which were selected to defease, or match, benefit promises.” Prior to the COVID-19 market downturn, U.S. public DB plan underfunding had swelled to $4 trillion. Globally, that deficit is estimated to be $34 trillion.
Defined contribution (DC) plans shift the responsibility to save and choose investments to participants. The paper says that these participants also bear longevity risk, particularly if they draw down their assets too quickly. These workers may not even participate in their DC plan, or contribute too little, the paper says. Part-time or lower-paid workers may not even be offered a retirement savings plan.
Further complicating the outlook for both DB and DC plan participants is that interest rates have been very low for the past several years, the paper says. “This reality has contributed to severe DB underfunding, particularly when actual returns fall far below those assumed when computing contribution obligations,” the paper says. “DC plans, which are now the norm in many countries, face even more complex challenges, since they do not have explicit funding targets, yet they also suffer when capital markets underperform.”
Then came the coronavirus outbreak in late 2019 in China. As the outbreak entered the United States, U.S. equity markets began crashing on February 24, and in March, global stock markets lost trillions.
The paper notes that the COVID-19 pandemic could depress returns for decades. Citing one researcher who looked into the effects of past European pandemics, the after-effects persist for roughly 40 years, “with real rates of return substantially depressed.”
In the U.S., the employment to population ratio fell from 60% in January to 52% in April, leading the federal government to increase its debt levels to offer relief. But that raises worries about U.S. fiscal sustainability, the paper notes.
How This Affects Retirement Plans
The effect of the coronavirus on the markets has made DB underfunding far worse, although, the paper notes, because accounting procedures permit these plans to “smooth their funding patterns over several years, it will take time before the full impact of their investment losses are fully recognized.”
“U.S. state and local pensions are also suffering, where plan funding has fallen from an estimated 52% to 37%,” the paper continues. “Even larger drops are foreseen for Connecticut (28%), Kentucky (25%), New Jersey (24%) and Illinois (20%), leaving only a few years of assets with which to pay benefits.”
Corporate DB plans’ underfunding went from $329 billion at the end of 2019 to $619 billion in March, according to Morgan Stanley.
And the U.S. Social Security system is projected to be able to pay only three-quarters of scheduled benefits within a dozen years, but the pandemic might hasten that contraction to as soon as 2029.
Because of rising unemployment, many employers are permitting their workers to take out larger loans from their DC plans. In the U.S., a participant can take out as much as $100,000. The paper says that, by one estimate, half of U.S. workers have already dipped or plan to dip into their DC retirement funds.
On top of this, some employers are reducing or stopping their 401(k) matches, and as many as 200,000 firms may terminate their DC plans completely.
Because COVID-19 has exposed so many people to “catastrophically expensive health problems,” some financial advisers are revising the recommendation that retirees withdraw 4% of their assets each year to 2.4%.
In the U.S. the “cost of retirement,” or the amount of money one would need to save in order to generate a payment of $1 a year for 25 years has risen by 14%, from $21 for a target retirement in 2040 in 2019, to nearly $24 in March.
How can people offset these challenges? One option is to work longer and postpone a potential retirement date. A March survey of Americans between the ages of 55 and 60 found that 44% would like to work longer. However, that may not be possible in the near term, as there could be massive unemployment for some time to come, according to the paper. And those who decide to take their pensions early are likely to find their benefits reduced.
How to Strengthen Retirement Plans
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, which was passed last year, permits private sector employers to establish multiple employer pension plans and requires them to give part-time and part-year workers access to DC plans.
Six states are now offering state-based DC plans that employers are required to offer if they do not already have a retirement plan. These are helpful in covering lower-paid workers at small firms, the paper says.
The pandemic will likely result in fewer pension plans in the U.S., as they struggle to pay benefits and maintain adequate funding following the pandemic, according to the paper. Some might remain in place but make cost-of-living adjustments (COLAs).
Since DC plans will become even more pronounced if there are fewer pension plans, it is expected that more of them will adopt automatic enrollment and automatic escalation. If returns remain low, as they are expected to, workers will need to save more. One researcher says that if returns are 2% and a worker has only 20 years to save, they will need to save as much as 33%, or even 48%, of their pay. Someone with 30 years to save would need to save 15% to 16% of their pay.
Target-date funds (TDFs) can boost retirement wealth by as much as 50% over a 30-year savings horizon. The paper suggests that robo-advice may be used in retirement plans to help guide workers on how to allocate their savings.
The paper also says that with governments making such massive fiscal expenditures due to the coronavirus, they may decide to make all DC plans Roth plans, so they can collect the taxes on the front end.
The paper also expects that DC plans will begin to help workers with the decumulation phase, perhaps converting their savings into annuities that guarantee lifetime income.
“In sum, post COVID-19, it will be challenging but critical to provide more retirees access to low-cost annuities and high-quality but low-cost investment advice,” the paper says. “Additional research and product development will be required, to make the retirement decumulation process easier for retirees to manage.”
Insurers could more accurately price longevity risk if policymakers found a way to provide more granular data about mortality and morbidity patterns. And Social Security and pensions need to be better funded, the paper says. Policymakers could encourage delayed retirement and employers could also delink health care benefits from employment and, instead, make them available through associations or multiple employer plans.
Finally, policymakers should ensure that more people are educated about the importance of saving for retirement. “With more information, people do a better job planning, saving and decumulating during retirement,” the paper says.
« Can the DOL Effectively Police Pension Fiduciary Breaches Alone?