Don't Count On Government to Do Your Saving for You
California is considering implementing a version of the Ghilarducci Plan, in which automatic payroll deductions are used to create a defined-benefit fund run by the government, guaranteeing a modest minimum return, which is then rolled into an annuity at the age of 65. The Guardian's Helaine Olen likes the idea, which has been put forward by Kevin de Leon, a California state legislator:
De Leon's initiative would automatically deduct 3% for retirement savings from workers' pay at firms with at least five employees and no 401k already in place. The money would be pooled and managed in a newly established entity. Participants would get a 3% return, which is very modest. An insurance policy would underwrite the plan, so taxpayers would not be financially liable if the plan loses money. At retirement, the account balance will be turned into an annuity.
What the plan does is provide a kind of pension - from their own earnings - for people who don't work at big, established firms that have big corporate infrastructure. Very often, these are people without the luxury of retirement planning, or the access to good financial advice. In de Leon's words:
"It's right for lower income and middle income to have access to retirement security."
It's in some ways a pension for all of us: something Americans tell pollsters time and time again they would prefer over a defined contribution plan.
Obviously, no one can retire on 3 percent of their earnings. The plan is conceived as a supplement to Social Security benefits. But how good a supplement will it be?
The guaranteed minimum return is modest indeed -- to keep the thing fully funded over the next 40 years means that the state could only guarantee a 3 percent nominal return -- which is to say, before controlling for inflation. Since inflation is generally targeted at 2 percent a year, this plan is barely better than sticking 3 percent of your paycheck in a bank account.
Even a 3 percent real return wouldn't do that much. I created two fictional taxpayers, call them "Adam" and "Eve," who spent their whole lives paying into the system, and retire upon their 40th year in the workforce. Eve is a professional who starts at a low salary out of college -- around $25,000 a year -- and eventually works her way up to a $75,000 salary by the time she's ready to retire. "Adam" is a lower skilled worker who starts at $16,500 a year (about $8.25 an hour) and finishes at $38,000. To make things simpler, and give the guaranteed pension the most generous possible chance, I assumed mostly continuously scaling earnings, with a few big promotions weighted toward the early part of their career, and no work interruptions -- no unpaid leave for kids, no unemployment or major illness. Under these extremely rosy conditions, how much do our primeval pair collect in retirement?
According to this handy CNN annuity calculator, Adam gets $300 a month. Eve gets a little over $500. It's a little bit of a boost to Social Security, but it's not even close to income replacement. And that's assuming a 3 percent real -- i.e. post-inflation -- return. At a 1 percent return, Eve gets about $375 a month, while Adam gets $210. Obviously, a guaranteed return of 3 percent is much better for the pensioner, but then the system won't pay for itself, and the state will have to kick in money.
Of course, even $210 or $375 is better than nothing! But, also of course, that money is not free. To pay for it, they need to give up 3 percent of their salary right now, every year until they retire. While Olen likes the guarantee, my take is that the guarantee is not doing most of the work here; almost all of the benefit comes simply from the quasi-mandatory saving. In fact, the majority of people would be better off if you took that 3 percent and stuck it in an S&P 500 index fund. Your real return, after taxes and fees and inflation, from 1982 to 2012 would have been about5.8 percent.
Which demonstrates two things. The first is that for all the nostalgia about defined-benefit pensions, guaranteeing a benefit is really, really expensive. There's a reason that DB pensions were really popular up until 1974, when congress passed ERISA, the law that forces companies to fully fund these commitments in advance. Starting in the 1980s, the popularity of these plans began rapidly declining, precisely because they were extremely expensive, and worse, tended to demand top-up contributions during recessions, right when you were least able to make them.
And the second point is that you need to save a whole lot of money for retirement if you want to have a decent shot at living comfortably in your golden years. Three percent isn't going to cut it. And my calculations used 3 percent every year for 40 years, which is not what the majority of people do. The majority of people have employment gaps, lean times when they slow or stop their contributions and so forth. If you want to make sure you have enough income in retirement, a government guarantee will in no way make up for those vicissitudes. What you need is to put away lots and lots of cash.
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Megan McArdle at firstname.lastname@example.org