SOCIAL SECURITY, PENSIONS & RETIREMENT INCOME eJOURNAL
This paper begins with a brief overview of the Retirement Security Projection Model® (RSPM), a national model developed by the Employee Benefit Research Institute (EBRI) in 2003, and then updates the results for 2014. It then provides basic sensitivity analysis of the model to show the impact of changing assumptions with respect to rate of return, utilization of housing for financing retirement, and potential modifications to future Social Security retirement benefits. The final section focuses on how the probability of not running short of money in retirement (measured by the EBRI Retirement Readiness Ratings® (RRRs)) varies with respect to longevity, investment return, and potential long-term health care costs in retirement (e.g., nursing home costs). Due to the increase in financial market and housing values during 2013, the probability that Baby Boomers and Generation Xers would NOT run short of money in retirement increases between 0.5 and 1.6 percentage points, based on EBRI’s Retirement Readiness Ratings (RRRs). Eligibility for participation in an employer-sponsored defined contribution plan remains one of the most important factors for retirement income adequacy. RRR values double for Gen Xers in the lowest-income quartile when comparing those with 20 or more years of future eligibility with those with no years of future eligibility, while those in the middle income quartiles experience increases in RRR values by 27.1-30.3 percentage points. Future Social Security benefits make a huge difference for the retirement income adequacy of some households, especially Gen Xers in the lowest-income quartile. If Social Security benefits are subject to proportionate decreases beginning in 2033 (according to the values in Figure 8), the RRR values for those households will drop by more than 50 percent: from 20.9 percent to 10.3 percent. Longevity risk and stochastic health care risk are associated with huge variations in retirement income adequacy. For both of these factors, a comparison between the most “risky” quartile with the least risky quartile shows a spread of approximately 30 percentage points for the lowest income range, approximately 25 to 40 percentage points for the highest income range, and even larger spreads for those in the middle income ranges. A great deal of the variability in retirement income adequacy could be mitigated by appropriate risk-management techniques at or near retirement age. For example, the annuitization of a portion of the defined contribution and IRA balances may substantially increase the probability of not running short of money in retirement. Moreover, a well-functioning market in long-term care insurance would appear to provide an extremely useful technique to help control the volatility from the stochastic, long-term health care risk, especially for those in the middle income quartiles.
This paper analyzes how the possibility to complement social income insurance schemes with private insurance affects the political support for social insurance. It is shown that political support for social insurance is weakly decreasing in the replacement rate. Policy makers seeking to maintain support for social insurance schemes can do so by lowering the replacement rate and allowing topping up contracts. The strategy is likely to be a partial explanation for the continued political support for welfare states with universal social insurance schemes such as those in Scandinavia.
Tontines are investment vehicles that can be used to provide retirement income. Basically, a tontine is a financial product that combines features of an annuity and a lottery. In a simple tontine, a group of investors pool their money together to buy a portfolio of investments, and, as investors die, their shares are forfeited, with the entire fund going to the last surviving investor. Over the years, this last-survivor-takes-all approach has made for some great fiction. For example, on the television show “Mash,” Colonel Sherman T. Potter, as the last survivor of his World War I unit, got to open the bottle of French cognac that he and his buddies bought (and share it with his Korean War compatriots). On the other hand, sometimes the fictional plots involved nefarious characters trying to kill off the rest of the investors and “inherit” the fund.
To be sure, a tontine can be designed to avoid such mischief. For example, instead of distributing all of the contributions to the last survivor, a tontine could make periodic distributions. Each time a member dies, her contribution would be distributed among the survivors. The tontine could solicit new investors to replace those that die. In that regard, elsewhere, one of us (Sabin) has described how these tontine funds could be used to create perpetual “tontine annuities” that could be sold to individual investors.
In this Article, we consider how the tontine principle could be used to create “tontine pensions” that could be adopted by large employers to provide retirement income for their employees. We also show that these tontine pensions would have several major advantages over most of today’s pensions, annuities, and other retirement income products.
At the outset, Part II of this Article explains how the current U.S. retirement system works and how retirees can use pensions, annuities, and other financial products to generate retirement income.
Next, Part III of this Article offers a step-by-step explanation of how tontine funds, tontine annuities, and tontine pensions could work today. Part III then compares tontine pensions with traditional defined benefit pension plans, with defined contribution plans, and with so-called “hybrid pensions” (i.e., cash balance plans). In particular, Part III shows that tontine pensions have the two major advantages over traditional pensions. First, unlike traditional pensions — which are frequently underfunded, tontine pensions would always be fully funded. Second, unlike a traditional pension — where the pension plan sponsor must bear all the investment and actuarial risks, with a tontine pension, the plan sponsor bears neither of those risks. These two features should make tontine pensions a particularly attractive alternative for employers who care about providing retirement income security for their employees but who want to avoid the risks associated with having a traditional pension.
Part IV of this Article then develops a model tontine pension for a typical large employer, and we use that model to estimate the benefits that would be paid to retirees. For simplicity, the model assumes that, each year, an employer would contribute 10% of salary to a tontine pension for each employee each year (in the real world, employers could choose to contribute a greater or lesser percentage of salary on behalf of their employees). The model generates tontine pension benefits for each retiree that would closely resemble an actuarially fair variable annuity (i.e. one without high insurance company fees [“loads”]). More specifically, unlike commercial annuities which must support insurance agent commissions and insurance company reserves, risk-taking, and profits; the management and recordkeeping fees involved with running a tontine pension would be minimal. That means that tontine pensions would provide significantly higher retirement benefits than commercial annuities.
Part V of this Article then shows how such a model tontine pension could be used to replace a typical, large traditional pension plan like the California State Teachers’ Retirement System (CalSTRS). Pertinent here, like so many other state-run pension plans, CalSTRS is underfunded; for example, as of June 30, 2012, the CalSTRS traditional pension plan was just 67.0% funded, with an unfunded liability of almost $71 billion. While replacing CalSTRS with a tontine pension would do nothing to reduce that $71 billion obligation, it would ensure that California would never again have to worry about underfunding attributable to future benefit accruals.
Finally, Part VI of this Article discusses how to solve some of the technical problems that would arise in implementing a tontine pension, and Part VII of this Article offers some concluding remarks.