Americans are scared about their future retirement security. Politicians have promised to fix this “retirement crisis” through a combination of expanded Social Security benefits and new retirement plans set up by state governments. But what if our governments are themselves the biggest contributors to this “retirement savings gap”?
That’s a question I explore in a new study comparing retirement saving by American households with government funding of the various retirement plans Americans depend upon. The best estimates show that underfunded retirement benefits are overwhelmingly a problem caused by government, not undersaving by individuals.
A variety of studies have found that U.S. households aren’t saving enough for retirement, but those studies vary dramatically in their estimates of how big the shortfall may be. The most pessimistic of them, published by the National Institute for Retirement Security — an industry group funded by the defined-benefit pensions industry — finds that 84% of American households are falling short of reasonable retirement savings targets, and that total household undersaving may reach $14 trillion.
By contrast, several academic studies find that only 25% to 30% of households are undersaving for retirement. Moreover, shortfalls for those undersaving households are relatively modest. I estimate that these academic studies would find a household savings gap of less than $1 trillion, which is small compared to total private retirement savings of about $18 trillion and accrued Social Security benefits of $30 trillion.
But before concluding that government needs to take a bigger role, we should also look at how well governments fund their own retirement plans. These include everything from Social Security to federal employee and military pensions, to state and local government plans.
Almost no pensions at any level of government are fully funded, and estimates of total funding shortfalls for government-run plans range from a low of $14.3 trillion to a high of $26.1 trillion. The higher estimates are generated by economists who seek to more accurately measure the benefit liabilities of public sector pensions.
Think about those results: The largest estimates of undersaving by households are smaller than the lowest estimates of government underfunding of retirement plans. Using the most credible estimates made by academic economists, which show government underfunding of $26 trillion vs. only about a $1 trillion household-saving shortfall, the total retirement savings gap in the United States is almost wholly a problem on the government side of the ledger.
What explains these differences? To be sure, individuals can be financially illiterate. But at root, the incentives are in the right direction: A person who fails to save today is only cheating himself in the future. So while people make errors in financial planning, one award-winning academic study found that more Americans are actually oversaving for retirement than undersaving.
Solutions to household undersaving deal mostly with making retirement plan designs account for individuals’ weaknesses. Some people forget to sign up for a 401(k), despite a tax advantage and an employer match. Others lack the financial literacy to manage their investments. Still others fall prey to high management fees.
But practical problems have practical solutions. Today, over half of U.S. employers automatically enroll their employees in retirement plans, which can raise participation rates dramatically. The rapid rise of so-called “target date funds,” which automatically shift an employee’s 401(k) from stocks to bonds as they near retirement, reduces the need for workers to constantly monitor their investments. Employer contributions to 401(k)s are rising. And competition among 401(k) providers has cut per-participant fees in half since 2006. More needs to be done, but the progress is undeniable.
In government, by contrast, the incentives are in the wrong direction. When government retirement plans are underfunded, politicians can keep current taxes low while handing the bill to future generations. And of course future generations don’t vote in today’s elections. This explains why Congress has done nothing to fix Social Security, despite knowing since the late 1980s that the program needs reforms.
Incentives also explain why state and local government pensions use accounting methods that are at odds with international standards and which economists almost universally believe substantially understate the funding gaps for these plans. By lowballing pension liabilities, state and local governments dramatically reduce their current contributions, while leaving trillions in pension costs for future taxpayers.
And that’s not only true in the United States. A recent study by the World Economic Forum examined retirement savings shortfalls in different countries. For the United States, the WEF concluded that 85% of the retirement savings shortfall is in government plans, with corporate plans making up 2% and households the remaining 13%. In the United Kingdom, 74% of the retirement saving gap is attributable to government underfunding, while in Canada, government’s share is 93%. There was only one country studied — India — where the household retirement saving gap exceeded the government’s funding shortfall.
It’s human nature to promise things without wanting to pay for them, and politicians are nothing if not human. Barring a change to human nature, retirement policy needs to build on what’s working while avoiding the pitfalls of the past.
That means further improvements to 401(k) plans, in particular policies to increase auto-enrollment and expand coverage by small businesses. But it also means we should be very skeptical about expanding Social Security.
When you’re already over $10 trillion in the hole, it’s time to stop digging.