The Real Retirement Crisis Is in the Private Sector

Last year, legislators in Illinois passed a law that decreases pension benefits for public employees, and in Detroit a bankruptcy judge required municipal employees to get in line with other creditors owed money by the bankrupt city. The focus on these trouble spots feeds a misperception that public pensions, generally, are in crisis. In reality, most public-sector plan sponsors have taken significant steps to stabilize their plans in the wake of the financial crisis. If the stock market does not crash again in the next few years, many plans will report steady improvement.

Current retirees are living in a “golden age” that will fade as Baby Boomers and Generation Xers reach retirement age.

The real area of concern is the private sector.

Americans weaned on post-war affluence have come to expect an extended period of leisure at the end of their working lives. And, indeed, the majority of today’s retirees are able to afford a decent retirement. However, this group is living in a “golden age” that will fade as Baby Boomers and Generation Xers reach traditional retirement age in the coming decades.

This gloomy forecast is due to the changing retirement income landscape. Baby Boomers and Generation Xers will be retiring in a different environment than their parents did. Due to longer life spans, retirees face the prospect of supporting themselves for 20 years with no earnings from work while their replacement rates, retirement benefits, compared to what they earned while working, are falling for a number of reasons.

First, at any given retirement age, Social Security benefits will replace a smaller fraction of pre-retirement earnings. As Social Security’s full retirement age increases from 65 to 67, it will reduce benefits across the board. In addition, Medicare premiums are automatically deducted from Social Security benefits, and these premiums have been rising rapidly. Finally, more households will have to pay federal income tax on Social Security benefits. And replacement rates could drop further if additional benefit cuts are enacted to shore up Social Security.

Second, the employer-sponsored system will produce only modest benefits. Only about half of private sector workers are covered by any sort of retirement plan. This lack of coverage means roughly one third of households ends up with no retirement savings and must rely solely on declining Social Security benefits.

Equally important, the nature of retirement plans in the private sector has changed dramatically. In the 1980s, the majority of workers who were lucky enough to be covered by an employer-sponsored plan had defined benefit plans. Employers made the contributions, managed the assets, bore the risk, and provided lifetime benefits (based on years of service and final salary). Today, however, most workers rely exclusively on 401(k) plans, where individuals are responsible for their own saving.

These 401(k) plans shift all decision-making and risk from the employer to the individual. So while in theory 401(k) plans could provide adequate retirement income, to date they have not. The reason is that employees make mistakes at each stage in the process. About 20 percent of eligible employees do not join the plan, about 90 percent of participants contribute less than maximum amounts, most do not make good investment decisions, and many cash out when they change jobs or face large mid-life expenses. As a result, according to the 2010 Federal Reserve’s Survey of Consumer Finances, the median balance in 401(k) and Individual Retirement Accounts for households approaching retirement (age 55-64) is $120,000. That may sound like a lot of money, but it will generate only $400-$500 per month.

Third, most of the working-age population saves very little outside their employer-sponsored pension plans. In 2010, the average household approaching retirement held only $18,300 in financial assets outside of retirement plans. These balances were depressed by the financial crisis, but even in 2007, financial assets for this group amounted to only $29,600.

In addition to a lengthening period of retirement and falling replacement rates, out-of-pocket medical expenses are projected to consume a greater proportion of retirement income.

And asset returns in general, bond yields in particular, have declined over the past two decades, so retirement assets will yield less income. As a result, retirees are going to face a retirement income crunch.

To quantify the impact of that crunch, the Center for Retirement Research at Boston College has developed the National Retirement Risk Index. The Index measures the share of working-age American households at risk of being unable to maintain their pre-retirement standard of living in retirement. The results for 2010 showed that 53 percent of working households were at risk of falling short. Given the rebound in the stock market, that percentage is slightly lower today, but still hovers around half of households.

One way to substantially improve the 401(k) system is for the government to require that all 401(k) plan sponsors automatically enroll all their employees and automatically increase their saving rate over time, unless the employees opt out. The other pressing issue is to establish a retirement saving plan for workers who have no pension coverage; various proposals have been suggested for accomplishing this goal.

So, yes, Detroit and Illinois represent dramatic developments in the public sector, but about 85 percent of the workforce is employed in the private sector. Many of those workers face a bleak retirement outlook if no changes are made.


Alicia H. Munnell is a professor and director of the Center for Retirement Research at Boston College. During the Clinton administration, she served on the President’s Council on Economic Affairs.