3 June 2020

Downside Of Mandatory Retirement Contributions

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As the U.S. and other developed countries increasingly look toward defined-contribution systems as the solution to retirement security, many people have suggested taking it one step further: Make participation mandatory.

Conceptually, it makes sense. After all, if people won’t save enough on their own, it might be best to give them no choice at all. But dig deeper into this idea, and all sorts of unintended consequences arise, which should give all of us pause.

For one thing, when it’s completely automatic, workers could become disengaged from the process, further contributing to an already dismal level of financial literacy world-wide. Look no further than our own “mandatory” Social Security system where most individuals consume their benefits prematurely, forgoing more attractive lifetime income payments.

Chile, with one of the first mandatory defined contribution systems in the world, recently saw  public backlash  from its first batch of retirees who spent their entire careers contributing to the program. Their retirement savings, and resulting lifetime retirement income, fell well below expectations. Not the type of surprise any of us want to hear at our retirement party.

Although many factors were at play here, a highly automated, opaque process that removed employee involvement from the equation led to little worker engagement, education and advocacy. In this case, ill-informed pension expectations were built on a little known assumption that workers remained employed continuously for 30 years—something unique to a country where entering and exiting the formal workforce is common.

Another well-known mandatory defined-contribution system—Australia’s—highlight a different type of unintended consequence. In Australia, employers are currently mandated to annually contribute 9.5%—rising to 12% by 2025—of an employee’s salary. Workers in the defined-contribution plan their entire careers have been rewarded handsomely with 2016 household balances averaging about US$314,000 (A$441,620) for those just reaching retirement age.

What is lesser known is almost the perfect correlation of household debt to retirement savings levels since the program’s inception in 1992, according to one research report. One could surmise: Families seeing a nice uptick each year in their retirement accounts lulled many to take on more debt.

In addition, Australia has faced claims of excessive investor fees, underperforming investment options that may be the result of a system unintentionally designed to limit employee engagement--creating what I believe is a governance structure not so great on checks and balances.

These countries and others highlight another piece that I think any mandatory system would need: a retirement income default solution for when workers are ready to retire. That is, if you are going to default the individual through the savings process, taking them out of the picture you should follow suit on the drawdown side where the risks and complications facing retirees dwarf the savings side.

Chile automates the transfer to a lifetime-income option in the form of an annuity but Australia doesn’t. In fact, Australia’s underdeveloped insurance market where individuals could purchase guaranteed lifetime income—such as an annuity—essentially doesn’t exist, leaving retirees to their own volition for managing down their assets. No easy proposition.

The U.K., meanwhile, has abandoned their defined-contribution lifetime income default option for “pension freedoms,” which basically means retirees are on their own. Not surprisingly, retirees appear to be making less-than-ideal choices with their newfound freedom, like taking all their defined-contribution savings in one lump sum upon retirement.

The good news is that it appears that steps are being taken at the federal level in these countries—Australia, Chile and the U.K.—to acknowledge and remedy many of these deficiencies.

Back in the U.S., we do know people need nudges, defaults and the like to counteract our general malaise to save and our taste for immediate gratification. Although still a work-in-process with plenty of weaknesses, our defined-contribution retirement system to a large degree seems to be a good cultural fit for us.

Still, while a pure voluntary defined-contribution retirement system is foolhardy, it’s important to learn from other countries that a mandatory one also has plenty of drawbacks.

Perhaps there’s a middle ground in there that makes the most sense. First, the top priority should be to continue to bring more U.S. workers into the retirement savings system. And then, once in it, have a series of opt-out defaults as many have already adopted for saving, followed by opt-out defaults for systematically withdrawing those assets once a person retires. That may be our best chance for delivering financial security.

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