A new paper is evaluating how global retirement systems are faring in the wake of the coronavirus pandemic and what reforms will be required to facilitate the retirements of future generations.
The paper, ‘Building better retirement systems in the wake of the global pandemic,’ by Olivia Mitchell, a professor and executive director of the pension research council at the University of Pennsylvania’s Wharton Business School, offered an assessment of the status quo prior to the spread of the coronavirus, examined insurance and financial market products that may render retirement systems more resilient for the world’s aging population and evaluated potential roles for policy-makers.
“It appears certain that low interest rates, low fertility rates and population aging are going to be with us for a long time,” says Mitchell. “In this light, there are few ‘automatic’ stabilizers which will remedy the worlds’ retirement systems without some serious reforms. That is, we cannot simply hope that the capital market will pay high returns, we can’t assume that a growing number of younger workers will be around to keep unfunded pensions afloat and rising longevity will inflict increased demands on retirement systems. So now is the time to move forward to reforms.”
In assessing the pre-coronavirus status quo, the paper noted that many of the most troubled pension systems around the world are defined benefit, which have been facing rising underfunding for many years. Mitchell says she doesn’t expect the traditional DB pension model to return to viability, at least not in most developed countries.
“Workers today fail to value the DB promises and prefer defined contribution plans, particularly in light of their increased mobility. Plan sponsors now realize how extraordinarily expensive DB plans are to fully fund. Governments who offered back-stop or reinsurance systems face insolvency.”
On the other hand, the paper noted that DC plan assets, as long as required employee and employer contributions are deposited, are, by definition, equal to what is owed to plan members. However, while DC plan sponsors bear no underfunding risk, it highlighted that investment risk is transferred onto employees’ shoulders and these plans don’t guarantee any particular benefit level in retirement.
“DC plan participants also bear longevity risk, perhaps running out of assets if they draw down their accounts too quickly,” said the paper. “This is a concern in many countries, including the U.S. and Australia, where DC plans have traditionally not provided retirees a simple way to convert retirement assets into insured income payouts. This problem is a growing concern, as cognitive aging problems increasingly beset the world’s aging population.”
For the impact of the coronavirus on retirement systems, the paper noted that early evidence implies far more worrisome levels of underfunding in DB plans than before. However, because many DB plans are able to smooth their funding patterns over several years, it will take time before the full impact of these investment losses is fully recognized.
“Even the Dutch pension plans, previously among the best funded in the world, fell from a 105 per cent funding rate before the COVID-19 shock, to below 70 per cent,” said the paper. “This is likely to require important benefit cuts under that system’s rules.”
DC plans have also experienced the market pounding of 2020, it noted, and several countries have permitted plan members to withdraw assets from their retirement accounts to ease financial shortfalls during the pandemic period. “For instance, Australia has allowed withdrawals of up to A$20,000 from workers’ retirement accounts and congressional groups in Chile and Peru have proposed giving workers early access to a portion of their accumulated funds intended for retirement.”
Nevertheless, the paper said it’s already clear that such systems will require additional funding in order to make good on retiree benefit promises. And, beyond emptying out DB and DC pension accounts, the pandemic has also altered peoples’ retirement prospects, as workers and retirees begin to recognize their far greater susceptibility to catastrophically expensive health problems.
Against this backdrop of uncertainty, it’s important to identify and facilitate pension reforms that can enhance workers’ ability to save and invest for retirement, said the paper, noting one potential lesson is the riskiness of tying pensions to an employment relationship. As a result, the paper suggested that, in the wake of the pandemic, retirement and health insurance coverage are likely to be delinked from employer-provided plans in many countries.
“The U.S. SECURE Act of 2019 now allows private sector employers to establish and operate multiple-employer pension plans; this had been infeasible in the past due to rules requiring all sponsor firms to be in the same industry. The new law also requires employers to offer part-time and part-year workers access to the firms’ DC plans, which could potentially benefit workers as the labour market recovers. . . . A different approach to expand coverage in the U.S. has been led by six states (Oregon, California, Illinois, Connecticut, Maryland and New Jersey), which have launched state-based DC plans that employers must make available to workers if they do not offer a retirement plan.”
The paper also suggested that the recent financial disruption will likely hasten the demise of the remaining traditional DB plans around the world, unless they receive substantial financial transfers to bail them out or are dramatically altered to survive in different form.
These different forms could include an alternative model, which shares the risk between employees and employers, said the paper. “As one example, a hybrid plan can include a commitment to change benefits or discontinue benefit cost-of-living adjustments if funding levels fall. A hybrid plan could alternatively raise contributions if the plan’s financial position declined below some threshold.”
The Netherlands, for example, has implemented DB-type defined ambition plans where, instead of guaranteeing a benefit, the pension seeks to target promised benefits at some per cent (i.e., 75 per cent) of career-average pay. However, whether this model will survive the pandemic is unclear, according to the paper, particularly given the 70 per cent funding levels the plans appear to have at present and forecasts of long-term, poor capital market performance.
Around the world, says Mitchell, DC plans have long been the engine of growth, with their assets substantially exceeding DB assets. “So the best tack, it seems to me, would be to work to enhance DC plans to better meet the needs of workers saving for retirement and retirees during their retirement phase.”
The paper referred to the widespread adoption of DC plan features like auto-enrolment of new workers and auto-escalation of contribution rates. A related issue is how DC plan members will choose to allocate their retirement assets. Many U.S. employers, for example, have made target-date funds their default offering. “In other countries such as Chile and Mexico, the governments have instituted glide paths which depend on investor age, moving participants into less risky funds as they near retirement.”
In the wake of the coronavirus crisis, efforts to build better retirement plans will likely clash with governments’ efforts to raise taxes on pension savings, as they seek to recoup the massive fiscal expenditures prompted by the pandemic, noted the paper. “As a result, there may be substantial change in how retirement saving plans are taxed.”
As well, the paper said delayed retirement is likely to become increasingly necessary post-pandemic, given low expected returns, pension shortfalls and rising longevity. Accordingly, retirement saving plans that permit and even encourage continued work, allow for worker mobility across companies and countries and offer low-cost investment advice are likely to help enhance old-age security.
On the decumulation front, the paper noted one topic commanding recent attention is how to help DC plan savers convert their retirement nest eggs into lifelong annuities protecting them from outliving their savings. “In the DC space, there has been much progress in terms of cutting costs of plan administration and establishing default investments in the form of target-date funds,” says Mitchell. “What we now need is more attention to deferred annuities in the payout phase, so as to protect people from outliving their retirement assets.”
According to the paper, some countries have explicitly required that annuities be embedded into the payout phase, such as the German Riester plans. Singapore also requires that all retirees covered by its Central Provident Fund use a portion of their retirement savings to purchase a deferred annuity. And Chile mandates either annuitization or a so-called programmed withdrawal process regulating how quickly money can be withdrawn in retirement.
The paper also noted that many different types of annuities exist and that the diversity around these financial products generates complexity and misunderstanding. For instance, plan members’ cognitive abilities and financial literacy strongly influence their willingness to purchase annuities, partly because these are rare decisions for people and partly because they can be “steered” toward or away from lifetime annuity products depending on how the products are presented or framed.
“In sum, post COVID-19, it will be challenging but critical to provide more retirees access to low-cost annuities and high-quality but low-cost investment advice,” said the paper. “Additional research and product development will be required to make the retirement decumulation process easier for retirees to manage. Moreover, different delivery systems for financial advice will likely be appealing to different subsets of consumers.”
Looking at the role of policy-makers, the paper noted that, even after the pandemic is brought under control, the world will continue to age, giving even greater urgency to reform old-age systems to help support the aging population. “Policy-makers can play a critically important role in this process, as they move to reform retirement systems while setting in motion broader plans to emerge from the pandemic.”
As a result, the paper suggested five key changes for global policy-makers to consider:
- Generate and make available better quality and more granular data about mortality and morbidity patterns. These could help insurers seeking to price longevity risk around the world;
- Develop a consistent and economically coherent set of guidelines for measuring and forecasting social security and pension assets and liabilities, as well as the assessment of long-term care needs for the aging population;
- Encourage delayed retirement, delicately where possible;
- De-link the provision of benefits from employment. Instead of pensions, health-care and insurance programs being offered though the workplace, these could be made available by associations, multiple-employer programs or workplace platforms; and
- Offer greater flexibility, like the gig economy, since this sector can provide older people with the opportunity to engage in flexible, part-time and other on-demand work opportunities.
“Policy-makers could enhance the decision-making environment by providing better data to price insurance products and by formulating better forecasts and establishing plans to respond to the aging population’s needs,” said the paper. “Raising retirement ages, incentivizing continued work and helping people save more are also likely to be part of the solution, though answers will vary across countries. Taken together, these can strengthen not only retirement systems around the globe, but also the economic vitality of our economies more broadly.”