"The Coming Retirement Crisis - Mater Artium Necessitas"

Sydney M. Williams

Thought of the Day

“The Coming Retirement Crisis - Mater Artium Necessitas”

January 3, 2011

It was the Revenue Act of 1913 recognizing the tax exempt nature of pension trusts that first promoted the concept of defined retirement plans. The Act was a consequence of the February 3, 1913 ratification of the 16th Amendment, which gave Congress the right to levy an income tax, without apportioning the tax among the states or basing it on census results, as the Constitution stipulated.

The concept of pensions spread slowly. It was not until 1940 that General Motors’ chairman, Charles Wilson designed the first modern pension fund. Potential problems surfaced in 1963 when Studebaker terminated its underfunded pension plan, leaving employees with no legal recourse for their pension promises. Thus, the next piece of major pension legislation: The 1974 Employee Retirement Income Security Act (ERISA). That Act put in place reporting and disclosure obligations and minimum standards for participation, vesting, accruing and funding. It established fiduciary standards for administrators and asset managers and established the Pension Benefit Guaranty Corporation (PBGC) to protect participants of terminated plans. Additionally, the Act authorized qualified Employee Stock Ownership Plans (ESOPs) and IRA plans.

The growth in pension and retirement plans then exploded. According to Wikipedia, by 1980 there were “approximately 250,000 plans covered by PBGC. Peter Drucker, in the spring 1991 issue of the Harvard Business Review, wrote that pension and retirement funds had $2.5 trillion in assets and owned 40% of American common stock.

Before the advent of pension plans (and before the start of Social Security) people were left to cope on their own. The very small number of wealthy people were, of course, ok. The rest had to rely on whatever meager savings they had managed to accumulate, but more often on the generosity of family, friends and charitable organizations, such as churches. It made for an untenable and Dickensenian situation.

The risk of unfunded liabilities to companies (and to the PBGC) of defined benefit plans prompted the transformation of retirement plans toward defined contribution plans, including 401(k) plans – where the individual could put a percent of his income, up to a certain level, that may be matched by the employer, into that individuals account. The Revenue Act of 1978 included a provision that allowed employees not to be taxed on income they elect to receive as deferred compensation rather than direct cash payments. By 1982 many of America’s largest companies had adopted such plans. The Tax Reform Acts of 1984 and 1986 modified the plans tightening the nondiscrimination rules and reducing the before-tax salary deferrals. In terms of numbers, in 1984 7,540,000 participants had accumulated assets of $91.75 billion, or a little over $12,000 on average. Six years later, 19,548,000 held $384.85 billion, just under $20,000 on average.

The trend continues. In 1980 there were approximately 250,000 Defined Benefit Pension Plans in the U.S. By 2005, there were less than 80,000, as defined benefit plans gave way to defined contribution ones – but those remain seriously underfunded.

Today, millions of Americans facing retirement have insufficient funds. Starting this week, on average, 10,000 baby boomers will turn 65 every day for the next eighteen years. At the peak of the stock market in 2007, according to the Employee Benefit Research Institute (EBRI), the median balance for a Defined Contribution/401(k) Plan was $31,800 and the median plan balance for an IRA/Keogh Plan was $34,000. The combination of the two plans suggest how grossly ill prepared is the average person for a retirement that could continue for at least twenty plus years. With the S&P 500 trading 14.3% below where it was at the end of 2007 and with unemployment just under 10%, those numbers must be lower today. Inadequate savings, coupled with an increase in retirees, combined with anemic economic growth suggest troubled times ahead.

The last bastions of defined benefit plans lie principally today with unionized state workers. One has only to look at the severity of finances in places like California, Illinois, New York and New Jersey to recognize that that path is strewn with obstacles and will lead, without significant change, to bankruptcy. States will find themselves moving toward defined contribution plans.

There are about 55 million baby boomers. They all need liquid assets in order to retire. Given current trends, they will not be able to count on Social Security. Thus, at a minimum, a retiree will have to have at least $500,000 in liquid assets in order to retire, about eight times more than the average of today’s combined defined contribution/401(k) and IRA/Keogh Plans. An average of $500,000 suggests $27.5 trillion, or about one half of the total capital markets in the United States. And this only includes the 65 million baby boomers – not those younger, or older.

It is the critical nature of this problem that a resolution must be (and will be) found. In 1519, the then headmaster of Eton used the term mater artium necessitas in his Grammar, Vulgaria, to describe the concept of necessity being the mother of invention. There are only two possible answers to the conundrum of too many people retiring with insufficient means. One, the least desirable, is that millions of retirees will become wards of the state; a condition that will only increase dependency on the state. The second not only will require policy changes, but also depends on more educated, independent-thinking and self-sufficient individuals. It means that demonizing capital markets is unhealthy and counter productive – it will mean acknowledging that Wall Street and Main Street are linked in a symbiotic relationship. Policies will have to encourage investments and savings. The past fifty years have seen the country become increasingly consumption focused – concerned with the present, leaving the future to take care of itself. That will have to reverse.

Besides being necessary, the benefits of such change are obvious. More capital invested will encourage entrepreneurs; it will allow businesses to expand, thereby fostering stronger economic growth, which will add to employment. On the other hand, if the problem is allowed to fester the consequences will be severe. Thus, there is little question in my mind it is the enormity and severity of this looming problem that will sow the seeds of an answer – mater artium necessitas.