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Is the Average US Citizen Able to Retire?

The richest generation in the US is about to retire, while the average citizen has barely any savings for retirement. The baby-boomers generation is a vast demographic of people born after the Second World War. At the moment a huge number of them have already started to retire and the effects of this demographic shift are frightening the pension fund managers. 


The problem that some of the US pension funds are facing is that the pension obligations they face are bigger than the number of assets they have at their disposal. This clearly poses a problem for the pension funds, namely, how are they going to pay out the benefits they have promised and why do they not have the money they promised?


In the US, the most common retirement plans can roughly be divided into two categories: defined-benefit plans and defined-contribution plans. In the first plan, the employee’s retirement benefits are defined by the length of one’s career and the amount of one’s salary. 


The employer, who can be either the government or a company, is responsible for paying the employees a fixed monthly sum after retiring. This plan is more common in the public sector and due to employer responsibility, this plan has been popular among employees but not so much amongst employers. The defined-contribution plan puts the responsibility on the employee as one has to make monthly contributions to one’s pension plan and not the employer. The most common retirement account in this plan is probably the 401(k) where the employee gets to pick the mutual funds or other investment vehicles he wants to invest his retirement money in. 


The defined-benefit plan used to be the most common one, but since the 1980s it has decreased in popularity. Nowadays the defined-contribution plan is the most common one but there are still a lot of people, especially in the public sector, who have a defined-benefit pension plan. 


The people who have chosen a 401(k) plan are going to draw their pension benefits from that account and are thus dependent on the performance of their investments in stocks, bonds and mutual funds. The people opting for a defined-benefit plan on the other hand count on the state or the company they worked for to provide for their pension benefits. 


However, in the last years, it has become increasingly clear that some of the state pension funds will have difficulties in meeting their obligations. 


According to a study made by The Pew Charitable Trust, as of 2017 US state pensions on average have less than 70% of the assets they need in order to pay the promised benefits for current retirees. The three states with the highest shortfalls are: California $190.4 billion, New Jersey $142.3 billion and Illinois with a shortfall of $136.9 billion. These are all defined benefit pension funds and thus most of the affected people are government employees. The total underfunding of the US public defined benefit pensions are estimated to be around $1-6 trillion. The estimation that the pensions are underfunded by $6 trillion is made by the American Legislative Exchange Council. The reason why the estimations vary so widely is that the public pensions are not subject to the same type of internationally standardized reporting as most exchange-listed companies are which creates ambiguity in the calculations. 


The defined-benefit pension plans are insured by the Pension Benefit Guaranty Corporation (PBGC). However, PBGC is expected to become insolvent in the year 2025 which according to estimates will lead to huge pension cuts where retirees would only get to keep 2% of their promised benefits. The macroeconomic effects of the failure of the defined-benefit plans have been estimated by Matrix Global Advisors. According to them, the loss of projected pensions will lead to a job loss of more than 55,000 people in the US and the US GDP would drop by $5 billion.


What about the people who have contributed to a defined-contribution plan, are they better off? Due to the income inequality in the US, the wealthiest Americans can definitely rely on their 401(k) plans and other sources of income. But for the average American, the numbers are not that promising. According to Fidelity, a financial services company, the amount of savings a 401(k) account should have for a 67 years old US citizen who earns 75k a year is 600k. 


The actual statistics show that the average 401(k) has 195,500$ saved and the median amount of savings in a 401(k) is 62,000$. Of course, there are different types of retirement accounts as well like the IRA, but the numbers are not much better for them either. 


These numbers might be worrisome for people who do not have the means to retire at all. In fact, the amount of Americans aged 65 and older who stay in the workforce has increased by 35% between 2011 and 2016. This group is projected to be the fastest-growing segment in the workforce by 2024 according to the US Bureau of Labor Statistics. These people are trying to top up their savings accounts, but some of them are also working not out of the need for money, but due to their own choice. The 401(k) accounts have seen record highs in recent years due to the highest ever recorded stock market in human history. This leads people to speculate about how long the bull market will last and what happens to their pension income in a possible market downfall?


People who have contributed to a defined-benefit retirement plan are rightly worried about their retirement income. Why then do they then find themselves in a situation where they can expect a cut in their pension benefits? There are many reasons for the underfunding of pension funds and one of them is their investment return assumptions. A common expectation lies at around 7-8% annually, which has been criticised as overly optimistic. If the expectations were lowered, the contributions by employees would go up and the pensions wouldn’t be as underfunded. The problem is that most of the funds have not met their expectations and have ended up losing money during bad times like the 2000 tech boom and the 2008 financial crisis. In 2008 some state pensions lost up to 40% of their money. In addition, the low-interest rates that have faced the world since 2000 have made it difficult for pension funds to earn reasonable returns on e.g. treasury bonds. This has led pension funds to invest in riskier asset classes in hopes of higher returns. 


Also, the pension funds are suffering from a demographic shift where the amount of workers per retiree ratio is declining. The US had 4.6 workers per retiree in 2010, but in 2050 that number is predicted to decline to 2.5. The shift is mainly due to increased life expectancy and a decreased fertility rate. The actuaries did not expect the workers per retiree ratio to fall this sharply and consequently used overly optimistic calculations which in return led to lower contributions. Even though the problem has gained attention the US states have not taken proper action to cover the pension deficits.


Some solutions have been proposed to address the issues of underfunded pension funds. 


The first one is to change the worker per retiree ratio in the form of increasing the retirement age, encouraging higher birth rates and allowing for more immigration. The second solution is to change the financing. This would come in the form of higher taxes, reductions in pension benefits, and the encouragement of savings. The US House of Representatives has already passed the Rehabilitation for Multiemployer Pensions Act which has the aim of protecting the defined-benefit pensions. Lastly, some have also speculated that the government will have to bail out the unfunded pension funds and thus the taxpayer will be the one picking the cost. As the problems have been known for some time now there is optimism for a possible solution.


In conclusion, no matter if you have a defined-benefit or defined-contribution plan, the outlook for the average US retiree does not look too good. The one who has a defined-benefit plan might find themselves without a proper pension and, thus, forced to work past retirement age. While the one who has a defined-contribution plan might have to keep working as well but is also at the mercy of his 401(k) investment performance which historically tends to be volatile. 

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