The mainstream media can hardly go a day without publishing some missive about egregious pension benefits of the past compromising private sector businesses or public entities. In typical media fashion, the face off is always between greedy unions or collective bargaining groups on one side and unfeeling, dishonest CEO’s or politicians on the other. After all, that’s what makes it news. In all cases, promises were made. In many instances, keeping those promises is either financially impossible or implausible. There is no silver bullet, and these problems will have to be worked out over time by the parties involved. It will be messy.
What we should be talking about, however, is reforming the pension system for the future. In my 2007 book, Generation R: A Retirement Nation at Risk, I estimated that as many as 20 million Baby Boomers will end up as dependent retirees, subsisting solely on government and social services programs like Social Security and Medicare. Pensions are in fact a vital and necessary solution to help future retirees sustain a comfortable lifestyle for a 30 year retirement. In our view, there are three essential elements to pension design to make future plans work. The subject is far too complex to outline in its entirety here, but the basic pillars follow:
1. We need to define a target range of replacement income to maintain a standard of living in retirement.
The financial industry has long used the “80% rule”. That is, you’ll need 80% of your pre-retirement income level to maintain your living standard in retirement. This income falls into two categories; cost of living income (which covers the basics like food, mortgage, vehicles, etc.) and lifestyle income (which covers the things that make life worth living – cruises, golf, etc.) We would suggest that a pension needs to cover the portion of retirement income dedicated to costs of living only. Let’s assume for simplicity’s sake it’s half, or 40% of pre-retirement income. Why? Because you can alter your lifestyle. You can’t alter the costs of living. The good news? For most workers, Social Security will cover a portion of this cost of living expense, as it already acts like a pension. A true workplace pension would simply supplement it. So, it might look something like this:
Pre-retirement income: $100,000
Estimated annual post-retirement income target: $ 80,000
(includes costs of living and lifestyle expenses)
Estimated costs of living only: $ 40,000
Estimated Social Security benefit: $ 22,000
Pension income needed: $ 18,000
So, the prospect of funding a pension may not be as onerous as one might imagine.
2. We need to define the required contribution rate to achieve the required result.
Once we know what is needed in pension income, we can solve for what’s needed in contributions using number of working years, an assumed rate of return, and other relevant metrics.
3. Contributions need to be made by both the worker and the employer.
In decades past, employers fully funded the pension plan. This created unsustainable plans, as we see in the paper each day. Today, the pendulum has shifted far to the other side, where the risks of funding retirement rest solely with the employee – many of whom have neither the skills nor the interest in managing it. Everyone needs to have skin in the game.
The bottom line is that pension reform is a necessary evil, and it needs to happen sooner rather than later.
If you’d like a copy of my book, Generation R: A Retirement Nation at Risk, email me and I’ll send you a free copy.