Redefining Retirement in the 21st Century for the Small Employer and America
People are living much longer, which demands greater retirement savings. But the recent trend has been toward saving less. Greater longevity increases the chance that people will require long-term or assisted-living care, and without the funds to pay for such care, Medicaid will be stressed. Greater longevity provides added challenges to our social safety net programs. This article discusses how longevity affects our social programs and what changes can be made to adapt to the effects. Permanent alimony is under attack and has been questioned. In response, our statutes recently changed limiting eligibility. But even this public policy program requires a revisit to deal with the effects of greater longevity. Otherwise, it too becomes a thing of the past and everybody is left to fend for themselves as once happened before the 20th century.
The 20th century began with few worker rights.[1] Employees worked until they died or could no longer perform any services, and retirement frequently meant their children provided them with housing and basic care.[2] This changed after the Great Depression with the New Deal, by providing a social safety net and collective bargaining rights.[3] When wages were frozen in 1943,[4] unions used collective bargaining sessions to negotiate for health and retirement benefits.[5] These altered the landscape of retirement planning. When these new benefits were combined with the social security benefits, the two provided seniors with independence and dignity in their retirement and twilight years.
Wages, employee benefits, and workers’ rights saw improvements throughout the 1950s, 1960s, and 1970s, but ended beginning with the 1980s as studies have shown.[6] The 1980s began with a period of runaway inflation.[7] High inflation was attended by very high rates of return on money market funds, CDs, bond yields, and stocks.[8] But the high rate of inflation ate into the security of pension payments made to the retirees of the period, which was first met with private pension plans adding cost-of-living adjustments (COLA) for pension plan benefits. That, however, was very expensive to fund and was met with IRS resistance when it published its final I.R.C. §415 regulations defining the upper dollar limit based upon a life annuity that employers could provide and deduct as a necessary business expense under I.R.C. §404. This upper limit was defined as the lesser of 100% of average compensation, or a dollar amount that would be adjusted for inflation as the cost of living required. This changed the way COLA benefits were funded, necessitating they be added on an ad hoc basis for qualified plans and adopted after the dollar limit was raised by inflation. To overcome inflationary concerns of the period, and the inability to fund those increased benefits, the 1980s saw the explosion of the 401(k) plan.[9] It was designed to supplement traditional pension plans during a period of high inflation, by providing an extra plan that was intended to be inflation proof, because runaway inflation brought with it high rates of return.[10]
The birth of the 401(k) retirement plan occurred ostensibly during the same time that the individual tax rate was lowered.[11] The lower tax rate paved the way for huge corporate bonuses that beforehand were pointless because so little reached the corporate CEO or CFO after taxes were paid.[12] The lower tax rate altered the direction of corporate growth from solely long-term growth, where employees were the most important asset driving long-term growth, shifting the focus to short-term corporate gain, where employees flipped from the most important corporate asset to a liability that interfered with corporate profit.[13] The reverse role employees played afterward slowed wage and benefit growth, allowing runaway bonuses for the corporate top. Such a change caused the corporate focus to shift to controlling employee cost, so that more and more bonuses could be paid.
The middle and late 1980s saw many corporate mergers and acquisitions that allowed jobs to be streamlined and eliminated. The acquisitions were partly underwritten with pension-rich funding by the purchasing company terminating the acquired company’s pension plan trust and recapturing its pre-funded assets. The problem was so widespread it caused Congress to address and stop it by adding a 50% excise on recaptured assets to the corporate tax that would typically attach to earnings.[14] Eventually, when there was no more room to create more corporate profit through efficiency measures, mergers/acquisitions, or other means, as in recapturing pre-funded pension plan reserves, corporations began migrating jobs to Asia, where employee wages are a fraction of what American workers are paid.[15] Job migration weakened the employee’s bargaining position for improved wages and perks, and employee benefits began to decline and even disappear, as did the growth of worker’s wages.[16]
Improved life expectancy, which otherwise exacerbated a dismal trend of wage and benefit growth, together with the unprecedented growth of 401(k) plans, eventually led to the decline and near extinction of pension benefits because actuarially forecasted costs were understated, allowing the 401(k) plan to be the primary retirement plan. Future old-age Social Security benefits came under attack because people were living so much longer,[17] and that was first dealt with during the Reagan administration by changing the retirement age from 65 to 67, which was delayed for 11 years and was phased in over a period of a few years.[18] The Social Security System is a pay-as-you-go pension plan because the current workforce pays the benefits of current retirees.[19] Longer life expectancy spelled further trouble for the beleaguered system once Baby Boomers retired and fewer workers supported many more retirees.
When there were many more workers than needed to pay current benefits, the excess taxes paid were used to buy government bonds, and this built an impressive Social Security reserve.[20] But that came to a grinding halt as the Baby Boomers began to retire.[21] This was an important milestone reached during the Great Recession, requiring changes to strengthen the system.[22]
• Demographic Populations for Funding Pension and Old-Age Social Security — Three phases are used to characterize demographic populations.[23] The first is a young working population in which most in the group are very young. They are the new entrants into pension plans and the old age Social Security system. Applied to pension funding, this characteristic is important because fewer claims are made and the fund builds rapidly. The second phase reached is referred to as a stationary condition. This status is perfect for making mathematical modeling predictions, because a stationary population condition is achieved when retirees who draw from the funds are replaced by a specific number of new employees entering the workforce sufficient to provide funding to fully pay the new retirees leaving. The fund neither increases nor decreases during this condition, signaling a stationary condition has been reached. The third and final phase is a mature population consisting of mostly retirees.
The buildup of reserves occurred during a young demographic population, created by the explosion of births following World War II. Before passing to a mature population, the final phase, where there are more retirees than workers to support them, the next usual step is to move into a stationary population. A stationary population is manifested with an equal number of new workers paying the Social Security wages of retirees, which completely offsets the money needed to pay retirees benefits so that there is no further buildup of reserves, but also no draw against reserve, allowing some time to deal with the fixes. But this didn’t happen with old-age Social Security because of both widespread immigration creating new entrants with the fund buildup and then massive job loss during the Great Recession.
Widespread immigration was enormously helpful to the Social Security reserves because the base of workers entering the workforce increased beyond normal births.[24] Japan, with its closed-door immigration policy, experienced far more problems than we did as baby boomers advanced in age.[25] But the Great Recession worked to undo those gains brought about by widespread immigration. It accelerated the number who left the workforce because older people who lost their jobs were forced into retirement. This caused the system to move past an important milestone with insufficient time to deal with the problem. The normal way to deal with this is either by lowering the benefits or by raising Social Security taxes, or both,[26] but neither is a practical fix during terrible economic times. The Great Recession caused so many to retire at once and earlier than they normally would have. Thus, ostensibly, it moved from a young worker population into a mature population (skipping the stationary phase), where more benefits are paid out than received in current Social Security taxes, thereby drawing against fund reserves to pay benefits for the very first time since its inception.[27] Because Baby Boomers are so plentiful and so many are retired, this trend will continue absent fixes, which will likely deplete all of its reserves before 20 years have elapsed.[28] When that happens, only 77% of benefits may be paid because current taxes only pay 77% of Social Security benefits.[29] As most Americans no longer have pension plans, but only the plans designed to bolster them, and people are living so much longer, workers either need to redefine how they will retire or revert back to the poverty they faced during old age in the early 20th century, and because they live so much longer, those that run out of money will live in abject poverty for a very long time before they die.
Retirement Takes a New Form
If, when employees retire, they have 20 times their highest pay in assets when they reach their normal Social Security age of 67, they likely have enough to retire with.[30] However, most Americans scarcely have six or seven times their highest income and these Americans must do a number of things to make their money last.
• First Step — Those contemplating retiring will need an estimate of the amount of money they can withdraw from their savings each month over their lifetime. This amount needs to be determined by an actuary or a certified pension consultant familiar with actuarial principles. It must factor in mortality for the demographic under which they find themselves living. The monthly allowance must use an interest rate that reflects retirement living, not a rosy projection professionals selling investments tend to use,[31] which means an interest rate that they themselves can achieve and not a rate only a large investor could achieve.[32] The interest rate used should reflect the fact that they are in retirement, which is very different from someone continuing to work. It should be set 3 percentage points below the estimate the investor could earn if they were working full time, when they could ride out valleys in the market.[33] Retirees must withdraw money on which to live when the market is depressed and when the market is posting gains, and Americans need to understand that. They could avoid the problem by keeping one-third of their savings in money markets at all times, currently earning nearly no interest, and instead paying benefits from it, but that has about the same effect as lowering the expected return by three percentage points.
• Next Step (Phased-in Retirement) — Retirees must work well beyond age 67 and cut back hours as needed to reflect their reduced capabilities due to aging. This will reduce their cost of living during this phased-in period. They may even be able to save smaller amounts of money, which compound the improvement. Working to age 72 will increase the amount of money they have by 33.822% (determined at 6%) even without additional savings. Because they haven’t drawn against it during the five years of extended work, they’ve improved that result by another 16.364781%, solely because they will need to withdraw the money for five fewer years.[34] The impact of the two effectively gives them 55.721678% more money on which to live,[35] produced solely by working five additional years. Because mortality increases as one continues to work, reducing the draw from age 72 to age 77 by cutting hours in half can have an identical effect, doubling what one started with solely by a 10-year phased in retirement. For example, that 16.364781% improvement for five years becomes 61.18644575% for 10 years.[36] The next five yields another 33.822% improvement at 6% yielding 79.083277% for the 10 years. The combination of the two produces almost three times the monthly draw one started with, and when that delay allows 3% more earnings on funds (because nothing is withdrawn) it improves the money supply by almost four times[37] solely by modifying retirement at age 67 to modified phased-in retirement for the 10 years discussed herein. People that can work beyond age 77 should do so, because they could be the very same people that live past 100.[38]
• Avoid Lump-Sum Payments — De-risking: It is not difficult to understand that company and municipal plan sponsors were not happy when prior costs were underestimated based on people living much longer than expected, so they shifted away from providing traditional pension plans. Those that kept their plans introduced de-risking, where the participants were offered lump-sum benefits in exchange for the promise to pay a monthly benefit for life.[39] This benefit feature reduces the plan’s exposure if mortality continues to improve as it is projected.[40] More importantly, the pensions are commuted to a lump-sum amount based on the investment earnings that the plans are expected to receive.[41] The alternative lump sums are large and tempting for that reason. If accepted, this short changes the participants in two important ways.[42] The plan trust has liquidity on deferred retirees and can absorb the bear market losses, thereby reaping the higher returns that a participant-retiree offered the buyout cannot achieve. Then, the trust has a far better negotiated position to reap higher returns simply because it has so much more money to invest than what the employee can achieve alone. For those same reasons, the plan sponsors could always purchase annuities from insurance providers at a fraction of the cost the individual annuitant would have to pay. The lower returns and higher priced annuities, when combined, will represent a significantly lower value for the participant than the income the lump sum replaces, exacerbating an otherwise worsening situation for retirees.[43]
Of course, employees in poor health always present exceptions and many may consider accepting the lump-sum offer without incurring loss and may be better off by the conversion. That depends, however, on whether they have beneficiaries and whether survivor rights have been elected.
Small-Employer Retirement Plans
The decision of a small employer to adopt a defined benefit plan was often based on tax savings after netting against those savings the cost of covering non-family members and non-key employees. Before the Pension Protection Act of 2006 (PPA) maximum deductible contributions were capped at the full funding limit, which was the current unfunded accrued liability under the elected actuarial funding method, which penalized good investment results. It also penalized employers when they had great profits and punished them in bad years since the IRS balanced its interest in higher taxes with oversight on enforcing minimum funding standards,[44] thereby souring the appeal of these plans for the small employer. That policy undermined the funding and security of future benefits and was partially responsible for mass exit from such plans for bigger employers that provided them to attract the best employees.
The PPA increased the effectiveness of these plans as tax shelters, by increasing I.R.C. §415 maximum benefits well beyond initial ERISA levels, more than doubling them, and tying future increases to the CPI.[45] It also expanded maximum deductible contributions as an ordinary business expense by creating both a 50% cushion of accrued liability and an at-risk component, both of which could be funded and deducted as an ordinary business expense.[46] The latter was designed to strengthen funding by allowing companies to make much higher contributions when they had greater profits, off-setting bad years when they couldn’t meet their current costs. This overcomes the small employer’s reluctance to adopt such plans based on the ability of the employer meeting future liabilities in bad years.
Many plan designs in Florida focus on maximum deductible contributions, giving little thought to the flexibility that the PPA provides. This flexibility need not affect targeted deductions and can be maximized with proper plan design by utilizing the maximum deductibility feature with lower benefits, and by raising benefit levels after enough funding has been established. These changes provide the small employer with a unique incentive to revisit their employee benefit policy as a better way to attract and maintain the best employees. Owners of small businesses survive in bad years with the accumulation of capital and are among those least prepared to face retirement in the 21st century,[47] especially when that retirement is brought about involuntarily either by business failure or by their disability.[48]
Conclusion
People are living much longer, and retirees have far less money than they understand. They will either run out of money while they are retired, or they will work many more years to make up the deficit, which will redefine retirement for America. With retirement redefined, it will affect so many areas of law and alimony issues in family law, forcing change for retirement. It will affect the amount of damages that plaintiffs can try to recover in nearly all areas of law. It will have its greatest impact on elder law because, as people live longer, there will be a sea change in the number of people entering long-term care facilities as the rate of morbidity increases exponentially with age. This will likely affect who can qualify for Medicaid as states are forced to reconsider qualification under the liberal impoverished rules established by Congress in 1986, which form the underpinnings of Medicaid planning. No matter what form the change takes, it always presents opportunity for those individuals with the foresight and the ambition to find solutions or otherwise find ways to adapt to change.
[1] Donald Fisk, American Labor in the 20th Century, Bureau of Labor Statistics (Jan. 31, 2003).
[2] Margaret Wente, Who Cares for the Elderly, if Not their Kids? Op. Ed., Globe and Mail (Mar. 7, 2015).
[3] Social Security Administration, Frequently Asked Questions (2018).
[4] FDR Executive Order 9328 (Apr. 8, 1943).
[5] In 1947, a series of administrative proceedings and court decisions under the National Labor Relations Act of 1935 held that pensions were a form of remuneration for the purposes of that act, and they accordingly became mandatory subjects of collective bargaining. (Inland Steel Company v. NLRB, 107 F.2d 247 (7th Cir. 1948), cert. den., 336 U.S. 960 (1949)).
[6] John Weicher, Distribution of Wealth in America 1983- 2013, The Hudson Institute (Jan. 31, 2017); see also Inequality in America: The Rich, the Poor, and the Growing Gap Between Them, The Economist (June 15, 2006); Serena Lei, Nine Charts About Wealth Inequality in America, Urban Institute (Oct. 2015).
[7] Bureau of Labor and Statistics, Historical Consumer Price Index through 2017.
[8] Michael Bryan, The Great Inflation, Federal Reserve Bank Atlanta (Nov. 13, 2013).
[9] Kathleen Elikins, A Brief History of the 401(k) Plan, Which Changed How Americans Retire, CNBC (Jan. 4, 2017); see also Andrew Petersen & Emily Kessler, Retirement 20/20: What’s it All About? Where Have We Been? Where Are We Going? Society of Actuaries, The Actuary Magazine (Apr. 2009).
[10] Investopedia.com, Why Were 401(k) Plans Created? (June 21, 2017).
[11] The Reagan Tax Cut occurred in 1981. While 401(k) plans were developed in 1978, they didn’t really grow until 1981 when the IRS created rules for individual accounts allowing pre-tax contributions to be made. See Elkins, A Brief History of the 401(k) Plan.
[12] Lawrence Mishel & Alyssa Davis, CEO Pay Has Grown 90% Faster Than Typical Worker Pay Since 1978, Economic Policy Institute (July 1, 2015).
[13] Before Reagan, the individual marginal rate was 70%. When combined with state income, made the after-tax dollar yield was so low that the focus was instead on growing the business the person served and using capital gains on growth of the corporate stock holdings to grow wealth.
[14] 26 U.S.C. §4980(d) effective plans years beginning in 1989, or for plans that began the termination process after March 31, 1985, but transferred the assets after December 31, 1988. 26 U.S.C. §4980(c)(E)(ii).
[15] Staff, Where American Jobs Went, The Week Magazine (Mar. 18, 2011).
[16] See note 6.
[17] Social Security Administration, Benefit Planner: Retirement (2018).
[18] Public Law 98-21 (Apr. 20, 1983).
[19] National Academy of Social Insurance What Is Social Security? (Overview) (2018), https://asi.org.
[20] Investments in federal government bonds is mandated by Social Security law. This is typical funding for such programs all over the world because of the sheer size of the program. Private funding has recently emerged as a hot political topic but fails to consider that there simply are not enough securities to invest in, which is why all social security systems around the world are similarly invested. Jeffrey Kunkel, Actuarial Note 142, Social Security Administration: Office of the Actuary (Jan. 1999).
[21] David Pattison, Social Security Trust Funds Cash Funds and Reserves, Bulletin 75 No.1, Social Security Office of Retirement and Disability Policy (2015).
[22] Occurred for the first time in 2009. While it had been expected when the Baby Boomers retired, it occurred much sooner because so many Baby Boomers retired earlier than expected due to the inability to find work. Id.
[23] See note 21, panels a through f.
[24] Brookings Institute, The Cost and Benefits of Immigration (2016).
[25] Chikako Kashiwazaki & Tsuneo Akaha, Japanese Immigration Policy: Responding to Conflicting Pressure, Migration Policy Institute (Nov. 1, 2006).
[26] All of these remedies occurred with the 1983 amendment and were delayed for 11 years before it took effect. The requirement that excess of collected Social Security taxes over payouts be invested in treasury bills took effect immediately.
[27] Pattison, Social Security Trust Fund Cash Flows and Reserves.
[28] Margarido Correia, Social Security Trust Fund Reserves on Track To Be Depleted by 2034, BIC Financial Planning (June 5, 2018).
[29] Id.
[30] In the 1980s, only a handful of people lived past 100 years of age. By the 2010 census, more than 100,000 people in the U.S. were living past 100 years of age.
[31] Daniel McGinn, The Epidemic that Swept England now Threatens America, 29 The Actuary (Mar. 1995).
[32] Id.
[33] This result was achieved superimposing the S&P 500 market variability swings (1980 through 2003) assuming 9% rate of return, amortizing the fund over the lifetime for a 55-year-old.
[34] Not discussed or incorporated in these results is the ability to amass further savings by not cutting back hours.
[35] All percentages stated apply to the monthly amount available, not fund size.
[36] Uses RP 2000 (males) with projected mortality. The measurement started with the group that began at age 67. As people age, the probability increases they survive to an older age. But with respect to any one member of the starting group, it does not, which is why actuaries increase fund values for survivorship. The actual improvement on account of survivorship is a little over 13%. The balance is the effect of shortening the period by 0 years. Measurements are done at age 67 because the calculation assumes that the individual will follow the average mortality of the group.
[37] 2.89872174 using 6% interest and RP 2000 combined (male) with projection. However, by delaying retirement, that 3% setback does not apply, improving the increase to 3.83192036%.
[38] See note 30.
[39] Paula Gladych, Conditions Are Right for Employers to Derisk Their Pension Plans, Employee Benefit News (May 21, 2018).
[40] Does not represent a problem for the employee when annuities are purchased, because that transfers the risk to the insurance company. This is seldom done since the plan can usually realize a much higher return than the insurance company selling the product is willing to offer.
[41] Typical in governmental plans and terminated qualified plans paying benefits from a wasting trust.
[42] Mark Miller, When Your Pension Sponsor Talks ‘De-Risking’ — Watch out, Reuters (Nov. 19, 2013).
[43] Id.
[44] 26 U.S.C. §412.
[45] From $90,000 per year to $225,000 (2019). See 26 U.S.C. §415(b).
[46] See 26 U.S.C. §404(0)(2)-(3).
[47] Nancy Forster-Holt, Retirement Preparedness of the Business Owner, 3(4) J. of Retirement 87 (Spring 2016).
[48] If most small employers have no retirement plan (see note 47), it follows they cannot retire when forced by circumstances beyond their control.
Jerry Reiss is a federally licensed pension actuary. He has written over 40 articles dealing with multiple disciplines, 13 published in The Florida Bar Journal.
Roberta C. Watson is a partner with The Wagner Law Group. She is past chair of the Employee Benefits Committees for the ABA’s Tax and Health Sections, and of its Joint Committee on Employee Benefits.
This column is submitted on behalf of the Tax Law Section, Janette M. McCurley, chair, and Taso Milonas, Charlotte A. Erdmann, and Jeanette E. Moffa, editors.
