Rely on Social Security, Not 401k Funds

The right way to fix U.S. retirement funding

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Kenneth P. Thomas is professor of Political Science and fellow in the Center for International Studies at the University of Missouri-St. Louis. He is the author of "Competing for Capital: Europe and North America in a Global Era" and "Investment Incentives and the Global Competition for Capital." He blogs at Middle Class Political Economist.

Matt Yglesias has a good post today about how the "401k world" announced by Thomas Friedman is no bowlful of cherries. The reason is that 401k retirement plans are generally not very good. Among the points Yglesias makes, they don't benefit the poor at all, because they can't save enough to use them, and the financial industry has created a bunch of retirement products for the middle class (many of whom also can't save enough) that are overloaded with fees, risk and transaction costs from too much trading. As he colorfully puts it, "A small number of highly compensated folks now have lucrative careers offering bad investment products to a middle class market based on their ability to swindle people."

Private saving via 401k programs was intended to be just one leg of a three-legged stool for ensuring a prosperous retirement, combined with Social Security and an employer-based defined-benefit pension plan. The problem: employers started replacing their defined-benefit plans with defined-contribution 401k accounts, since the latter are less expensive for employers.

According to a report by the Social Security Administration, the private sector cut defined-benefit pensions in half between 1980 and 2008, with coverage dropping from 38 percent to 20 percent of the private workforce. Workers receiving only 401k plans increased from 8 percent to 31 percent of the private workforce. Doing the math shows that 49 percent of people in the private workforce have no retirement plan at all. That means all they have is Social Security plus whatever they can save on their own.

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But savings for retirement, as Yglesias mentions, is grossly inadequate. According to a report by the Senate Health, Education, Labor, & Pensions Committee, there is a $6.6 trillion shortfall in retirement savings. This is more than twice what is in the Social Security Trust Fund: in other words, we are talking about a huge amount of money. Moreover, a Washington Post story documents that over one quarter of all retirement accounts have had loans taken out against them (an amazing third of workers in their 40s have done this). In other words, the already inadequate 401k system has been sharply undermined by family economic insecurity, most notably in the Great Recession and its aftermath.

Not only that. Via Trust Your Instincts and Wall Street on Parade, an episode of PBS' "Frontline" series last month showed that if you earn 7 percent annually on your 401k and pay 2 percent in fees, over 50 years the fees will actually eat up five-eighths of your money. This underscores what Yglesias writes about the importance of putting your retirement money in diversified, low fee funds (read: index funds).

If two legs of the stool are broken with the continuing demise of true pensions and the gross inadequacy of 401k funds, what's the solution? I think Duncan Black's suggestion is the best: expand Social Security, don't cut it! As I have pointed out elsewhere, Social Security is completely portable among employers and raising it places no additional administrative burden on companies.

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Though the numbers would need to be worked out, the easiest way to fund this is to eliminate the cap on income currently subject to the Social Security payroll tax while increasing the replacement rate for earnings in the middle class income range. Currently, Social Security only replaces 32 percent of income between $767 and $4,624 per month; something like 100 percent replacement for the first $2,000 in monthly income, and 50 percent for the next $2,000, would ensure more people a decent standard of living in their old age.

According to a recent paper by Timothy Smeeding, 28.4 percent of the elderly live in relative poverty (50 percent of median income, the usual measure for international comparisons) already, compared to 6.3 percent in Canada (and only 1.1 percent of Canadian seniors live below the U.S. absolute poverty line, compared to 9.2 percent in the U.S.). How much higher does senior poverty have to go before we realize that cutting Social Security is disastrous and raising it is absolutely essential?

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