State Guaranteed Retirement Accounts

Our nation is on the brink of a retirement crisis that could have severe consequences for both future retirees and society as a whole. The steady erosion in the voluntary employer-sponsored retirement system has made it more difficult for workers to save for retirement. This crisis will not only impact retirees, but the next generation of workers, who will be left with the tab when federal, state, and local governments are forced to expand to help millions of additional elderly Americans who will be living in poverty. 1

Since World War II the share of the workforce with traditional pensions relied on them to supplement Social Security and maintain living standards in retirement. Virtually no retiree with a traditional pension is poor. 2 But the employer-sponsored retirement system is on the decline. Over the past decade alone, the percentage of workers whose employer did not sponsor a retirement plan rose from 39 percent to 47 percent—a 21 percent increase. 3 Minorities have even less coverage: 65 percent of Hispanics, 51 percent of Asians and Native Americans, and 47 percent of Black workers were not covered by a retirement plan at work in 2010 (see Figure 4 below). 4

In some of the most populous states, the share of uncovered workers has risen more dramatically than the national average. This alarming trend is a call to action for state and local policymakers who want to prevent old age hardship by ensuring all workers can invest adequately, efficiently, and safely for their own retirement.

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Moreover, even if workers are covered by a retirement plan through their employer, the quality of that coverage has diminished: traditional defined benefit (DB) plans, in which workers were guaranteed payments for life based on years of service and salary, have been replaced by defined contribution (DC) or individual account 401k-type plans. DC plans shift all the risks and costs of retirement savings onto the shoulders of workers: they charge excessive fees that erode a worker’s nest egg by as much as 30 percent 5. require workers to choose from a menu of unsuitable investment options chosen by the employer rather than a long-term investment professional, and will be likely exhausted before the end of a worker’s life.

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Social Security is the bedrock of our nation’s retirement system but it was never meant to be the sole source of retirement income. The average benefit is $12,100 per year—barely enough to “keep the lights on.” Yet despite its modest benefits, Social Security provides the vast majority (over 80 percent) of income for 40 percent of older Americans today, 6 and will continue to do so for future generations of retirees 7 unless we make changes to our retirement system.

All workers need a supplemental retirement plan that invests their savings efficiently with low costs, earns a secure and sufficient rate of return, and preserves savings for retirement. Therefore, the policy challenge is to expand access to individual account-based retirement plans and to address the critical failures in the existing system by making a new retirement savings vehicle available that meets three key criteria for retirement income security:

Helps workers make adequate retirement account contributions and prevents early withdrawals.

Provides low-cost, quality investment vehicles that are professionally managed and helps shield individual workers from investment and market risks.

Provides a lifetime guaranteed stream of income at retirement.

Creating a nationwide, individual retirement plan that incorporates the goals of adequate contributions, safe and appropriate investments, and lifetime income, would efficiently and practically solve the upcoming retirement crisis. But if the nation’s policymakers won’t act, each state can tailor the State Guaranteed Retirement Account plan—which meets all of the above criteria for an efficient and adequate retirement savings plan—to meet their unique needs and to secure retirement income for each state’s workforce.

Given the current state of retirement income security in the United States, we propose states offer all workers a voluntary, low-fee, low-risk, retirement plan to help boost savings for retirement.

What is the State GRA?

State Guaranteed Retirement Accounts (State GRAs) are individual “cash balance” accounts where benefits at retirement are based solely on contributions and returns. A cash balance plan is an already-existing type of defined benefit pension plan that incorporates some features of a defined contribution plan. The State GRA’s major features are:

Consistent contributions: as in a 401(k)-type plan, workers and/or their employers would contribute at least 3 percent of pay into their individual State GRA.

Guaranteed returns: each account would be guaranteed to earn a return of at least 3 percent, or about 1 percent above inflation. This guarantee ensures that funds are protected from the volatility of the stock market; workers do not have to worry about losing a significant portion of their savings right before retirement.

Pooled investments: All individual account assets would be invested together in one large pool, with an emphasis on low-risk, long-term gains. Pooling takes advantage of economies of scale and minimizes financial risks.

Portable accounts: Individual State GRAs would be portable; the account would automatically move with a worker from job to job, unlike 401(k)s, which are tied to a particular job and difficult to roll over.

Investment management costs could be minimized by using the already-existing public pension infrastructure to invest the funds. State pension funds, which operate on a not-for-profit basis, have highly skilled, professional investment managers and administrators that are charged with overseeing and investing more than $3.1 trillion in retirement savings. 8 In such an arrangement, assets in State GRAs would be kept in a separate investment pool from public pension fund assets.

Why is a State Gra a Better Retirement Plan than a 401(k)?

The 401(k) system is inherently inefficient because it generates high adminis- trative and investment management costs that are ultimately absorbed by the workers themselves. 9 401(k)s also expose workers to a host of risks: 10

Market risk: workers who have 401(k)s risk losing a chunk of their savings in a market downturn, a particularly damaging prospect for workers nearing retirement.

Longevity risk: retirees relying on their 401(k) to supplement Social Security may outlive their savings.

Investment risk: 401(k)s force workers to manage their own portfolios, which often leads to lower-than-optimal performance for many reasons: workers sell losing investments while holding winning investments, tend to hold undiversified portfolios, are invested in too many high-risk stocks, and generally lack the expertise necessary to earn high returns. 11

Contribution risk: workers often contribute too little or too inconsistently to their accounts to accumulate a sufficient nest egg. High account fees can exacerbate this problem, taking a big bite out of already-inadequate savings.

These risks and costs are an inherent part of the 401(k) system. Thus, reforms like stricter regulations on brokers, disclosure of 401(k) fees, or requiring plan sponsors to offer more lower-cost index funds, would be band-aids; they wouldn’t fix this fundamentally broken system. Fees would still remain high and workers would still be forced to shoulder most of the risks.

On the other hand, the State GRA would encourage workers to save consistently, and their hard-earned savings would be invested in financial vehicles that charge low fees and provide steady returns. At retirement, their nest egg would be converted into a low-cost annuity to ensure that they have a guaranteed stream of income for the rest of their lives.

State GRA: Who Benefits

What workers would benefit the most from a State GRA? The workers who would benefit the most from a State GRA are those not offered any type of workplace retirement plan (DB or DC). Nationally, 58.5 million people, or 47 percent of the overall workforce, did not have access to a retirement plan at work in 2010. This is a significant increase from 2000, when 39 percent reported not having access to a workplace plan. 12 By state, the percentage of workers who reported not having access to a retirement plan through work ranged anywhere from a high of 56 percent in Florida to a low of 37 percent in Kansas (see Figure 2 above). California has the highest number of uncovered workers—7.9 million—while Wyoming has the lowest at 100,106 (see Figure 3). 13

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Workers with no plan are disproportionally low or middle-income or of color. Latino workers have particularly low coverage rates: 65 percent are not covered by a work- place retirement plan. Across the workforce, the workers most likely to lack coverage are self-employed or work for small firms. Small employers are less likely to sponsor any kind of plan 14 because retirement plans, like health insurance, are a voluntary expense, and because small firms have less time, money, and expertise to navigate regulations and take on the extra administrative burden.

In addition to workers that have no plan, workers who do have a 401(k) plan at work may prefer a supplemental vehicle for their retirement savings that is more secure. By saving in a State GRA, workers can save consistently and invest in financial vehicles that yield steady returns, charge low fees, and minimize investment and market risks.

How Will This Affect Workers’ Ability to Save in 401(k)s?

The State-GRA is a complement—not a replacement—for the 401(k). Workers would still be able to save additional funds in their 401(k). The State GRA allows all workers, particularly low- and middle-income workers and those working for smaller employers, to prepare for retirement. High income workers who have the vast majority of 401(k) assets will likely continue to save additional funds in their 401(k).

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Implementation and Oversight

Who Would Oversee and Administer This Plan?

A newly created independent board of trustees would oversee the plans’ operations. The board would assume all fiduciary, or legal, responsibility for the fund’s investment decisions and administration. Fiduciary duty requires all decisions be made entirely for the sole interest of the savers— not the share-holders of the financial service industry— which is a higher standard than the professional standards currently required of 401(k) providers. This also relieves employers, the fiduciaries of their 401(k) plans, of choosing a 401(k) provider and taking on legal exposure to the performance and regulatory compliance of their plans.

The board would likely include the state treasurer, comptroller, and representatives appointed by the governor and state legislature, including stakeholders from the business community and the public at large. The board would delegate investment management to the state pension fund which would bid out actual investment of the funds to private sector investment companies. They would likely contract out the fund’s recordkeeping and participant communications to third parties.

Is Legislation Needed to Implement This Plan?

Yes—legislation would be needed to establish an independent board of trustees and specify guidelines for fund investment, participation, vesting, and benefit accrual. These guidelines would include principles and restrictions concerning how funds are managed and invested, limits on administrative expenses, the length and timing of enrollment periods, employer and employee contribution limits, and payout options, among other details.

Who Is On the Hook If the Fund Becomes Insolvent?

Private insurance contracts would back all assets in the fund. In the unlikely event that there were any shortfalls, private insurers would make up the difference. The insurance premiums would be paid out of State GRA participants’ returns. The cost to insure the plan would be low, since the risk that the fund would fall short of its promised returns would be minimal (see below for a discussion of the fund’s minimal investment risk). Neither the state nor the employer would be held liable or bear any fiduciary responsibility for the fund.

Would the State GRA Comply With Existing Federal Pension Regulations?

The Employee Retirement Income Security Act of 1974 (ERISA) regulates all private workplace retirement plans. ERISA is a federal law enforced by the Department of Labor (DOL) that requires employer-sponsored retirement plans to meet certain minimum standards regarding participation, vesting, benefit accrual and funding. ERISA also holds plan fiduciaries accountable and requires plans to regularly provide participants with plan information. If a traditional pension plan is terminated because of insolvency, ERISA guarantees payment of certain benefits through the Pension Benefit Guaranty Corporation.

Because the State GRA uses employers’ payroll tax system to direct funds, it is essentially a multi-employer plan and would likely be subject to ERISA standards. A State GRA fund would need to cooperate with the DOL to waive employers’ fiduciary liability for the fund’s management. Such a waiver would be a boon for small and mid-size employers who, under the current system, are wary of the extra administrative and legal burden that sponsoring a retirement plan for their employees creates.

Investment of State GRA Funds

Who Would Invest the Funds?

The board of trustees would contract out the fund’s investment and management to the state pension fund(s). States, through their employee pension plans, sponsor excellent financial institutions that, on a not-for-profit basis, get the highest returns for the least cost. In short, because they pool longevity risk, can offer a well-diversified portfolio with longer-term investments, and are professionally managed, public pension funds deliver the same level of benefits as DC plans at only 46 percent of the cost. 15 Any funds invested with the state pension fund would be kept in a separate investment pool from public sector funds.

How Are the Funds Invested?

The State GRA aims to shield workers from the high fees and poor investment choices they often face in the retail 401(k) and IRA market (detailed in the “Costs” section below and “State GRA” section above). To provide a low-cost, low-risk alternative to 401(k)s, assets in State GRAs would be professionally invested in one large pool. Pooling assets has a number of significant advantages:

• Professional Investment Management. in the 401(k) system, investment decisions are made by employers and individuals. Pooling individual assets allows investment decisions instead to be made by professional investment managers, who consistently outperform individual investors. 16
• Longer-term Investment Horizon. To minimize market risk, 401(k) investors have to shift towards increasingly conservative portfolios as they age, often at the expense of higher potential returns. This tradeoff is costly because it reduces returns the most at a time when workers’ assets are at their peak: when they’re nearing retirement. In contrast, when assets are invested as a pool, there is no need for such a tradeoff. Because new workers are constantly entering the pool as older workers retire, the fund’s investment managers can maximize returns over the long-term, not just over an individual worker’s lifetime.
• Lower Fees. By taking advantage of economies of scale, pooling reduces both investment management and administrative costs. See the section on “Costs” for a more detailed explanation of the State GRA’s investment and administrative fees.

The Guaranteed Rate of Return

What is the Guaranteed Minimum Rate of Return?

The guaranteed minimum rate of return is one of the defining characteristics of the State GRA. It ensures that at retirement, savers receive a benefit that includes the total amount of funds they deposited into their account over their work life plus at least some annual minimum rate of return on their assets.

This minimum guarantee insures workers against the possibility of losing a significant portion of their hard-earned savings during bad economic times while also allowing them to capture higher investment returns when the market is performing well. Even in a year of poor investment returns, participants would be guaranteed at least a 3 percent rate of return on their investments, or 1 percent after adjusting for inflation. However, in high-performing years participants would receive additional returns, projected to be as high as 7 percent (5 percent after adjusting for inflation). 17 To enable the fund to meet its 3 percent guarantee in low-earning years, some of the investment earnings in excess of the guarantee would also be deposited into a “rainy day fund”.

This is not a radical idea: TIAA-CREF, one of the largest investment firms in the country, has offered a similar fund, their TIAA Traditional Annuity Fund, to non-profit workers and teachers for over 80 years.

How Is the Rate of Return Determined?