In the defined-contribution era, though, things don’t work nearly so well. Most 401(k) plans pay out benefits as a lump sum, and government regulations do not require plans to offer an annuity option.26 A lump sum looks attractive, but it has big disadvantages. For one thing, the tax hit can be shockingly high: withdrawals from pension accounts are taxable in full, and workers must pay the tax up-front. Plus, since the withdrawals count as income, the worker looks “rich” in that year and often falls into a much higher tax bracket than usual.
Lump-sum payouts are also problematic because they tempt workers to spend now and worry about later, well, later. Anne’s grandmother used to call that “money burning a hole in your pocket,” and it’s a well-known psychological effect: when people have cash to spend, they tend to spend it, even if they know perfectly well that the money is supposed to last them a long time.27
But even the most disciplined and prudent person cannot ensure that her savings will last her lifetime. Investment risk is part of the problem. If Alice lives a long time—say, to age ninety-five—she has to manage her money for thirty years after she retires. With such a long retirement, the markets are sure to bounce up and down, and retirement savings could fall prey to another Great Recession. You might think that a retiree could protect herself by investing only in super-safe investments like bank accounts or Treasury bonds. The problem is that risk-free investments pay very low rates of return. If a worker takes that road, she could find that her savings grow too slowly to preserve her purchasing power, especially over a thirty-year period.
And there’s absolutely nothing a worker can do to stretch her money if she lives a lot longer than average. That’s the really scary scenario: if she finds herself at age ninety-five with nothing but Social Security to live on, she will either have to cut her expenses to the bone or hope that she’ll have family willing to take her in or support her. That’s a harsh choice for anyone, and it’s one that is especially cruel when it falls on the very old.
You might suppose that a retiree could buy an annuity from an insurance company. As we’ve noted, some employers used to buy annuities for their workers, and that worked out great, because insurance companies are good at insuring large pools of workers and the long-lived are balanced out by the short-lived. If workers could use their 401(k) payout to buy an annuity, they could rest assured that they would never outlive their money.
The problem is that there is no functional private market for annuities for individuals. Some large employers still buy annuities for their workers, and as long as they have a large pool to insure, the system works just fine. But the individual annuity market suffers from a predictable failure: adverse selection, mentioned in Chapter 5. An example will help explain why this failure occurs.
Imagine a simple society with just two people, Rose and John, both nearing retirement age. Rose’s mother, father, and all of her grandparents lived past ninety-five, and she’s never been sick a day in her life. She’s thinking of running a triathlon next year. John’s parents died in their late 60s of heart disease, and he’s trying to ignore some recurring chest pain that could signal a heart condition of his own.
Now, imagine that an insurance company offers both Rose and John an annuity on the same terms. The company calculates that the average person lives to about eighty-five. So they offer a guaranteed annuity of $16,000 per year in exchange for a one-time payment (funded out of retirement savings) at age sixty-five of $200,000. Rose jumps at the annuity, because it’s a good deal for someone likely to live to a hundred or so. John decides to pass, because he’s convinced he’ll die by age seventy, and he can come out ahead if he pays his own way.
This is all rational enough, but the dynamic is destructive to the annuity markets. As short-lived people like John leave the market, the people who remain are those likely to live a long time. When the average person in the pool (that is, Rose) is likely to live thirty-five years after age sixty-five instead of just twenty years, the insurance company has to redo its calculations. They can only offer $12,000 per year if they are going to make a profit and stay in business. At that point, Rose may exit the market herself, because what she’s being offered is no longer an especially good deal.
Now, you might think that the insurance company could solve the problem by asking Rose and John a few questions and maybe having them agree to a medical exam. If you’ve ever bought life insurance, you know that’s the process: the insurance company is trying to figure out who’s likely to die early and who will live a long time. The problem, though, is that the insurance companies can’t know as much about you as you do. John’s secret chest pain and Rose’s triathlon plans aren’t observable to the insurance actuaries.
Adverse selection is very real, and it has basically destroyed the individual annuity market in the United States. Technically, an individual can buy a life annuity. The problem is that adverse selection has made annuities a bad financial choice for nearly everyone (except those, like Rose, who just know they’ll live to a hundred).28
What would it take to offer annuities on reasonable terms that would be attractive to many people? You won’t be too surprised by our answer (which happens to be confirmed by both economic theory and real-world evidence): it takes a public option. Let’s see why.
A Bold Public Option
Today’s retirement system has failed by nearly any reasonable measure, and the result—unless we act—will be to load Social Security with a burden it wasn’t meant to bear. We stand at the brink of an unintended experiment, as generations of Americans approach retirement with inadequate savings. If we act now, we can stave off a disruptive future that could create chaos in politics and the economy, as the elderly and their children lobby for aid and orderly retirement becomes a thing of the past.
But the failures of the 401(k) model can serve as a road map to reform. A realistic savings policy should clear a path to retirement security for everyone, not just the rich. A successful program should also meet people where they are: it isn’t realistic to expect workers to act like financial experts or to save consistently on their own.
Enter the public option. A public option for retirement savings could:
Offer coverage to all workers, without gaps when they change jobs
Enroll workers automatically (unless they opt out)
Provide simple, sound investment choices with low fees
Pay out benefits as life annuities
The boldest—and best—idea would be to create a baseline public option that would operate nationwide and enroll everyone automatically. The program could withhold, say, 3 percent or 5 percent from every worker’s paycheck. The money would be deposited in a retirement savings account and locked up for retirement. Savers would have limited investment choices, and every item on the short menu would be a low-fee index fund. At retirement, the balance would be converted to a life annuity, paying a guaranteed sum every month for the worker’s life.
Automatic enrollment would ensure that all workers can save consistently, even if they work for a firm that doesn’t offer a 401(k). Coverage would continue as workers changed jobs. A short menu of low-cost investment options would enable workers to make reasonable decisions without becoming financial experts. And annuitization at retirement would help ensure that workers didn’t outlive their savings.
To make all this concrete, let’s imagine a hypothetical worker making $50,000 per year. Suppose the public option sets her savings at 5 percent per year. And suppose the fees are 0.5 percent per year. (Actual fees could be lower: the federal government’s Thrift Savings Plan averages just 0.33 percent.)29 If this person worked forty years, she would save $2,500 per year, every year, even if she changed jobs. And thanks to the public option, she would pay investment fees of just 0.5 percent instead of 1 percent. The result? If she retires at age sixty-five, she would have $268,000. But instead of having to manage a lump-sum payout and reinvest the money, she would receive an annuity, calculated on the basis of her balance, of $11
,000 per year for life.30
The public option wouldn’t make this worker rich. But it would help her save more than she could today. And it would guarantee her a steady supplement to her Social Security benefit, no matter how long she lives.
The key feature of the bold public option is that it could, at zero cost to the government, improve retirement security for all Americans. The administrative and investment costs would have to be studied (we give some ranges later in this chapter), but the public option could be entirely self-funded: workers would pay all administrative costs of the program and would fund their accounts entirely through payroll withholding. Firms already withhold Social Security and Medicare taxes, so the new program could be administered using the very same system, which means there would be no learning curve (and no extra costs) for employers.
The bold public option could be a huge boon to business. No longer would firms have to create and administer 401(k)s and track a changing workforce. Pension administration would be centralized in the hands of the government. Small businesses and service firms that don’t offer pensions now would benefit from improved morale and productivity in a newly secure workforce—at no extra cost to the firm.
By reforming the U.S. pension system, a public option could motivate policy makers to clean up the existing tangle of tax subsidies for retirement. The federal government spends upward of $180 billion a year on tax subsidies that, in theory, motivate workers to put money into 401(k)s, IRAs, and other retirement savings plans.31 But these subsidies are doubly flawed. For one thing, they don’t actually encourage saving. Economists have concluded that, for the most part, these tax subsidies just pay people who would have saved the same amount even without a subsidy. For another, the beneficiaries of the tax subsidies are overwhelmingly at the high end of the income spectrum.32
These subsidies ought to be a national scandal. But without a better program in place, they’re hard to repeal, because something seems better than nothing. With a bold public option, however, there would no longer be a defensible rationale for these lopsided subsidies. Policy makers could reform these subsidies so that they benefit all retirement savers equally—or, even better, could redirect the funds to the low earners who need assistance most.
Just to put an idea on the table: Congress could create a universal match, which would add a certain percentage of annual savings to each saver’s account (say, 50 percent of the first $2,000 of annual savings). That would mean that an average worker earning $40,000 per year would save $2,000 of her own money (recall the 5 percent rate for the bold public option) and the government would kick in another $1,000, for a total of $3,000.
The public option raises plenty of design issues, and we will highlight some of those in a moment. But the details are less important than the big idea: policy makers could act right now to improve retirement security and benefit business, all at no cost to the public at large. Why on earth wouldn’t we do that?
The bold public option may be daring by American standards, but other countries and several U.S. states have enacted similar programs.33 For instance, the United Kingdom has a competitive public option, the National Employment Savings Trust (NEST).34 In 2012, the British government required all employers to provide pension coverage for their workers, and it mandated certain standards for investment quality and safety. The NEST program adds a public option to this regulatory approach. Employers can choose to manage their retirement plans on their own, as long as they meet regulatory standards. But employers can also choose to use NEST, which has an easy interface for firms and workers and has a limited set of investment options.35
Several states now have automatic IRA-type plans for workers. In California, for instance, the CalSavers program will offer a competitive public option to workers without a workplace pension plan. Firms without pension plans will be required either to offer a private plan or to enroll workers in the CalSavers plan. Those workers will have a portable, defined-contribution pension account.36
At a minimum, a public option in retirement should coexist with (not replace) Social Security, should provide universal access at an affordable price, and should exist alongside market options for those who want to save more. The public option should also be designed to mitigate the four risks we highlighted above: the risk of not saving, investment risk, the risk of being cheated, and the risk of outliving one’s savings.
Beyond those basics, we can imagine a variety of options. For instance, we propose a baseline public option, but a competitive public option would be a reasonable step too. A competitive public option would permit, but not require, workers to save for retirement via a public plan. Employers could still offer their own 401(k)s, and financial firms could offer IRAs. But all workers would have a secure, basic pension savings option that would be simple and low-cost.
A competitive public option would be a substantial improvement over today’s policies. Still, we see three disadvantages. First, a competitive public option would put the burden on workers to sign up for the program and to choose to save. As we’ve seen, human nature and the high cost of living conspire to make it difficult to save when people have to make an affirmative choice. Many studies have shown that automatic enrollment produces far greater participation.37
Second, a competitive public option would impose higher administrative costs, because workers would come into and out of the system, and they could (presumably) elect different savings percentages. Employers would have higher costs, too, because they’d have to track which employees had elected to save via the public option, and firms would have to remit the savings periodically to the public option administrator. That’s far more difficult than deducting a straight 5 percent from everyone. And the IRS has not, in the past, had great success in requiring employers to administer optional public programs.38
Third and finally, a competitive public option might not surmount the adverse selection barrier to annuitization. As we’ve seen, annuitization works best with a large, representative pool of retirees. If it turned out that the competitive public option attracted mostly long-lived participants, its annuity program might collapse, just as the pure private market has.
For all these reasons, we think that a baseline public option is the way to go. But even under the umbrella of a baseline public option, there are a number of design issues that require further study. From the government’s perspective, the major issues are administrative. For instance, how would the government pick investment managers to invest the fund’s money? A public option plan would be a huge customer for any money manager, even with a very small fee. This is a serious issue, because the administrators of the public option should ensure that any private provider acts ethically and efficiently. But interacting with private contractors is a familiar issue throughout government, and there are a variety of bidding and contract structures and other practices already in place.
Still on the administrative side, there is the matter of collecting and coordinating information for 150 million workers so that contributions are tracked accurately. The government also has relevant experience here: the Social Security system tracks those same 150 million workers and monitors their wages, addresses, and work histories. Integrating a new public option retirement fund wouldn’t be entirely simple, but it certainly has precedent.
From the citizen perspective, design issues include investment choice. How simple should a simple plan really be? At one end of the spectrum, the plan might offer no choice at all. Everyone of the same age would be invested in the same retirement date fund (these are funds, now offered by firms like Vanguard, that adjust the mix of investments for risk and liquidity based on whether people are near retirement or far away). At the other end of the spectrum, a relatively simple plan could offer three to five investment choices. Still, choice multiplies the opportunity for misunderstanding of risk—and multiplies costs to investors and the cost of customer service.
While some of the details would have to be worked out, the bigger picture is that
a public option for retirement savings could go a long way toward addressing the coming retirement crisis in America.
8
Higher Education
Imagine that you’ve just been hired to head admissions for a for-profit college. Your job is to admit as many students as possible, because your college makes money mostly by tapping student loan programs, Pell Grants, and military aid to pay tuition. You’ve been told that the job is a numbers game: get them in the door, and don’t worry about whether they have what it takes to do college work. And don’t ask too many questions about the quality of education your college provides. That’s not your department. Anyway, students are adults, and it’s up to them to do their due diligence.
Now, maybe you wouldn’t take that job to begin with. The red flags are large and numerous. But imagine that somehow you find yourself working under those conditions. You might, logically enough, develop strategies to target people unlikely to have many other college options.
Hollie Harsh and her fiancé, Brian French, certainly fell into the “unlikely to go to college” category. By the spring of 2012, Hollie and Brian had been addicted to methamphetamines, homeless, and living in a tent for about four years. And yet Corinthian Colleges, a for-profit higher education corporation, treated them as promising applicants. The two had decided to clean themselves up and improve their lives, and Brian took the initiative to go online and do some research on grants. The day after filling out an online form, he got a call from a Corinthian recruiter, who offered Brian and Hollie money to tour Heald College. When the two told the recruiter their story, including that they were homeless, he said it wouldn’t be a problem and signed them up for classes—as well as $30,000 in student loans.
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