Special Report on Investments and Personal Finance : Time to Fix the Retirement System Before It’s Broke

Financing retirement of the large postwar generation of Americans looms as perhaps the biggest crisis of the next several decades.

Why? Because the U.S. government and, in a sense, all of us--voters and politicians alike--have been careless about our once-impressive retirement system. We have allowed Social Security to become overburdened and its future reserves to be dissipated on current expenditure.

We have allowed private pensions to change from professional management and guaranteed income to personal investment plans without adequately preparing employees, so that many people don’t save and those that do often save unwisely. “More than 40% of the people over 45 have no retirement savings,” says Eli Broad, chairman of SunAmerica Inc., a company specializing in retirement investments.

We have run an economy that favors the old at the expense of the young. The mysterious “decline in purchasing power of the wages and salaries of the lower-income half of the population in the 1980s was to a large degree the result of the rising consumption of the retired cohort of the population,” says economist S. Jay Levy of the Levy Institute at Annandale, N.Y.

The economy failed to grow and increase productivity rapidly enough to finance both more medical care for retirees and rising living standards for active workers, Levy, who is 73, explains in a study provocatively titled “The Economics of Aging: Can We Afford Grandma and Grandpa?”

We have basked in illusions: that saving by the 76 million baby boomers born between 1946 and 1962 would provide a national nest egg, or that values in residential real estate would transfer wealth to the next generation and all would be right.

But the investment research firm of Sanford C. Bernstein finds that slow wage growth has left “large numbers of lower-income baby boomers with limited ability to save.”

And as to real estate, it’s hard to see windfalls in a market of baby-bust generations, with fewer home buyers.

So the fears of many Americans that all won’t be right are well founded. But it is also true that our very concern will lead to reforms. Big changes are inevitable in the next few years to fix the retirement system, and we will need understanding and resolve. But if we see them through, we can turn retirement saving into a major business opportunity.

To begin with, Social Security should not be used to make the federal deficit seem smaller than it is. The system now collects $58 billion more in payroll taxes than it pays out to current retirees. But that surplus, by law, is invested only in Treasury securities, thus paying for the current cost of government.

In 1994, the Social Security surplus made an actual deficit of $251 billion seem like $193 billion. Politicians in both parties who prate about “not touching Social Security” are intentionally misleading the public.

In any case, that surplus is diminishing fast because payments for Medicare and to longer-lived retirees are higher than was anticipated a decade ago and wage growth is slower.

One certain reform is that the retirement age will be pushed back to 70, says benefits consultant Steven Vernon of Wyatt Co. Another could be that benefits will be further “means tested”--taxed heavily to higher-income individuals or even put on allocation according to wealth at retirement.

Looking to better performance in the future, the Social Security surplus might be freed to earn more by investing in common stocks and bonds, as private pension funds do.

Americans may be forced to save in private pension plans as a supplement or a substitute for Social Security. In Chile, all employees must put 12% of their pay into privately managed pension plans, in a system that has made Chilean retirees better off than American ones.

In Australia, the government mandated pension plans as a sub stitute for government-paid retirement, which is reserved only for the poor.

In the United States, incentives may be widened for earning tax-deferred retirement income in 401(k) and Keogh plans and individual retirement accounts. Incentives work. In the last five years, 401(k) plans, in which employees put aside pretax income, have grown 26% a year to $540 billion in assets.

Even so, there is a problem, says Eli Broad. “Most employees are too conservative, choosing money market funds or guaranteed, fixed-return investments that do a poor job of outpacing inflation,” he says. “History tells us that over the long haul, investments in stocks produce the strongest inflation-adjusted returns.”

The record over the last seven decades is that common stocks return 9% to 10% a year while fixed-income investments return about 6% to 7% annually.

Deferring taxes is critical because a return of 7% a year can be cut almost in half by annual taxes, while money earning 7% a year tax-deferred doubles every 10 years.

That’s why Broad, who built home builder Kaufman & Broad, chose its insurance subsidiary SunAmerica in 1989 as his vehicle for the retirement saving business. As an insurance company, SunAmerica can offer tax deferral, and death benefits, through annuity insurance policies that are really investment plans.

The business has grown dramatically, as every kind of financial company has seen the possibilities in retirement saving. SunAmerica has linkages for distributing investment plans with First Interstate and Chase Manhattan among banks, and with Merrill Lynch and Edward D. Jones among brokerage houses.

It also distributes through 4,700 independent financial planners, a growth occupation for this retirement-conscious age when people want advice. What do planners do? “Basically, help people invest for retirement, college tuition or any other purpose,” says Kevin McCarthy, a Pasadena-based financial planner. “We are able to counsel on a broad variety of investments, but saving is pretty basic and personal.”

And simple, says Broad: “First, invest as many pretax dollars as you can in 401(k) plans. Then look forward from your age now to the age at which you want to retire, draw up a plan to invest so much per month or per year, and get on with the program.”

If more Americans do that, financing baby boomer retirement may yet be turned from a crisis into one of the great business opportunities of the next few decades.