In this PIMCO DC Dialogue, Professor Laurence Kotlikoff of Boston University discusses changes in retirement in the United States and the importance of defined contribution savings plans in a world where we are all on our own when it comes to saving for the future.

1. PIMCO
DC Practice
PIMCO DC Dialogue ™
It’s Your Living Standard.
September 2011 In this PIMCO DC Dialogue, we talk with Larry Kotlikoff
about the changes in retirement, focusing first on
generational transfer payments and the reality that we’re
all on our own to save for the future. He shares his concerns
about our current Social Security system and proposes a
This issue features an interview with
Laurence Kotlikoff, revamped system, including private, fully funded accounts.
prolific author, entrepreneur,
Larry emphasizes the importance of saving in DC accounts,
and Boston University professor
w w w.esplanner.com yet suggests that this saving be balanced over one’s lifetime
to allow a more stable living standard, or what he calls
“consumption smoothing.” He offers the suggestion that
plan sponsors provide a higher contribution to accounts of
younger workers, who are less able to save, given other pulls
Moderated by on their resources. Finally, Larry discusses the market risk
Stacy L. Schaus, CFP ® and uncertainty we face in the future. He underscores
PIMCO Senior Vice President and
Defined Contribution Practice Leader
that participants should not be exposed to risk,
which may endanger their living standard
Volume 6, Issue 8
or may trigger fear.

2. DC Dialogue
D
C Dialogue: How has retirement changed?
L
arry Kotlikoff: As we know, for many centuries, retirement really didn’t exist. People
died before they reached their forties. If they did make it beyond that
age, people used their children as an insurance market; the deal being,
if I make it to old age, the kids will take care of me. If I die before then,
I leave them my money. As modern life evolved, kids left home
and these kinds of family arrangements broke down. Fertility rates
also declined.
Today, there’s pretty strong evidence that parents and adult kids are
acting like independent households, not sharing risk. The kids are not
going to provide annuities for their parents’ retirement. So now we
have the problem of people having to save for their own retirement. As
longevity increases, for some people, retirement’s going to be longer
than their working lives. We all have to take care of ourselves. And
“Today, there’s pretty
we’re not doing a great job of it.
strong evidence
that parents and DCD: Do you think this breakdown in generational support is happening
adult kids are acting just in the U.S.?
like independent Kotlikoff: Each country has its own culture and behaviors. For instance, in Asia,
households, not the culture continues to be oriented toward the extended family, and
sharing risk.” financial flows between family members are significant.
But in the U.S., for the vast majority of the population, we don’t see
significant flows of income and support between adult children and
their parents or vice versa, regardless of whether one side is much
better off than the other. There is some support for the kids while
they’re getting their higher education. Yet the fact that so many young
people today leave college with massive amounts of student debt
suggests that too many parents have left the financial problem of their
children’s education to their children.
So, the behavior of typical households is that the generations are on
their own. They’re almost, in some ways, at war with each other.
Or at least there is a clash between the generations.
DCD: Why do you think there is a clash between generations?
Kotlikoff: I think part of it is the heterogeneity in our society. Broadly speaking,
I don’t think the older people in our country see the children of our
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country as their own. In countries like Sweden where the
population is very homogeneous, you don’t see this kind of problem.
But when you have great heterogeneity, you say, “Well, if I’m going to
do anything, I’m going to do it for my kids. I’m not going to vote for
raising taxes in my local community to provide better schooling
for my neighbors’ kids because they’re not mine.”
And if I’m a 60- or 70-year-old, am I going to support a higher property
“Baby boomers are
tax in order to educate somebody else’s kids? You see communities in
reaching retirement
Florida where the older people are voting against those propositions.
age and expecting the
Of course, it’s selfish behavior. But we are so diverse that we don’t
actually see our common interests anymore. huge transfers they’ve
been promised.“
DCD: You’re suggesting the older generations won’t spend to provide
for the younger generations, yet the young are taxed to support
the elderly.
Kotlikoff: Well, yes. The vast majority of the obligations facing today’s
18-year-old who just became eligible to vote have been piling up for
decades before that person was even born. While that person was a
child, during all those years when we expanded Social Security, made
promises to the current elderly, and expanded Medicare and Medicaid,
these young people who are now left with the bill were given no say.
They were not franchised to vote because they were under 18.
So, this is definitely taxation without representation, which we fought
the Revolutionary War to prevent. We’ve piled up these obligations in
a way that is particularly despicable because we’ve used in my opinion
fraudulent deficit accounting to hide what we’re doing. We’ve run this
massive transfer payments scheme for six decades as a pay-as-you-go
system where we’ve taken ever larger sums from young people and
called it taxes and given it to older people as benefits. And we’ve told
each set of young people, “Don’t worry. Yes, you’re going to have to
pay these very high taxes now. But when you’re old, you’re going to get
all these taxes back in benefits plus a whole lot more.”
But now the baby boomers are reaching retirement age and expecting
the huge transfers they’ve been promised. And, of course, we haven’t
had enough children and they’re not earning enough for this all to work
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out. This pay-as-you-go accounting meant that all these obligations
to pay the baby boomers, which will total over $3 trillion a year, in
today’s dollars, year after year when they’re fully retired, never showed
up on the books as official debt because we never used the words
“borrowing” and “repayment of principal plus interest.”
So it’s all implicit debt. And our fiscal gap at this point, which really
records the sum of all our explicit and implicit debt, is $211 trillion,
which is about 14 times GDP. There is only so much money you can
extract from young people. And, at some point, if you start taking too
much, they start leaving the country. We saw that in Uruguay where
they have super-high tax rates and young people headed off in droves
to Spain and other countries. That could happen here because there’s a
“There’s a limit to limit to our generational expropriation, and we’re reaching that limit.
our generational
DCD: How may the current deficits and funding of Social Security affect
expropriation, and
baby boomers and younger generations as they seek to retire?
we’re reaching
Kotlikoff: I think older people know that current fiscal problems could lead to a
that limit.”
financial collapse of an even bigger magnitude than we saw in 2008.
They know that we’re coming to the end of this transfer payment
scheme and that their Social Security benefits are in danger—maybe
not directly through Social Security benefit cuts, but indirectly through
higher taxes on their benefits. A total of 85% of Medicare expenditures
and 70% of Medicaid expenditures goes to the elderly in the form of
old-age nursing home support. And they know that their Medicare and
Medicaid benefits are in danger.
These three big programs—Medicare, Medicaid, and Social
Security—are now spending $30,000 per old person, if you add up
the expenditures of these three programs and divide by the number of
old people. That’s about two-thirds of the per capita GDP. When the
baby boomers fully retire, the projection is that they’ll receive at least
$40,000 per head in today’s dollars. This will represent close to 85% of
per capita GDP. The bill is just going to be too big.
The older people who realize this are saying, “Gee, this won’t work
out for the country. My benefits will be cut. We’re going to have to pay
more out of pocket for health care and retirement. How am I going
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to make it through? I’m going to keep working.” But, of course, not
everybody can keep working, physically, nor is every employer willing
to keep the elderly on the job. So, this is a very anxious country.
There are ways to dig ourselves out of this hole, but it’s not going
to be easy.
DCD: How do we dig out of this hole, especially related to retirement
funding? With the concern you’ve raised about Social Security, does “We need a modern
that leave defined contribution plans to meet the retirement income version of Social
needs for workers?
Security, which
Kotlikoff: DC plans are part of the answer. We need workers to save in these I would call the
programs. Workers need to realize that no one is going to bail them Personal Security
out. Unfortunately, there are a lot of workers who say, “Well, the
System—a system
employer is putting in some basic money for me, so I don’t really need
that would provide a
to put in that much myself. Uncle Sam’s providing Social Security
basic level of support
and Medicare and Medicaid. I’m going to be taken care of. So I don’t
need to save on my own.” The percentage of people who contribute
via fully funded
has been too low and the amount they put in is also often too low. private accounts that
Plus, the returns clearly haven’t been that great for some generations, are sustainable and
depending on what they invested in and when they did it. transparent.”
But we cannot rely on defined contribution alone. We also need to fix
Social Security. We need a modern version of Social Security, which I
would call the Personal Security System—a system that would provide
a basic level of support via fully funded private accounts that are
sustainable and transparent. Social Security now has 2,728 rules in its
handbook that make the system almost entirely indecipherable.
DCD: How much would people need to save in the private account system,
and how might it work?
Kotlikoff: To replace the Social Security coverage in place today (including to
cover survivor insurance, life insurance, and disability insurance), the
government would need to mandate that everybody contribute 10% of
their salary into this system. Right now the OASDI tax rate for Social
Security is 12.4%. So the private system would require a somewhat
lower contribution overall. But you’d know for sure what was being
done with the contributions.
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I suggest that the contribution be divided 50-50 between legal
partners and spouses so that they each have an equal size account
if one’s not working. In addition, the government would need to
make matching contributions on behalf of the poor and the disabled
and the unemployed. So everybody would have an account. Then,
I would invest this money in a globally diversified, market-weighted
index portfolio and have the government annuitize each cohort
gradually starting at age 60. Although these are personal accounts, the
government, actually a government computer, would do the investing
at zero cost to participants. Investment companies and insurance
companies would play no role in the system.
Plus, I suggest that the accounts attach a government guarantee of
the inflation-adjusted principal invested—a zero real rate of return.
So you know you’re never going to lose your contribution. You’re
“A fully funded system
not going to have the leeway to invest it on your own. You’ll be fully
leaves no future globally diversified.
generation on
That’s my vision for a fully funded system that leaves no future
the hook for any
generation on the hook for any current generation. You’d be able to
current generation.” check your individual account balance and understand how it’s being
invested. It would be a very simple, transparent system. Of course, we
also need to address health care. While there are no simple solutions,
we need to realize that there’s no other option—we’re in a very deep
hole. Changes must be made.
DCD: If people contribute 10% of pay to your revised Social Security
system, how much more would they need to save to meet their
income-replacement goal in retirement?
Kotlikoff: First, let’s talk about the “rule of thumb” for income replacement.
The industry has told us that we need to replace 75% to 85% of our
pre-retirement earnings to maintain our living standard in retirement.
For a lot of people, I believe that replacement goal is too high. This
is particularly true for pre-retirees who have expenses that won’t
carry into retirement, such as college funding, mortgage payments,
supporting a parent, and so on. I fear that if you set a target that’s too
high for people, they start turning pale because it means they’d have
to save every penny and starve. Many retirees may be able to maintain
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their living standard on 45% to 55% of pre-retirement pay.
Unfortunately, many financial experts and models suggest a savings
goal that is inflated, and then they often say, “Don’t worry. You can
save less if you take on more risk.” And it’s true that the probability
of reaching the target may be much higher. But so may the
probability of losing most of what you’ve invested.
So, I think the industry has put people into riskier securities than is “The industry has
necessarily appropriate and has not fully explained the downside put people into riskier
risk in terms of the way they’ve done their Monte Carlo analysis. securities than is
Over the years, they’ve had lots of Monte Carlo tools that show the
necessarily appropriate
probability of making your target. They typically don’t show the
and has not fully
probability of losing everything. If we’re going to invest in something
explained the
that involves risk, we need to understand the downside as well as the
upside risk to our living standard. downside risk.”
DCD: How would you determine how much a person must save to meet
their expenses in retirement or to maintain their living standard?
Kotlikoff: The appropriate target should be based on figuring out how much
you need to save in order to have a smooth living standard. So the
appropriate target comes from thinking about trying to have the same
living standard in the future that you’re having now. That’s what
economics says. This calculation should be run for each individual.
Unfortunately, calculating the savings amount correctly is extremely
complicated, as it requires assumptions about taxes every year for the
rest of your life. I’ve tackled these complexities by creating financial
planning software with my colleagues that embeds a mathematical
technique called dynamic programming. This type of modeling does
what economists call “consumption smoothing”—it is designed to help
people maintain the same living standard during both working and
retirement years.
If you ask households to save too much, they may sacrifice their youth.
Yet, if they save too little, they may be unable to retire or they may
be required to reduce their living standard during retirement. I believe
we have about 20% of our population that is saving too much, while
at least 40% is saving far too little. To economists, the whole story of
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personal financial planning is about your living standard. It’s not about
some arbitrary number that you’re supposed to hit at retirement.
DCD: Consumption smoothing, or maintaining your living standard,
pre- and post-retirement is a reasonable goal. Yet, to calculate
what’s needed to accomplish this is a challenge. We need default
assumptions for DC savings. What do you suggest?
Kotlikoff: To answer this question, I would need to know more about what other
funding sources the population has. If we assume they only have a DC
plan in addition to Social Security and that they have typical expenses
at certain ages, I would suggest a lower saving rate initially.
My sense is that for young people who have children, are paying
a mortgage, and may be helping out their parents financially, an
appropriate contribution may be only 3% and the employer ideally
“If you ask households would contribute, say 6%. As the worker’s income increases and
to save too much, expenses decrease, they can contribute a higher percentage of pay and
they may sacrifice perhaps the employer wouldn’t need to contribute as much. To smooth
their youth.” consumption, younger workers simply need more help. DC plan rules
may not allow different contribution levels based on age, yet from a
lifestyle management standpoint, I believe that would be better.
DCD: What do you believe is the appropriate default investment for a
DC plan?
Kotlikoff: The default investment has to be relatively low risk. I would start with
inflation-indexed bonds such as Treasury Inflation-Protected Securities
(TIPS), and then add risk cautiously. Participant assets shouldn’t be
defaulted into the riskiest securities. Yet, we can push people into a set
of investments with risk-adjusted return potential that may be too low.
We’ve got to get the right balance here. So, in terms of investment risk,
economists think about living standard risk. What does it mean if you
invest in high-risk securities? What is the downside risk to your living
standard? What’s the upside? Because, as you stay in the stock market,
if there’s a chance for a fantastic upside, there is also a chance for a
fantastic downside. So this is like a random walk to heaven or hell.
Plan sponsors need to consider living standard risk as they select the
default. Whatever the risk level, participants need to be shown what
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they may face in both a possible downside and a possible upside to
their lifestyle or living standard. Of course, through time, that risk to
your living standard will depend not just on how you intend to invest,
but also on how you intend to spend.
If you’re going to spend more aggressively each year, thinking that
you’re going to do well on these risky investments, and they don’t turn
out, then you’re likely to have a more substantial downside in your
“Whatever the risk
future. For example, let’s just say that you spent a certain amount when
level, participants
you were younger, because you were pretty sure that you were going
need to be shown
to do well in the market. If that turns out not to be the case, you’re
likely going to suffer a bigger downside than if you had not
what they may face
consumed so aggressively earlier on. in both a possible
downside and a
We also need to recognize that people may adjust their spending based
on how their investments perform. If they lose a lot of money, they’ll possible upside to
reduce spending. If they make a lot of money, they’ll likely increase their lifestyle or
spending. They’re going to respond to their circumstances. They’re living standard. “
probably not going to spend the same amount each year independent
of whether their asset values decline or rise dramatically. No one
typically acts the way conventional financial planning recommends
they act, which says volumes about conventional financial planning.
We need to have them think carefully and make sure that the tools plan
sponsors are using and providing their employees are the best possible
planning tools.
If you were retired in 2008 with $1 million in assets and it went down
to half a million, you probably aren’t going to spend the same amount
you did before. In fact, you may have sold out at the bottom, and
now you’re investing much more conservatively and, unfortunately,
experiencing a lower living standard.
The bottom line is that we need to show people the potential
consequences to their living standard of not contributing sufficiently to
their retirement plan, as well as what may happen if they take on too
much risk. We also need to understand that younger participants may
need more help in saving. Maybe the employer offers a contribution
percentage that’s the same for all workers, but with a minimum dollar
amount that would give younger workers a greater contribution.
That’s just one idea.
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DCD: As people grow older, they do tend to save more in DC plans as a
percentage of pay.
Kotlikoff: That’s right. If you look at the typical pattern of life cycle savings,
people save relatively small amounts when they’re young. When
they’re between 45 and 55—or even 50 and 60—that’s when most of
the life cycle savings for retirement occurs.
If you look at longitudinal pictures of actual wealth accumulation
with age, you see this picture. And it makes perfect sense because
it’s exactly what the theory predicts. When you have more mouths to
feed, when the kids are young, you’re going to have to spend more on
consumption just to keep everybody’s living standard relatively smooth
compared to where it’s going to be in the future.
DCD: When you look at what’s happened with the financial crisis and the
“When there’s
markets recently, how does that affect thinking about managing
uncertainty in retirement savings and income?
the markets, this
Kotlikoff: I think the investment environment is riskier—we’re dealing with far
can literally and
greater uncertainty. It’s not just the financial system that’s riskier. The
uncontrollably fiscal policies of the different countries also are producing a lot more
transmit fear in risk. So the employer, if they’re making the call about how to default
human brains. people or they’re talking to their employees about their investing
Emotions often strategies, has to be aware of these increased risks. Unfortunately, when
drive economic anxious investors are frightened out of the market, they tend to stay
decision making.” there rather than commit to taking risk again. Once bitten, twice shy.
We’re emotional creatures. When there’s uncertainty in the markets,
this can literally and uncontrollably transmit fear in human brains.
Emotions often drive economic decision making.
Our weakened economy has to enter into an employer’s thinking and
also into an employee’s thinking. It’s made life much more difficult.
It’s not like we’re in an era where we can count on the stock market
delivering consistently positive returns so that we don’t have to worry
about changing economic realities.
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We’ve always had risks in the economy. But this environment seems
to be much more uncertain. We need to manage retirement assets
with the reality of generally higher risk and likely future inflation. That
may mean adding more conservative investments, as well as inflation-
hedging securities such as TIPS, as well as commodities, real estate,
and natural resources. Inflation risk tends to be significant for retirees,
yet fortunately can be managed.
“We need to manage
DCD: What else might you suggest to plan sponsors? retirement assets
Kotlikoff: As fiduciaries, plan sponsors have an obligation to think about their with the reality
investment choices very carefully. They can’t just leave it to the of generally higher
company that’s selling them or the employees financial products or DC risk and likely
services to make these decisions for them. They have to ask questions future inflation.”
and they have to adjust what they’re doing through time in light of how
they see the economy and markets progressing.
We have put employers in a difficult place. I don’t think they should
have been put in this position, but they are because we’ve created an
environment in which the employer can influence their employees’
ability to save as well as pay taxes. Employers often have to play this
role because if they choose to sponsor a retirement plan for their
employees, it becomes part of their responsibility at this point, as well
as running their companies. We need to have them think carefully and
make sure that the tools they’re using and providing their employees
are the best possible tools. They also need to think carefully about risk,
particularly in the default investment. Even if risky assets perform well
over the long run, they may entail a bumpy living-standard ride…which
some may find intolerable.
Unfortunately, we only go around once. Our lifetime happiness
depends on our lifestyle or living standard at all ages, not just
retirement. How plan sponsors structure DC plans, both from a
saving and investment standpoint, can make a huge difference in their
workers’ current as well as retirement living standards. That’s a lot of
responsibility resting with the employer!
DCD: Thank you, Larry.
Kotlikoff: My pleasure.
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About PIMCO and Our DC Practice
Based in Newport Beach, California, PIMCO is a global investment
management firm with over 1,400 dedicated professionals focusing
on a single mission: to manage risks and deliver returns for our clients.
For four decades, we have managed the retirement and investment
assets for a wide range of investors, including corporations, governments,
not-for-profits, and other organizations, as well as for individuals around
the globe.
As of June 30, 2011 our:
n Clients include more than two-thirds the Fortune 100
n Investment professionals on staff exceed 500
n Global presence includes offices in 11 locations
n Total assets under management are $1.3 trillion
n DC assets under management nearly $170 billion
Our PIMCO DC Practice is dedicated to promoting effective DC plan
Laurence J. Kotlikoff
design and innovative retirement solutions. We are among the largest
Professor of Economics, managers of assets in defined contribution plans, offering investment
Boston University and management for stable value, fixed-income, inflation protection, equity
President, Economic
and asset allocation strategies such as target-date solutions. We also
Security Planning, Inc.
provide analytic modeling, plus can help plan sponsors identify DC
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consultant resources. Our team is pleased to support our clients and the
w w w . kotlikoff.net broader retirement community by sharing ideas and developments for DC
kotlikoff@gmail.com plans in the hopes of fostering a more secure financial future for workers.
If you have any questions about the PIMCO DC Practice, please contact
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