California’s clever opt-out retirement idea

By Felix Salmon
August 31, 2012
said that states should not adopt defined-contribution pension schemes: they should stick intend to the defined-benefit plans they've had until now. I still believe that -- but I'm also a big fan of SB 1234, a bill making its way through the California legislature.

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Last year, I said that states should not adopt defined-contribution pension schemes: they should stick instead to the defined-benefit plans they’ve had until now. I still believe that — but I’m also a big fan of SB 1234, a bill making its way through the California legislature. The bill would create the Golden State Retirement Savings Trust — a kind of pooled defined-contribution pension plan for the millions of Californians who lack access to a workplace retirement plan.

The point here is that the state of California itself is a good employer, providing retirement benefits to its employees. But not all Californian employers do likewise, and many Californians, especially those on low wages, have no retirement savings at all.

SB 1234 would change that, by asking employers to place 3% of their employees’ paychecks into the Golden State Retirement Savings Trust. This would be an opt-out scheme: if you didn’t want to take part, you wouldn’t have to, but the default would be that you would. The money would be invested conservatively; one detailed paper reckons that the mix might be 47% Treasuries, split equally between bills, notes, and bonds; 43% in the S&P 500; 7% in small-cap stocks; and 3% in corporate bonds.

There are two big distractions here, and it’s all too easy to get caught up in things which don’t matter, and miss the big thing which does matter. The first distraction is the question of investment guarantees. Because these workers can’t afford to lose this money, it would have to be guaranteed, either by the public sector or the private sector. If you’re investing over a long time horizon, and guaranteeing only very modest returns of between 0% and 2%, such guarantees are cheap — but that doesn’t stop alarmists from talking about “another potential pension disaster” in terms of guarantor losses.

The second distraction is the question of investment returns: will the money be invested well, or does California have “a poor record of managing its existing public pensions” which should somehow disqualify it from looking after even more retirement funds? Frankly, this doesn’t matter much at all. Big pension funds nearly always have higher internal rates of return than individuals get on their 401(k) plans and similar, and that’s really all that matters.

The main thing to focus on here is the same thing I told savers with 401(k) accounts: the best way to save money is to save money. If you take 3% of your paycheck and you put it somewhere which is very difficult to get ahold of, then over time that sum will grow to a nice little nest egg — even if the internal rate of return is zero. And if you want to get millions of largely low-wage Californians to save money, the mere existence of savings accounts and IRAs at banks and credit unions isn’t enough. Those involve effort, while the genius of SB 1234 is that it’s effortless. All you need to do is nothing, and you automatically start saving money.

Anybody who would rather use their own IRA is more than welcome to do so, of course. And anybody who is happy going without retirement savings at all can simply opt out of the scheme and receive their paycheck in full. But most of us want some kind of retirement security beyond Social Security; the problem is that we procrastinate, and we have bigger priorities, and there are short-term expenditures we need to make, and there’s never any spare money in the account, and, well you get the picture.

The financial-services industry is lobbying hard against this bill, for obvious reasons: it provides a simpler, cheaper, better alternative to their own savings products. As a result, this idea will probably never happen. But it makes sense for California, and it makes sense for the rest of the country as well.

As for the details, they can be ironed out relatively easily. But the final scheme could be a bit of a mix between defined-contribution and defined-benefit. Like DC plans, the amount you got out would entirely be a function of the amount you put in. But like DB plans, more would go into calculating your final payout than simply the investment returns on your money. Instead, there would be some kind of a collar: in return for giving up infinite upside, you would be protected on the downside. For instance, the returns might have a floor at 2%, and a ceiling at 8%. The scheme could simply pay excess returns over 8% into a reserve fund which would be used to protect the downside for savers seeing returns of less than 2%.

Similar products exist elsewhere in the world: Denmark, for instance, has a nationwide mandatory defined-contribution pension plan with a minimum return guarantee. This is America, so a mandatory program wouldn’t fly. But a voluntary, opt-out program could. Let’s give it a try.

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