Why Should Retirement Planning be Confusing and Expensive?

by Neil H. Buchanan

Notwithstanding Candidate Trump's promises not to cut Social Security, his enablers in the Republican Party have long salivated at the idea of privatizing our retirement system.  Given the utter chaos of the one-month-old Trump presidency, will the Republican true believers finally get their way?

If they do, there will be an endless number of questions that will need to be answered.  But the biggest question is what will happen when millions of Americans will suddenly be forced to deal with for-profit financial marketing companies that will be selling advice and products in the brave new world of private retirement accounts.

The experiences of other countries can give us some sense of what Americans would have to deal with in a post-Social Security world.  Here, I will explain the basics of what a privatization plan would entail, and I will then look at Australia and New Zealand to highlight one particularly costly aspect of any retirement system that forces individual investors to make what amount to life-or-death decisions about how to finance their retirements.

The failed 2005 Bush Administration effort to partially privatize Social Security is a good place to start.  That proposal involved diverting two percent out of the 12.4 percent total (employee plus employer) Social Security contributions that come out of every worker's paycheck (levied against annual incomes of up to roughly $120,000).

The Bush plan would accordingly have reduced guaranteed Social Security benefits commensurate with the reduction in tax withholding, and everyone would then have been responsible for choosing how to invest the two percent of their salaries every pay period.  This was unsurprisingly billed as "freedom of choice" rather than a trap or a burden, but no matter how we describe it, the bottom line is that people would have taken on investment risks that they currently do not have to face.

This column is not the place to rehash the debate over whether Social Security is going "bankrupt" or any such nonsense.  I have written about that particular scare tactic many times, most recently in a Verdict column in March of 2016.  I will return to that issue again in the near future, but for the purposes of this column, the question is not whether it is necessary to replace Social Security -- it isn't -- but what would happen if we did.

To simplify matters, let us imagine that the Republicans succeed in a full-on privatization of Social Security, not the camel's-nose-under-the-tent version from 2005.  In that case, a person who earns, say, $75,000 per year would have $9300 each year to invest.  What would she do?

In a system of pure free choice, there would be no rules beyond the requirement that $9300 untaxed dollars would have to be put into a savings account.  Because that kind of rule can be easily evaded by depositing the relevant funds on each payday and then withdrawing them the next day, there would have to be 401(k)-like rules that would force people to keep their money invested in their preferred savings vehicles until retirement.

There would also have to be rules determining which savings vehicles are permissible destinations for workers' retirement dollars.  Condo development schemes and junk bonds would be out, for example, to prevent people from being bilked.   People would also have to work through approved financial planning companies, to prevent fly-by-night operators from absconding with the funds.

It would be tempting to think that this is a simple matter of enforcing uncontroversial financial laws, at least in the sense that it is seemingly straightforward to describe how financial advisors are supposed to behave.

However, given that Republicans are hell-bent on repealing an Obama-written regulation requiring financial advisors to live by the standards of fiduciaries -- that is, to give advice that is in the interests of the clients, rather than recommending that clients' money be deposited into the funds that pay bigger fees to the advisors -- it is not at all obvious what the rules would be for the companies that would be permitted to handle the trillions of future dollars of retirement savings.

I have recently begun to study the retirement system in Australia, which combines a means-tested income support system with a large and relatively complicated system of private savings accounts, the latter of which is called the "superannuation" system.  The Australian system has very tight regulations of financial advisors, much tighter than Republicans in the U.S. would be likely to tolerate.  [Note: I updated the first sentence in this paragraph on March 23, 2023, to correct an error of fact in what I had written in 2017 about the non-superannuation support system.]

Even with those strong protections for savers, the Australian superannuation system is extremely expensive.  Taking account only of the direct fees that financial companies charge savers for managing their money, Australians pay on average more than one percent annually of the total funds on deposit.  (The study to which I am referring, written by researchers at the University of New South Wales in Sydney, seems not to be available online.)

This means that a worker with a reasonably healthy retirement account balance of $500,000, which sounds like a lot of money but is actually only large enough to replicate the standard of living of someone who earned roughly $50,000 in her final years in the workforce, would pay about five thousand dollars per year in fees to her financial institution.  Depending on how clever the financial institutions are, those fees would not necessarily be obvious to the saver.

Where is that money going?  Essentially, the people who are managing the investment funds are draining off part of people's retirement savings in the form of managers' salaries, overhead, and marketing fees.  (Social Security obviously has no marketing fees.)  This is why Wall Street has been so excited about privatizing Social Security.  It is the mother lode of potential fees.

But I have found that the most interesting aspect of the Australian system (and a similar one in New Zealand) is that it also requires the diversion of economic resources to create what the Aussies call "financial literacy" and Kiwis call "financial capability."  As a recent paper by three Australian professors explains, the governments of these two countries are putting serious efforts into trying to educate their citizens in how to be financially savvy retirement investors.

Although I used the anodyne phrase "diversion of economic resources" in the paragraph above, a simpler word is "cost."  That is, the governments of these countries are spending money to get people to learn how to maximize their retirement returns, and the people themselves have to spend time and effort (and money, because many of them still need to hire financial planners in addition to paying their investment fund managers) in an often futile attempt to learn the concepts of wise investing.

These costs are most definitely not included in the one percent estimate that I described above.  They are purely the result of people having to use their free time to learn how to invest, a task that many people (not just Down Under, but everywhere) find tedious and intimidating.

If people hate filling out tax returns, imagine how they will despise having to learn how to be savvy investors.  If nothing else, the stakes are much higher, because making mistakes with regard to retirement investments accumulate over a lifetime, whereas annual errors on tax computations do not necessarily repeat themselves.  Making errors in one's retirement savings decisions can mean the difference between a long and comfortable retirement and being too poor to live.

And we should remember that this is not a self-selecting group of people who are otherwise inclined to learn financial concepts.  This is everyone, and even very smart people can be very bad at dealing with these decisions.  For example, an Economics professor at Harvard confessed in a New York Times column in 2015 that he is a terrible retirement planner (regarding his own retirement savings beyond Social Security), even though he has all of the intellectual firepower and training needed to make savvy decisions.  He avoids thinking about it, and he is poorer because of it.

One way to deal with the reality that plenty of people will never become financially literate/capable is to set up default rules that allow them to avoid making decisions.  That, however, merely means that we could respond to the high costs of individual retirement planning by making the privatized retirement system look an awfully lot like Social Security -- hands-off systems in which deposits disappear into a set of legal rules that then spit out regulated retirement benefits in the future.

In my research on the Australian superannuation system, I plan to address the question of whether that country has already gone so far down this road that it would be too complicated to unravel the system and return to something like a Social Security setup.  I am honestly not sure what the evidence will show, which is why this will be a fun project.

We do know, however, that Americans who want to play the markets are already free to do so with any money that they do not spend.  People who either have no extra money to save or who choose not to become financially educated need not hassle with financial planners or investment companies, avoiding both the human cost and the high fees that non-Social Security retirement planning entails.

As I noted above, this column cannot take on every aspect of the privatization debate.  There are costs and benefits of Social Security, and there are costs and benefits of private saving/investing.  I am focusing here on the costs of private financial management, both because they are so high and because they come in many surprising forms.

The bottom line is that most people will fare much worse under a privatized system, but the Republicans do not represent most people when they rally for privatization.  They are trying to serve up a heaping helping of fees to their campaign contributors, and they do not care that most people do not want to be forced to fend for themselves in the financial jungle.  The rest of us, however, should care.