April 08, 2014
For those who have been worried about the plight of the poor boys and girls who work in the financial sector, Jonathan Cowan and Jim Kessler, respectively the president and vice-president of Third Way, have a plan to help. In a NYT column yesterday, headlined “Capitalize Workers!,” Cowan and Kessler proposed a supplemental retirement system which would require employers to put 50 cents an hour into a retirement fund for all of their workers. Cowan and Kessler tell us that this should lead to an accumulation of $160,000 for a worker who works full-time from ages 22 to 67, leading to an annuity of $790 a month. What’s not to like?
First, we should give Cowan and Kessler credit for effective recycling. Mandated savings plans like this are not exactly new, so getting this plan published in the NYT as a remarkable new idea to address inequality is a pretty good feat.
Getting to the substance, the requirement that employers pay 50 cents an hour for their workers’ retirement is a nice little trick for the kiddies, but all the adults in the room know that this money will come out of workers’ wages.(The assumption that employer side payments on wages are in the long-run deducted from wages is almost universally accepted among economists.) This deduction would actually be a substantial hit to low wage workers. Cowan and Kessler’s proposal would effectively amount to a 5 percent tax on the wages of someone earning $10 an hour. That is not exactly trivial — the Social Security trustees project that we could fully fund the program for the next 75 years with a tax increase that is a bit more than half this size.
The next issue is the $160k accumulation that Cowan and Kessler project. They qualify this comment by saying:
“if stocks and bonds enjoy the same average rates of return as they did over the last 45 years.”
That is a huge “if.” Given current price to earnings ratios in the stock market and growth projections for the economy, it is almost inconceivable that stocks and bonds will enjoy the same average returns in the future as they did over the last 45 years. With the ratio of stock prices to trend earnings now approaching 20 to 1, we should anticipate real returns in the stock market going forward to average roughly 5 percent. If we assume real returns on bonds of 3.0 percent (this is probably a bit high), then a portfolio that is invested half in stock and half in bonds should produce a real return on 4.0 percent, before deducting fees.
Fees are a very big issue. These are income to the financial industry and a direct cost to workers. Fees on retirement accounts often exceed 1.0 percent of the funds invested. If that proves to be the case with these accounts (and fees average 1.0 percent), then the after fee return will average less than 3.0 percent annually. In this case, a worker can expect an accumulation of $92,700 by age 67. If we assume that the industry exhibits some restraint and keeps their fees to just 0.5 percent, then the accumulation will be $105,800 at age 67. Since most of these accounts are likely to be relatively small, the average fees will likely be high since the overhead costs will have to be spread over a smaller amount of money.
It is worth noting that fees can be substantially reduced if this money was administered through a public system like the Thrift Savings Plan (TSP) that is available to federal employees. Fees for this plan are less than 0.2 percent of the value of the fund. Cowan and Kessler could have suggested going this route, but that would actually hurt Wall Street, since making such accounts available would likely pull money away from the financial industry as people take divert money from high cost private 401(k)s.
There is real money at stake here. After twenty years these accounts will have accumulated close to $5 trillion (in 2014 dollars). If the financial industry is siphoning off 0.5 percent of this every year in fees, that amounts to $25 billion a year in revenue. If its fees average 1.0 percent it would translate into $50 billion a year in revenue.
That sounds like a pretty good deal for the financial industry, but as they say on the late night TV commercials: but wait, there’s more. The financial industry charges people to convert their money into annuities. The costs range between 10-20 percent. If assume that 2.5 million workers a year annuitize accounts that average $100,000 a piece, then the fees from annuitization will amount to between $25 billion and $50 billion a year when the system has fully matured. Again, the fees could be largely avoided with a publicly run TSP-type system, but that doesn’t appear to be Cowan and Kessler’s agenda.
If we assume that annuities will cost 10 percent of the accumulation, then a worker in the Cowan-Kessler system can expect a $500 monthly payment after 45 years of full-time full year work. (Most workers do not work full-time, full-year for anywhere close to this number of years.) If a worker has bad luck and pays 1.0 percent in annual fees and 20 percent for an annuity then their monthly payment would be closer to $400 a year. This is better than nothing, but perhaps not the best use of their money.
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