IB#8-20

Introduction

The financial crisis has sparked proposals to reform the retirement income system. One component of such a system could be a new tier of retirement accounts. These accounts would augment declining Social Security replacement rates for low-wage workers and provide a buffer of security for middle- and upper-wage workers who, increasingly, will rely totally on 401(k) plans to supplement their Social Security. Designing such a new tier requires answering a number of questions: Mandatory or voluntary? Employee and/or employer contributions? Subsidies for low earners? Payments as lump sums or annuities? Tax favored or not? But the most fundamental question is whether the goal of the new tier is to provide a defined contribution account, where the retirement income will depend on market performance, or an account that can provide a certain percent of final earnings – that is, a target replacement rate.

This brief takes the first step in exploring the question of how much risk is acceptable. The first section makes the case for a new tier of retirement income. The second section describes the implications of using a defined contribution approach for the new tier. The third section uses a model developed by Gary Burtless to demonstrate that even using target date funds and full annuitization at retirement, a defined contribution approach produces enormous variation in outcomes. The fourth section explores the implications of modifying these fluctuations. The final section concludes.

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