Retirement Roulette

These days, William droms can shock people in two different ways. When he’s in his classroom at Georgetown University, the finance professor tells his students how much they’ll need to save on their own, year by year, to retire. Start saving early enough, he says, and you could sock away a million bucks by putting away just 4 percent annually. They’re pretty confident they can do it, he says, until they see how fast inflation eats away at their nest egg.

Outside the classroom, Droms runs a financial-planning firm. Many of his clients lost 40 percent or more in the stock market during the 2008 crash.

“You heard of the thousand-yard stare?” Droms asked. “I’d never seen it until some of the people came in and we went through their finances.” What made it worse, he recalled, was telling them that—even after all those losses—the only way they could rebuild their retirement savings was to go right back into the roller-coaster stock market.

It’s part of the American Dream: the ability to relax during your supposed golden years. Maybe your particular dream involves golf or grandkids or skydiving. Any of these requires money—a lot of money. Baby boomers reaching age 65 can now expect, on average, to live another 12 to 15 years, and the members of Gen X and Gen Y likely will live well into their 80s and 90s. To afford a reasonably comfortable lifestyle, by Droms’s calculations, a single person will probably need to have saved up at least $1 million by the time they are 65.

That’s a daunting enough task already. Traditionally, there have been some easy, almost carefree ways to build up that much money. However, thanks to a combination of factors, those options are pretty much gone. To save for retirement, Americans must take on risks that they’ve never faced before. In making sure that we don’t outlive our money, we are essentially on our own.

The problem is that there’s no safe-yet-lucrative way to save anymore. The broad stock market has had several epic rallies and nosedives in the past decade, and many experts say that wild swings are here to stay. All the while, inflation will inevitably eat away at the value of people’s savings. What’s more, the safe, fixed-income investments—from bank CDs to government bonds—are paying next to nothing these days. During the past few years, the federal government has tried to alleviate some risk and, in some cases, to save us from temptation.

Ultimately, though, all the pressure to build a nest egg doesn’t rest on an employer’s magnanimity, a financial planner’s shrewdness, or a hotshot broker’s daring. It’s on you. And that may be the riskiest thing of all.

PENSIONS—REMEMBER THOSE?

There are plenty of reasons why saving for retirement has become so much tougher. But for most people, it starts with the fact that, until recently, the need to build your own retirement money was a hypothetical. For decades, tens of millions of Americans assured themselves of a comfortable retirement just by showing up at work. Companies big and small, along with nearly every government employer, offered defined-benefit plans.

After a couple of decades on the job, employees were entitled to a pension, which paid them a set amount of money each year after retiring. That amount was often enough to live on, and if it wasn’t, Social Security took up the slack. For the most part, it was a risk-free way to save. You didn’t have to worry about the stock or bond markets, European debt crises, the price of gold, the yuan-to-dollar exchange rate, or anything else. Your employer saved for you while you worked, and when you retired, money appeared in your mailbox each month; you deposited the check on the way to the golf course.

As anyone under age 40 knows, though, pensions are something that your parents talk about wistfully and that you’ll probably never see. For most people in the corporate world, pensions have been replaced by defined-contribution plans to which the company commits a promised amount of money during your working years—but once you leave, that’s it. A 401(k) account, for instance, is a defined-contribution plan. So now, while you spend your 20s through your 60s building a career, getting married, and raising kids, you must also learn how to invest like a pro—watching the stock market, learning what a bond is—all to ensure that you don’t wind up in dire fiscal straits if or when you decide to stop working. Employers may offer “default” options for 401(k) plans—hodgepodge mutual funds—but many of those fared worse during the 2008 financial crisis than the broader stock market did.

Consider the transformation in progress at General Electric, the 120-year-old-plus company that still ranks sixth among the Fortune 500. Even as GE helped to supply the world with lightbulbs and aircraft engines, it also supplied its workers—starting in 1912—with a retirement plan. If you worked a certain stretch at GE, the company promised to pay you a percentage of your salary after you left. GE set aside tens of billions of dollars to live up to that promise; indeed, the company put aside so much money in the 1970s and 1980s, vastly overfunding its pension plan, that it hasn’t contributed anything to it since 1987. Each year, GE pays a few hundred to several thousand dollars a month, typically, to about 500,000 pension beneficiaries. Retirees were assured of a monthly check for the rest of their lives, amounting possibly to 50 percent or more of their salary, depending on when they retired. If inflation went up, pensions rose to compensate.

Those days are gone. GE will continue to pay pensions to its existing retirees, and it will send a check to current employees once they retire. However, in contract negotiations last spring with two of its largest labor unions, GE sought to end pensions for new employees. In exchange for an up-front cash bonus of $500 and a guarantee of periodic raises, the unions agreed.

Starting in 2012, most of GE’s newly hired unionized employees—electricians and the like—will receive no pensions. Instead, a lump sum equal to 3 percent of their salaries will be put annually into a 401(k), and the company will match up to 4 percent of workers’ contributions. Compared to other employers nowadays, that’s generous; the average corporate match is 2.1 percent, according to the Profit Sharing/401(k) Council of America. Even so, it means that GE’s own savvy financiers will no longer handle the employees’ retirement savings. (This is the company, after all, that made $14 billion profit in 2010 and reportedly paid almost no federal income taxes.) Instead, the company’s newly hired welders, electricians, engineers, and other recruits will be on their own.

In the public sector, most jobs still provide pensions. Even so, the deep fiscal problems that many states and localities face are forcing major changes. As of last April, the pension system for California’s teachers held $56 billion less than it will need to cover the benefits of more than 200,000 former teachers. With the state itself already more than $140 billion in debt, it’s no surprise that Gov. Jerry Brown, a think-outside-the-box Democrat, has proposed a new system of benefits that relies on a 401(k) plan and caps the size of the pensions that state workers can receive. Illinois, too, is looking to switch nearly all current state workers to 401(k) plans. State governments across the country will be lucky to pay their current obligations to retirees, experts say—leaving few, if any, guarantees for those still on the job.

THE THIRD RAIL

This leaves the one defined-benefit program to which nearly all Americans are entitled: Social Security. The venerable program, however, faces problems similar to those of many state governments: an insufficiency of money to cover the promised benefits. There’s an easy fix: Raise the retirement age and phase out payments to affluent beneficiaries. “Simple math,” as Droms put it.

But the politics are daunting, because it means that workers would have to wait longer for less-generous checks. Older people are the most reliable of voters; some 63 percent of Americans 60 and older went to the polls in 2008, a larger share than of any other age group. This has famously made Social Security the third rail of American politics, and there’s no reason to think that this has changed. Seniors’ intransigence and voting power have prompted younger workers to wonder if Social Security will still be solvent when they retire.

Even if Social Security remains in the black, for most people it won’t be enough to live on. Saving anything more is, increasingly, up to us. Yet few of us are investment experts or even want to be. So, isn’t there a single investment that we can buy, then forget about for a few decades, and count on to yield enough for a comfortable retirement?

Well, there was: the U.S. Treasury bond, backed by the full faith and credit of the U.S. government. Despite all the handwringing over a government default or downgrades of the nation’s credit rating, there is no surer bet than that the United States will pay off investors who buy its bonds. This is why many professional investors describe the interest earned on a Treasury bond as the “risk-free” rate.

Since late in the Carter administration, investments in U.S. bonds have paid handsomely. If you invested $10,000 in a 30-year Treasury bond in 1980, when its interest rate was around 10 percent, the feds would have paid you $1,000 a year for the past 30 years; then in 2010, you’d have gotten back your 10 grand. That’s a 300 percent return. The only real risk was in tying up your money for three decades—the opportunity cost, in economists’ jargon. Anytime from 1980 to 2000, buying 30-year bonds was a pretty good deal; they never paid less than 5 percent a year.

Not anymore. These days, Treasury bonds look like a terrible long-term investment. The rate on the 30-year Treasury is about 3 percent; that’s roughly the same as the annual rate of inflation over the past 100 years. Investing in the “risk-free” 30-year Treasury bond now means tying up your money until the 2040s while inflation keeps eating away at the buying power of the interest you earn. You could wait for rates to rise, but that could take another two years or more. (The Federal Reserve Board intends to keep interest rates low until at least 2013 in hopes of goosing the economy.) “Three percent [earned interest] will be nowhere near enough to retire on,” cautioned Jim Swanson, chief investment strategist for MFS Investment Management, which oversees more than $220 billion in assets.

Ironically, as topsy-turvy as the stock market has been—and surely will continue to be—it just might be the least-risky way to save for retirement. Publicly traded companies, as a group, are more profitable than ever, yet their market valuations are about the same as in 1990. Many are spending their hoards of profits on dividends to stockholders—so much so that the average dividend yield on the Standard & Poor’s 500 is about 2.2 percent, higher than what the government will pay you on a 10-year Treasury bond.

The danger with investing in stocks, of course, is that your portfolio shrivels and grows from hour to hour. Sometimes there are crashes. But these days, the risks of losing your retirement savings in the market are lower than the risk of never being able to build up enough money for retirement in the first place.

The author is senior markets editor at SmartMoney, the personal-finance magazine of The Wall Street Journal.