The three-legged stool of retirement planning is collapsing.
Modern workers have long depended upon Social Security, employer-based pension plans and personal savings to support them in retirement. Surprisingly, it is not an impending Social Security crisis but the replacement of traditional pension plans with 401(k)s that is the biggest problem for funding retirement. Too many workers rely upon the mistaken belief that contributing 6 percent of their salaries annually to a 401(k) is prudent planning.
For many, the 6 percent contribution is achieved by reducing the personal savings that was previously intended as the third leg of the stool. Furthermore, the funding crisis for many private employer and public employee pension plans suggests that the 6 percent (or 9 percent, including the typical, but not assured, employer match) contribution rate most frequently chosen by 401(k) participants is insufficient to ensure viability of the middle leg of the three-legged stool.
The Wisconsin Retirement System, the only fully funded public plan in the nation, has had an average annual contribution rate of 10.5 percent over the past 20 years and will require a contribution rate of 13.3 percent in 2013 to remain fully funded. But 401(k) and other individual retirement plans face two additional risks that traditional plans such as Wisconsin’s don’t face.
There is the risk that an individual retiree may live longer than expected. A pension pool with many participants can be quite certain of the number of people living to any given age so that this longevity risk is minimal. The second additional risk faced by 401(k) participants is investment risk. If a traditional plan earns less than projected, the shortfall can be made up in future years because there are always new workers and additional contributions coming into the system. However, each worker only has one life, and that lifetime is limited and cannot be repeated if savings turn out to be inadequate.
The first of these additional risks (outliving resources) could be reduced if workers annuitized their savings. However, the historically low interest rates in recent years and for the foreseeable future mean that workers must have accumulated much more savings than previously thought necessary.
The second risk, investment, can only be reduced by contributing extraordinarily large amounts. Individuals must expect to contribute substantially more to their 401(k) plans than their employers did to defined benefit pension plans to achieve the same results.
Here at Ball State, I am leading research into the appropriate contribution rate for 401(k) plans. We found that, assuming investment securities have the same distribution of returns as occurred during the past 85 years, 23 percent of the time a contribution rate of 10 percent would fail to replace half of a person’s preretirement income for the average retirement life expectancy of 18 years.
At the same time, one in four married couples in retirement will have at least one member live beyond age 90.
If the worker faithfully contributes 10 percent of income during the working career, 57 percent of the time this would fail to provide adequate support if retirement lasts 30 years. Yet, the average retirement nest egg at age 65 would have been eight times the final working income, an amount that Fidelity Investments, among others, considers a reasonable goal for retirement planning. Raising the annual contribution rate to 20 percent of one’s income increases the likelihood of successfully funding 18 years of retirement to 99 percent and 30 years to 94 percent; the average accumulation at retirement would be 16 times income.
Many market savants note that the investment experience of the past 85 years should not be expected to be repeated. If the actual returns going forward are just 1 percent per year less than the historical norms, then an annual contribution of 10 percent would be sufficient to fund the average single life expectancy of 18 years just about 44 percent of the time. A 20 percent annual contribution would fail 4 percent of the time after 18 years and 16 percent after 30 years of retirement.
A planned contribution expected with a success rate of 44 percent under a plausible scenario is clearly inadequate. Focusing on the needs of 44 percent of the people is bad business. It is even worse financial planning.